Industry
Blowing Hot: How climate crisis can rain on FMCG’s FY25 show
Summary
- From the lush jungles of West Africa to the vast plantations in Southeast Asia, climate change is disrupting production of key agri commodities like palm oil and cocoa. What downside risk does this pose for India’s fast-moving consumer goods companies?
New Delhi: On a winter day more than 60 years ago, American mathematician and meteorologist Edward Lorenz punched some data into a simple digital computer to simulate weather patterns. This was not the first time he had run this simulation, which was based on 12 variables like temperature and wind speed.
After entering all the data, he went downstairs from his office at the Massachusetts Institute of Technology (MIT) to grab some coffee while the computer ran the program. When he returned, he noticed the result was drastically different from the earlier simulations he had conducted.
Combing through the numbers, Lorenz noticed he had rounded off one variable from 0.506127 to 0.506. This seemingly minuscule alteration resulted in a tremendous impact on the final outcome.
And thus was born modern chaos theory, also known as the ‘butterfly effect’—a rather poetic denotation of the flapping of a butterfly’s wing culminating in a tornado halfway across the globe.
The ‘butterfly effect’, which demonstrates how complex and intertwined our world is, finds usage in fields as diverse as meteorology, economics, biology, finance, history and even pop culture.
Which begs the question—if even small events can result in big consequences, what will be the aftermath of mega trends? Like climate change, for example?
India’s fast-moving consumer goods (FMCG) companies may soon just find out.
Palm Pressure
Palm fruit oil, commonly known as palm oil, is the most widely consumed vegetable oil on the planet.
To say that palm oil is the lifeblood of the FMCG sector would hardly be an overstatement.
Palm oil and its derivatives are the primary inputs for a wide range of FMCG products, from processed food items like biscuits, chocolates, chips, instant noodles and bread to household products such as soaps, lotions, shampoos and detergents.
It is among the most widely tracked input cost heads of consumer staples companies. For example, palm oil accounts for 50-60% of the input costs in soap manufacturing.
India is the world’s biggest importer of palm oil. The country’s palm oil imports surged 24% to a record 9.79 million metric tonnes (mt) in the 2022-23 marketing year ended 31 October, as per the Solvent Extractors’ Association of India (SEA), an industry body.
India constitutes over 20% of the global palm oil trade, more than double than the next biggest importer China. Almost all of India’s palm oil demand is met through overseas shipments. Around 70% of domestic palm oil consumption is in the form of edible oil by households and commercial establishments, with the rest being used by the FMCG sector and other industries.
On the production side, Indonesia is the world’s largest producer of palm oil (53 million tonnes in 2023), followed by Malaysia (18.5 million tonnes). These two countries are the lynchpins of the global palm oil industry, accounting for around 80% of the total exports.
Nature too seems to have reserved her bounty for these two nations.
Around 90% of the world’s oil palm trees are grown on a few islands in Malaysia and Indonesia—islands with the most biodiverse tropical forests in the world.
The oil palm tree (Elaeis Guineensis) thrives on sun and humidity. It needs plenty of sunshine, a temperature range of 24°C and 32°C, and rainfall evenly distributed throughout the year. However, this careful equilibrium risks being upended by extreme weather events caused by climate change.
Palm oil output in Indonesia and Malaysia is forecast to remain stagnant in 2024 or even decline from last year’s level, analysts told the edible oil industry’s biggest annual conference in Kuala Lumpur on 6 March. At the same conference, Dorab Mistry, director at Godrej International Ltd, highlighted how “capricious climate" is the biggest factor affecting agri-commodity prices.
While the El Nino phenomenon of 2023 turned out to be a lot milder than expected and hardly affected the palm belt, analysts caution against complacency when it comes to extreme weather events.
“Climate change is disrupting weather patterns, which is clearly having an impact on palm oil production. While the current spurt in prices is also due to seasonal factors, as production typically drops in the beginning of the year and there are labour shortages too in Indonesia and Malaysia due to Ramzan, one cannot ignore the impact climate change is having on the palm oil ecosystem," Sanjeeban Sarkar, a commodities analyst who tracks palm oil, told Mint on phone from London.
Speculators are also trying to cash in on the climate change-triggered volatility, which is further driving prices northward, he added.
Sarkar, a former commodities editor at the Economist Intelligence Unit (EIU), highlighted that a lot of agri-commodities are witnessing weather-related disturbance. For example, a few years back, freak episodes of frost in Brazil decimated the coffee crop.
“One can observe this with many commodities. If seen in isolation, these headlines can appear anecdotal, but looking at the overall picture, one can clearly see ominous signs of climate change in action," he added.
Paradoxically, the palm oil industry might be a victim of its own dynamics. Thanks to soaring demand and gushing profits, growers are cutting down tropical forests to increase the size of their plantations. But this deforestation itself is accelerating the negative effects of global warming, with the sector being one of the major sufferers.
In a widely-cited research paper a couple of years back, Ahmed A., Mohd Y. B. I. and Abdullah A. M., faculty of forestry and environment at Universiti Putra Malaysia (UPM), wrote that climate change imposes serious challenges in oil palm production and the current pace of adaptation and mitigation cannot continue to support production.
“...it is currently estimated that 208,000 or 12% of the land under oil palm cultivation would become marginal and hardly support oil palm plantation when the current trend of warming continues...," the paper stated.
Other factors too are weighing on global palm oil supply, including inadequate replanting, falling yields, elevated labour costs and government-mandated biofuel mixing policies in Indonesia and Malaysia.
Palm oil prices have firmed up around 10% from February-end and the near-term outlook remains challenging.
“Global palm oil prices are expected to average higher in 2024 compared to 2023, according to an S&P Global industry poll we conducted in January. The market sentiment remains the same currently," S&P Global Commodity Insights, a commodities research and analytics firm, said in response to a questionnaire from Mint.
Crude palm oil futures contract on Malaysia’s commodity exchange—which influence global palm oil and vegetable oil markets—is expected to average at Malaysian Ringgit (MR) 4,000/mt ($845.12/mt) in 2024, compared to the average price of MR 3,799/mt in 2023, it said.
“From our observation and interaction with industry experts, factors such as stagnating output at main producers Indonesia and Malaysia, robust food demand and palm oil’s rising use in making biodiesel are expected to squeeze supplies in 2024," it added.
Bitter Harvest
If you think it is only the mid- and small-cap stocks which have been on a tear recently, buckle up for a bitter-sweet ride through the lush jungles of Western Africa. Prices of cocoa, the main ingredient for making chocolate, have tripled year-on-year. On 26 March, futures for May delivery breached the $10,000 per tonne mark for the first time ever, a head-spinning episode in financial history which made cocoa beans pricier than the bellwether industrial metal copper (at around $8,500/tonne).
Cocoa has more than doubled in the first three months of this year, eclipsing the returns of superstar stocks like Nvidia and sending shares of chocolate makers plunging across the world.
Fluctuating weather coupled with crop pests have taken a toll on cocoa production in West Africa, which accounts for around 70% of the total global output of about 5 million tonnes. The two largest producers are Côte d’Ivoire and Ghana.
These two nations were battered by heavy rain and extreme heat recently.
In its quarterly bulletin of cocoa statistics published recently, the International Cocoa Organization (ICCO) projected an 11% drop in global cocoa output this year, mainly due to the after-effects of extreme weather.
“Significant declines in production are expected from the top producing countries as they are envisaged to feel the detrimental effect of unfavourable weather conditions and diseases. Moreover, old trees in these countries are producing with lower yields," the industry body said.
Just like oil palm, cocoa requires favourable climatic conditions at every stage of growth. Its yield is more impacted by precipitation than any other climate variable.
Late last year, heavy rains pummelled the cocoa crop in Côte d’Ivoire and Ghana. Total precipitation was more than double the 30-year average for the time of year.
Adding to the woes, the wet conditions gave rise to black pod disease, causing the plants to rot.
However, no sooner had the farmers come to grips with the calamity, another misfortune followed in February 2024 in the form of droughts typical of El Niño. This once again decimated yields as cocoa is highly sensitive to saturation levels.
In line with the conventional pattern in climate change-induced weather anomalies, farmers went from overabundance of water to a situation of scarcity in just a couple of months.
FMCG Outlook
In contrast to the wild weather swings in some parts of the world, the condition of Indian FMCG investors has been uniformly morose.
Nifty FMCG was among the worst performing sectoral indices in 2023-24, rising 20% compared to the benchmark Nifty’s 28% gains. Its performance looks even more piteous when compared to the fiscal year’s stars like Nifty Realty (up 133%), PSU Bank (93%) and Auto (77%).
The FMCG sector is currently grappling with anemic volume growth on the back of elevated inflation and weak consumer sentiment, particularly in rural markets. The sector’s volume growth in the third quarter slipped to 6.4% from 8.6% in the previous quarter, while on an absolute basis it has remained the same for the past three quarters.
“High inflation in the past two years greatly impacted mass segment consumption, particularly FMCG products in rural areas. Slow income growth and high inflation reduced the desire to consume," domestic brokerage house Motilal Oswal said in a report last week.
However, the companies managed to post healthy results in the previous quarter ended December 2023 as cooling input costs gave a fillip to their gross margins. But with prices of key raw materials like palm oil and cocoa on the upswing, analysts anticipate fresh challenges for the FMCG pack.
“After cooling off in the past few quarters, raw material prices have turned inflationary. As raw material prices deflated, companies had largely retained the benefits. Considering the competitive intensity, pressure on volumes and strong gross margins, we think companies would be reluctant to hike prices in the near term," global investment bank BNP Paribas stated in a report dated 22 March.
It sees the increase in raw material prices in the current demand environment as a negative development for the sector.
“Crude, palm oil, LAB (Linear alkylbenzene) and coffee prices rose q-q and y-y, while mentha and tea prices rose q-q but are still lower y-y. This poses a risk to consensus’ margin assumptions. Specifically, increase in prices of cocoa (which have tripled y-y), coffee and sugar poses a risk to Nestle India’s margins," it added.
The input cost trend is mixed for India’s biggest FMCG firm Hindustan Unilever.
“The company’s commodity basket has seen a mixed bag of price fluctuation. Prices of palm oil and palm fatty acid, crucial inputs for the company, increased QoQ. Additionally, tea prices fell substantially, while coffee prices increased. Furthermore, the company has decreased prices to compete with smaller and regional players," Motilal Oswal added.
But overall, the Street’s near-term view on the sector remains bearish.
“We expect a weak 4QFY24 for FMCG companies. Pricing contribution is likely to be mostly neutral to negative, while we do not expect any major recovery in volumes. Higher raw material cost is a new headwind and pose a further downside risk to consensus earnings estimates," BNP Paribas stated.
