Description

Long: Golden Agri-Resources, one of the world’s largest palm oil producers.

In 2022, after Russia invaded Ukraine, food prices jumped, sparking concerns about famine and food security. But even against this backdrop, the price of vegetable was an outlier. Vegetable oil prices soared far higher than everything else, increasing 65% yoy.

Why?

First, there were the one-offs. Ukraine produces a lot of sunflower oil. There was a drought in South America, hurting soybean oil production. But beneath these ephemeral issues was something structural, something that applies particularly to palm oil, the cheapest and most common vegetable oil. Even before the war, the price of palm oil was already going up. The reason: after decades of rapid growth, the supply of palm oil has suddenly become fixed.

Indonesia is the world’s largest palm oil producer, producing 60% of the world’s palm oil, which equates to 25% of vegetable oil overall. Malaysia is in second place, with 27% market share in palm oil and 11% in overall vegetable oil. Palm oil is in practically everything from moisturizer to processed food. It’s a staple throughout the world, comprising 10-15% of many people’s daily caloric intake. Over the last two decades, huge swaths of Indonesian and Malaysian forests were destroyed to create palm oil plantations. These forests not only clean the air locally, they’re a strategic necessity preventing climate change in the eyes of many. The deforestation sparked uproar in the West. Both consumers and environmental groups called for boycotts of palm oil. NGOs, consumer brands, and ESG activists launched efforts to secure zero-deforestation commitments from palm oil producers.

Personally I think ESG exists to flatter the narcissism of people who believe Disney movies are real. But these loathsome bastards are magnificently correct that burning down old-growth rainforest is a disastrous idea. And to be onboard with this, you don’t need to believe every claim of the environmental movement. You only need to believe that something irreplaceable, which has existed for thousands of years and which measurably reduces pollutants other than just carbon, is something the human race might not want to destroy. I mention this because it’s an instance where ESG concerns overlap with antifragility, old-fashioned prudence, and beliefs that even the average person holds. Perhaps as a result, the zero-deforestation efforts have been shockingly successful. 85% of palm oil is now exported by groups with zero-deforestation commitments, per the Stockholm Environment Institute (“SEI”).

From a S&P Global article: “‘There is no new land... We have to focus on high-value products and downstream development,’ said Lee Yeow Chor, managing director of IOI Corp Berhad, one of the largest palm oil companies in the world, and chairman of industry group Malaysian Palm Oil Association. Malaysia capped its area under palm oil plantations to 6.5 million hectares. In the last few years, the planted area has shrunk to about 5.6 million hectares, with urbanization claiming agricultural land, statistics from the government regulator Malaysian Palm Oil Board showed.”

The numbers back up what the man is saying. Per SEI, “In 2018–2020, deforestation for palm oil was 45,285 hectare per year – only 18% of its peak in 2008–2012.”

By fixing the amount of land dedicated to palm oil production, the activists, without meaning to, have fixed supply and created the conditions for a sustained boom in palm oil prices. Another unintended consequence: their initiatives have crushed yields. So not only is the amount of land devoted to palm oil production restricted, but less palm oil is being yielded from that fixed amount of land. The reason: the industry has neglected replanting palm oil trees. This is especially so for “smallholders”, farmers with less than 100 acres. These smallholders aren’t a de minimus part of the market either. They account for 40% of production in Malaysia and 50% in Indonesia. These farmers already have yields half of what the majors achieve, but due to strict sustainability requirements and rising costs overall, they now have little incentive to reinvest in their trees, further choking off supply. This is terrible for them but good for firms like Golden Agri-Resources.

The world hasn’t caught on yet, but the results of all this are beginning to take effect. Palm oil production, which grew 6% a year from 2013 to 2019, has flatlined. You can see the possible fallout this will have on the broader vegetable oil market below.

From 1999 to 2019, ex palm oil, production of vegetable oil has been stagnant. Even sunflower oil’s 60% cumulative growth over 20 years translates to just 2.5% growth annually. Over this time, however, demand for vegetable oil grew 4.5% a year. The only reason the increase in demand was met was due to the massive increase in palm oil production, which grew 260% cumulatively—7% annually—from 1999 to 2019. Palm oil is the workhorse of the industry. It’s the cheapest vegetable oil, and since vegetable oils are easily substituted for one another, it keeps the price of the others down. But now the trend which has defined the market for the last two decades has come to an end. Since 2019, the deforestation commitments have gone into effect, and palm oil production has grown just 1% a year.

By the way, even that 1% growth rate is shaky. Note how production fell off after 2019 but then spiked suddenly in 2022. Due to the Ukraine war, palm oil prices soared from $900 to $1600/ton. Absent that price spike, marginal production would probably have remained offline, and palm oil supply would have shrunk since 2019. And this dynamic isn’t a blip on the radar. Over the long-run, the OECD projects palm oil production will grow just 1% a year through 2030. By contrast, demand is projected to grow 4.5% a year, resulting in a 3.5% deficit. Exacerbating the potential deficit are clean fuel mandates. Already 14% of the world’s vegetable oil supply goes into biodiesel. The problem is that these mandates escalate substantially in the coming years, which adds further tightness to an already-tight market.

Putting it all together, current vegetable oil consumption is 220MM mt a year. That number is set to become 285MM mt by 2030. But unlike before, palm oil output isn’t going to grow 250% like it did from 1999 to 2019. That ship has sailed. As a result, both palm oil and the overall vegetable oil market appear structurally under-supplied. The only escape valve is higher prices.

It's also worth noting the prices that prevailed over the last 10 or 20 years weren’t enough to incentivize additional vegetable oil production outside palm oil. So if the world goes into deficit, there is no group ready, willing, and able to provide supply at current economics. It’s also worth noting that palm oil producers made their ESG commitments when palm oil prices were low. The only thing that could get them to erode those commitments is if the price becomes high. But either way, something needs to happen that encourages an additional 3.5% supply in coming years and ultimately an additional 65MM mt of vegetable oil production by 2030. Otherwise there’s going to be a massive shortage. And it won’t be the poor countries that go without. They’ll just impose export bans and feed their people first.

In fact what’s already underway in Indonesia highlights one of the market’s biggest fears, which is that producers will hold onto their own production. Domestic use of palm oil in Indonesia is surging, going from 32% of production in 2018 to 40% in 2020. Increasingly Indonesia wants to keep more and more of its palm oil for itself. And when the price skyrocketed last year due to the war, the country banned palm oil exports, further contributing to soaring prices.

Enter Golden Agri-Resources, one of the largest palm oil producers in the world.

Golden produces 3.5% of the world’s palm oil, which equates to 1.5% of the world’s vegetable oil. Two things depict Golden’s current state of affairs: the price of palm oil and the long-term performance of Golden’s shares.

2008 to 2011 were boom times for Golden. Then the price of palm oil entered a sustained bear market from 2013 to 2019, and the stock experienced a lost decade. Nonetheless in recent years, as palm oil prices have risen, FCF bounced back. Over the last decade, the company has produced $1.5 billion in cumulative FCF, two-thirds of its market cap.

In 2022, when palm oil prices skyrocketed, the company made $880MM in FCF, or forty percent of its market cap. Given the company is levered to rising palm oil prices, there’s a good chance the company can sustainably earn $600MM a year, which would put the stock at 4x earnings. 16x is a reasonable multiple if the thesis plays out and a world enamored with tech and SaaS and everything nice once again sees the value of hard assets. That would make the stock worth 400% more.

Catalyst

Deficit.