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The conventional wisdom, or at least the knee-jerk reaction, appears to be that investors should buy the fertilizer stocks and specifically the potash miners due to the conflict in Ukraine. The theory is that potential sanctions against Russia could reduce the recent market share seized by the country upon the breakup of the Belarussian cartel and price cuts of the commodity to primarily gain contracts in China.
The breakup of the partnership between Belaruskali and OAO Uralkali, which controlled nearly half of the world market, had great implications for North American miners that are apart of the Canpotex marketing arrangement. Shares of Potash Corp (NYSE: POT ) , Mosaic (NYSE: MOS ) , and Intrepid Potash (NYSE: IPI ) were crushed in the process due to the slashing of the high prices and large margins maintained by the arrangement.
The theory appears to have a lot of holes, however. These range from the concept that sanctions against Russia would include fertilizers needed for global food supply to feed the world to the idea that the primary potash customer of China would accept paying higher prices to obtain its potash from Belarus and Canada. This is especially problematic considering that the North American miners generated outlandish profits prior to the pricing collapse. It is hard to justify that sanctions could return the power to exhort market-leading margins.
Potash Corp would benefit the most
In the event that China actually complies with a sanction that would allow fertilizer and especially potash prices to soar, Potash Corp would be the major beneficiary. The company controls roughly 50% of Canpotex and had sky-high 50% gross margins for potash that shrunk to 40% during the fourth quarter of 2013. The other fertilizers produced by Potash Corp struggle to reach even the 40% gross margin level. The company's stock previously traded around $43 and collapsed to below $30 on the breakup in Russia. If anything, the recent stock price return to over $33 appears to be unjustified considering the structural change in the sector that isn't likely to return.
Both Mosaic and Intrepid Potash would provide secondary options to benefit from a return of pricing power. Mosaic obtains substantially more revenue from phosphates, but the potash business was nearly as lucrative with the substantially higher margins. In the fourth quarter alone, Mosaic recorded gross margins of 12% on phosphates sales of $1.6 billion and 21% on potash sales of $652 million. The gross margin for potash plunged from 41% in the previous year period.
Intrepid Potash is a risky small play in the sector, only generating revenue of $336 million in 2013. Due to lower pricing for potash and operational issues, the company generated a loss for the fourth quarter. Intrepid Potash is clearly at the mercy of the pricing arrangements obtained from the global players.
China controls the keys
As with just about all global commodities outside of oil, the insatiable demand to modernize and grow the power of China has made the country the primary user of most major commodities. In that manner, the country can typically drive the price of commodities based on usage. Potash is no different, with the recent breakup of the Belarussian arrangement allowing Russia to snap up market share in China by offering lower prices. As of last October, Uralkali had dramatically increased market share in China to 73%; this was up from only 26% back in May.
Recently, Canpotex made news by signing a contract to deliver 700,000 tons to China. Considering that the pricing wasn't released, the general theory is that the North American cartel had to accept substantially reduced prices.
Investors should use great caution rushing into investing in fertilizer stocks on the back of expected sanctions in Russia. Any sanction would unlikely include potash that is needed to grow the world's food supply. Not to mention, China is a major customer that would unlikely accept paying higher prices. If anything, a cornered Russia might dump potash in China to obtain much-needed cash to fund the government under sanctions. The margins for potash are still higher than other fertilizers, suggesting an unlikely road to higher prices in the future.
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