Big News for Natural Gas Is Big News for This Industy

The price of natural gas seems far more newsworthy than the price of nitrogen fertilizers, but the two are tied closely together. Here is what to expect in the earnings from fertilizer companies when the price of natural gas fluctuates.

Jun 24, 2014 at 12:57PM

The media is buzzing with natural gas news, ranging from the effects of global warming initiatives on the industry to reports of Russia cutting off their supply of natural gas to Ukraine. Meanwhile, the fertilizer industry sits quietly behind the forefront of the natural gas dominance, remaining highly dependent on both domestic and international natural gas pricing.

Potash Corp (NYSE:POT), Agrium (NYSE:AGU), and CF Industries (NYSE:CF) are among the biggest players in nitrogen-based fertilizer, and their near-term futures depend on the natural gas news that has recently been widely broadcast.

Two factors to watch
Determining the effects of natural gas prices on the overall nitrogen fertilizer market is fairly simple. Natural gas is by far the most expensive 'ingredient' in the making of nitrogen-based fertilizer, and thus the price of natural gas and natural gas futures plays directly into the operating expenses incurred by fertilizer producers.

The first and most easily understood factor is the domestic price of natural gas. Lower natural gas prices in North America translate to lower production costs of ammonia. Through large purchase agreements, the largest fertilizer producers are somewhat buffered from the ups and downs in natural gas pricing, but higher natural gas prices over the long run will not favor fertilizer companies, which lower natural gas prices can help to expand their margins.

Announcements like the proposed U.S. Environmental Protection Agency's Clean Power Plan, which calls for substantial cuts in carbon emissions by 2030, may lead to natural gas power plants continuing to replace coal power plants and have a secondary impact on the fertilizer industry. The announcement spurred initial increases in natural gas futures pricing, though the proposal would not substantially change natural gas consumption in the short term and natural gas consumption may be tempered over the long term by renewable energy sources growing to fill the changing power sector. Nonetheless, if domestic natural gas futures increase in response to such announcements and projected demand, margins could be tightened for fertilizer producers.

The second and slightly more convoluted factor is international natural gas pricing, particularly in the now sensitive Ukraine region. Nitrogen commodity prices have historically been established by Ukrainian producers, and the price that these producers pay for natural gas plays a critical role in the price that they set for their ammonia-based products. In general, if natural gas prices increase in Eastern Europe, fertilizer prices will follow suit.

Three months ago the Russian-Ukrainian dispute led to questions on the persistence of relatively affordable Ukrainian sourcing of natural gas from Russia. The move by the Russian company Gazprom, the world's largest extractor of natural gas, to cut off natural gas supplies to Ukraine answers many of the lingering questions as to how long Ukraine can maintain affordable sourcing of Russian gas supplies.

While Ukraine does have its share of natural gas reserves, the country's consumption outweighs its production, and a cut-off of Russian supply will inevitably spur higher natural gas prices, particularly when the winter approaches and seasonal demand grows. Further complicating the Ukrainian natural gas situation is the presence of significant reserves believed to be in the Black Sea off of the Crimean coast. High natural gas prices, even if some agreement could be reached between Ukraine and Russia, are the ongoing reality for the region, and if the commodity pricing continues to be set by Ukrainian producers, the price of nitrogen fertilizers will be on the rise.

The takeaway
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 and has encouraged speculation about rising prices, but Gazprom's move to cut off supplies to Ukraine is now substantive evidence that natural gas prices in the region will push higher. Domestic natural gas costs may also be on the rise, but the trend will be tempered in comparison to that in Eastern Europe.

Accordingly, expect to see small increases in the operating expenses for nitrogen fertilizer companies due to rising domestic natural gas costs paired with larger increases in their sales revenue through higher commodity pricing set in Ukraine. It may still be a while before the effects take hold, but the tie between natural gas and nitrogen is too tight for the fertilizer industry to not be affected by big news in natural gas.

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Shamus Funk owns shares of CF Industries Holdings. The Motley Fool owns shares of CF Industries Holdings and 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.

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