This research is to investigate the effect of economic variables Interest Rate, Exchange Rate and crude oil prices towards the price of crude palm oil in Malaysia in short-term and long-term relationship. It is can’t be denied that, the economic growth in Malaysia is heavily dependent on the energy consumption, therefore it is very important for us to understand the effect of economic variables towards energy commodities. According to the source from Malaysian Palm Oil Board (MPOB), Malaysia is the second world’s largest palm oil exporter after Indonesia.

Crude Palm Oil

Palm oil is an important source for global oils, and has become one of the world’s most highly consumed edible oils. There is around 60% of crude palm oil produced in Malaysia are export to China, the European Union, Pakistan, United States and India. Those countries import crude palm oil are mostly made into cooking oil, margarine, specialty fats and oleochemicals. Besides that, western countries are also looking for substitution of energy sources. Thus, Malaysia government had been mainly focus on study of produce biodiesel by using crude palm oil and government also declared that all diesel must contain 5% of palm oil in year 2007. The reason of Malaysia government to implement this strategy is to increase the amount of palm oil produce and produce another sources of energy to substitute the crude oil in order to meet the demand of European countries, China and India. Due to that, the demand and price of crude palm oil are higher than previous year. Therefore, the domestic market and export market in Malaysia can be expanded. Abdul et al.(2011) also disclose that the prices of crude palm oil can be stabilized by increasing the demand of palm diesel.

Crude palm oil futures was firstly introduced in October, 1980 at the Kuala Lumpur Commodity Exchange (KLCE). Bursa Malaysia is the largest palm oil futures trading in the world. There are 2 economic reasons to launched FCPO in Malaysia. Firstly, to provide an efficient price discovery mechanisms for the palm oil industry. Secondly, the reasons are to provide a hedging mechanism against the risk of price instability.

In the past decade, the volatility in the energy commodity prices creates uncertainty which in turn forms an unstable economy while this has caused many difficulties to many economies and developed economies (Abdul et al.,2011). According to the table 1, it indicates that the Crude palm oil prices have the highest instability index which are 2.24 is relatively volatile compare with other commodities product in Malaysia. The fluctuation prices of crude palm oil is a notable risk facing by the producers, traders, consumers, and anyone who involved in the production and marketing of palm oil.

The price forecasts for crude palm oil is necessary for decision making in such situation of uncertainty and high risk. Precise price predict are very important in order to stimulate an efficient decision making as there is time lag intervenes between making decisions and the actual output of the commodity in the market (Mad Nasir and Fatimah, 1991).

Figure 1.0: Palm Oil Yearly Price – Malaysia Ringgit per Metric Ton

(Source: World Bank, http://www.indexmundi.com/commodities/?commodity=palm-oil&months=120&currency=myr)

According to the above Figure 1.0, it indicated that the Malaysia Crude Palm Oil price was fluctuated from year 2002 to year 2012. There are many factors causes the volatility of crude palm oil price such as weather condition, demand and supply as well as price of other substitute’s product. In the past decades, crude palm oil is mostly used in manufacture cooking oil, margarine, and food products. However, in the recent year, demand of biodiesel had been steadily increase thus it causes the demand of palm oil to be increasing too, which biodiesel is an alternative to petroleum (Abdul et al., 2011)

From the Figure 1.0 indicates that there is a sharply increase of crude palm oil price from November 2006 to May 2008 as approximately RM3.65k per metric ton. Furthermore, the Figure 1.0 also shows that the highest price of crude palm oil from year 2002 to year 2012 is approximately RM3.8k per metric ton in February 2011. Because of the crude palm oil can be utilized to substitute the petroleum fuels and manufactured biodiesel, so causes the demand of crude palm oil increasing. Therefore, there is a correlation between crude oil and crude palm oil prices (Basiron, 2008).

Interest Rate

Interest rate can be defined as the rate surcharge on the money borrowed or loan. However, it also can be defined as the return derived from an investment. The interest rate in a country is setting by the country’s central bank. We also called it as the lending rate (BLR). For example, the U.S. Fed funds rate is the amount banks charge each other for the overnight loans. Interest Rate is changed based on the fiscal policy or monetary policy implement by government. As a results, interest rate is necessary for determinant the commodity prices. Increasing on the interest rate will decrease the demand for storable commodities or increase the supply of the commodity through a variety of channels: by increasing the incentive for extraction today rather than tomorrow (think of the rates at which oil is pumped, gold mined, forests logged, or livestock herds culled); by decreasing firms’ desire to carry inventories because of the cost of carrying inventory increased (think of oil inventories held in tanks); by encouraging speculators to shift out of spot commodity contracts, and into treasury bills (Jeffrey Frankel, 2008). Moreover, when the interest rate is higher, consumers have to pay more to finance their consumption. The demand of commodity will decrease because of higher required payments, thus it affect the prices of commodity go down. However, if the interest rate is lower it will have the inverse effect. Nowadays, commodities are asset that’s part of the portfolio for hedge funds. If interest rate is lower, investor will want to invest in stock, bonds and also include taking open positions in financial market for commodities. The interest rate using for this study is based on the lending rate (BLR) of Bank Negara Malaysia.

Exchange Rate

Exchange rate can be described as the rate of one currency can be exchange for another different currency and it also can be defined as the price of one currency expressed in terms of another different currency. Exchange rate for a currency is changing from time to time, it is due to the currencies are traded on an open market and demand for them varies based on what is happening in that country. The profit of multinational corporations can be affected by the changes in the exchange rate from time to time. There are several factors can cause the exchange rate move up and down such as, interest rate, economic growth, demand and supply, and political issues. The changes in the exchange rate will also affect the value of foreign investment held by individual investors. There are many researches had been prove that there is an impact on the volume of export and import towards the fluctuation of the exchange rate. The quantities of supply and demand for commodity products export and import can be influenced by the volatility on the exchange rate. On the point view of an exporter, if the exchange rate is appreciate, it will cause reducing the competiveness of exporter in international market, the sales and profit will shrink and the stock price will decrease. However, in the point view as an importer, importer will receive benefit such as increasing their competiveness in the domestic market while the local currency of the exporter is appreciated. Thus, this will increase their profit and sales. In contrary, while the exchange rate is depreciated, it will cause the inverse effect to the importers and exporters. Therefore, the volatility of exchange rate can displace the global market equilibrium. According the above theory, it is very important and necessary to investigate the relationship between the exchange rate and price of crude palm oil. The exchange rate of Malaysia Ringgit to USD will be using in this studies and the data is collected from Bank Negara Malaysia.

Crude Oil Price

Crude oil also can call as petroleum, where it is naturally occurring substances found deep beneath the earth’s surface. It can refined into gasoline, diesel, jet fuel, kerosene, heating oil, and literally thousands of other products called petrochemicals. Crude oil plays a important role to the society including in economy, politics and technology. The volatility of the crude oil can cause the direct and indirect impact to the world economy. Thus, investors are very concern on movement of the crude oil price in global. The highest of crude oil price is bad for global economy. The increasing in the price of crude oil will brings effect to the industries and business across the board. There is many researches had been done on the study of the effect of changes in crude oil price towards the economic growth and also investigates the relationship between commodity price and crude oil price. Moreover, many studies had been done indicates that higher price of crude oil cause the high inflation and recession economy. Thus, the increasing on the crude oil price will increase the risk to the global economy growth. According to the Figure 2.0, there is an upward trend on the price of crude oil throughout the 10 years. This results a heavy burden towards the world’s economic growth. During the financial crisis in year 2008, the Figure 2.0 shows that the price of crude oil is the most highest among the 10 years, where the price of crude oil is RM430.78 per barrel. As a results, the higher price of crude oil will advances palm oil futures. The higher price of crude oil stimulated the countries of export crude palm oil such as Malaysia and Indonesia take the advantages of purchase and selling big amount of fertilizer at discounted price to planters of crude palm oil and rubber to promote famers to plant more oil palm. Therefore, the volume of supply crude palm oil will increase and this also will cause them to meet the growing demands for palm oil.

Figure 2.0: Crude Oil(Petroleum) Yearly Price-Malaysia Ringgit per Barrel

1.2: Problem Statement

Nowadays, due to the crude palm oil can using to produce bio-fuel, the demand of the crude palm oil had been increasing over this few years. Crude palm oil is the one of the major source in contributing the economic growth in Malaysia. It is because Malaysia is the second largest exporter of crude palm oil in the world. Same to the other agriculture commodities, crude palm oil price is posed to significant price volatility. In the past decades, the price of crude palm oil is changed without any clear tendency. Due to the fluctuations in crude palm oil is the significant risk to economic growth in Malaysia, producers of palm oil, traders and consumers, therefore, it is necessary for us to determine the effect of economic variable and crude oil prices on the price of crude palm oil. There is many researches had been done on the study of the changes in crude palm oil price, but they do not much focus on study the short-term and long term relationships of interest rate, exchange rate, and crude oil prices with the price of crude palm oil. The dynamic relations of economic variables and crude oil price on the price of crude palm oil must be first considered. Therefore, the problem statement of this research is to find out that “What are the relationship of interest rate, foreign exchange rate and crude oil price towards the price of crude palm oil?”

1.3: Research Question

This research is conducted to solve the following question:

To determine whether there is any effect of interest rate, exchange rate, and price of crude oil towards the crude palm oil prices?

Does the relationship of interest rate, foreign exchange rate and crude oil price towards the price of crude palm oil is in short run, or long run, or both?

1.4: Research Objective

The overall objective of this study is to observe and explore how the interest rate, exchange rate and crude oil price are directly and indirectly affect the price of crude palm oil. Thus, this research aims at investigating the short-term and long-term relationship between the interest rate, foreign exchange rate and crude oil price towards the price of crude palm oil.

1.5: Scope of the Study

The scopes of this research are using the monthly time series data from January 2001 through December 2011 in Malaysia which is obtained from the World Bank. This secondary data would be used for investigating the effect of interest rate, exchange rate, and price of crude oil towards the price of crude palm oil.

1.6: Significance of the Study

The proposed research will determine the effect of interest rate, exchange rate, and crude oil prices toward the price of crude palm oil. The results of this study will benefit the producers, traders and consumers in the production of crude palm oil. They can predict and forecast the crude palm oil price by analyzing the trend and pattern of interest rate, exchange rate and price of crude oil. Furthermore, they also can hedge their investment portfolio effectively from the information in this study.

Chapter 2

Literature Review

2.0: Introduction

This chapter will cover the literature review of the relationship of interest rate, exchange rate, and price of crude oil towards the price of crude palm oil.