Dr. James Fry_lmc

Price and Supply-Demand Outlook in the Vegetable Oil Market Todayby Dr James Fry, LMC Internationalto PALMEX Thailand, September, 2011www.LMC.co.uk

I will start by describing one of the most surprising changes in the behaviour of the world vegetable oil market, which has occurred within the past five years. This is the way in which vegetable oils have become part of the petroleum complex, as regards pricing. I will explain why and how this has happened.This has far-reaching consequences for the future behaviour of vegetable oil prices. In particular, while supply-demand balances do matter, they are less important than they used to be in setting oils prices.Palm oil stocks are still the main driver of price differentials within the oils complex, and so I will examine the recent trends in global palm oil output.Outline of my presentation today

The revolution in vegetable oil price behaviour

Before 2007 there was no link evident between petroleum and vegetable oil prices. CPO was often cheaper than crude oil per tonne.

Since 2007, a price band has appeared, linking vegetable oil prices to crude oil prices, within a price band with vegetable oils at a premium.

The two lauric oils are not so strongly tied to the new price band, but their premium over crude petroleum has shrunk sharply in recent weeks.

Examining differentials vs. diesel for oils, we can see that, after a sharp correction after January, the CPO premium has settled near its average.

We can now see very clearly that there is a price band in place, which became established in 2007. When vegetable oil prices get too far above crude oil, a correction occurs, and typically quite fast. We saw such a correction in 2008 and again this year.Since the floor of the band is set by crude oil prices, it seems likely that biofuels are the key to the link. This view is reinforced by the evidence that lauric oils, which are distinct from the other oils and are not used in biofuels, are less closely tied to the new price band.However, I suppose the link could be caused by basic commodity speculation, and so I now turn to examine whether there is a good reason for the band to exist.The emergence of a price band is the major revolution in vegetable oil pricing

Biodiesel demand has changed the balance within the oil and meal sectors

Biofuels have pulled demand growth rates for oil ahead of those for protein meal. This boosts the reliance upon high oil-content crops.

If we look back 40 years, we see that, by coincidence, global demand for oils and meals grew in step with one another.The feedback from income growth to oil demand (for food) and meal demand (for meat) meant that the global consumption of oils and meals rose in parallel. Since 2000, world vegetable oil demand has grown faster than meal demand, with the divergence between the two curves widening steadily.The best reason for the change has to be biofuels. They generate a demand for oils, but without any corresponding demand for protein meal.Until ten years ago, the growth rates in the demand for oils and meals were similar

Among oil-bearing crops, oil palms oil yield/ha. averages five times that of rapeseed, six times that of sunflower and seven times soybeans.

In contrast, oil palm has by far the lowest meal content of leading oilseeds. Hence, oil palm is the oil crop best placed for the new biofuel era.

Palm oil has captured market share thanks to rapid output growth. It has overtaken soybean oil to become the worlds most important oil.

Now that we are in a world that craves more and more vegetable oil, and is doing so at a faster rate than its demand for meal, it wants more of the world oilseed output to come from a crop that gives us a lot of oil and relatively little meal.The crop that best meets this need is called oil palm!As a result, it is not simply because oil palm is a highly productive and cost-competitive crop that it has captured a greater share of world supply.In reality, the world needs more palm oil, rather than other oils, if it is to avoid the problems of large surpluses of unwanted oilseed meal to dispose of.The new global balance of consumption growth plays to oil palms strengths

Biodiesel demand is very sensitive to the biodiesel premium over diesel

Biodiesel use in Germany and the US, reacts quickly to swings in the biodiesel premium over diesel. This links biodiesel to diesel prices.

The same is true of biodiesel demand in the UK where biofuel users can pay the government money not to use biofuels if they get too costly.

Around the world, biodiesel users cut back demand when biodiesel became very expensive vs. diesel. Some of the cutbacks were temporary, as blenders waited until biodiesel became cheaper. Some were caused by users buying out their mandatesIn a few cases, governments responded to high food prices by reducing their legal mandate targets.In Thailand, your government reacted to low palm oil output by cutting the mandate for a while.The effect of all these changes was to pull biodiesel prices (and hence vegetable oil prices) closer to the price of diesel, narrowing the spread in the market.Biodiesel demand has been affected by high price differentials earlier this year.

Understanding vegetable oil prices

I hope that I have persuaded you that you have to take account of biofuels today. In English, we talk about a tail wagging the dog. In oils today, the tail of biofuels, with only one eighth of world oil demand is waging the dog of the global vegetable oil market (with the other seven eighths of demand).Because of the price band, petroleum prices are undoubtedly a major factor behind oils pricing today.Vegetable oil stocks also influence prices. The recent period of low palm oil output has passed, and I will next study how the upturn is affecting stocks.Finally, vegetable oils compete. I will illustrate this with evidence from price-sensitive Indian imports.The main factors behind vegetable oil price levels today now include biofuels

Stocks and oil supply-demand balances

Strong palm oil output this year will be crucial in lifting growth in output of the main vegetable oils to 6 million tonnes worldwide in 2011/12.

High prices will slow 2011/12 world demand growth and cause it to lag behind output growth, after two years when demand exceeded output.

Oil output will be sustained in 2011 by cutting oilseed stocks. Biofuel price sensitivity will be crucial to balancing world oil supply vs. demand.

Oilseed stocks are big enough to ensure high growth in world oil output, while high prices slow demand.Within the world oil total, palm oil will make a bigger contribution to global production growth in 2011/12 than it did in 2010/11, rising 3.0-3.5 million tonnes.This increase will be crucial in keeping world supply expanding in line with the rise in global oils demand. The key looking further ahead will be the speed of the revival in palm oil output growth. Newly mature areas and good rains in the past year should keep world year-on-year CPO production growth strong for a few more months, as I will now demonstrate.Seed stocks provide a cushion for oil output

In palm oil, it is clear that the unusually slow Malaysian CPO output growth in 2010 was a temporary aberration and that growth is back.

Here we can see both how much more wildly Thai CPO output fluctuates than Malaysias, and we can also see the poor upturn in 2010.

It is interesting to see that the recent production cycle has been spread throughout the world of oil palm all the way from SE Asia to S America.

Here we see the scale of the problems in palm kernel output in 2010 and early 2011, which explains the recent wild swings in PKO prices.

2010 was undoubtedly an unusual year, in that the year-on-year increases in both CPO and PK output were very modest by historical standards (which may have been a result of low fertiliser use in 2008-09 in reaction to high costs), and it ended with sharp year-on-year declines in Q4 production of CPO and PK.Palm kernel output was hit harder than CPO in the downturn, but was displaying very strong growth again by the second quarter of 2011.Looking at the growth patterns, we must be close to the peaks. Malaysias and Indonesias year-on-year growth rates peaked in May-June, while the Thai rate of growth almost certainly touched its peak in July. We are near the peak of the current palm oil and palm kernel growth cycles.

What is the role of palm oil stocks?

Until 2006, the year-on-year changes in CPO prices used to be fairly easily explained in terms of changes in Malaysian stock levels.

Since 2007 stock and price changes have tended to move together. Prices are still growing year-on-year despite the big increase in Malaysian stocks.

It is clear that palm oil stocks (we use Malaysian stocks as the reference) no longer drive CPO prices. Instead, our theories must adjust to reflect the band.Logic suggests that, with a price band, a floor exists to CPO prices when high stocks have driven prices down so far that it becomes profitable to make and use biodiesel without any government subsidy.However, when stocks are low, food demand for oils should pull CPO far enough above the price floor for food use to compete oil away from biodiesel output. So, we expect the CPO premium over diesel to be inversely related to the stock level, i.e., the premium should be high when stocks are low and vice versa.If stocks no longer determine CPO prices, we must look instead inside the price band

Here we plot stocks against the CPO premium over diesel. Early in 2011, the premium was too high, but it is now back down near its average .

Looking ahead to falling palm oil stocks, the premium over diesel should rise a little, but not back to the peaks of early this year.

In the background, competition between palm and soy oil in vital markets such as India keeps soy oil prices from moving too far above CPO.

This is why, with CPOs premium now close to normal, the soy oil premium, which is already high, is not expected to rise much further.

The picture I have described is quite different from that you may have expected.We are now in a new world in which vegetable oils trade in price band, created by biofuels, which links vegetable oils inextricably to the petroleum price.The old fashioned drivers of oils prices, i.e., supply-demand and stocks, are still a factor in setting prices, but the supply-demand balance only influences prices within limits that are set by petroleum.Therefore, I will end with a few remarks about the outlook for the petroleum market.The new world is different from the old one.We have to analyse the petroleum market as well as supply-demand in vegetable oils.

What is the petroleum market doing?

Looking at short term oil supply, high prices are encouraging lots of drilling. This should boost output, especially when Libyan supplies return.

On the demand side, petroleum use in the US, still by far the biggest consumer, has stabilised, but high prices have pushed it below its peak.

Meanwhile, US stocks are still high in terms of its demand; yet, prices were much lower in the past, when stocks were also much lower.

The cure for high prices is high prices.This is as true for petroleum as it is for other markets.High crude oil prices are stimulating new discoveries and output, including from deep offshore fields and from unconventional sources such as tar sands.High crude oil prices are also hitting demand, both as users save energy and turn to cheaper alternatives, led by natural gas, but also by making a double dip recession much more likely.This is why I believe the petroleum prices must fall, and this will have a direct and negative impact on all vegetable oil prices, as a result of the price band.It is hard to see why petroleum prices should remain at current high levels

Thank You

www.LMC.co.uk

Acknowledgements: EIA, IMF, Jacobsen, MPOB, National Biodiesel Board, Oil World, OPEC, Public Ledger, SEA, TNS, UFOP, US Commerce Dept., USDA, World Bank

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T +603 5513 5573F +603 5510 [email protected] LMC International, 2011All rights reservedThis presentation and its contents are to be held confidential by the client, and are not to be disclosed, in whole or in part, in any manner, to a third party without the prior written consent of LMC International.While LMC has endeavoured to ensure the accuracy of the data, estimates and forecasts contained in this presentation, any decisions based on them (including those involving investment and planning) are at the clients own risk. LMC International can accept no liability regarding information analysis and forecasts contained in this presentation.

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