CRUDE PALM OIL (CPO) prices have enjoyed a resurgence as of late. After bottoming out at just above RM1,900 per tonne back in September, settlement prices have crept back up to RM2,345.50 as at Jan 14, according to data provided by the Malaysian Palm Oil Board (MPOB). Similarly, the benchmark April 2015 forward active contract for CPO closed at RM2,344 on Jan 15, marking a 11% increase since Dec 1 (see chart).

In spite of the gains, experts are saying that the current rally may be a temporary spike as overall fundamentals have not changed, or more worryingly, may have worsened over the past two months.

At present, CPO prices are seeing strong support due to a decline in production. MPOB’s latest industry data for December shows a 22% fall in total output to 1.36 million tonnes, compared with 1.75 million tonnes in November. Total stock for CPO and processed palm oil also fell by 11% to 2.01 million tonnes in December from 2.28 tonnes the month before.

While the December to February period is known to be seasonally weak for palm oil production, the recent flooding in several states in Peninsular Malaysia has exacerbated supply concerns as vast tracts of oil palm land were inundated with water. On Jan 1, Plantations Industries and Commodity Minister Datuk Amar Douglas Unggah Embas said that up to 190,600ha of plantation land were affected, consisting of smallholdings as well as estates.

As the extent of the flood damage is still unclear, the consequences of a delay in harvesting as well as mill shutdowns will only be seen in the coming months. The forecasted drop in supply bodes well for CPO prices as well as for producers who need to clear their stocks after a good harvest last year.

However, the market has factored in recent developments, as evidenced by the rally in CPO.

“We believe that the impact of the floods to the industry will be short-lived as this occurrence will not severely impact fresh fruit bunch (FFB) yields, unlike in the event of hot and dry weather. As the water subsides, production is expected to normalise,” says MIDF research analyst Nadia Kamil in a Jan 13 report.

Malaysia is the world’s second largest producer of palm oil after Indonesia, where production is expected to be flat this year after a bumper harvest in 2014.

On the demand side however, prevailing headwinds have not abated. For example, demand by China, which has traditionally been Malaysia’s biggest exports destination, has declined substantially on a year-on-year basis. For 2014, palm oil exports to China amounted to 2.84 million tonnes, a 23% drop from 3.7 million tonnes in 2013.

India had picked up the slack in China’s import demand at the tail end of last year with 363,580 tonnes in December compared with China’s 257,380 tonnes. This was partly because Indian farmers had held on to soy crops from crushing operations due to low soy prices, forcing refiners to increase palm oil imports to meet their edible oil production needs. Furthermore, duty-free exports from Malaysia contributed to the higher imports.

To counteract this, on Dec 26, India’s government hiked its import duty on CPO imports to 7.5% from 2.5%, which could force refiners to seek locally sourced crops instead.

Rabobank International’s head of food and agribusiness research director Pawan Kumar believes that a multitude of unfavourable fundamental factors are working against the current CPO price recovery.

“First of all, there is still a global oversupply situation in edible oils, with the bumper soy harvest in the United States causing prices to stay low everywhere. Now, with India’s tax hike, Malaysia might not see such big import numbers from the country going forward,” says Kumar.

Another mounting concern is the biofuels segment, which has become less economically feasible to produce due to the severe drop in crude oil prices. Governments across the world had initiated mandates for renewable energy, including the use of palm oil blended with diesel in Malaysia, a move that was intended to boost CPO consumption.

Cheap crude oil’s effect on biodiesel demand has been drastic. In December, biodiesel exports fell to just 614 tonnes, or a 97% month-on-month decline from 22,753 tonnes in November. Between Dec 1 and Jan 1, Brent crude fell from US$72 per barrel to US$56 per barrel, or a 22% decline.

“In a cheap crude situation, it will be hard to justify increasing the palm oil blend for biofuels on a pricing standpoint alone. Global demand will slow down as consumers opt for less ‘green’ fuel sources,” adds Rabobank’s Kumar, who does not foresee prices exceed RM2,300 due to weak underlying fundamentals on the demand side.

While the existing mandates are backed by government subsidies and policies, discretionary demand has plummeted as biofuel production costs are typically passed through to consumers, making them much more expensive compared to diesel at present prices.

“Discretionary demand could be largely lost at the current Brent crude price of US$50 per barrel as it is no longer economically attractive,” says Maybank IB Research analyst Ong Chee Ting in a Jan 13 note.

As it stands, the upward direction of CPO prices could be capped as a clearer picture from the damage by the floods emerge, while demand factors remain weak and crude oil continues to fall.

This article first appeared in The Edge Malaysia Weekly, on January 19 - 25 , 2015.

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