Nitrogen Fertilizer – Just Like Ethylene; But Different

gcopley
Print Friendly, PDF & Email

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

May 16th, 2016

Nitrogen Fertilizer – Just Like Ethylene; But Different

  • Urea economics look similar to ethylene – large natural gas based producers in various parts of the world and significant higher cost coal based production in China – a steep cost curve steeper for ethylene than urea currently protecting producers in the US and the Middle East
    • While there is no “oil” based production for urea, there is plenty of natural gas based production where the price of natural gas is tied to oil
    • Like ethylene, today the marginal producer is likely a China based coal, but based on coal that is a lot cheaper than it was – there appear to be other subsidies helping also. Coal is a more significant starting block for Urea than ethylene and China is the price setter today
  • But Urea is different in two very distinct ways
    • China is a major net exporter of Urea – China imports ethylene (as polyethylene)
    • The US is a major importer of Urea but a major exporter of ethylene (as derivatives) and the US export volumes of ethylene are set to increase meaningfully – see prior research
  • Long-term US Urea prices should remain higher than the global clearing price (despite attractive production economics locally) – because the marginal ton is shipped in from a higher cost player
    • The US ethylene prices are likely to settle out below the global average price to enable exports – but lower natural gas prices in the US should ensure positive margins if oil stays at or above current levels – the US has a margin umbrella in both products
  • The Urea cost curve suggests stable pricing (derived from China higher cost coal economics) until either oil pricing rises above 75-80 per barrel – at which point higher cost natural gas based producers in Europe and Asia become the price setter; or coal rises
    • On the downside, pricing would only fall if enough lower cost new capacity were added to make the high cost China coal based production redundant, while oil remained low
  • We prefer CF to Yara given CFs increasing leverage to low cost US economics – Yara has a good business but does not look as attractively valued as CF relative to potential leverage
    • We suspect that the low in oil prices in Q1 2016 probably drove a sentiment (rather than cost curve) driven low in Urea pricing and possibly a bottom
    • Yara and CF will follow the same pattern, but increased leverage at CF should create a gap

Exhibit 1

Source: Capital IQ, Bloomberg, SSR Analysis

Overview

Unlike potash and potassium based fertilizers, nitrogen based fertilizers are manufactured rather than mined which gives a very different dynamic to the market. For Urea and UAN it’s all about who has the cheapest feedstock – natural gas – rather than who has the lowest cost deposit. Ammonia (the precursor to urea) and methanol are the two large volume chemicals manufactured directly from methane and as such their cost of manufacture is generally tied to the alternate value of the methane as a fuel. Ethylene is a little different in that it can be made from a variety of different hydrocarbon based feedstocks (but not methane directly), but the winners are generally those with low cost NGL’s generally associated with a low value plentiful methane market.

One immediately jumps to the Middle East and North America when looking for obvious sources of low cost natural gas, and while this is part of the story for ammonia and urea, it is only part, and the supply dynamics are in fact very different than they are for ethylene.

Natural gas discoveries in the US and Western Europe were immediately put into use as a fuel as large sophisticated pipeline networks were quickly constructed to move the gas to market. Large gas discoveries in the former Soviet Union were either too far from population growth or were seen as a potential source of hard currency and the region built up a significant export capacity which still exists today. The US, despite abundant natural gas has remained deficit Urea and continues to import roughly half its need. The other dominant production base is East Asia (China) based on coal gasification. With crude oil at $45, the less efficient coal based production in China is the price setter today. Other natural gas based producers in Asia and Europe start to suffer economically as crude prices rise.

With the shale wave we are seeing new urea investment in the US, but unlike the ethylene wave, these new pounds will displace some but not all imports rather create even greater exports. Most of the urea produced in the world is of a much higher cost than in the US at current natural gas prices and as long as the US remains a net importer pricing should reflect the importers economics, not local production costs. As natural gas around the world is more closely aligned with alternate fuel – i.e. crude oil – it is the price of crude that is the more dominant driver of urea pricing volatility.

Companies like CF and Yara, while way off their highs, reflect the fact that there remains a steep(ish) cost curve for urea and that there is still a margin for those with a low cost base. Higher crude prices will likely drive a higher margin again, as it would for ethylene. This is very different than the race to the bottom that we have seen in potash as we try and determine who the marginal producer is with most playing off a much more level field. The cost curve for Urea is not as steep as for ethylene and fixed costs are a significant component of delivered costs. It should also be noted that there are many geographies in the world, including the US (CA for example) where Urea pricing is materially higher because of the logistics of supply. In the US prices rise with distance from the Mississippi river and some import terminals on the East Coast. As an example of the logistic constraints/costs Urea pricing in some parts of Latin America are twice what they are in the US.

Exhibit 2

Source: Company Reports, Capital IQ, SSR Analysis

The negative sentiment for CF and Yara (consistent with industry commentary) is based on results that reflect the very low oil price of the first quarter and this may well represent a bottom in the market for urea pricing (which appears to have been January and February). While the world is adding a lot of capacity over the next few years we do not expect the marginal producer’s costs to get any lower and if oil rises the marginal producer may again become a high cost natural gas based facility putting further upward pressure on prices.

Trade – Lots of Urea on the Water – The US Very Deficit

Back in the early 2000s, when the price of natural gas jumped dramatically in the US, we, under a different brand name, were the first to write about the unintended consequences of very high priced gas in the US – both in absolute terms and relative to crude. At the time we talked about the possible death of the US chemical industry – a theme taken up in Washington by the industry and later mentioned specifically in the House by the then Chairman of the Federal Reserve. Ethylene stood a chance because most producers had the ability to switch from a natural gas based feed to a crude based feed and because NGL’s traded at a discount to methane for a while – still several ethylene facilities closed (some of which have restarted in the last few years). Methanol and ammonia had no alternate feed and most US capacity closed with the industry choosing to import methanol and urea instead. While we are seeing some new capacity for both products in the US either recently started (methanol) or soon to start (CF with urea) we have not rebuilt what was closed and the collapse in crude prices has scarred investors away because of concern that the competitive edge might be lost again.

The result is a very deficit North American urea market (Exhibit 3) – note that the chart is “nutrient ingredients” i.e. nitrogen – the volume is more than double to get to tons of urea itself.

Exhibit 3

Source: IFA, SSR Analysis

The risk is that the US could build more and push itself into surplus – like ethylene. We think it is a brave investor who does that today given energy volatility, the high cost of build and the significant uncertainty around returns. Gas is cheap today, as is oil and inventories of both are high – Exhibits 4 and 5. But the US rig count in the US has to be a leading indicator of something – yes the industry has become more efficient – but not that much more efficient – Exhibit 6. Anyone starting construction today of any facility that relies on either natural gas, crude or any derivative/co-product of either has to question the environment in which they will start up.

Exhibit 4

Source: EIA, SSR Analysis

Exhibit 5

Source: EIA, SSR Analysis

Exhibit 6

Source: Baker Hughes, SSR Analysis

What Sets the Urea Price?

For this analysis we have borrowed from a few CF company presentations in the exhibit below, but have made some changes to help explain the dynamics. Natural gas (methane) is the primary feedstock to produce the hydrogen needed in the production of ammonia. Natural gas can be pumped out of the ground or it can be manufactured from coal gasification. Even with historically low coal pricing around the world – Exhibit 7 – coal is the high cost route to methane today and it is the coal based producers in China that are the marginal producer today. China would not be the marginal supplier if it consumed all of its own Urea or if any surplus was consumed close by, given low coal conversation costs as high logistic costs. This is not the case today, and if we believe the rhetoric from CF, China costs could rise with the removal of subsidies and in addition some facilities could close – pushing the price setter further to the right of the curve. We have heard countless closure stories in China in countless industries so we would place this firmly in the “hope” bucket and not an idea to base a strategy around. Current cost curve economics suggest stable to positive pricing pressure for Urea as we believe that psychological pressure of low crude prices in the seasonal weak period drove prices below stable levels in Q1 2016 – not that the current cost curve suggests much upside.

Exhibit 7

Source: Capital IQ, SSR Analysis

Can prices go lower? The answer is yes under certain conditions:

  1. Coal prices in China would need to fall further – but this is unlikely. In this instance urea pricing would come down as coal prices came down.
  2. Enough lower cost capacity would need to come on line to make the higher cost Chinese coal based capacity redundant. There is new capacity under construction in the US and the Middle East which would be to the left of the cost curve, but it should not be enough as long as demand grows as predicted (trend). Oil would need to stay low for this to play out – prices could drop $20-30 per ton to find a new stable level – driven by current oil prices.

What would take prices higher?

  1. Obviously – higher coal prices – unlikely without reform and mine closures in China, despite pollution issues.
  2. A meaningful increase in oil – enough to take international natural gas prices with it and raising the costs of producers with the red bars in the cost curve chart.
    1. However, this may be an asymmetric move in that international gas prices may not rise as linearly with oil as they fell given significant increases in LNG availability – most noticeably from the US. A doubling of the oil price may not double gas prices in Europe and Asia.
    2. If oil moved to $80 and LNG and international gas moved proportionally we would see at least a $50 per ton rise in Urea pricing and probably more as freight rates would also increase with fuel costs.

In the chart below, not everything marked in red has a linear correlation to the price of crude as different locations have different logistic challenges getting natural gas to an alternate market which reflects the crude alternate.

Exhibit 8

Source: CF Company Presentations, SSR Analysis

Exhibit 9

Source: Bloomberg, Capital IQ, SSR Analysis

History suggests that Urea should do some strengthening as crude straightens – Exhibit 10.

Exhibit 10

Source: Bloomberg, Capital IQ, SSR Analysis

CF Complexity – Another Possible Drag

We have written at length about how business complexity can be something of a turn off for investors – see the research linked here. While CF is a fairly simple product story, its recent deals with Terra, OCI and CHS can get a bit confusing. The schematic below summarizes our understanding of the picture. The OCI deal is a “tax inversion” and so under scrutiny but the company has recently moved the proposed headquarters to the Netherlands which may offset some of the concerns with regard to taxes paid in the US. The OCI deal will make CF industries a much bigger company with more nitrogen assets and more exposure per share and better distribution – this should be a positive. The CHS deal is most simply looked at as a loan – cash up front, paid back in chunks that represent production margins in any period, effectively giving CHS urea and UAN at cost, although each sale is at market price. This has helped the cash component of the balance sheet but is really a loan. TNH is an MLP, taking advantage of the MLP tax treatment with CF owning 75% and the rest publicly traded – CF effectively gets a cash dividend from TNH each quarter as would others with partnership interests. Part of the recent weakness in CF lies with what must have been a very poor Q1 for TNH, given low pricing and a very weak January and February.

The schematic below looks complicated and the OCI deal is not yet done, which adds uncertainty, but it has likely created an interesting entry point for CF in our view.

Exhibit 11

Source: Company Reports, SSR Analysis

Normal Valuation

CF and Yara both enjoyed high returns on capital in the mid-2000s, but current returns are well off prior peaks. If we think of normalized earnings as being somewhere in the middle of these two extremes (so using an average for the line of best fit in the return on capital charts below), both stocks look significantly cheap based on the current sub-trend earnings – CF more so than Yara.

Exhibit 12


Source: Capital IQ, SSR Analysis

Exhibit 13


Source: Capital IQ, SSR Analysis

©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

Print Friendly, PDF & Email