How you can trade Southeast Asia's haze

Nyshka Chandran CNBC 23 Sep 15;

The price of palm oil has rallied 7 percent in the past fortnight as a cloak of smog, combined with unusually dry weather, disrupts supply in key Southeast Asian producing countries, and analysts say the gains are set to continue.

Futures on the Bursa Malaysia Derivatives Exchange shot up to a one-week high of about $508 a metric ton on Wednesday, a sharp turnaround from a six-year low of $426 plumbed in late August. Bursa Malaysia is the world's biggest palm oil futures trading hub.

Many experts now expect the edible oil to close out the year higher: Religare Institutional Research's year-end target is around $750 a ton, while others like CIMB and Nomura expect more gradual gains to $513 and $529, respectively.

Palm oil, derived from the palm fruit, is used as a raw material in everything from food products to detergents, cosmetics and biofuel. Global palm oil exports last year was valued at $34 billion, according to reports.

Indonesia and Malaysia are two of the world's biggest producers but the region's seasonal haze is lowering production.

Read MoreSingapore's clouds have a pretty hazy lining
Every year, farmers in Indonesia engage in the 'slash-and-burn' technique of cutting down vegetation on a patch of land, then burning off the undergrowth to make space for new plantations. While it is the easiest, fastest and most cost-effective way to clear land, the use of fire is deemed illegal by the Indonesian government since it produces a dense layer of smog across the country as well as over Malaysia and neighboring Singapore, sending air quality readings to alarmingly low levels.

Increased public complaints about the pollution this year have whipped Indonesian President Joko Widodo's administration into action. A supplier of Golden Agri Resources, the world's second largest oil palm company, was sanctioned this week for allegedly causing forest fires. More than 200 plantation and forestry companies are currently being investigated, according to local media reports, including one Singapore-listed firm.

As for the impact on the palm fruit, "heavy haze reduces the amount of sunlight reaching the trees and disrupts harvesting during the peak production season," explained Nomura analyst June Ng.

As a result of the smog, companies are finding it difficult to bring their workers to plantations, which is reducing productivity and further weighing on production, added Nirgunan Tiruchelvam, research director at Religare Capital Markets.


Don’t forget about El Nino

Religare is especially bullish on the commodity's outlook in the face of tightening supply as a result of El Nino, the weather phenomenon that brings severe drought to Asia. This year's event may be one of the most severe on record, according to a September forecast by the World Meteorological Organization.

"A strong 2015-16 El Nino event could disrupt palm oil supply growth in Indonesia and Malaysia. Global palm oil supply could increase by only 1.4 million tons in 2015, before declining by 1.1 million in 2016," warned Ivy Lee, CIMB analyst.

A severe drought at palm oil estates will negatively impact palm oil yields, as the lower rainfall and soil moisture cause trees to experience bunch failure four-to-six months later, she explained.

Read MoreWhy El Niño could mean more pain for energy sector
Indeed, historical evidence points to higher prices. Two out of the three El Nino events since 2002 resulted in higher prices, with palm oil surging 26 percent from 2006-2007 sequentially, said Nomura's Ng.

But Lee and Ng are slightly less bullish on prices compared to Religare's Tiruchelvam, warning that price gains will be slow due to the high level of existing palm oil stocks. August's stockpile rose 10 percent on month to 2.49 million metric tons, noted Nomura.

Stocks to watch

Palm oil producers with high production growth potential like Singapore-listed First Resources are set to benefit from rising prices.

About a third of First Resources' hectarage is expected to enter maturity over 2015-17, which should increase its output growth, Tiruchelvam said, while Lee likes Malaysia's Genting Plantations because of its young estates.

First Resources looks particularly attractive given the added benefit of currency movements, Tiruchelvam notes. Its revenues are denoted in dollars, while its costs are in rupiah, so the latter's 18 depreciation against the U.S. dollar year-to-date supports the company.

"In the event of a prolonged El Nino weather event and oil price volatility, we believe liquid big cap stocks with high correlation to the palm oil price are likely to benefit given their higher leverage to price upside," said Nomura's Ng.