The ongoing dispute over Crimea has sent the entire market through its shares of ups and downs, but when the dust settles the long-term effects on nitrogen-producing fertilizer companies like Potash Corp (NYSE:POT), CF Industries (NYSE:CF), and Agrium (NYSE:AGU) may be positive.
Nitrogen is largely about natural gas
In many ways, natural gas prices may actually be a better indicator than fertilizer prices for predicting how North American fertilizer companies will perform, due to the need for natural gas to synthesize ammonia. Volatility in the supply and demand (and inevitably also the cost) of natural gas both domestically and abroad typically far exceeds that for fertilizer products, further intensifying the impact of natural gas on the nitrogen fertilizer market.
Intense fluctuations in natural gas prices make the global supply and demand projections for nitrogen prices in need of constant revision and largely speculative in nature. Yes, demand for nitrogen-based fertilizers is expected to increase at a slow and steady rate over the next few years, but demand is just one small cog in the complex machine responsible for determining fertilizer prices.
What makes the situation in Ukraine unique to the fertilizer industry is that nitrogen commodity prices have typically been established by Ukrainian producers. These producers have historically paid more for natural gas than North American producers, and subsequently they need to sell nitrogen fertilizers at higher prices to make the business viable.
Ukraine has significant natural gas reserves, but its consumption of natural gas still far overshadows the country's production, thus necessitating significant imports from Russia. The natural gas trade between Russia and Ukraine has always been a sensitive entity. Since the dissolution of the Soviet Union, gas disputes between Russia and Ukraine have been commonplace regarding debts, suspended deliveries, and transit issues (much of the Russian gas supplies intended for Europe had to make its way first through Ukraine).
While recent agreements between the two countries suggested the potential for Ukrainian fertilizer producers to source more affordable natural gas from Russia, the likelihood of these agreements to hold up under current political conditions is highly unlikely. The more likely near-term result is a significant increase in gas prices for Ukraine.
Natural gas prices and the corresponding nitrogen prices realized in Ukraine are just one-half of the story for North American fertilizer producers. The second consideration that cannot be ignored is the domestic price of natural gas. The key to strong margins for North American producers is a strong disparity between their natural gas expenses with the costs incurred for natural gas by Ukrainian producers. As the gap widens, the margins grow. Though the domestic price of natural gas has been relatively high throughout the beginning of the year, futures prices are dropping with hopes that spring weather will finally ease the heating demand.
Just over a month ago, the situation was very different from where it sits today. Though civil unrest in Ukraine was more than evident, the situation seemed relatively calm until demonstrators clashed violently with police in mid-February. Prior to that, Ukraine saw potential for decreasing natural gas prices from Russia, and natural gas futures prices in the U.S. were rising. This sudden transformation in the global fertilizer picture should serve as a reminder to the volatility of nitrogen prices. Should the U.S. decide to export natural gas to Europe in an attempt to limit Russia's political and economic influence in Ukraine and Europe, the expected price increases could be tempered.
Because natural gas is the most expensive component in the production of ammonia, the natural gas market has as much to do with the success of nitrogen-based fertilizer investments as does the actual fertilizer market. Volatility in Eastern European and North American natural gas prices makes fertilizer prices and nitrogen producers' profits more difficult to project than might be expected for a seemingly straightforward commodity. However, with the most recent developments in the global fertilizer industry taken into consideration, North American producers should see favorable conditions moving forward.
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Shamus Funk has no position in any stocks mentioned. The Motley Fool owns shares of PotashCorp. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.