Palm oil is a commodity that is used in wide range of products. The main usage is as vegetable oils, for example, as cooking oils or ingredients in other food products. It’s also used in the process of making soap, candle, shampoo, detergent, etc. Over the past decade, it’s increasingly used as biodiesel to blend with diesel so that the blended oil can be used to run machines, e.g. cars.
Upstream & Downstream
The business of palm oil is divided into upstream and downstream. Upstream is planting the oil palm trees, harvesting the fruits (Fresh Fruits Bunches or FFB) and milling the FFB to get crude palm oil (CPO). The FFB also produces by-products called palm kernel, which can be sold. Downstream is about processing the CPO further to get refined products, e.g. cooking oils.
About 70% of the usage is in food related products, 15-20% in non-food and the remaining 10-15% in biodiesel. The overall demand of palm oil has been growing quite consistently at around 4% per year over the past decade. The increasing demand comes from growing population, increasing consumption per capita especially from emerging countries (as life gets better, people tend to eat more to a certain extent) and increasing usage for biodiesel due to new mandate by several governments to mix palm oil and diesel.
The supply mainly comes from Indonesia and Malaysia. Supply growth has been rapid over the past decade due to rising commodity prices, including palm oil. However, supply growth has been slowing down in the last few years as costs have increased substantially and lands become more limited for planting.
I can write several pages about the palm oil supply and growth drivers and it’s certainly too much to write it here. In fact, I think above is already too much for any amateur investor to absorb. Let’s go straight to profit.
CPO producers make sales from selling the CPO. The sales is volume x selling price. Current CPO price is ~RM2150 per ton (Malaysian Ringgit). The unit cost ranges from RM900 to RM2000/ton. Efficient producers have unit cost of production below RM1100. Assuming unit cost of RM1100/ton and selling price of RM2150/ton, the operating margin is RM1050/ton. Now, if the plantation estate is able to grow its CPO production by 15% per year for the next 3-5 years, we will get a rough estimate on the volume.
With the estimated operating margin and volumes, we will be able to estimate the profit.
Challenges in Forecast
That sounds easy, however, it’s far from it. Commodity prices fluctuates like stock market (quite unpredictable). Over the past 3 years I was in hedge fund, the market analysts have generally been wrong more often than right. When they have realized they were wrong, they would adjust their forecast commodity prices to be closer to the actual prices. (Did any analyst forecast that crude oil price would fall from $100/bbl to $50/bbl?) Costs will usually rise along the years, some more than others and there could be one-off cost or unexpected costs. Weather can affect the production and weather is another thing that is rather unpredictable. Actual production can differ from target due to weather or natural fluctuation in the trees’ production or due to internal operational issues. Government may change regulation that can increase/decrease the palm oil consumption. So, you see, there are many variables that can make forecasting the earnings of the companies challenging, and that’s what most analysts in the banks (sell side) and investment funds (buy side) do: making a detail earnings forecast that can be affected by more variables than you can think of. Usually this is done in an Excel model, which provides a detail estimation of the revenue, costs, sales volume, interest cost, capital expenditure, working capital, etc. Some models can be so complicated and so large that it may crash your computer if it’s not a powerful one. (I received one excel model from an analyst at BAML, and it crashed my excel a few times until I upgraded my computer to a better spec).
Above is not trying to discourage you to forecast the company’s earnings, but to tell you that there are many variables (some unforeseen) that can affect the earnings and the risk of getting it wrong is high. Those Profit and Lost forecast you see in analysts’ reports are as good (or bad) as the assumptions they make. Don’t even assume that reputable banks will have good forecasts. So, beware of the flaw in relying on the exact earnings forecast if that’s how you make your investment decision.
Still trying to estimate
On the other hand, with the visibility of the current commodity price and reasonable assumption on cost, we can get good guidance on the margin. What’s left is the sales volume, which is generally based on the production. On normal weather, actual production can be quite close to the target production. All these provide you a rough estimate of the company’s earnings. If your rough estimate is higher than last year’s earnings, that’s how you see the company could grow its earnings.
There will be too much to discuss about what assumptions are reasonable in one post. Let’s leave it to future discussion. The above doesn’t apply to palm oil upstream sector only (plantation), but also to other sectors as generally sales is price x volume, cost is variable + fixed cost and margin is sales – cost.
For palm oil downstream (refinery), the key is usually the margin because what these downstream players earn is the margin itself. So, they may buy CPO at RM 2200/ton and sell it at RM 2600/ton with processing cost of RM 300/ton. So, the sales is selling price x volume x margin. The margin can be in the range 3-5%. If you margin fluctuates from 3% to 4%, that may sounds tiny to you in absolute term (just 1%), but that’s 33% increase in revenue (in relative term), if all else are the same. When the margin is so small and fluctuating, you must know that the margin of error in forecasting is very high. Relying on your earnings forecast to make investment decision will likely lead you to disappointment.
That’s all for my first investing related post. A rather long one. I think it’s better that I share my thoughts on investment decision process by focusing on each small process at a time rather than several processes together.