Additional Thoughts on the Disruption in the Fertilizer Market

gcopley

The global fertilizer market remains in a state of shock in the wake of Uralkali’s announcement that it would abandon the output limits that have supported global potash prices. Uralkali announced that it was leaving the export cartel in which it had participated (along with Belaruskali) since 2005.  The cartel sought to balance supply with demand to maintain levels of profitability for the global potash market.  Uralkali and Belaruskali together represent about 43% of the global export market.

If Uralkali sticks with this decision and Belaruskali walks the same path because it is forced to, investors have to wonder what the future is for Canpotex (the Canadian version of the Russian potash marketing organization, BPC).  Canpotex is owned by POT, AGU and MOS.  Investors have to consider the possibility that instead of an industry profit structure that reflects export cartels managing volume to meet the downstream production demands of the global agricultural industry, the industry may revert to pricing that more accurately reflects the marginal cost of production (Exhibit 1).  While the current thinking by Uralkali is that prices will settle in around $300 per ton, ultimately the price will be a market-clearing price, so we think it is unwise for investors to value these names using that pricing assumption.

Earlier in the week, we ran with the Marlboro Friday analogy, an apt one, we believe, when examining the duration with which a stock may underperform in light of this type of action.  Today, we thought we would take a look at the impact of Saudi Arabia’s decision to flood the market with crude oil in the mid-1980s after a half decade effort of pushing for production quotas in order to stabilize prices while at the same time slashing its own output by nearly 25% from 1980 to 1985.  In the face of non-compliance by other member nations (and keep in mind that Uralkali has accused Belaruskali of “cheating” outside the cartel), Saudi Arabia elected to increase production – the result was a decline in the price of crude oil to $10 per barrel (Exhibit 2).  It took the better part of decade and a war to restore the price of crude to the level seen prior to the actions by Saudi Arabia.  It is also interesting to note that the decline in the price of crude oil made certain high cost production regions (the North Sea comes to mind as an example) uncompetitive – similar to what will likely happen if Uralkali sticks to its guns here.  One can’t help but wonder if the Russians have been reading a bit of history.

Whither BHP’s fifth pillar?  Back in August of 2010, BHP made a hostile bid for shares of POT in an effort to diversify the company away from BHP’s four pillar base of iron, coal, copper and petroleum.  The $40 billion bid ($130 per share, $43.33 per share adjusted for POT’s 2011 stock split) was rejected by POT’s board and faced opposition from local and national officials as well.  Instead, BHP committed to a greenfield project in Saskatchewan that represents an investment of $15 billion over the next decade.  It is unclear to us whether or not the economics of this project (or similarly situated projects around the globe that were begun and funded based on price assumptions that now seem unlikely) make sense.  Uralkali, with this move, may have rationalized future supply and demand by forcing the elimination of future capacity increases in the face of a potentially weakened demand profile.  Of course, if demand strengthens, Uralkali will have delayed increases in capacity multiple years, perhaps setting the company up to enjoy higher prices with a greatly increased market share at some point in the future.   With regards to BHP and POT, that was a bad breakup to the extent that the two companies ever really dated, so we see it as unlikely that BHP steps up for another kiss at the pig.

What is also interesting about BHP’s intentions with respect to potash is that the company made it clear that it would not become a member of Canpotex once (or if ever) its greenfield project begins production.  The company’s intentions had it purchased POT are unclear, but what is clear is that BHP, in its other 4 pillars, prefers to let the market dictate price.

There are other examples of global capacity additions in process or being contemplated by smaller mining companies – most of the incremental capacity represents a cost profile in excess of $175 per ton.  For example, Sirius Minerals is planning a $1.9 billion potash mine in the UK – based on ICL’s operations in that country, the cost per ton is likely closer to $240.  Quite frankly, while we embrace the long-term global agricultural growth case based on world population and income growth leading to increased grain, oilseed and protein consumption, we see existing capacity as likely sufficient for the foreseeable future.  The capacity additions were, in some cases, simply chasing prices that, for a brief period, ticked $1,000 per ton for potash.

We don’t have a handbook for investing in end of the world scenarios, and the potash world as investors have come to understand it may be ending, make no mistake.  In the face of this uncertainty, we anticipate short-term volatility, but that these companies are a source of funds over the medium term (3-6 months) absent any change of heart with respect to restoration of the cartel pricing algorithm.  We would favor lower cost producers (Uralkali) in what is an uncertain demand environment given the price trends in global grains and oilseeds and eschew higher cost production companies such as K&S.

Exhibit 1:  Potash Cost Curve
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Exhibit 2:  Crude Oil in the 1980s

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