Why Potash Corp and Mosaic Have Nothing to Fear From BHP Billiton's $15 Billion Mine

Recently, there has been the worry that mining giant BHP Billiton Limited (NYSE: BHP  ) will enter into the potash space and crush the potash margins of The Mosaic Company (NYSE: MOS  ) and Potash Corp  (NYSE: POT  ) . The worry, specifically, is that once BHP Billiton's Jansen mine comes online, the mine will produce so much potash that a repeat of 2013 would occur, when the break up between Uralkali and Belaruskali of the Belarusian Potash Company sent potash prices falling from $400 per metric ton to $300 per metric ton soon afterward.

On the surface this worry seems warranted. BHP Billiton's Jansen project is indeed intimidating. At its peak, Jansen is slated to produce 10 million metric tons of potash a year. This is a huge sum in relation to the total annual potash production of 59 million metric tons.

Furthermore, BHP Billiton itself is a company with great resources and dedication to potash. The company, for example, earned $10 billion in profits and reported operating cash flows of $18 billion last year. BHP Billiton's CEO has also explicitly said that it aims to make potash into the company's fifth pillar, in addition to iron ore, copper, coal, and petroleum. Given BHP Billiton's significant resources and dedication, some fear that the company will operate its potash division at a loss to drive out the weaker players as well.

Those things being said, there are some key extenuating circumstances to the worry that Jansen will destroy the gross margins of potash producers:

4 extenuating circumstances
One circumstance is that the Jansen project will take a long time to develop. Potash production at Jansen, specifically, will not start until 2018 at the earliest. Full production may take even longer. Because of the long lead time, the rise in demand for potash may offset some of Jansen's extra supply. The world's population, is after all, increasing by 0.9% ever year. Also, as more people in Africa and Asia move up the food ladder and eat more meat, potash demand will only increase further.

The second circumstance is that Jansen has questionable economics. Conventional wisdom says that if Jansen were a slam dunk, it would already be operating. Since it hasn't been developed, there must be something unattractive about it. That something, specifically, is that the economics don't make sense. According to BMO Capital analysts Joel Jackson and Tony Robson, Jansen would only yield an internal rate of return of 10% assuming potash prices of $450/ton. (At present day prices of approximately $300/ton, Citigroup estimates that the Jansen mine would be worth negative $2.2 billion). A 10% internal rate of return is an exceptionally low rate of return, especially given the fact that the Jansen mine may cost as much as $15 billion to completely develop. Because the mine requires large upfront capital expenditures and yields a questionable rate of return, BHP Billiton itself has not fully committed to Jansen. 

The third circumstance is that BHP Billiton ultimately answers to its shareholders. The company, for example, recently laid off a portion of its workforce in an effort to cut costs. Because it answers to its shareholders, even though the company may have great resources, it can only compete as much as shareholders allow it to compete. Given that Jansen has higher production costs than Potash Corp or Mosaic mines, BHP Billiton cannot realistically force out its competition unless it loses a massive amount of money. Losing a lot of money is something that BHP Billiton shareholders will not allow management to do. Since it can't optimize for production by forcing out its competitors, BHP Billiton is much more likely to optimize for price. Optimizing for price will not hurt Mosaic or Potash Corp as much.

Finally, the knowledge that BHP Billiton will develop Jansen will likely dissuade many junior miners from developing new potash mines because those miners fear future oversupply. Because of this, the overall supply of potash with Jansen may not be too different from the overall supply without Jansen. BHP Billiton would basically just be taking junior miners' place.

The bottom line
The critics are right in believing that Jansen will adversely affect potash prices. But given Jansen's long lead time, questionable economics, substantial capital commitment, and repulsive effect on junior potash miners, the net effect of Jansen on the gross margins of Potash Corp and Mosaic is far from certain. The net effect could easily be marginal.

Given all the extenuating circumstances and significant unknowns, Potash Corp and Mosaic have nothing to fear from BHP Billiton.

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