An Investor’s Guide to Palm

Oil
To the novice investor or otherwise uninitiated, the ubiquity of palm oil as a
global commodity cannot be overstated. It is a super crop with EBITDA
margins > 50%, is the world’s most consumed edible oil, and is one of the
most versatile raw material/substrate bases known to industry. This article
explores the sparsely understood world of palm, including its cultivation,
harvest, and application processes; its financial and investment profile; and
ultimately the trends governing its future.

Executive Summary

What is palm oil?

 Palm oil (elaeis guineensis) is a tropical vegetable oil derived from
the pulp (mesocarp) of the palm fruit to yield crude palm oil (CPO)
and from the fruit kernel (endosperm) to yield palm kernel oil (PKO),
both of which differ in quality, density, composition, and end
application.
 It is a super crop that is the world’s most consumed edible
oil, comprising over half of all packaged products consumed globally.
 Beyond its food applications, palm oil is one of the most versatile raw
material/substrate bases known to industry, cutting across industries
from food to cosmetics, chemicals to energy, and pharmaceuticals to
animal feed.

 As an investment, efficient palm plantations (upstream) boast 50% -

60% EBITDA margins for mature fields; 3% - 12% margins for
midstream (crushing, refining, and processing); and 15% - 25% for
downstream.

Which countries are the largest producers of palm oil?

  Palm oil production is an effective oligopoly, dominated by two
countries: Indonesia (53% of global output) and Malaysia (31% of
global output).
 Together, these markets account for 84% of global CPO volumes.
 Recently, Nigeria, Thailand, and Colombia have been emerging as
more relevant global producers, collectively accounting for an
incremental 7% - 8% of total global CPO output and rising.

What are the different ways to invest in palm oil?

 Investors seeking to gain exposure to palm can do so in two ways: (1)
by investing in real assets and (2) by investing in financial
instruments.

 Real asset investing includes investing in any of an upstream

plantation, midstream processing assets (e.g., crushing mills,
refineries, or oleochemical plants), or downstream assets (e.g.,
vegetable oil, soap, or other consumer discretionary brands).

 Financial assets include publicly traded equities, publicly traded debt,

or palm oil futures.

Introduction

For the novice or otherwise uninitiated, the importance and ubiquity of palm oil as a global
commodity can never be overstated. It is a super crop that comprises over half of all
packaged products consumed globally, is the world’s most consumed edible oil, and is one
the most versatile raw material/substrate bases known to industry. Its applications cut across
industries from food to cosmetics, chemicals to energy, and pharmaceuticals to animal feed;
and its profit profile is so lucrative that it has literally seen to the rise and fall of many an
emerging market regime. Palm oil, for decades, has been the quiet stuff of legends.
But despite its success as a crop, palm oil’s planting, cultivation, and harvesting process
presents material sustainability challenges that threaten its future prolificacy. These
challenges include deforestation, greenhouse gas (GHG) emissions, child labor and
community exploitation, and conflict: challenges that influence the industry’s demand-supply
balance, and thus its pricing and investment dynamics.
This article presents you, our uninitiated finance enthusiast, with the sparsely understood
world of palm, exploring its cultivation, harvesting, and application process; its financial and
investment profile; and ultimately the trends governing its future.

The Palm Universe

Palm oil (elaeis guineensis) is a tropical edible vegetable oil derived from both the pulp
(mesocarp) of the palm fruit, yielding crude palm oil (CPO), and from the palm’s fruit kernel
(endosperm), yielding palm kernel oil (PKO); oils that differ in quality, density, composition,
and end application.
Palm oil, which we will refer to herein as CPO, accounts for 35% of the world’s vegetable oil
market. The oil palm tree grows under strict agro-ecological conditions only found in tropical
regions that fall within 10 degrees north or south of the equator. These regions must be
characterized by abundant levels of rainfall throughout the year, given the perennial profile of
the crop, with minimum rainfall of approximately 325 liters per day per planted tree.
As of 2016, there were 17 million hectares of mature palm oil plantations across the equator,
producing a total of 65 million tons of CPO for global consumption. By way of context, the
next largest global vegetable oil by volume is soya bean, which had 120 million planted
hectares producing 48 million tons of soya oil as of 2016.

Regional Distribution

Since 1980, palm oil production has been dominated by two countries: Indonesia (53% of
output) and Malaysia (31% of output), which collectively account for 84% of global CPO
volumes. Recently, however, Nigeria, Thailand, and Columbia have emerged as globally
competitive players, collectively accounting for another 7% - 8% of total global CPO output
and rising.
Commensurately, the world’s largest consumers of palm oil are India and China, who import
21% and 16% of the world’s CPO, respectively, followed by the European Union—
specifically, Italy, the Netherlands, Spain, Germany, and the UK—whose confectionary and
biomass industries collectively account for another 7% - 8% of global consumption.

The Palm Value Chain

The palm oil value chain is thought of and structured similarly to that of the crude oil
(petroleum) industry. It is comprised of an upstream segment (planting, cultivation, and
harvest), a midstream segment (refining and processing) and a downstream segment (retail of
end-products, brands, and industrial derivatives).
UPSTREAM: PLANTING, CULTIVATION, AND HARVESTING

Palm oil is planted in two stages. The first, the nursery stage, involves artificially germinating
palm seeds (slightly larger than grapes) in plastic containers and growing them in
controlled net houses. At the three-month mark, these germinated plants are transferred to an
open field for another 6 - 8 months (yielding a total of one year), until final transplantation to
an open field. Here, the young palms are planted about nine meters apart, resulting in 128 to
140 trees per hectare.
Oil palm generally begins to bear fruit 30 months (two and a half years) after field planting,
with commercial harvest commencing six months later. However, the yield of an oil palm
tree is relatively low at this stage and remains so until year seven. It is only at year seven that
the tree reaches peak production, where its output remains until its 18th year, after which it
begins its decline. The typical commercial lifespan of an oil palm tree is approximately 25
years.
Fully mature oil palms produce 18 to 30 metric tons of fresh fruit bunches (FFB) per hectare.
The yield depends on a variety of factors, including age, seed quality, soil and climatic
conditions, quality of plantation management, and the timely harvesting and processing of
FFB. The ripeness of FFB harvested is critical in maximizing the quality and quantity of palm
oil extracted.

At this juncture, it is important to note that the first eight years are really the most critical to a
plantation’s success and where an experienced management team is critical. Details such as a
sub-optimal spacing between trees during planting, an ineffective irrigation system, poor
fertilizer, water inefficiency, and insufficient disease control can result in a sub-optimized
upstream investment for the remaining 22-year duration of the plantation’s life—an
expensive and often devastating mistake made by inexperienced plantation owners.

MIDSTREAM: CRUSHING, REFINING, AND PROCESSING

The milling of fresh fruit bunches (FFB) must take place within 24 hours of harvesting to
minimize the buildup of fatty acids that lower the commercial value of the processed palm.
FFB are first transferred to the palm oil mills for sterilization (high-pressure steam),
whereupon the palm fruits are enzyme-deactivated and separated from the palm bunches.
After steaming, the palm fruitlets are crushed in a pressing machine to obtain the palm oil.
As previously mentioned, the palm oil palm comes in two types: CPO from the flesh of the
fruit, and PKO from the seed or kernel. For every ten tons of CPO derived, one ton of PKO is
produced. For CPO, waste and water is then cleared and separated from the CPO by means of
a centrifuge. The cleared CPO is then sent for refining, while the palm kernel nut is sent for
crushing. The empty fruit bunches and liquid waste arising from the process are recycled as
fertilizer in the plantations.
Both CPO and PKO then go through a second stage of refining where impurities, colors (by
bleaching), and odors (by deodorizing) are removed and the oil is processed into different
grades via fractionation. The output of these processes are palm stearin (solid at room
temperature) and palm olein (liquid at room temperature) fractions, whose different
properties make them suitable for a variety of food and non-food products.

DOWNSTREAM: END APPLICATION

The downstream segment of palm oil simply represents the retailing of the
end-derivatives/products produced by the refining process. These include palm olein (CPO),
palm stearin (CPO and PKO), palm kernel cake (PKO), and other substrate bases. Of the
various derivatives, CPO olein and stearin are the leading segments among palm’s
derivatives, owing to their versatility and application range, from edible oil, surfactants, and
cosmetics to biofuel, animal feed, and lubricants.

The full range of end categories and products that use CPO and PKO derivatives as raw
materials are as follows:

 Food: Palm oil is the major ingredient in cooking oils, industrial frying fats,
margarine, vegetable ghee, confectionary, ice cream, non-dairy creamer, salad
dressing, cheese analog, supplements, and condiments.
 Cosmetics and Personal Care: Palm is one of the major ingredients in most
cosmetic products. It is used widely in balms and lipsticks due to its luster and
color-holding aspects; in soaps, candles, and detergents due to its texture; and
as a base ingredient in creams and skin-based pharmaceuticals (especially
anti-aging products) because of its tocopherol and tocotrienol properties, both
known to be absorptive, healing agents.
  Oleochemicals: Oleochemicals are the oils and fats derived from natural
plants and animals subsequently broken down into fatty acids, esters, glycerol,
and others. Palm oil is a raw material in oleoresins, used in the production of
surfactants, agrochemicals, lubricants, grease, industrial cleaning products,
and printing ink.
 Energy and Biomass: Palm oil is used as cheap feedstock for the many
biodiesel plants across Southeast Asia and Europe, an end application that has
been one of the major drivers of palm’s recent success and growth.
 Livestock: Palm kernel, due to its high average protein level of 22%, is a
fantastic but cheap source of nutritional value in animal feed and
supplemental products.

The Global Palm Oil Market

As of year end 2015, 62 million metric tons of palm oil were produced with a production
value of $65.7 billion. Over the last two decades, palm oil production has grown tenfold (at a
YoY CAGR of 7.5%), with estimates that production will reach $93 billion by value or > 70
billion tons by volume by 2021.
Historical Drivers of Palm Oil Growth

The historical success of oil palm can be attributed, principally, to its intrinsic qualities. First,
it is the most productive of all the vegetable oil crops globally, yielding 7x and 11x more
oil per hectare than rapeseed and soybean, respectively, which exist as the two next most
productive oils.
Secondly, palm oil is one of the most versatile and widely applied substrate bases globally.
Specifically, the food sector consumes about 70 percent of all palm production, but as
presented in previous sections, it is also used as an input base for everything from
margarines, soaps, lipsticks, and polishes to confectionary, cooking oils, surfactants, and
industrial lubricants.
Third, palm oil is the most price competitive of the global edible/vegetable oils, historically
trading at 0.85x the price of soybean oil and 0.9x the price of coconut oil (PKO). Recently,
the affordability of palm oil has driven its continued demand in high-consuming emerging
markets such as India and China and also across Africa—an end market that is fast becoming
a material consumer of the commodity on the back of its explosive demographic growth.
Future Drivers of Palm

Looking forward, most of the legacy drivers of palm—productivity, versatility, and value—
will continue to hold. In addition, demographic growth, improvements in economic
conditions/standard of living, and associated changes in dietary habits will also contribute
meaningfully to the consumption-driven growth of palm. Specifically, India and China
respectively consume 21% and 16% of the world’s CPO today, representing approximately
16 kg and 21 kg of vegetable oil per capita. Compared to the 67 kg per capita consumed by
the West, there remains plenty of runway for further consumption upside in emerging market
food segments, which will account for the bulk of palm growth and demand. Note that these
stats are ex-Southeast Asian consumption, which, according to research boutique Frost &
Sullivan, is slated to grow at a CAGR of 11% over the next three to five years, driven
primarily by domestic Indonesian consumption.

Further, new demand markets, such as biodiesel, which uses palm oil as feedstock, have and
will continue to emerge as a powerful driver of growth. Biodiesel now consumes around 20
million tons of vegetable oil on a global basis, equating to approximately 13% of vegetable
oil usage.
It is worth noting that many countries, Southeast Asian and Western alike, have
introduced biodiesel mandates whereby a minimum quantity (20% in Indonesia and China) of
palm oil-based diesel must be blended with traditional diesel as a going energy concern.
These policies have effectively set floors on the palm oil-based biodiesel demand for years to
come, and as a consequence increased the crop’s correlation to energy (crude oil) prices,
which has the effect of propelling CPO prices into a new trading range.
The final major driver of forward-looking palm oil growth is “sustainability factors.”
Specifically, there has been rising hostility and policy against GMO-based oils in Europe and
an outright ban on trans-fat foods in the US, both of which have resulted in a migration away
from soybean and sunflower oil toward palm oil as a raw material base in food.
Investing and the Financial Markets

Though I will focus mostly on the public equities markets for the remainder of this article,
there are in fact many ways for a prospective investor to play palm oil—with some more
lucrative than others. The major investment strategies include investing in real assets and
investing in publicly traded financial instruments. More specifically, these can be broken
down as follows:
1. Investing in upstream plantations, either greenfield or brownfield (real assets)

2. Investing in midstream assets such as crushing mills and refineries (real

assets)

3. Investing in downstream assets such as vegetable oil brands and production

assets, personal care brands and production assets, or industrial product
brands and production assets (real and intangible assets)

4. Investing in public equities markets or public debt markets

5. Investing in palm oil futures

Each of these classes have their merits and demerits, profit profiles, and risks, with upstream
plantations being the most lucrative.
Public Markets

From a financial market perspective, palm oil production and trading companies are
principally listed across four global exchanges: (1) Malaysia’s Stock Exchange (Bursa
Malaysia/MYX); (2) the Indonesian Stock Exchange (IDX); (3) the Stock Exchange of
Singapore; and (4) the London Stock Exchange (AIM).

As of Q3 2017, the listed value or aggregate market capitalization of the palm oil sector was
$85 billion, with a capital value of approximately $200 billion, according to Hardman & Co,
a capital markets research company.
Amongst the public exchanges, Malaysian assets command premium valuations with the
EV/ha range $10,000 - $44,000 but with valuations typically clustering in a tighter range of
$14, 000 - $23,000, while Indonesian valuations exhibit lower clustering, ranging from
$8,000 - $17,000 EV/ha. Given that the Singaporean listed planters are largely Indonesian
plantation holders and operations, their valuations mirror those of Indonesian listed
companies. African valuations, typically listed in London, are lowest in class, ranging from
$7,000 to $16,000 but concentrating mostly in the range of $7,000 - $10,000 EV/ha.
At this juncture, it is important to note that because Malaysia and Indonesia represent a global
production oligopoly with 85% production share of palm oil volume, much of the following
analysis will focus specifically on their dynamics and relative to one another.

Malaysia Listed and Operated Companies

As previously stated, Malaysia listed and operated companies command a premium over

other global palm oil companies, for a number of reasons. First, they exhibit a higher
incidence of horizontal and vertical integration and diversification relative to their Indonesian
and African counterparts. The largest listed Malaysian palm oil companies often have in-
house mills, processing and refining capacity, and branded FMCG brands (vertical
integration). The most mature of these companies also hold vast commercial and residential
property holdings, and they run agro-industrial operations as well as other, somewhat
tangential business units ranging from healthcare to auto distribution. More to the pro, these
companies also often have cutting-edge R&D capabilities in-house that have led to higher
FFB yields and more efficient chemical operations relative to their Indonesian and African
counterparts.
The second driver of Malaysia-listed valuations is the higher incidence of prime age
plantations in the country relative to Indonesia and Africa. The result is a higher FFB yield
ratio relative to Indonesian plantations currently but a projected inversion of this relationship
over the next ten to fifteen years at current planting rates in Indonesia relative to Malaysia.
The final driver of Malaysia-listed valuation premiums is the lower incidence of government
involvement in the sector relative to Indonesia, especially with regard to socially volatile
smallholder schemes. Specifically, smallholder farmer schemes only account for a 14% share
of plantation ownership (compared to 42% in Indonesia) with the government directly
holding another 24% and the private sector controlling ~62% (vs. 50% in Indonesia).
Indonesia Listed and Operated Companies

Indonesian and Singaporean listed companies, both of which are comprised of Indonesia-

based plantations, tend to trade at a discount to Malaysia listed companies. The first reason
for this is Indonesian plantations in general tend to be far less vertically integrated and
diversified than their Malaysian counterparts, and are thus more susceptible to concentrated
swings in commodity prices and sector-specific issues that might create short term demand-
supply imbalances.
By way of illustration, in recent years, Indonesia has been plagued by a number of ongoing
community issues that have led to the government reallocating large portions (up to 30%) of
private palm land to smallholder farmers. This, coupled with the fact that Indonesia consumes
25 - 30% of all palm oil it produces, domestically, relative to Malaysia’s 12% - 15%, led to
lower domestic CPO prices and an impact to the bottom line of Indonesia listed companies.
The perception of such concentration risk and exposure is but one reason why the markets
tend to treat Indonesia listed companies as riskier bets than their Malaysian counterparts.
The second reason why Indonesian companies tend to trade at a discount to their Malaysian
counterparts is that Indonesia’s government is in the midst of driving a mandate to accelerate
the development of local refining and downstream capacity reflected in the recent
implementation of a CPO export tax regime. Specifically, Indonesia has lowered the export
taxes of processed palm oil products but raised dramatically the taxes on CPO—a strategy
that is broadly reflective of the more hands-on approach by the Indonesian government—in
an attempt to control supply and demand dynamics of palm oil in the near to medium term.
According to Hardman & Co, a global agri-research house, the third reason why Indonesian
companies tend to trade at a discount to their Malaysian counterparts is due to operational
efficiency. Cost per ton of CPO varies from operator to operator and region to region, with
Indonesia reflecting a higher cost per ton than Malaysia due to its weak and decaying
transportation infrastructure. Typically the cost of production range is $380 - $550 per MT,
with >$380 per MT being possible only for mature estates found in greater concentrations in
Malaysia.

Palm Oil Sector Headwinds

As mentioned much earlier in this article, with the runaway success of palm oil has also
come large-scale social, environmental, and sustainability challenges: challenges such as
deforestation (resulting in the extinction of a number of endangered species and bio-
ecosystems), greenhouse gas (GHG) emissions (palm oil is estimated to account for 4% of
GHG emissions globally), child labor exploitation, and social conflicts with local
communities.

Each of these categories impacts the growth and thus investment prospects of the palm oil
sector as a whole.
By way of illustration, climate change creates more erratic weather patterns and variations in
temperature, resulting in more instances of prolonged drought as well as severe flooding,
which can degrade and inundate farms and livestock operations. El Niño represents the most
recent case in point, reducing palm oil yields globally by 30% in 2015/2016.
By way of a second illustration, numerous lawsuits have been brought against palm oil
plantation owners, spanning issues from deforestation to global warming contributions and
working condition abuses, with the Government of Indonesia recently prosecuting publicly
traded companies associated with air pollution produced by palm oil fires.

In 2004, an industry group called the Roundtable on Sustainable Palm Oil (RSPO) was

formed to work with the palm oil industry to address its environmental concerns. The EU in
particular, as the third largest importer of palm oil globally, has been especially disciplined
about enforcing RSPO compliance terms by exporting planters it trades with.

The Path Forward

Current sustainability headwinds notwithstanding, palm oil is well positioned to continue its
ascent as a global super-commodity well into the future. The global palm market is forecast
to exceed 70 billion tons of output value ($93 billion worth of financial value) by 2021,
driven by increased demand for sustainable palm in edible and non-edible food applications,
biodiesel growth, and increased hostility toward GMOs and trans-fat oils by the West.

As expected, not far behind these fundamentals is technology, which is poised to play an
ever-larger role where data aggregation, yield propagation, and sustainability are concerned,
with startups such as Poladrone and Litchi leading the way. With these positive tailwinds
combined, continued dedication by planters to adhering to the RSPO’s sustainability
parameters, and Africa stepping up to make up for the land shortages becoming more acute in
Southeast Asia, palm oil will undoubtedly be a dominant force for decades to come.

UNDERSTANDING THE BASICS

What is palm oil?
Palm oil (elaeis guineensis) is a tropical vegetable oil derived from the pulp
(mesocarp) of the palm fruit to yield crude palm oil (CPO) and from the fruit
kernel (endosperm) to yield palm kernel oil (PKO).
What are the end uses of palm oil?
The end applications for palm oil are vast, and include food (cooking oils, frying
fats, confectionary), cosmetics (lipsticks, balms), anti-aging pharmaceuticals,
oleochemicals (grease, lubricants, industrial cleaning products), feedstock for
biomass, and animal feed.

What are the different ways to invest in palm oil?

Investors seeking to gain exposure to palm can do so in two ways: (1) by investing
in real assets (upstream plantations, midstream refineries, or downstream brands);
and (2) by investing in publicly traded financial instruments (publicly traded
equities and debt, palm oil futures).