SINCE the start of the year, the plantation sector, as measured by the Kuala Lumpur Plantation Index (KLPI), has underperformed the FBM KLCI by 8.4%, as the former is down 16.5% year-to-date while the latter is lower by 8.1% for the same period.
The KLPI is primarily the index that measures 42 companies under the plantation companies and among them include the three constituents that are also index constituents of the FBM KLCI itself. This includes Sime Darby Plantation Bhd (SDP) with a market capitalisation of RM23.8bil, IOI Corp Bhd and Kuala Lumpur Kepong Bhd (KLK) with their market capitalisations of RM23.3bil and RM20.8bil, respectively.
Outside the top-30 FBM KLCI-linked stocks, there are a couple of other large-capitalised plantation stocks too and this includes the likes of Genting Plantations Bhd (GenP) with a market capitalisation of RM5.8bil and United Plantations Bhd (UP) with a market capitalisation of RM5.6bil.
There are three other large plantation companies – Batu Kawan Bhd, FGV Holdings Bhd and IJM Plantations Bhd (IJMP) – but these three companies were not taken into consideration for the simple fact that Batu Kawan owns 47% of KLK, while FGV and IJMP share prices were distorted by takeover offers.
As plantation companies are exposed to the commodity sector, it is natural that the fortunes of these companies are driven by demand and supply dynamics, which drive prices.
The supply of palm oil is a function of weather patterns, tree stress, availability of labour force and whether the planters are able to harvest the fruits due to the movement control order (MCO).
The closing monthly stock level too is an important component of market prices for crude palm oil (CPO). Demand, on the other hand, is driven by economic factors, environmental issues, prices of competing vegetable oil, and even crude oil as CPO is also increasingly being used as biodiesel, either voluntarily or by a government mandate.
Just like any other commodity which has been enjoying spectacular runs, CPO too has been on a tear this year and, based on the benchmark third month forward contract in the futures market, hit an all-time high of RM4,457 per tonne on May 18, 2021.
Ironically, this is after just about a year after it sank to a multi-year low of RM1,946 per tonne on May, 2020.
Naturally, one would have thought that if CPO prices are rising, shouldn’t the share prices of plantation-based companies be in a bull market phase, just like how our glovemakers did about a year ago?
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Ironically not so. As can be seen in the chart on the relative performance of CPO and the KLPI from Jan 5, 2018 to Aug 5, 2021, while in general there has always been a correlation between the CPO price and the plantation sector, as measured by the KLPI, that correlation has been broken over the past 15 months.
At the end of 2017, when CPO was at RM2,503 per tonne and the KLPI was at about 7,903pts, both trended lower that year as prices weakened due to a bumper harvest and weak soybean oil prices. This trend continued throughout 2018 as CPO prices then fell by about 15.3% to RM2,121, while the KLPI eased about 12.7% to close at 6,903pts.
In 2019, the CPO price rose back to the RM2,500 mark by November and closed the year at RM3,052, and hence it rose by 43.9% in that year. The KLPI too rallied as the index rose to 7,733pts by end-2019 and was up 12% for the year.
Last year, the CPO price rallied strongly after hitting the May 2020 low to close the year at RM3,600 per tonne, up 18% but the KLPI closed the year down 5.6%.
Year-to-date, CPO prices have continued to gain ground, mainly on supply disruption and continuous decline in palm oil stock levels. CPO prices were last seen at RM4,213 per tonne, up 17%, but the KLPI went the complete opposite direction, down 16.5%, and was last seen at 6,098pts.
From the table, we can see that the KLPI has underperformed the rally in CPO prices, which determines the profitability of the sector, but even the FBM KLCI. For example, while the FBM KLCI is still higher by 8.6% from the time when the CPO price hit its low on May 6, 2020, the KLPI is down by 2.9%.
This was mainly dragged by the 31.3% fall in GenP, followed by a 28.2% decline in SDP, while IOI and KLK are down by 5.6% and 6.7%, respectively. Only UP defied the odds and is higher by 8.8% from its price level on May 6, 2020.
Year-to-date, while the CPO price is up 17%, all the major plantation companies have underperformed with losses ranging from 6.6% for UP to as much as 34.4% for GenP.
One would have thought that surely with higher CPO prices, all the plantation companies will be reporting bumper profits, and hence, with the higher earnings, valuations will be attractive. This is of course on the assumption that the current high prices can be either maintained or remain elevated for a foreseeable time.
Based on the futures market, CPO prices are in backwardation, ie, future prices are lower than the spot market price or even the benchmark third month market price. In fact, the discount between the third month benchmark and the sixth and ninth-month futures contract is at 6.8% and 11.9%, respectively.
Hence, to a large extent, market expectations of CPO prices are bearish and hence the market is pricing in this discount.
However, if one were to look at the performance of companies over the past five quarters, one would note that plantation companies have seen profits and revenue rising.
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The chart on plantation revenues and earnings shows the combined revenue and net earnings of the five companies for the period between the first quarter (Q1) of 2020 and Q1 of 2021. It is conclusive that as revenue rose, on the back of firming CPO prices over the past five quarters, net earnings too expanded.
However, despite rising CPO prices and improved earnings, the plantation sector has underperformed for reasons that are beyond the financial performance of the companies concerned.
There are many reasons to explain the underperformance of the plantation sector and the top of the list is issues related to environmental, social and governance (ESG). The plantation sector has long been a target among environmentalists, as planters are seen engaging in activities that are detrimental to the environment, in particular the deforestation issue.
While steps are taken by our planters to be certified under the Roundtable on Sustainable Palm Oil (RSPO) and the Malaysian Sustainable Palm Oil (MSPO) standards, the international buyers have now turned their attention to other issues, in particular, labour-related issues, which among others include forced labour, living conditions, and wages.
Some of these activists have launched reports with the United States Customs and Border Protection (CBP) against Malaysian planters like FGV, SDP, and IOI, resulting in our local boys being subjected to some sort of scrutiny on the issues that have been raised, including a ban on exports from the companies concerned.
With reference to labour issues, the industry itself has been facing labour shortages mainly due to the closed Malaysian borders. With a reduced workforce, the planters are unable to harvest all the fruits that are produced, resulting in production losses. Hence, with lower output, the higher CPO price is of little help as the planters are not able to benefit fully.
Let’s face it, ESG is not going to go away and Malaysian companies must get their act together in ensuring we meet the international standards when it comes to labour practices, committed fully to environmental issues related to deforestation, and communicate to the stakeholders the positive steps that Malaysia is taking.
For example, according to the Malaysian Palm Oil Board (MPOB), as of July 29, 2021, some 5.279 million ha of oil palm planted areas out of a total 5.865 million ha, representing some 90% of the total area, have been certified with MSPO.
On labour issues, similar to what we have seen among our glove companies, our planters too need to address accusations that have been hurled against them and take corrective actions to provide not only better living conditions but also wages, issues related to recruitment of foreign workers and forced labour practices.
It is for the future of the oil palm industry that all stakeholders take note of ESG issues. Failing to do so will see the market discounting whatever premium that Malaysian planters have been enjoying all these years and the disconnect between CPO price and the KLPI will only widen.
At a time when CPO prices are at near-record levels but the KLPI is hovering just above the March 2020 low, one cannot imagine where would the KLPI be should the CPO price turns bearish.
Pankaj C Kumar is a long-time investment analyst. The views expressed here are his own.