Malaysian Journal of Economic Studies Vol.Development on 1 & Palm Oil Industry Impacts of Biodiesel XXXXIII Nos.

the 2, 2006

ISSN 1511-4554

Impacts of Biodiesel Development on the Palm Oil Industry

JAHARA Yahaya*, SABRI Ahmad **and Scott W. KENNEDY*** *University of Malaya **Golden Hope Plantations Berhad ***STE Consulting
Abstract: This paper examines the impacts of biodiesel growth on the palm oil industry. The implications of biodiesel growth are discussed within the context of the overall oil seeds industry. Insufficient supply of the most major oil seed used for biodieselrapeseed has given rise to a raw material supply gap. In this context, the complementary role of palm oil is expected to become more significant. Major producers of palm oil are keen to use biodiesel as a stock management mechanism for palm oil which is currently perceived to be undervalued in terms of pricing. Ongoing work to increase yield through sustainable plantation practices and improvement of planting materials is being intensified in anticipation of strong palm oil demand. Other measures to meet rising energy demands include increasing oil palm hectarage in a responsible way and producing cellulosic ethanol from palm biomass. A system dynamics model for examining the inter-linkages between palm oil, petroleum and biodiesel is presented. The model shows that when crude oil price is around USD38/ bbl or less, palm biodiesel is not profitable even for a very low CPO price of USD200/ tonne. At a crude oil price of USD70/bbl, palm biodiesel is profitable for CPO at around USD450/tonne or less. The dynamics of the system is also explored to see how biodiesel and CPO prices respond dynamically to changes in the oil price and CPO production rates. Keywords: biofuel policy, crude oil price, energy demands, oilseed JEL classification: O13, Q01, Q41, Q42

1. Introduction
Palm oil is a form of edible vegetable oil obtained from the fruit of the oil palm tree. It is the second most widely produced edible oil, after soybean oil . Its export rose by 41-fold from a mere 0.55 million tonnes in 1962 to 23.3 million tonnes in 2004, making it the worlds largest traded vegetable oil. Palm oils share of the oils and fats market expanded from 9.2 to 51 per cent during this period of time (Basiron and Simeh 2005). Malaysia, the worlds largest producer and exporter of palm oil today, produces about 47 per cent of the worlds supply of palm oil. The palm oil industry is the backbone of rural development and the nations political stability. It is also worth noting that this industry does not enjoy government subsidies and is highly taxed (Chandran 2005). Indonesia, the second largest world producer of palm oil, produces approximately 36 per cent of world palm oil volume (Wikipedia 2006). Both countries are actively expanding their palm oil

Professor, Department of Development Studies, Faculty of Economics and Administration, University of Malaya, 50603 Kuala Lumpur. Email: jahara@um.edu.my ** Group Chief Executive, Golden Hope Plantations Berhad *** Consultant, STE Consulting, Kuala Lumpur *

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production capacity to meet the increasing market demand caused by increasing population, income and per capita consumption. High crude oil prices have forced the world to review alternative fuel sources. The petroleum crisis is expected to be long drawn due to lack of new reserves, instability in the the Middle East region, shortage of production capacity and a significant increase in demand by countries like China and India (Promar International 2005). In addition, many signatory countries to the Kyoto Protocol are also rushing to reduce their greenhouse gas emissions by 2012. Being the worlds largest producer of palm oil, the Malaysian government and oil palm companies have responded quickly to take advantage of the rush to find cleaner fuels.

2. Palm-based Biodiesel Development in Malaysia

With increasing emphasis on the use of esters as diesel fuel, the term biodiesel increasingly refers to alkyl esters of vegetable oils and animal fats, and not the oils or fats themselves (Knothe and Dunne 2004 ). The earliest known use of alkyl esters appears in a Belgian patent granted in 1937 to G. Chavanne (#422,877). This patent describes the use of ethyl esters of palm oil. Oil palm is apparently biologically superior to other oilseed crops in terms of efficiency and productivity (Chandran 2005). For example, one hectare of oil palm (mesocarp and kernel) can produce 4.17 tonnes of oil whereas soybean and rapeseed can only produce 0.44 tonne and 0.65 tonne respectively as shown in Table 1.
Table 1: Oilseeds: oil contents and yields (average values) Crop Oil bearing tissue Mesocarp Kernel Copra Seed Seed Seed Seed Seed Oil content in oil bearing tissue (wt per cent) 49 49 68 20 50 20 45 45 Oil yield (t/ha)

Oil Palm* Oil Palm* Coconut Soybean Groundnut Cottonseed Rapeseed Sunflowerseed

3.7 0.47 0.37 0.44 0.45 0.19 0.65 0.54

Note: *tenera palms Source: PORIM & Oil World Annual 1999

Figure 1 illustrates the evolution path of Malaysias biodiesel development. The countrys involvement in biodiesel could be traced back to the late 1980s. During the 19871990 period, the Palm Oil Research Institute Malaysia (PORIM) carried out work on palm diesel, which included testing the palm diesel on bus fleets which used Daimler Benz engines. The work was extended to passenger cars using Elsbett engines. Even though the tests proved successful, there was no commercial interest due to the low cost of petroleum diesel in Malaysia.

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Macro Environment

No commercial interest in palm diesel due to low cost of petroleum

National energy diversification initiative MPOB and Petronas work to commercialise biodiesel

MPOB announcement: push for biofuel implementation; three companies selected as commercialisation partners

Msian Biofuel Policy

R&D

PORIM carried out work on palm diesel testing it in bus fleets and passenger cars 1987 1990s 2001

Project did not materialise; left to MPOB to pursue Tests continued on the use of palm oil as biofuel for blending with MFO and diesel for industrial applications 2002 2003 2005 2006

Figure 1: Evolution path of Malaysias biodiesel development

In early 2001, as part of the countrys energy diversification initiative, the Malaysian Palm Oil Board (MPOB) and the National Petroleum Company (PETRONAS) embarked on serious efforts to commercialise biodiesel. This initiative had the support and commitment of several palm oil companies. Unfortunately, in January 2003, the project did not materialise and it was left to MPOB to continue with the work. From 2002-05, tests continued on the use of palm oil (refined products) as biofuel for blending with medium fuel oil (MFO) and diesel mainly for industrial applications. Tests using crude palm oil (CPO) as fuel for power plants had been carried out earlier when the price of CPO was below RM1000/tonne. In March 2005, MPOB announced its desire to push for biofuel implementation. This move was to be part of the price stabilisation strategy as practised by other commodity products such as sugar, corn, soy and rapeseed. Seven months later, MPOB announced that three companies (Golden Hope Plantations Berhad, Kumpulan Fimas Fima Bulkers Sdn. Bhd. and JC Chang Johor groups Carotino Sdn. Bhd.) had been selected to implement and operate palm biodiesel plants using MPOB technology. MPOB was to provide part of the capital investment, recoverable on instalments. The biodiesel plants two in Klang and one in Pasir Gudang, Johor are estimated to cost about RM40m each with a combined production capacity of 180,000 tonnes (60,000 tonnes each) per year and targeted mainly for export, especially to the EU. The plants are expected to be operational by early 2007.

3. The Malaysian Biofuel Policy

As seen earlier, biofuel initiatives are not new to Malaysia. In 2001, when CPO price was below RM900 per tonne, the government had used palm oil in power stations and boilers to

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stabilise the price by getting rid of excess palm oil stocks in the country. However, this interest was not sustained, when CPO prices recovered. More recently, fossil fuel shortage has reignited government interest in biofuels. The government announced the National Biofuel Policy on 21 March 2006 (Malaysia 2006). This policy aims to reduce the countrys fuel import bill, further promote demand for palm oil which will be the primary commodity for biofuel production as well as serve as a price stabilisation mechanism for palm oil during periods of low export demand. These are some of the key initiatives included in the Policy: 1. Diesel for land and sea transport will be a blend of 5 per cent processed palm oil with 95 per cent petroleum diesel1 (B5 diesel). 2. B5 diesel will be supplied to the industrial sector including for firing boilers in manufacturing, construction machinery and generators. 3. The Malaysian Standard specifications for B5 diesel will be established. 4. Support or tax incentives will be provided for setting up a palm oil biodiesel plant.

4. Biodiesel Players in Malaysia

Figure 2 shows Malaysian companies that have announced their biodiesel venture plans. They include Sabah-based Palm Oil Biodiesel International Sdn Bhd, IOI Corp Bhd, Golden Hope Plantations Bhd, Johor-based Carotino Sdn Bhd, Ipoh-based Carotech Bhd, Kumpulan Fima Bhd, Kulim (Malaysia) Bhd, TSH Resources Bhd and the Federal Land Development Authority (Felda). To date, seven plants have been approved with a total capacity of 500,000 tonnes per annum. In addition, there are 20 license applications with a total capacity of 2 million tonnes per annum still under consideration.

Palm Oil Diesel Int1 (Sabah)

TSH Resources Kulim (Msia)

IOI Corp

Biodiesel Players in Malaysia

Kumpulan FIRMA Carotech (Ipoh)

Golden Hope Plantations

Carotino (Johor)

FELDA

Figure 2: Biodiesel players in Malaysia

Total diesel consumption in Malaysia = 10 million tones per annum; 5 per cent RBD palm olein = 500,000 tonnes per annum. According to MPOBs leverage model, removal of 500,000 tonnes palm oil from stocks will result in an average CPO price increase of around RM300 per tonne.

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From a Malaysian perspective, it would be very interesting to analyse the impact of biodiesel growth on the palm oil industry for at least three reasons: (i) this industry provides direct employment to 570,000 people, (ii) it is a significant foreign exchange earner2, and (iii) it has one of the highest social standards in the agricultural sector (Chandran 2005).

5. Implications of Biodiesel Growth on the Palm Oil Industry

The implications of biodiesel growth on the palm oil industry are analysed along the palm oil value chain (Figure 3). Five key implications have been identified raw materials supply gap, stock management mechanism, intensification of R&D efforts to improve yield, increase in hectarage and the opening up of new research frontiers producing cellulosic ethanol from palm biomass.

Oleochemicals Plantations Milling Refining Biodiesel Palm biomass from replanting, EFB, fibres and fruit shells Customer

- Increase yield: (i) i n t e n s i f y sustainable plantation practices (ii) c o n t i n u o u s improvement in planting materials - Increase hectarage in a responsible way

Raw materials supply gap

Stock management mechanism

R&D: cellulosic bio-ethanol

Figure 3: Implications of biodiesel growth along the palm oil value chain

5.1 Raw Materials Supply Gap The European Union (EU) with Germany taking the lead, is now the major user of vegetable oils for fuel (Figure 4) and Promar International (2005) expects it to remain so in the foreseeable future. The EUs production of biodiesel has jumped four-fold over the last five years (Figure 5) and is targeted to reach 13.5 million mt/year in 2010. The rapid growth in demand for vegetable oils to produce biodiesel in Europe has significantly contributed to increased pressure on global supplies because it will need to draw supplementary supplies of oilseeds
2

RM30 bn or USD7.9 bn in 2004.

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and oil for food, fuel and industrial use from the world market (Promar International 2005). Across the Atlantic, the US biodiesel production is also rising (Figure 6). It is worth noting that even in 2005, the US production was only 27 per cent of the EU production in 2001.
million tonnes 2.00 1.60 1.20 0.80 0.40 0.00 EU World US 0.29 0.14 Worldwide 1.93

Source: CIMB estimates, European Biodiesel Board

Figure 4: Global biodiesel output in 2004

EU
000 MT

5,000 4,000 3,000 2,000 1,000 0 926 2001

Production Capacity
2048 1065 2002 1434 2003 1933 2004 2246

4060

2005

Source: European Biodiesel Board Figure 5: EUs production of biodiesel

700000 600000 500000 400000 300000 200000 100000 0

16850 40000 2001 50550 60000 70000 67400 2003 84250 2004 2005 252750

Production Capacity

606600

2002

Note: Capacity information for 2004 was not available Source: National Biodiesel Board and IEA (2004) Figure 6: USAs biodiesel production

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If the demand expectation of vegetable oil for fuel use materialises, it will bring substantial increment over an already rapid pace of growth in world consumption. Currently, 84 per cent of the raw materials for biodiesel production come from rapeseed oil (Figure 7). Production of vegetable oils like rapeseed and soybean has been stretched. Given that the European biodiesel demand is expected to rise to 13.5 million tonne per annum and production in other major markets like the US is also expected to increase, it would be difficult for the rapeseed and sunflower industry to provide all the raw materials required. Hence, the palm oil industry could play a complementary role in filling the raw materials supply gap and also balance the supply of oil for food.

Source: CIMB Report (Nov. 2005); Austrian Biofuels Institute

Figure 7: Raw materials for biodiesel production

5.2 Stock Management Mechanism Historically, a high portion of the rise in demand has been from the food sector which absorbs the bulk of global edible oils. Vegetable oil prices have been observed to stabilise as a result of competing applications like biodiesel production. In fact, certain modelling work suggests a substantial uplift in vegetable oil prices above historical levels because of the increased demand for fuel and industrial purposes (Promar International 2005). Palm oil prices are perceived to be undervalued at the moment due to lack of negotiating power, especially with big importers like India who have leveraged the price downward by imposing heavy import duties. Malaysia and Indonesia are keen to change the predicament of undervalued palm oil. It would be possible to direct palm oil to biodiesel if the food industry refuses to pay a fair price for this oil that has superior nutritional properties over other vegetable oils. For example, it is the only oil that can contribute towards improved vitamin A intake of the population; palm olein is better than olive oil in terms of nutritional value, according to studies contracted out by the Malaysian Palm Oil Promotion Council (MPOPC). 5.3 Efforts to Increase Yield 5.3.1 Intensify Sustainable Plantation Practices With increasing environmental awareness, people are also looking at clean fuels in a more complete sense. They want not just fuel free of harmful pollutants such as sulphur dioxide and emits less carbon dioxide than conventional fuels, but are also concerned about the

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environmental sustainability of the fuel source. For example, whilst ethanol-based fuels have reached a high commercial sophistication in Brazil, Brazils sugar industry is also facing opposition at home. Brazilian campaign groups blame sugar plantations for a multiplicity of sins, including soil degradation, deforestation, urbanisation and poor labour conditions. People do not want a fuel that is good for the climate, but comes from a source that is disastrous for the environment. This underscores the importance of sustainable plantation practices. In response to increasing palm oil demands, Malaysian oil palm companies are intensifying sustainable plantation practices as a measure to increase yield. These practices include soil conservation, water management, effluent treatment and oil mill waste recycling. One particularly interesting example is the zero burning replanting technique which is a practice in which the old and uneconomical stands of oil palm and other tree crops are felled and shredded and left to decompose in situ. It allows all plant tissues to be recycled and enhances the organic matter in soil. This helps to restore and improve soil fertility. The biomass of the palm residue through decomposition recycles nutrients into the soil and reduces the input of inorganic fertilisers (Sabri et al. 2004). It is worth noting that the aforementioned sustainable plantation practices are not secret competitive advantages of one or two plantation companies but are shared knowledge within the oil palm industry in Malaysia. Through the Roundtable for Sustainable Palm Oil (RSPO), Malaysian companies are also working to share these practices with their Indonesian counterparts because both countries, which produce 80 per cent of the worlds palm oil, should jointly carry the custodianship responsibilities of the palm oil industry. 5.3.2 Continuous Improvement in Planting Materials Besides focusing on the quality of planting techniques, the oil palm industry also continues to work on improving the quality of planting materials. For example, the oil palm breeding programme at the Golden Hope Research Centre has resulted in high quality planting materials that are well known for their high oil yield, adaptability and uniformity in the plantation industry. The latest GH 500 series DxP3 materials have a very high laboratory oil-to-bunch ratio exceeding 31per cent, which provides a potential oil extraction rate (OER) exceeding 25 per cent in commercial oil mills (Golden Hope Annual Report 2005). Further, tissue culture enables another 30 per cent increase in yield over DxP materials. 5.4 Increased Plantation Hectarage Besides pushing forward on the yield enhancement front, there are also plans to increase plantation hectarage to meet increasing palm oil demand. As increasing plantation hectarage can raise biodiversity concerns, a further discussion of this issue would be relevant. While biodiversity refers to the full variety of flora and fauna, it is often the potential impact on large animals, such as the orang utan, that receives the most public concern. The Malaysian and Indonesian governments are planning to jointly fund biodiversity research and conservation programmes for orang utan. The Malaysian Palm Oil Board (MPOB) is DxP is a cross between Dura and Pisifera mother palms.

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already undertaking studies on whether the development of land for oil palm plantations has resulted in biodiversity reduction and whether some species can make oil palm plantations as their habitat. It is not uncommon for considerable mud-throwing in such NGO-industry attacks and counter-attacks. People need to come to terms with the reality that plantation companies are here to stay in the foreseeable future because the world depends on them for food to a considerable extent Malaysian palm oil is consumed in over 140 countries worldwide (Chandran 2005). Hence, the essence underlying the debates and controversies is not about who wins the argument or who is able to nail the other party but rather, whether plantation companies perceive custodianship or ownership over people, planet and profits. In this context, the ethos of the industry is perceived to be progressing in the direction of custodianship. Evidence that supports this perception include environment-friendly measures such as planned land management, environment impact assessments and integrated pest management when new plantations are being established. Environmental quality is also further enhanced by biodiversity and conservation practices like establishment of green lungs, riparian borders and high conservation value forests. In addition, the industrys sustainable practices also include socio-economic provisions of utilities, housing, medical facilities and welfare for plantation workers (Golden Hope 2005; Bek-Nielsen 2006). All these examples point towards a sense of custodianship instead of ownership which tends to lead to abuse and exploitation. The next question that the world should ask is how we might help exemplary plantation companies to coach and induce the relatively small number of wayward companies that cause sustainability concerns to play by the rules. Building lines of communication and expanding benign influence is the way forward. Shunning an entire industry just because of a few black sheep is not appropriate. 5.5 R&D: Cellulosic Ethanol from Palm Biomass In response to the growth in demand for biofuels, Malaysian oil palm companies are planning R&D to produce cellulosic ethanol from palm biomass, which is almost 100 per cent environment friendly. The cellulosic material of interest here are palm biomass from replanting, empty fruit bunches, fibres and fruit shells of the palm tree, which are fibrous and do not threaten food supply. Producing biodiesel also requires alcohol. Apparently, among the most land-efficient and energy-efficient methods of producing alcohol are from hydrolysis and fermentation of plant cellulose (Briggs 2004). The US National Resources Defence Council (NRDC) and the Union of Concerned Scientists said in a joint statement that cellulosic ethanol is at least as likely as hydrogen to be the fuel of choice in a sustainable transportation sector of the future. Shell Oil predicted the global market for biofuels such as cellulosic ethanol would grow to exceed USD10 billion by 2012. Hence, cellulosic ethanol is something that the oil palm industry would definitely want to look at. A frequent concern about biomass fuels is that they might reduce food supplies. However, current technology suggests that large scale conversion of lignocellulosic biomass to fuels and chemicals may make human food and animal feed both cheaper and more abundant because foods/feeds are co-produced with fuels and chemicals from plant biomass

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(Figure 8). The large capital infrastructure associated with ethanol production is also likely to constitute the backbone for a future bio-refining industry that will produce a wide variety of industrial chemicals and materials.

Figure 8: Bio-refinery (Elde 2005)

6. Inter-Linkages between Petroleum, CPO and Biodiesel Prices

A question that many are asking is what level of petroleum price would make biodiesel profitable? The answer will vary according to location, on account of differing levels of incentives. Demand for biodiesel or other green energy is not as price sensitive as for edible use because demand for biodiesel is not only influenced by price, but also by factors such as those shown in Figure 9.
R&D: reduction in production cost of renewable fuels vs. changes in fossil fuel cost Price Increasing Energy Needs E.g. China and India Regulatory changes from tax incentives to fuel substitution obligation could alter involvement of oil majors Mandatory Government policies: Regulations encourage local consumption/export?

Carbon emissions Kyoto Protocol

Demand for Biodiesel/ Green Energy

Protectionist/National Reflexes - Domestic support to agriculture and farmers - Policy instrument to provide domestic agricultural employment: sustainable development

EU Directive 2003/96/EC: minimum taxation for all energy products for use or sale as motor or heating fuel

Security - Instability in the Middle East region - Political necessity of reducing dependence on OPEC - Priority could be given to domestic crops to increase security

Figure 9: Factors that influence the demand for biodiesel/green energy

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To gain insights into the inter-linkages between petroleum, CPO, and biodiesel prices, a system dynamics model (Kennedy 2006) was developed to explore the inter-linkages from two perspectives: 1. Equilibrium approach: palm biodiesel and petrodiesel prices are compared for given prices of crude palm oil and petroleum. Similar analyses have been performed on other feedstocks for biodiesel that illustrate the direct relationship between petroleum prices and biodiesel profitability. 2. Dynamic approach: assumption that prices must remain fixed is relaxed and how biodiesel and CPO prices respond dynamically to changes in the oil price and CPO production rates are examined. 6.1 Equilibrium Approach 6.1.1 Biodiesel Production Cost The production cost of palm biodiesel (PPD) can be calculated based on the price of crude palm oil and methanol for trans-esterification, plus a conversion cost, minus the revenue received from the glycerol by-product. The relationship is illustrated in the following formula: PPD = 1.04 x (PCPO + 0.112 PM + PC - 0.1 PG) where PCPO is the CPO price, PM is the methanol price, PC is the conversion price per tonne of CPO, and PG is the glycerol price. Current market prices are approximately USD405 per tonne for CPO (Anhar 2006) and USD290/mt for methanol (Platts 2006a). Without further processing, the glycerine by-product from current technology employed by MPOB can be sold for around USD150/mt (Anhar 2006). Conversion costs will be estimated at USD80/mt. With these values, the production cost of palm biodiesel is approximately USD523/mt, or USD0.47/ litre. The capital investment cost can be incorporated into the palm diesel price by assuming that the full initial investment must be recovered in T = 10 years with an interest rate of r = 10 per cent. Assuming an annual plant capacity, C = 150,000 tonnes and a capital investment of USD9 million, an additional USD0.0087/L must be added to the palm diesel price, coming to a total of USD0.48/L. The annual repayment, A, of the initial investment P, can be found from the following formula: A= (1)4

Pr
1000.C (1-(1+r)-T)

(2)

The coefficients for Equation 1 are from an unpublished report that cites MPOB. Since there is not much published data available on palm biodiesel yet, this is the only unpublished reference that Kennedy could find. The coefficients essentially come from the mass balance of converting crude palm oil into biodiesel.

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where the density of the biodiesel, , is 0.89kg/L. Considering that palm diesel delivers 10 per cent less energy per unit volume than petrol diesel, the price is then USD 0.53 per diesel equivalent litre of palm biodiesel. 6.1.2 Petrodiesel Price The price of petrodiesel is about linearly proportional to crude oil price. Weekly US market prices for diesel and US crude oil prices from January 1997 through February 2006 are shown with a linear trend line in Figure 10 to illustrate this relationship (EIA 2006).

Figure 10: Relationship between diesel and crude oil prices with trendline shown

A previous study by Promar International (2005) compared the profitability of soybean biodiesel with petrodiesel for a range of crude oil prices. A similar approach is used here except that now the price for soybean biodiesel is replaced by the price formula given in Eqn. (1) for palm biodiesel. The same values for methanol, glycerol and the conversion cost are used as given in the previous section. The delivered cost of petrodiesel was broken into the diesel price and the transport cost. Values used by Promar International (2005) are shown in Table 2. The cost of transporting B100 biodiesel to the terminal was assumed to rise linearly from USD0.026/L - USD0.032/L for crude oil prices ranging between USD20/bbl - USD70/bbl.
Table 2: Terminal diesel prices at alternative costs for crude oil (adapted from Promar International 2005) Crude petroleum price (USD/bbl) Diesel price (USD/L) Transport to terminal (USD/L) Diesel cost to terminal (USD/L) 20 0.17 0.037 0.20 30 0.25 0.040 0.29 40 0.32 0.042 0.37 50 0.40 0.045 0.45 60 0.48 0.048 0.53 70 0.56 0.050 0.61

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6.1.3 Results Figure 11 shows the profitability of palm biodiesel for crude oil prices ranging from USD20/ bbl to USD70/bbl. The profitability is found by subtracting the delivered cost of palm biodiesel from the delivered cost of petrodiesel. At positive profitability, the price of palm biodiesel is less than that of petrodiesel. When the crude oil price is around USD38/bbl or less, palm biodiesel is not profitable even for a very low CPO price of USD200/tonne. Meanwhile, at a crude oil price of USD70/bbl, the palm biodiesel is profitable for CPO at around USD450/tonne or less.

Figure 11: Palm biodiesel profitability as a function of oil price and crude palm oil price

6.2 Dynamic Approach In actual market conditions, it is well known that the price of crude oil never remains fixed, but rises and falls due to changes in the cost and availability of supply as well as changes in demand. Commodities such as diesel and crude palm oil are no different and prices and production rates both experience a high degree of volatility. Figure 12 shows the variation in CPO production rates in Malaysia from 1980 through 2004. The plot reveals an annual cycle in production superimposed on an exponentially increasing trend. The amplitude of the oscillations has increased as the mean annual production rate has risen. Figure 13 shows the local Malaysian prices for CPO from the year 2000 through 2004. In this case, an obvious trend or cyclical pattern is less apparent. While prices sometimes appear to fluctuate randomly, there is an often underlying structure on both the demand and supply side that influences market behaviour. Such a structure is often influenced by the time lags and capacity limits at different stages along the supply chain. The time varying behaviour is also affected by consumer delays in responding to price signals, or physical delays such as the maturation period for the oil palm crop.

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Figure 12: Production rate for crude palm oil in Malaysia (MPOB 2006)

Figure 13: Local crude palm oil prices in Malaysia (MPOB 2006)

For such time varying systems, system dynamics can be a powerful tool for exploring how the market structure and various system parameters affect system behaviour. For the present study, a system dynamics model has been developed to explore the interaction between CPO, oil, refined palm oil (RPO), and palm biodiesel prices; all based on local Malaysian prices and production volumes. A system dynamics model is built upon a set of variables that are interconnected by causal relationships. For instance, as oil palm cultivation increases, the amount of CPO produced will also increase, albeit with some delay. To generate a model that can run as a simulation, the causal relationships must be expressed as mathematical relationships; otherwise, purely conceptual models that do not require mathematical foundations can also

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be built to understand the system structure. In addition to the model variables, model parameters such as characteristic time delays or price elasticities constitute another important component. As the set of variables and parameters becomes interconnected, feedback loops become apparent. These loops tend to govern the dynamics of the system. For the palm biodiesel model, a simplified version of the full system dynamics model is shown in Figure 14. This illustration shows the models basic structure which comprises three feedback loops. The furthest loop to the left represents the influence of oil palm cultivation on the CPO price. As cultivated land increases, the production of CPO will also increase, raising stocks and lowering the CPO price. A lower CPO price reduces profitability, which will put downward pressure on expanding cultivation, thereby preventing the price from dropping further. As it takes more than two years for newly planted palm to bear fruit and up to seven years to reach peak output, there is obviously a long time lag in the cultivation feedback loop. The CPO price is also influenced by demand, which in the present model comprises the palm biodiesel and refined palm oil (RPO) markets. These two loops have a similar structure in that increases in both RPO and palm biodiesel prices constrain demand and the feedback response times are much shorter. The demand for palm biodiesel is also influenced by the total demand for biodiesel from all feedstocks, which is determined by the crude oil price and biodiesel subsidies. A more comprehensive picture of the full system dynamics model is included in the Appendix.

Figure 14: Primary feedback loops for system dynamics model of palm biodiesel, CPO and RPO markets

6.2.1 Price Setting Mechanisms A key building block of the model is the relationship between CPO availability and price. Historical price and availability data from MPOB (2006) reveal a strong relationship between the CPO price and inventory coverage. Inventory coverage is found from the stock for a given month divided by the sales rate. Hence, the inventory coverage is the length of time that present stocks will last at the current sales rate. The influence of inventory coverage

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on CPO price was found to be strongest when both quantities are averaged over a 17-month period, as shown in Figure 15. The data fit to a power law relationship that is shown in the figure. The relationship between CPO price and inventory coverage was found to be much stronger than the more frequently used correlation between CPO prices and stocks. By comparing prices to inventory coverage as opposed to stocks, the influence of demand on CPO availability is included more directly. The system dynamics model used the power law relationship shown in Figure 15 to determine a moving average CPO price based on the inventory coverage over the past 17 months.5 From the CPO price series shown previously, it is clear that prices can vary significantly from month to month. To capture the shorter term variability that is lost in the 17-month average, a second price component was added to the long-term trend. In this case, the 17month average was subtracted from the original price data and this resulting data, referred to as the price residual, was regressed linearly on the monthly inventory coverage. Figure 15 shows the inventory coverage and the price residuals for a given month. The model determines the CPO price for a given month from both the long- and shortterm price relations. First, the 17-month average inventory coverage is calculated and input into the power law formula to determine the 17-month average CPO price. Then, the inventory coverage for that given month alone is input into the linear relation shown in Figure 16 to determine the price residual, which is added to the 17-month average price to get the CPO price for that given month.

Figure 15: Relationship between CPO prices and inventory coverage averaged over 17 months

6.2.2 Palm Oil Extraction Rate An additional feedback, not shown in the simplified illustration in Figure 14, but shown in the Appendix, is the effect that the CPO price has on the oil extraction rate (OER). Examining the historical relationship between the CPO price and the OER, an interesting interdependence was observed. Figure 17 shows 14-month average values of the OER and CPO price. It appears that as the long-term average OER increases from 0.19 to higher

The averaging procedure utilised a first-order exponential smoothing technique (Sterman 2000).

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Figure 16: Price residual versus simultaneous inventory coverage

Figure 17: Inter-relationship between long-term average oil extraction rate and CPO price

values, the long-term average CPO price also increases. Yet, as the OER drops below 0.19, the CPO price increases. There has not been a detailed investigation into why this phenomenon occurs; however, it is hypothesised that the causal relationship between the OER and CPO price may be bi-directional. When CPO prices are high, there is sufficient incentive for producers to extract as much oil as possible out of the current crop, resulting in a high CPO price causing a relatively high OER. On the other hand, when there is a poor crop with a low OER, production rates are insufficient and the CPO price again will increase. In this case, the causation is reversed and the low OER causes an increase in the CPO price. For the present model, only the former mechanism is included and the CPO price for a given month is assumed to determine the OER. This mechanism provides an important negative feedback that responds on a much shorter time scale than the oil palm cultivation loop. High CPO prices cause an immediate increase in production through a raised OER, which has a moderate stabilising effect on the CPO price. The relationship between the OER

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Figure 18: Dependence of OER on CPO price

and CPO price for a given month (that is, not averaged over time) is shown in Figure 18. In this case, the axes have been switched to indicate that the CPO price is now considered as the independent variable that is causing a modification in the OER. 6.2.3 Model Validation In discussing the accuracy and appropriateness of the model, it should be emphasised that the primary intent of this study has been to develop an exploratory as opposed to a predictive tool. The model cannot be used to recreate and predict all aspects of the palm biodiesel market into the future, but can be used to examine the influence of particular system components. By modifying the values of individual parameters such as the peak fresh fruit bunches (FFB) production rate or the price elasticity of biodiesel demand, the digression of key model variables from a baseline can be assessed. The baseline scenario used in the following analyses has simply been the system equilibrium. Assuming fixed values for oil price and production costs (CPO, palm biodiesel and RPO), the model can be run to generate fixed values for all system variables. This equilibrium conforms to results obtained in Section 6.1. Modifications in any system parameters can easily be made to determine a new equilibrium. Other model components can be run in isolation to determine their accuracy. For example, the oil palm cultivation loop can be isolated and tested for a single pulse increase in cultivated area. In other words, assuming a given amount of hectares of land cultivated at year zero, the production rate of FFB over the next 30 years can be simulated and compared to typical production data. Other components of the model can be tested in a similar fashion. 6.2.4 Scenario Analysis To understand the dynamics of the modelled system, it will be useful to test the response to external shocks that perturb the system from its equilibrium. Equilibrium is defined when all prices, production rates, and demands are fixed in time. The three shocks that will be illustrated here include: 1. Oil price ramp-down from USD60/bbl to USD40/bbl over the course of one year

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Figure 19: Oil price ramp-down

2. 3.

Oil price ramp-up from USD60/bbl to USD80/bbl over one year CPO production rate oscillation according to an annual cycle

1. Oil price shock (ramp-down) In this scenario, the price of oil has a constant rate drop from USD60/bbl to USD40/bbl over the course of one year. The effect that the price drop has on the CPO price and the palm biodiesel demand is shown in Figure 19. A drop in the oil price reduces the overall demand for biodiesel, which reduces the demand and price for CPO. Before the price drop, the equilibrium values for the CPO price and palm biodiesel demand were USD358/tonne and 321,746 tonnes/month, respectively. While the price drop occurs over one year, it takes approximately four years for the CPO price and palm biodiesel demand to settle to their new equilibrium at USD340/tonne and 104,090 tonnes/month, respectively. The drop in CPO price is relatively small because the CPO price reduction has encouraged a higher demand for RPO. The RPO demand, not shown in the figure, has increased from 2.25 to 2.46 million tonnes per month. The total cultivated area experienced no change because the small change in profitability of CPO production is not sufficient to change replanting rate. The profitability of new cultivation is negative, so there is no new cultivation. 2. Oil price shock (ramp-up) In this scenario, the price of oil has a constant ramp-up rate from USD60/bbl to USD80/bbl over the course of one year. In this case, a higher oil price spurs greater biodiesel demand, which increases the demand for CPO. The response is similar to the oil price drop, except that now the CPO price peaks at about USD360/tonne after four years and then begins to slowly decline. The reason for the slow decline is due to the higher profitability of CPO production at the elevated CPO price, which encourages expanded cultivation at about 3,000 ha per year. There is a long delay for the new cultivation to increase production rates, hence a slow decline in the CPO price.

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Figure 20: Oil price ramp-up

3. Production rate oscillation In this scenario, the production rate oscillates with a 12-month period and maximum and minimum values that are 25 per cent above and below the mean. The oil price is kept constant at USD60/bbl. The intent of this scenario is to determine the lag at which the CPO price responds to changes in the production rate. As shown in Figure 21, there is a lag of 7 months between a peak in the production rate and a peak in the CPO price.

Figure 21: CPO production rate oscillation

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6.3 Further Work The scenarios tested and shown here have been relatively straightforward and used more as a means to introduce the model. There is a great deal of further analysis that could be undertaken. Ideally, the tool should be used interactively with experts in the field to refine the model structure and parameters and hopefully provide some insight. An example of an interesting application would be to assess the feasibility of using a varying biodiesel market mandate (for example, a mandated blending ratio) to stabilise the volatility of the CPO price. Difficulties that would complicate this mechanism are the time delays in the impact of biodiesel demand on the CPO price and the influence of a gradual increase in CPO production due to increased cultivation.

7. Future Outlook
The high oil price is a result of old fashioned demand and supply. Besides the lack of new reserves and shortage of production capacity, supplies are also threatened by violence in Iraq, a row over Irans nuclear ambitions, nationalistic governments in Latin America, instability in Nigeria and more. Many experts attribute USD10-USD15 of the current price of oil to geopolitical worries. 7.1 Supply High prices, and the absence of the usual cushion, have made the global economy vulnerable to disruptions, be they natural disasters such as Hurricane Katrina or power struggles like that between Russia and Ukraine.6 In Latin America, Hugo Chvez, Venezuelas president, is recently said to be planning to raise taxes and royalties on foreign oil companies. Some fear that this nationalistic move would hamper the effective exploitation of Venezuelas 77 billion barrels of proven reserves, the largest outside the Middle East. There are similar concerns over Mexicos nearly 15 billion barrels. Sustainable energy policies around the world and the drive by governments to reduce diesel subsidy augur well for the biodiesel industry. The Chinese government, for example, expects to have 20 per cent of Chinas energy supply from renewable energy by 2020. The Indian Government is also introducing a USD300 million programme to encourage biofuels development and production, and is also in the process of mandating the blending of biodiesel with mineral diesel. A 5 per cent blend is expected to be introduced shortly, rising to 20 per cent by 2020. Palm oil is well placed to meet the demand for vegetable oil demand of these two rapidly growing economies, both logistically (with short supply routes from Malaysia and Indonesia) and in terms of cost competitiveness. In his State of the Union address in January 2006, President George Bush backed financing for cutting-edge methods of producing ethanol, not just from corn but wood chips and stalks or switch grass with the goal of making ethanol competitive in six years. An energy bill has been enacted recently to mandate the use of 250 million gallons of cellulosic ethanol a year by 2013.

In January 2006, Russias president, Mr. Vladmir Putin, cut off gas supplies to Ukraine for two days over a price dispute, on the very day he became president of the G8 rich nations group.

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7.2 Demand Moving on to demand, Americas and Chinas hunger for oil continues apace. In his stateof-the-union speech, President George Bush confessed that America is addicted to oil. In 2003, China overtook Japan to become the worlds second largest oil consumer after America. Energy security therefore plays a growing part in Chinas foreign policy and we are seeing the consequences of that - China is making alliances with oil producers regardless of their democratic or human-rights credentials, for example with Sudan and Iran. India, with the second biggest pool of English speakers, a strong system of higher education, important natural resources and a business friendly government, is set to become a major player on the world economic stage. As these two new industrial powers rise, they will need an increasing amount of energy to support their growth. The growing energy and food demands are also fuelled by a growing world population. India, with an annual population growth of 1.6 per cent, twice that of Chinas rate, is expected to overtake its neighbour as the worlds most populous nation around 2035. The US Census Bureau estimates that world population will exceed 9 billion in 2050. Although predictions that people would multiply beyond their capacity to feed themselves have repeatedly been proved wrong7, 850m people are still starving today. This is one out of six people on the planet. The irony is that a vast majority of these people depend on agriculture. It is clear that agriculture has a role to play in alleviating poverty.

8. Conclusion
The pull between fuel and food for palm oil is expected to remain in the forseeable future. The constant tug will remind the world that resources of energy and food are not unlimited. Many think of biodiesel as a new source of power for supporting the fossil- fuelled technology, particularly the technology of transportation, and are now busy exploring the use of this power. However, the road of ever increasing personal mobility leads nowhere if it does not create maturity (Platts 2006b). Just like any other form of power, this form of power, too, tends to corrupt in the end. And absolute power corrupts absolutely. Hence, the palm oil industry needs to keep watch of its own activities amidst the enthusiasm of meeting increasing palm oil demand coming from the biodiesel industry. Players of the palm oil industry need to collectively shape activities and the development and allocation of resources to ensure that their companies undertake the work of meeting new oil demand in a responsible manner. A company does not exist purely to maximise shareholder value, but more importantly, to serve societys needs. In this context, industry leaders need to think about a companys long term potential and the role it plays for mankind. The three Ps bottomline principle people, planet and profit would serve as a good guideline in this process.

In 1798, Thomas Malthus foretold famine just as farm yields were taking off. To his credit, he later admitted that he was wrong. Not so Paul Ehrlich, an American biologist who wrote in 1969: The battle to feed humanity is over. In the 1970s hundreds of millions of people will starve to death. They did not. (Source: www.economist.com)

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Acknowledgements
The authors wish to thank Dr Yuen Yoong Loong, Tuan Haji Khairudin Hashim, Dr. Anhar Suki and Dr. V. Tripathi for their generous inputs and helpful comments.

References
Anhar, S. 2006. Feedback to Biodiesels Growth and its Impact on the Palm Oil Industry. Unpublished report. Kuala Lumpur: Golden Hope Plantations Bhd Basiron, Y. and Simeh, M. A. 2005. Vision 2020 - the palm oil phenomenon. Oil Palm Industry Economic Journal 5(2). Bek-Nielsen, C. 2006. Sustainable Palm Oil Production and the Price Outlook for 2006. Paper presented at the Price Outlook Conference 2006. Kuala Lumpur, Felda Marketing Services. Briggs, M. 2004. The Answer is Biodiesel, UNH Biodiesel. Chandran, M. R. 2005. Directions for the Plantation Industry to Focus for Productivity and Yield Enhancement. In BCDSM Seminar 2005: Latest Developments on Sustainability in the Palm Oil Industry. EIA. 2006. International and United States Petroleum (Oil) Price and Crude Oil Import Cost Tables, Energy Information Administration. Elde, R. 2005. Biomass: Status and Potential. Paper presented at the Workshop on Renewable Energy for Minnesota. Minnesota. Golden Hope. 2005. Golden Hope 2005 Annual Report. Kuala Lumpur, Golden Hope Plantations Berhad. IEA. 2004. Biofuels for Transport: An International Perspective, International Energy Agency. Kennedy, S. W. 2006. An Evaluation of Biodiesel, Crude Palm Oil and Petroleum Price Linkages; A Report Prepared for Golden Hope Plantations Bhd. Kuala Lumpur, STE Consulting. Knothe, G. and R. O. Dunne. 2004. Biodiesel: The Use of Vegetable Oils and Their Derivatives as Alternative Diesel Fuel, Oil Chemical Research, National Centre for Agricultural Utilization Research, Agricultural Research Service, US Department of Agriculture. Malaysia. 2006. The National Biofuel Policy. Kuala Lumpur, Ministry of Plantation Industries and Commodities. MPOB. 2006. Local prices of CPO, PK, and CPKO, Economics and Industry Development Region, Malaysian Palm Oil Board. Platts, J. 2006a. Methanex Rolls Over Asian Methanol CP for April at $330/mt CFR. Platts Petrochemical Report, http://www.platts.com. Platts, J. 2006b. Finding the Other Road. Concept Paper for the Automotive Academy. Cambridge, UK. Promar International. 2005. Evaluation and Analysis of Vegetable Oil Markets. Alexandria, VA, Promar International. Sabri, A., H. Khairudin and Y.L. Yuen. 2004. Sustainable Palm Oil Practices: Case Study of Golden Hope Plantations. Unpublished report. Kuala Lumpur: Golden Hope Plantations Bhd. Sterman, J.D. 2000. Business Dynamics: Modelling and Simulation for a Complex World. New York: McGraw Hill. Wikipedia. 2006. Palm Oil, http://en.wikipedia.org.

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Appendix

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Figure A1: Influence of oil price on biodiesel demand

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Figure A2: CPO price setting loop

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Figure A3: Palm biodiesel price setting loop

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Figure A4: RPO

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Figure A5: Oil palm cultivation loop