Vertical integration Possible sources of market power

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2.3.2 Vertical integration

Traditionally, the main raw material in cooking oil in Indonesia was coconut oil. Due to the limited growth in coconut oil production, this oil could no longer meet the demand from the cooking oil industry. As an alternative, cooking oil producers then used palm oil, which enjoys higher productivity and lower prices. Since 1984, palm oil has replaced coconut oil as the main raw material for cooking oil. From 1984 to 1990, on average, the share of palm oil as a raw material for cooking oil is almost 60 per cent Joint Marketing Office various issues. From 1996 to 2002, the share of palm oil increased even further, almost reached 80 per cent from the total raw material for cooking oil CIC 2003. Unlike CPO, cooking oil could be quickly produced and stored in response to price fluctuations, as long as there was a sufficient amount of CPO and refinery capacity. From 1998 to 2002, the refineries utilised only up to 53.9 per cent of their production capacity see Table 2.7. Table 2.7 Utilisation of the Indonesian refineries, 1998–2002 Description unit 1998 1999 2000 2001 2002 Capacity tonnes 7,855,372 7,855,375 8,200,000 8,200,000 8,200,000 Production tonnes 2,072,690 2,400,000 3,534,918 3,690,000 4,421,114 Utilisation per cent 26.4 30.6 43.1 45.0 53.9 Source: Department of Industry and Trade 2002. This under-utilisation condition was set to meet the higher demand during certain occasions, such as Ramadhan, Ied-Fitri and New Year. It also provided leeway for the integrated CPO producers, either to directly sell the CPO or to process it into cooking oil. Since most palm oil demand in international markets is in the CPO form, this also implies flexibility for producers to sell the product in the international or domestic markets. The main factor that determines their sale decision is the price ratio of these two markets. Since 1998, international market prices have been higher than domestic ones see Figure Universitas Sumatera Utara 30 2.10, giving the Indonesian producers an incentive to export more of their production. In the international market, CPO competes with various vegetable oils. Before the establishment of the World Trade Organization WTO in 1995, the soybean oil produced by the United States was highly subsidised and the United States became the dominant vegetable oil producer in the world. However, with the implementation of the WTO Agreement on Agriculture in 1995 domestic support for agricultural producers and the use of export subsidies in international trade have been progressively reduced Young 1994; Hathaway and Ingco 1995; Tanner 1996. In accordance with WTO rules, massive subsidies in international trade have been restricted. This led to a decrease in soybean exports and an increase in palm oil exports, as the two oils are close substitutes Othman et al. 1998. Figure 2.10 Average CPO prices in the domestic and international market, 1997–2004 2000 4000 6000 8000 10000 J a n -9 7 J u l-9 7 J a n -9 8 J u l-9 8 J a n -9 9 J u l-9 9 J a n -0 J u l-0 J a n -0 1 J u l-0 1 J a n -0 2 J u l-0 2 J a n -0 3 J u l-0 3 J a n -0 4 J u l-0 4 R p k g international domestic Source: Joint Marketing Office2004; Oil World 2004. From 1995 to 2002, the annual demand for palm oil in the international market increased from 14,710 tonnes to 24,952 tonnes. This increase enabled palm oil producers— including Indonesia’s—to increase their exports. If the domestic market share of Indonesian producers was significant, providing an option to sell in the world market and giving them an ability to influence the domestic market price and exercise market power. Universitas Sumatera Utara 31 In summary, since the distribution of the concessionary credits in 1986-1996, the CPO industry appears to be more concentrated and vertically integrated. This might stem from the high investment requirement for establishing new plantations, mills or refineries. More recent entrants face even higher costs to enter because concessionary credits are no longer available, and hence the incumbents earn persistently higher profits than the potential entrant. The increase in market share may provide the incumbents with an ability to influence market price. The incumbents also appear to be more vertically integrated—from oil palm plantations to CPO mills and cooking oil refineries—creating a further barrier to the new entrants. In addition, having a leeway to sell outputs in both the domestic and international markets, the CPO might have more ability to influence the domestic market price, hence exert some degree of market power

2.4 Concluding comments