PRICING OF PALM OIL FRESH FRUIT BUNCHES FOR

SMALLHOLDERS IN SOUTH SUMATRA

MARYADI ABDUL KARIM YUSUF

ANDY MULYANA

FAKULTAS PERTANIAN UNIVERSITAS SRIWIJAYA

2004

2

Table of Contents

Summary................................................................................................................ 3

Introduction........................................................................................................... 5

Background ......................................................................................................... 5 Research Objective ............................................................................................. 6

Research Method................................................................................................... 6

Location and Time .............................................................................................. 6 Method of Data Collection.................................................................................. 6 Method of Data Analysis..................................................................................... 7

Results .................................................................................................................... 7

Palm Oil Plantations in South Sumatra.............................................................. 7 Description of FFB Price Setting Policy ............................................................ 8 The “K” Index and FFB Price Determination at Private Prices ....................... 9 “K” Index and FFB Prices Determination at Social Prices ............................ 11 PAM Analysis.................................................................................................... 13

Revenue......................................................................................................... 14 Tradable Inputs.............................................................................................. 15 Domestic Factors........................................................................................... 15 Profits ............................................................................................................ 15

Conclusions and Recommendations .................................................................. 15

Conclusions....................................................................................................... 15 Recommendations ............................................................................................. 15

References ............................................................................................................ 16

2

3

SUMMARY South Sumatra is one of Indonesia’s centers of oil palm production with total planted area of 416,395 ha and production of 1,502,818 tons in 2002. There are 19 processing plants in the province, and the production of oil palm has increased progressively (Department of Estate of South Sumatera, 1999). Most production is of the Nucleus Estate Smallholder (NES) type, also called “PIR”, in which a nucleus plantation owned by a private company collaborates with numerous small farmers, each with about two hectares of oil palms.

The price determination of fresh fruit bunches from palms (FFB) changes every month. The nucleus firms that collect the produce from NES farmers have their own price establishment system, even though the law states that the price should be determined by the FFB Price Setting Team (Tim Penentuan Ketetapan Harga Tandan Buah Segar).1

Theoretically, the buyers’ demand and producers’ supply will determine the market price and the quantity of products to be sold. However, because the market structure of FFBs market is monopsonistic, (there is only one buyer and many sellers), it can be assumed that the behavior of the nuclear firm has a significant impact on the market place and hence on the prices received by small farmers.

The buying price of FFBs by nucleus companies is based on a formula. This price is then adjusted to the balanced real average price of Crude Palm Oil (CPO) and Palm Kernel Oil (PKO) according to the previous export (FOB) and local sales of each company. This research in this paper uses the PAM methodology to examine the private and social profits of palm oil Based on farm budget analysis, the report produces recommendations for improving the determination of FFB prices and increasing the prosperity of small-scale palm oil producers. The study focuses on how the “K” index is calculated. At present, all components of the “K” index are fully controlled by nucleus estates that do not act transparently. If the index parameters were controlled and regularly audited by a neutral agency, the floor price of the FFBs could be established fairly and beneficially for farmers. The study therefore recommends that:

1. The government should develop compulsory controls, based in law and implemented by an independent institution, to ensure that farmers receive appropriate prices for their FFBs.

1 The Decree Letter or “Keputusan Menteri Kehutanan dan Perkebunan Nomor 627/Kpts-II/98” on the regulation of buying price determination for FFBs modifies an earlier decree letter (Keputusan Menteri Pertanian Nomor 839/Kps/KB.320/8/97 dated 22 August. However, these regulations, which were expected to guarantee a reasonable price for FFBs produced by farmers and prevent unfair competition, do not work effectively.

3

4

2. There should be transparency from the processing firms in providing data on price and cost variables. All cost and price values, determined by the firm, should be audited and serve as public input for decision-making to ensure fair outcomes for the farmers.

3. The FFB conversion ratios from CPO and PKO, which are based on government research done in 1998, should be updated to ensure that they are appropriate

4

5

INTRODUCTION

Background

South Sumatra is one of Indonesia’s centers of oil palm production with total planted area of 416,395 ha and production of 1,502,818 tons in 2002. There are 19 processing plants in the province, and the production of oil palm has increased progressively (Department of Estate of South Sumatera, 1999). Most production is of the Nucleus Estate Smallholder (NES) type, also called “PIR”, in which a nucleus plantation owned by a private company collaborates with numerous small farmers, each with about two hectares of oil palms. Much controversy exists over how the farmers in the NES scheme should be paid for the fresh fruit bunches (FFBs) that they produce. Regulations state that the FFB price should be determined collectively by representatives of the nucleus companies, government institutions, and the farmers’ groups. The price determination of the FFB varies every month. The nucleus firms that collect the produce from NES farmers have their own price establishment system, even though the law states that the price should be determined by the FFB Price Setting Team (Tim Penentuan Ketetapan Harga Tandan Buah Segar). Farmers through their group leaders, with the aid of KUDs (cooperatives) as partners, do the marketing of oil palm FFBs from their farms. The KUDs then directly markets the FFBs to the nucleus firms. The FFBs are weighed, and then the price and the cost of transportation is determined. The payment for the FFBs to the farmer is made through the KUD. Prices are supposed to measure the value of products and services. Theoretically, the buyers’ demand and producers’ supply will determine the market price and the quantity of products to be sold. The prices of FFBs tend to fluctuate and change every month. The market structure of FFBs is monopsonistic, because there is only one buyer and many sellers of FFBs. The Decree Letter or “Keputusan Menteri Kehutanan dan Perkebunan Nomor 627/Kpts-II/98” on the regulation of buying price determination for FFBs modifies an earlier decree letter (Keputusan Menteri Pertanian Nomor 839/Kps/KB.320/8/97 dated 22 August. However, these regulations, which were expected to guarantee a reasonable price for FFBs produced by farmers and prevent unfair competition, do not work effectively. The buying price of FFBs by nucleus companies is based on a formula. This price is then adjusted to the balanced real average price of Crude Palm Oil (CPO) and Palm Kernel Oil (PKO) according to the previous export (FOB) and local sales of each company.

5

6

In 1998, the Governor of South Sumatra issued SK Nomor 898/SK/V/1998. Under that decree, the team for FFB price-setting formulates and sets up the FFB purchasing price, the “K” index, and communicates the average selling price of CPO and PKO to companies and farmers. The nucleus firms have to buy the FFBs from the farmers at prices based on the regulation. But this team has not worked effectively and transparently to the disadvantage of the farmers.

Research Objective

This research report aims to produce recommendations to improve the determination of FFB prices and increase the prosperity of small-scale, palm oil farmers. The study focuses on whether the “K” index is properly calculated. At present, all components of the “K” index are fully controlled by nucleus estates that do not act transparently. If those parameters were controlled and regularly audited by a neutral agency, the floor price of the FFBs could be established fairly and beneficially for farmers.

RESEARCH METHOD

Location and Time

The research was carried out in the Subdistrict of Sungai Lilin, District of

Musi Banyuasin, South Sumatra Province. The location was selected because it is the largest oil palm plantation of the NES type in the province. The field research was done for two months in 2003.

Method of Data Collection

Two types of information, primary and secondary data, were required for the analysis. The secondary data were collected from various institutions connected with the problems under investigation, such as the nucleus firm, regional/local government offices, statistics offices, regional development planning offices, and other relevant sources. Previous research reports on the subject matter also were utilized to obtain secondary data and information to enrich the analysis and discussion of the research results.

The primary data were collected by direct observation in the field using the method of interviews with sample respondents and certain key persons who know the major problems. The interviews were guided with questionnaires, and for certain purposes some in-depth studies were carried out.

All farmers, measured in family households, who were the members of an oil palm NES, were included in the observed population unit, together with the nucleus firm as the palm oil processor. Sample respondents were chosen using stratified random sampling based on ages of the palm trees, and the number of

6

7

respondents in each stratum was proportional. Fifty small-scale farmers were interviewed. The primary data, collected from the respondents, included the amount and size of oil palm land owned by the farmers, the process of output price determination, marketing structure of the fresh fruit bunches (FFBs), production process and inputs needed, yield or productivity and post-harvest handling aspects, and constraints and prospects for future developments.

Method of Data Analysis

The information collected was analyzed using the Policy Analysis Matrix (PAM) with the technique of Multi-period Benefit-Cost Analysis. The approach for measuring production costs of the farmers was to calculate total average cost of production per hectare per year. The components included fertilizer, FFB transportation, production fees, compulsory savings, taxes, equipment depreciation, and credits from the oil palm farm.

Farmers’ revenue was calculated from average FFB production per hectare per year for each planting year multiplied by the determined price. The difference between revenue and cost was the net revenue or profit of the farmers.

Palm oil trees presently in the field vary in age from three to 20 years. Information was collected on the ages of trees in an average plantation. The application of PAM analysis is possible for plantation commodities by calculating average costs and revenues per year or by using multi-year net present value (NPV) analysis, taking into account the cash flow during the economic period of the trees’ life.

RESULTS

Palm Oil Plantations in South Sumatra

In 2002, the total area planted in oil palm in South Sumatra was 416,395 hectares. Two-thirds was of the NES type. The distribution of palm oil plantation area is shown in Table 1.

Table 1. Area of Palm Oil Plantation by Estate Types in South Sumatra, 2002

No. Estate types Size(ha) %

1 Smallholder 4,692 1.13

2 Public large-scale 1,086 0.26

7

8

Table 1. Area of Palm Oil Plantation by Estate Types in South Sumatra, 2002

No. Estate types Size(ha) %

3 Private large-scale 133,121 31.97

4 NES 277,496 66.64

Total 416,395 100.00

Description of FFB Price Setting Policy

The process of FFB price determination is carried out every month based on the agreement among price setting team members. The team includes provincial government, forestry and plantation office, the nucleus firm, the farmers, and research center and other relevant institutions. Interviews revealed that the nucleus firms are dominant in FFP price determination.

The formula use for FFB price determination is stipulated as:

H TBS = K (H cpo x R cpo) + (H is x R is) where : H TBS = FFB price reference that will be accepted by the farmers K = proportion index as will be obtained by the farmers’ (%) H cpo = Average price of crude palm oil (Rp/Kg) R cpo = Conversion FFB into crude palm oil (%) H is = Weighted prices of palm kernel oil (Rp/Kg) R is = Conversion FFB into palm kernel oil (%) The determination of the “K” index is unfair for the farmers, since the palm oil processor dominates in deciding it. The index, as stated in the ministry decree letter, consists of several components – FOB price of crude palm oil, tax costs, marketing costs, transportation costs to the exporting board, conversion, FFB average price, percentage of selling volume, processing costs, depreciation, FFB value at processor weighting scale, administration costs, and TBS value at manufacturer. Several of the components of the “K” index can be manipulated so that the processor can obtain maximum profit. The farmers are made worse off if the processing firm overstates processing, marketing, administration, and depreciation costs or understates the conversion ratios of FFB into Crude Palm Oil (CPO). These costs and conversion ratios are not made transparent to the farmers and other members of the price-setting board.

8

9

The “K” Index and FFB Price Determination at Private Prices

The “K” index in the FFB price formulation is an index expressing the share of the price obtained by the farmers. Its determination is based on selling price, processing and transportation costs of CPO and PKO, and factory depreciation costs. The process of “K” index determination includes 15 components, detailed in Table 2.

Table 2. “K” Index Calculation at Private Prices

No. Description Crude palm oil (Local)

Palm kernel oil (Local)

1 FOB price (Rp/kg) 3.117,87 1.252,00

2 Taxes (Rp/kg) - -

3 Marketing cost (Rp/kg) 6,82 -

4 Net FOB price (Rp/kg) 3.111,05 1.252,00

5 Transportation to the board (Rp/kg) - -

6 Factory/tanker net price (Rp/kg) 3.111,05 1.252,00

7 Conversion (%) 21,10 4,10%

8 TBS price (Rp/kg) 656,43 51,33

9 Percentage of selling volume 100% 100%

10 Average TBS price ex-factory 707,76

11 Processing cost 87,80

12 Depreciation 62

13 TBS price at factory weight scale 557,97

14 Administration cost 27,90

15 TBS price at factory 530,07 “K” Index = 530,07/707,76 = 74.89% The first component is the FOB price of CPO. In the setting of the FOB price, the firm frequently refers to the contract prices of local sales to other companies. The research results show that FOB prices under such contracts are notably lower than the world FOB prices for CPO.

The firms also try to overstate marketing, processing, depreciation, and administrative costs. Irrelevant costs are frequently included in these cost components. When firms included the costs of health facilities for their

9

10

employees, for example, the farmers’ association protested and asked for the right to receive services from the facilities free of charge.

Other components that make the farmers worse off are inappropriate conversions of FFB into CPO and PKO. Based on the decree letter, the CPO and PKO conversions are determined according to planting year. Details underlying the conversions are presented in Table 3. Table 3. Conversion List of CPO and PKO in South Sumatra according to

“SK Menhutbun No.627/KPTS-II/98”

No. Planting Year CPO Conversion PKO Conversion 1 3 15.62% 3.70% 2 4 16.85% 3.70% 3 5 18.12% 4.10% 4 6 18.75% 4.25% 5 7 19.37% 4.45% 6 8 20.00% 4.60% 7 9 20.62% 4.80% 8 10 - 20 21.25% 5.00% 9 21 20.62% 5.00% 10 22 20.00% 5.00% 11 23 19.37% 5.00% 12 24 18.75% 5.00% 13 25 18.12% 5.00%

The field research revealed that the conversion calculations applied to the farmers are lower than their empirically determined values. For example, the FFB to CPO conversion set by the firm is 21.10 %, while the decree letter stipulates 21.25 %. The FFB to PKO conversion was set by the firms at 4.1 % compared to 5% if derived from the formula. These unfair practices in the field can be changed only through strong coordination and partnership between farmers and the government in monitoring the process. The formulation in the decree letter should be revised because there are weaknesses in the determination of the index, prices, and conversions. The revision should be focused on technical practices in the field so that the calculation would not be implemented unfairly and partially by the firm, but should be materially tested and validated. After the determination of the “K” index, the firm, the government, and farmers’ representatives formulate the FFB prices for the farmers. The

10

11

components influencing FFB prices are the “K” index, the prices of CPO and PKO, and the conversion factors. The results of price determination in detail for each planting year are presented in Table 4.

Table 4. FFB Prices (Rp/Kg) at Private Prices, According to Planting Year

Planting Year K H-Cpo R-MS H-Is R-IS H-TBS 1 3 74.89% 3111.05 15.62% 1252 3.70% 398.62 2 4 74.89% 3111.05 16.85% 1252 3.70% 427.27 3 5 74.89% 3111.05 18.12% 1252 4.10% 460.61 4 6 74.89% 3111.05 18.75% 1252 4.25% 476.70 5 7 74.89% 3111.05 19.37% 1252 4.45% 493.02 6 8 74.89% 3111.05 20.00% 1252 4.60% 509.10 7 9 74.89% 3111.05 20.62% 1252 4.80% 525.42 8 10 - 20 74.89% 3111.05 21.25% 1252 5.00% 541.98 9 21 74.89% 3111.05 20.62% 1252 5.00% 527.30 10 22 74.89% 3111.05 20.00% 1252 5.00% 512.85 11 23 74.89% 3111.05 19.37% 1252 5.00% 498.18 12 24 74.89% 3111.05 18.75% 1252 5.00% 483.73 13 25 74.89% 3111.05 18.12% 1252 5.00% 469.05

In the present FFB price determination, usually the government, research institution, and farmers have too little power to change the calculations made initially by the firm, so that every month the meeting coordinated by the government is only a debate arena. Usually the decision made by the firm comes into practice in the field. But the team should have legal power to verify and improve the decisions made by the firm.

“K” Index and FFB Prices Determination at Social Prices

The determination of the “K” index and FFB prices at social prices follows a process parallel to that taken in determining the index at private prices. However, social prices are intended to reflect the absence of market failures and policy distortions. Consequently, FOB prices of CPO and PKO change affecting the conversion values derived from the decree letter. These adjustments increase the “K” index and the prevailing FFB prices. The complete calculation can be observed in Tables 5 and 6.

11

12

Table 5. “K” Index Calculation at Social Prices

No. Description Crude palm oil

(Local) Palm kernel

(Local) 1 FOB price (Rp/kg) 3530 3855

2 Taxes (Rp/kg) - -

3 Marketing cost (Rp/kg) 6.82 0

4 Net FOB price (Rp/kg) 3523.18 3855

5 Transportation to the board (Rp/kg) - -

6 Factory/tanker net price (Rp/kg) 3523.18 3855

7 Conversion (%) 21.25 5

8 TBS price (Rp/kg) 748.67575 192.75

9 Percentage of selling volume 100% 100%

10 Average TBS price ex-factory 941.42

11 Processing cost 87.8

12 Depreciation 62

13 TBS price at factory weight scale 791.62

14 Administration cost 27.9

15 TBS price at factory 763.72 “K” Index = 763.72 / 941.42 = 81.12%

Table 6. FFB Prices at Social Prices (Rp/Kg), According to Planting Years

No Planting Year K H-Cpo R-MS H-Is R-IS H-TBS

1 3 81.12% 3,530 15.62% 3,855 3.70% 562.99 2 4 81.12% 3,530 16.85% 3,855 3.70% 598.21 3 5 81.12% 3,530 18.12% 3,855 4.10% 647.09 4 6 81.12% 3,530 18.75% 3,855 4.25% 669.82 5 7 81.12% 3,530 19.37% 3,855 4.45% 693.83 6 8 81.12% 3,530 20.00% 3,855 4.60% 716.56 7 9 81.12% 3,530 20.62% 3,855 4.80% 740.57 8 10 - 20 81.12% 3,530 21.25% 3,855 5.00% 764.86 9 21 81.12% 3,530 20.62% 3,855 5.00% 746.82

12

13

Table 6. FFB Prices at Social Prices (Rp/Kg), According to Planting Years

No Planting Year K H-Cpo R-MS H-Is R-IS H-TBS

10 22 81.12% 3,530 20.00% 3,855 5.00% 729.07 11 23 81.12% 3,530 19.37% 3,855 5.00% 711.03 12 24 81.12% 3,530 18.75% 3,855 5.00% 693.27 13 25 81.12% 3,530 18.12% 3,855 5.00% 675.23

In these price formulations, the market mechanism has little function and this tends to make the farmers worse off. The nucleus firms in monopsonistic positions can accrue high profits from the farmers. The government currently plays an insignificant role in helping the farmers. Any new policy interventions should be made transparent and be disciplined to benefit all participants.

If farmers were to receive higher FFB prices, they would have greater incentive to look after their farms in better ways in an effort to increase productivity. An expansion of FFB production would increase production of processed products such as olein, cooking fat, margarine, cocoa butter substitute, stearine, detergent, soap, glycerine, gasoline, plastics, particle board, paper pulp, feed stuff, fertilizer, salad oil and oleo-chemical, and carbon-active. More production of processed products would increase Indonesian export earnings.

PAM Analysis

Two different NPV PAM analyses are carried out. In one (Table 7), it is assumed that the private and social discount factors are different, and in the other (Table 8), the discount factors are assumed to be the same. Table 7. PAM Analysis for FFB Price Determination (Private and Social Discount

Factors are 12% and 16%, respectively)

Domestic Factors

Revenue Tradable Inputs Labor Capital Land Others

Profit

Private 54,983,962 10,032,464 9,393,987 2,372,325 22,408,331 5,829,211 4,947,646

Social 53,928,957 6,491,203 7,406,356 1,855,868 35,573,045 4,344,861 -1,742,377

Divergences 1,055,005 3,541,261 1,987,630 516,457 -13,164,715 1,484,350 6,690,022

13

14

Table 8. PAM Analysis for FFB Price Determination (Private and Social Discount Factor are Both 12%)

Domestic Factors

Revenue Tradable Inputs Labor Capital Land Others

Profit

Private 54,983,962 9,814,964 9,393,987 2,372,325 22,408,331 5,829,211 5,165,146

Social 77,475,190 8,180,506 9,393,987 2,372,325 44,816,662 5,829,211 6,882,500

Divergences -22,491,228 1,634,458 0 0 -22,408,331 0 -1,717,355

Table 9. Indicator Ratios

Indicator Private Discount Factor of 12% and Social Discount Factor of 16%

Private and Social Discount Factors of 12%

NPCO 1.02 00..7777

NPCI 1.55 11..2200

EPC 0.95 00..7711

ERP -0.05 --00..2299

PC -2.84 00..4411

SRP 0.12 --00..2277

Revenue

In Table 8, the discounted revenues received by farmers with existing FFB price methods are only Rp 55 million. But if farmers received the full FOB prices, they would earn revenues of Rp 77.5 million. Hence, the NPCO is 0.77 and farmers lose 23 percent of their revenues to the nucleus firms. This significant difference is caused by the occurrence of a market failure in the NES system – a monopsony controlled by the nucleus firm because farmers have the obligation to sell their FFB only to the nucleus firm, as stated in the agreement. The social prices for CPO and PKO were calculated as follows. The FOB price of CPO was US $437 per ton. With an exchange rate of Rp8,500 per US $1, it became Rp3,715 per kg. After deductions for transportation, handling, processing, and marketing costs of Rp185 per kg, the CPO social price at factory-gate was Rp3,530 per kg. The FOB price of PKO was Rp 454 per ton or Rp3,855 per kg at the factory-gate (PKO is a by-product of CPO).

14

15

Tradable Inputs

The tradable inputs are fertilizer and pesticides. The costs of fertilizer and pesticide per hectare per year at private prices are higher than at social prices. The fertilizer and pesticide prices paid by the farmers are 20 percent higher then they would be at world prices, because of local taxes and corruption in marketing.

Domestic Factors

There are no divergences in the labor or capital markets used by palm oil farmers. But there is a large negative divergence in the land market. The social opportunity cost of land was estimated as the social profit from the best alternative uses of the land, rubber plantations, which resulted in a net income of Rp 6.0 million per ha per year. The social opportunity cost for land was Rp 44.8 million per ha for the total economic life of the plantation. This value was much higher than the private land rental rate for oil palm, Rp 22.4 million per ha for the same duration. Palm oil farmers thus benefited from the sluggish land rental markets.

Profits

The private profitability of palm oil farms in the NES system was very high, because the amounts lost to the processing nucleus firms were largely offset by transfers caused by imperfections in the land rental markets. In Table 8, social profits are Rp 1.7 million higher than private profits, although the transfer to the processing firms amounts to Rp 22.5 million. These important results are underscored by the ratios presented in Table 9.

CONCLUSIONS AND RECOMMENDATIONS

Conclusions

The high gap between private and social values in palm oil revenues is caused by:

1. The existence of a monopsonistic marketing structure in the NES system, in which the farmers have to sell their Fresh Fruit Bunches (FFB) to the nucleus firm, as stated in the agreement letter.

2. The dominance of the nucleus firm in determining the “K” index and

prices of FFB, so that the calculation of relevant variables related to the minister’s decree letter are manipulated by the nucleus firm.

3. The lack of tight government controls on the FFB prices set by the firm.

Recommendations

15

16

16

1. The government should develop compulsory controls, based in law and implemented by an independent institution, to ensure that farmers receive appropriate prices for their FFBs.

2. There should be transparency from the processing firms in providing data

on price and cost variables. All cost and price values, determined by the firm, should be audited and serve as public input for decision-making to ensure fair outcomes for the farmers.

3. The FFB conversion ratios from CPO and PKO, which are based on

government research done in 1998, should be updated to ensure that they are appropriate.

REFERENCES

Gittinger, J. Price. 1986. Analisa Ekonomi Proyek-Proyek Pertanian. Penerbit Universitas Indonesia.

Gray, Clive dkk. 1992. Pengantar Evaluasi Proyek. Penerbit PT Gramedia

Pustaka Utama, Jakarta. Husnan, S. Dr dan Drs. Suwarsono, M.A. 1991. Studi Kelayakan Proyek. Unit

Penerbit dan Percetakan AMP YKPN, Yogyakarta. Irvin, George. 1985. Modern Cost Benefit Methods. Macmillan Publishers Ltd.

London. Kadariah. 1986. Evaluasi Proyek, Analisa Ekonomi. Lembaga Penerbit Fakultas

Ekonomi Universitas Indonesia. Pearce, D.W. and R.Kerry Turner. 1990. Economics Of Natural Resources And

The Environment. Harvester Wheatsheaf, New York. Pearson, Scott., Carl Gotsch, and Sjaful Bahri. 2003. Aplikasi Policy Analysis

Matrix Pada Pertanian Indonesia. Bahan Pelatihan PAM Lampung. Sugden, Robert and Alan Wiliams. 1979. The Principles of Practical Cost

Benefit Analisys. Oxford University Press.