Where oil grows on trees

Travellers flying into Kuala Lumpur could be forgiven for thinking the country is nothing more than a giant palm plantation. All around the city, neat rows of palms stretch to the horizon and beyond, covering an area bigger than Denmark in total.

These vast plantations produce one of the world's biggest supplies of palm oil, which has rapidly become one of Malaysia's most important export earners. Since 2005, overseas sales have been growing at a rate of 13.8% a year and in 2009 the country's exporters earned $11.8 billion from a total domestic crop of 17.7 million tonnes.

The growing demand for biodiesel during the past 20 years has, in turn, led to surging demand for crude palm oil and other edible oils, such as soybean, rapeseed and sunflower oils. This growth is expected to continue thanks to the rising consumption of palm oil products in developing countries such as China and India -- markets that have tripled in size during the past 10 years.

The market price for biodiesel fuel has proven to be resilient to downside moves in crude oil prices, protected in part by mandatory blending requirements that are being introduced around the world. To the upside, crude oil prices can still have a big run-on effect on palm oil. According to Bloomberg data, palm oil, which is the cheapest edible oil to use in making biodiesel, was at a significant premium to crude oil, as of April.

The challenge is meeting that demand. Gan Huey Ling, an analyst at AmResearch, says that growth in the biodiesel market has been stagnant recently and that there was even a fall in production last year, resulting in a shortfall in supply. Globally, biodiesel plants were operating at less than 50% capacity, indicating that current global production of biodiesel is far below the actual level of demand.

In response to the disappointing production levels last year, industry specialists such as Oil World, a German-based independent forecasting service that specialises in the oilseeds sectors, have this year called for a 20% increase in global biodiesel production for 2010. Overall, it is expected that growth will improve this year, based on lower feedstock costs and greater government initiatives aimed at stimulating biodiesel consumption.

Malaysians' personal commitment to ensuring growth in both the domestic and global markets has been well documented within the so-called New Economic Model. And, according to AmResearch, the government has also built six new petroleum depots at a total cost of $13 million.

More than just fuel

Malaysia's palm oil industry was well-established long before the biodiesel market started its boom. Back in the 1960s, the Malaysian government gained the upper hand as an early mover into Africa, setting up large-scale commercial planting operations in the native home of the oil palm (elaeis guineensis, which originated in West Africa and was first planted in Malaysia by William Sime and Henry Darby in 1910).

Before the rise of the biodiesel market, palm oil was simply a base food good and, even today, a big proportion of Malaysia's crop is still exported in the form of edible palm oil products. Indeed, it is expected that the food sector, as opposed to energy, will drive demand for palm oil during the next two years.

Today, about two-thirds of the refined palm oil that is produced in Malaysia is exported to China, the EU, India, Pakistan and the US. The main uses are for cooking oil, margarine, speciality fats and oleochemicals, which are chemicals that come from plant and animal fats.

Improving its competitiveness

Malaysia's biggest competitor in the export market for palm oil is Indonesia, which benefits from a greater land bank for cultivation and also from a cheaper labour force. As the industry grows, many of Malaysia's big producers, such as Sime Darby and IOI Corporation, are taking their expertise and their plantations to Indonesia to take advantage of the opportunity to increase production and lower costs.

This is another trend that is likely to continue, particularly as Malaysia pursues its plan to up its status to a high-income economy by 2020 -- a welcome social achievement, to be sure, but also a development that will make it more difficult to compete with the attractions being offered to palm oil producers next door in Indonesia.

To stay competitive, Malaysia's government has turned to research and development to re-establish a dominant position in the market. Indeed, lawmakers placed considerable emphasis on the future of the country's palm oil industry in the New Economic Model they rolled out in March. According to the finance ministry, the sector's contribution to economic growth could reach 7.6% by 2020, as long as the sector is able to realise the value-added gains from efficiency and innovation. To achieve such growth, the industry needs to look at new value added initiatives that will spin off into new investments, as well as research and development.

A 7.6% contribution to real GDP would translate into a yearly growth of 13.7% during the next 10 years. In addition to this, palm oil exports could grow by 7% a year to M$84.6 billion ($26 billion) by 2020. And, if the sector is able to successfully position new downstream operations, the growth rate for exports could be even more than the finance ministry's predictions.

Inclusivity is a key part of the plans. More than one-third of Malaysia's palm oil production is contributed by smallholders, who produce at lower yields than the vast commercial estates. It is these suppliers and producers that the government hopes will keep the industry up and growing, with the help of government-backed initiatives such as upgrading crop to better-yielding stock.  

With the framework for the New Economic Model, the Ministry of Finance reckons that 20% of planted areas by smallholders will need full rehabilitation, at a cost of approximately M$3,000 per hectare. Industry analysts predict that this could almost double production per hectare for smallholders. In addition to the reforms aimed at ensuring inclusivity and higher yields, the government is also concerned about sustainability. Not in the sense that palm oil is a base for green fuel technology, but as a matter of practicality -- Malaysia is physically running out of space to expand plantations and onshore operations.

With land being such a limited resource, the case for sustainability becomes not only a case for environmental stewardship, but also for economics and ensuring that the industry looks to support quality investments. It had been pointed out with the NEM framework that, "better use of land should see high value timber and other crops planted on hilly terrain, which is not suitable for oil palm, but can yield significant value through future sales of timber".

Other programmes that the government has identified to help with improving its competitiveness include encouraging businesses to move more production downstream, taking a leading position in carbon-trading initiatives, investing in genome research and continuing to work with smallholders.

Indeed, Malaysia's genome project holds promise. Under this scheme, the crop can be modified to produce higher oil yield, iodine value and stunt the growth of the plant to make harvesting easier. The goal here is to try to maximise the crop value per hectare. This will, it is hoped, help to ensure the quality of crop needed for small holders, as well as ensuring supplies for the larger corporate estates, so that they can maximise returns despite being constrained with the limited land available in Malaysia for expansion. In effect, the genome project will allow the local producers to work within a sustainable economic model that will be largely based on renewable resources.

Achieving this would help Malaysia on the path to becoming a global leader in an increasingly important field of science, as well as being a global first for the market in setting up a bio-based economy.

This story was first published in the June 2010 issue of FinanceAsia magazine.