OREANDA-NEWS. The sector outlook for Asian palm oil producers is improving as changes in supply and demand dynamics point to higher prices for crude palm oil (CPO) in 2016, says Fitch Ratings. Higher prices will be credit positive for producers as they will result in higher operating cash flows and improve CPO firms' credit profiles. While this is supportive of a stable sector outlook, there is a high positive correlation between CPO and crude oil. As a result, Fitch believes that the outlook for the sector remains muted, though improving.

The decline in CPO prices since April 2014 and consistent stock accumulation contributed to Fitch's initial negative sector outlook for 2016. Declining prices, in particular, resulted in CPO firms' funds from operations (FFO)-adjusted net leverage significantly increasing in 2015.

Fitch now expects CPO prices in 2016 to average higher than in 2015 as global demand holds up and output falls in Indonesia and Malaysia as a result of especially dry El Nino-related weather conditions. We expect the pre-export tax and levy CPO price to range between USD650/tonne and USD700/tonne this year.

Production has fallen significantly in Malaysia, with output declining to an 18-month low of 1.04 million tonnes in February 2016. This dragged stocks down from a peak of 53 days in November 2015 to as low as 27 days in March. Industry association estimates in Indonesia also forecast a reduction in output there in 2016 - the first annual fall in production in at least 15 years.

In Indonesia, domestic consumption is likely to increase substantially, which should also bolster global prices because less CPO is available for export. The Indonesian government has raised palm oil content in biodiesel to 20% in 2016, after increasing the blending rate to 15% in 2015 from 10%.

The Indonesian government's imposition of a flat export levy of USD50/tonne of CPO and USD30/tonne of processed palm oil products from May 2015, coupled with a price-linked progressive export tax structure subject to a minimum reference price of USD750/tonne, makes it more attractive for Indonesia-based CPO firms to cater to the domestic market.

Should the government's reference price rise above USD750/tonne, the levy will still apply, but the total amount an exporter pays will not exceed the applicable export tax. The export levy is meant to compensate for loss of export tax revenues, should the CPO reference price fall below USD750/tonne and to fund biodiesel subsidies.

It is important to note, though, that CPO prices depend on both industry supply-demand dynamics and the global economic environment. CPO prices have historically exhibited high positive correlation with crude oil because CPO is used as a biodiesel input. Therefore, a renewed or sustained downturn in crude oil prices would likely be a drag on CPO prices.