Why I’m Buying Potash Corporation

David Lee Roth left Van Halen in 1985, and the Van Halen loyal mourned his departure. Sadness turned to hand wringing, as the faithful worried the band's trademark sound a thing of the past. Sammy Hagar's subsequent hire did nothing to assuage their concerns, at least not immediately. But with 5150's subsequent release, and success, the mulleted Van Halen masses breathed relief. Van Halen's change was merely cosmetic. The same could be said of the potash industry. Its recent history is of a cozy fraternity. Instead of competing for market share, the industry's top players took a rational, price-centric approach to competition, ensuring tasty returns on capital and continuously increasing potash prices.

But a month ago, that comfy arrangement came to a screeching halt. Or so it seems. The Russians—a key player in the scheme—announced they aren't playing ball anymore. Instead, they intend to pursue a volume-focused strategy. The market, concerned potash players' cush margins are at risk, handed shares in the potash crop a drubbing. But like DLH's Van Halen dust up, things aren't as bad as they seem. In fact, I believe the very things that made investment in potash companies fetching—a strong secular demand profile, attractive economics for incumbents, and high barriers to entry—remain intact. Potash Corporation  (NYSE: POT  ) , as the industry's leader, is poised to benefit, but with the recent dramatics, shares are a lot cheaper. 

That's why I'm buying a position equal to 3% of my Real Money Portfolio.

 

Potash: Delicious and Nutritious?
What's blanketly called fertilizer is actually three market segments: potash, phosphates, and nitrogen-based fertilizers. Demand is cyclical in the short-run, tied to crop prices and, peripherally, the state of the world economy. But in the long-run, there's a certain inevitability associated with consumption. Taking a 20 year view: Fertilizer demand is apt to move higher amid growing worldwide per capita incomes, attempts to maximize crop yields, and a trend toward higher protein consumption in emerging markets, buttressed by China and India in particular.

Potash Corp is the world's largest supplier of potash, controlling 20% of capacity, and one of the lowest-cost producers. For would-be competitors, barriers to entry are sizable: Worldwide potash reserves are closely held, as five producers own rights to roughly 80% of industry capacity, and greenfield mine development costs are enormous. This, alongside a communal industry-dynamic, has contributed to years of very attractive returns.

Potash, the commodity, contributed almost 60% of 2012 gross profits, and despite cyclical demand, has helped the company reap high returns on capital with impressive consistency. Those successes haven't gone unnoticed. Despite massive upfront costs, mining giant BHP Billiton (NYSE: BHP  ) , is contemplating a large greenfield mine, which if completed, could increase industry capacity by 15-20% (more on that below).

Potash Corp also has its paws in the other crop nutrients, phosphates and nitrogen. Phosphate market dynamics are decent, and nitrogen just meh. In aggregate, these segments are characterized by lower barriers to entry, less consolidated end-markets, and less disciplined participants. But even so, Potash still retains key advantages.

Phosphate rock supply, a key input to phosphate fertilizers, is fairly concentrated, with Morocco controlling approximately 33% of worldwide export capacity. The country's acted much like OPEC in oil markets, but for phosphate rock, limiting supply to prop prices and keep investment returns healthy. A funny coincidence: Over the past decade, rock prices increased almost five-fold. Because approximately 30% of phosphate fertilizer producers buy rock from third parties, the consequence was somewhat predictable—higher phosphate fertilizer prices. For those producers that own rock mines, it's secured a huge cost advantage, and a durable source of above-market returns on capital. As the owner of rock mines, Potash Corp sits among the privileged.

Nitrogen markets are less attractive. Producers only need a manufacturing facility, and access to natural gas, which comprises 70-85% of cash costs. In this regard, U.S. producers are advantaged, possessing access to low-cost natural gas stores. Potash, which produces urea and ammonia in the U.S. and Trinidad, has a relative cost advantage to international players. That being said, it's not all cherries—capacity is highly fragmented, and producers haven't historically been a disciplined lot. Oversupply can, and has, rear its ugly head.

The Lay of the Land Changes
Until recently, the potash industry functioned as a tidy, formalized oligopoly. The five largest producers, effectively speaking, colluded. They sold potash supply into international markets via two consortiums—Canpotex, comprised of the three major North American players (Potash, Mosaic (NYSE: MOS  ) , and Agrium (NYSE: AGU  ) , and Belarusian Potash Company (BPC), formerly consisting of the two largest Eastern European players. They worked to limit market supply, prop prices, and ensure the group collectively earned solid returns on capital.

But the European cartel is now kaput. Or maybe it is. Uralkali, the bigger part of BPC, announced plans to leave BPC a month ago, and pursue a volume-focused strategy intended to push prices lower. Where recent contracts settled around $400/ton, Uralkali's reportedly targeting $300/ton for future deliveries.

Playing a stronger hand
The market's predictably shaken. But the reality, I believe, is much more nuanced: It stands to reason that the cartel still exists, but informally. The so-called potash cartels' coherence pivoted around a delicate game theory framework. The incumbent, large producers played nice, because it served each other's best interest. The two cartels cemented things. But the prospective BHP mine—BHP's management's wants to sell outside of the North American marketing consortium—threatened this equilibrium. Uralkali called BHP out. By exiting BPC, and at least temporarily pushing prices lower, Uralkali discourages BHP's investment plans—an elaborate poker match.

In effect, Uralkali appears to be doing the cartel's bidding, but outside of the framework. At the very least, Uralkali's move pushes the BHP mine's development timeline out, and in a best case (for the industry's heavyweights), the project ends up shuttered. BHP management's stated intention is to proceed with mine development at a "measured" rate. So, yes, Uralkali's plans will push prices lower. But for the industry, it also preserves relatively attractive, albeit lower, returns on capital—because it discourages new entrants.

But for sake of argument, suppose Uralkali's isn't just posturing. They're serious about leaving BPC. They produce at capacity, and take worldwide market share. In response, I'd wager that Canpotex, the North American cartel, throttles back production to balance the market and loses share. Prices stabilize, as consequence, and remain more or less as before. By my math, Potash Corp's earnings might decline 5-7% next year. But in the long-run, their earnings power is preserved.

My take: Uralkali's move amounts to greater parts cage rattling than substance.

The Crop Yield
Taking a long view, I expect that optimized fertilizer application rates; increased consumption of protein, fruits, and vegetables; and growing per capita incomes worldwide will slowly but surely push fertilizer consumption higher. To measure the probable impact, I've assumed that worldwide per capita fertilizer application rates, with the exception of Africa, converge on something between 50-65% of North American rates over a 20 year period, amounting to roughly 3% annualized volume growth.

I also expect that, on account of Uralkali's decision to leave BPC, potash prices will move lower, to $320 per ton, but remain higher than the marginal cost of supply. Despite Moroccan and Saudi producers' plans to bring additional phosphate supply to market, I expect end-markets to remain relatively balanced, as these players have historically behaved rationally. Last, amid U.S. supply additions, I expect nitrogen-based fertilizer prices to marginally decline. I've conservatively valued Potash's investments in Chemical and Mining Company of Chile (NYSE: SQM  ) , Arab Potash Company, Sinofert, and Israel Chemicals at current prices, which for Potash, amounts to roughly $6/share.

Add it up, and I peg Potash shares' worth at $46. That's tasty.

Risks
Chief among the risks to my investment in Potash are fertilizer prices, which borrow from a number of cues—crop prices, industry production, demand, and peripherally, the economy's health. Should Uralkali's move drive fertilizer prices to the marginal cost of production or lower, or BHP plow ahead with investments in its Jansen mine, I might reconsider my investment. Likewise, Potash is exposed to operational risks associated with its mines, including lower than expected potash recoveries, flooding, and accidents. Last, mining, and production of phosphate- and nitrogen-based products, are high fixed cost operations. While I believe it's unlikely, a material and sustained decline to prices could significantly impair Potash's cash-generating ability.

Bottom Line
People need to eat. And if I'm right, Potash can feed your portfolio. That's why I'm buying today.

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Read/Post Comments (12) | Recommend This Article (44)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 18, 2013, at 2:16 PM, snommis69 wrote:

    When Sammy left, Van Halen brought in Gary Cherone, and it was a disaster - that hand wringing was warrented. In fact, it was worse than expected. This could easily be the case here, however, I think you're right. I think the market over reacted to the Russians bolting the cartel.

  • Report this Comment On September 19, 2013, at 12:20 AM, sliderw wrote:

    When or if artificial (lab-grown) meat catches on, will that reduce the demand for feed and in turn reduce the demand for fertilizers?

  • Report this Comment On September 19, 2013, at 4:33 PM, ijrshore wrote:

    K.I.S.S.

    A well written article could have covered all of this info with half of the number of words.

  • Report this Comment On September 19, 2013, at 6:48 PM, Sandunga1000 wrote:

    WORLD OF DEBT!! (Hilarious Music Video):

    https://www.youtube.com/watch?v=99xsqxzJnXs

  • Report this Comment On September 19, 2013, at 7:56 PM, Borbality wrote:

    Van Hagar is absolutely terrible and unacceptable for any self-respecting V/-/ fan.

  • Report this Comment On September 19, 2013, at 8:45 PM, vravorka1 wrote:

    Buying 30 shares of POT is not exactly a large investment...lol

    If you're so positive it will go up, why buy only

    30 shares ??

  • Report this Comment On September 19, 2013, at 9:55 PM, PaulEngr wrote:

    You caught most of the major points. However this is not about pressuring bhp. That operation will not come online until about 2020. The "peak fertilizer" point is here now for the next few years until the middle east operation comes online. So the timing is all wrong to support this theory.

    Consider the fact that if the private Russian firm does not make payments on their loans (warrants?) to the state owned company, the state gets a 35% (controlling) interest in the private company. Consider that potash is making money and this kind of strong arm business tactic is standard procedure for the Russian government. It is more likely a move to take over the private potash company.

    If I'm right expect prices to go to around 200 for a couple years before we return to the same 5 (then 4) players. If this is the case it may be premature to jump in but the pricing is about right since potash is running 400 a ton, accounts for roughly 50% of pot's revenue, thus a 25% haircut was warranted for now, if this is accurate. Within a year we'll see what the real situation is. This is a watch right now, not a buy unless you are just going for a dead cat bounce scenario (market overreaction).

  • Report this Comment On September 19, 2013, at 9:55 PM, vireoman wrote:

    Given that the CEO of Uralkali was arrested in Belarus, I think your Machiavellian notion of the subtle games that are being played (ie, driving BHP from the game) is overly fanciful.

  • Report this Comment On September 20, 2013, at 4:47 PM, RBHarlow wrote:

    The author confuses BHP Billiton (NYSE: BHP) with Belaruski and the Belarusian Potash Company (BPC). BPC is the eastern cartel. It is (was) the sole supplier of potash fertilizers manufactured by Belaruskali (the Republic of Belarus) and Uralkali (the Russian Federation). The Belaruski company was cheating by selling outside of the BPC cartel, which motivated Uralkali to withdraw.

    BHP has nothing to do with this drama, except that it happens to have potash interests in the west. Yes, it may be affected, as may POT, but these firms are not part of the dispute.

  • Report this Comment On September 20, 2013, at 8:23 PM, ryanalexanderson wrote:

    > K.I.S.S.

    Stay focused. We're talking about Van Halen, not KISS.

    And Hagar beats Roth any day, IMHO. But they were both good.

  • Report this Comment On September 20, 2013, at 8:41 PM, kirkydu wrote:

    I agree with PaulEngr, POT is an avoid or watch right now. There are too many uncertainties at best. At worst, the Russians indeed are after the one two of killing competition and seeing Belarus default on their $2 billion loan which results in Belaruskali going to the Russians. That is a multi-year process.

    http://www.marketwatch.com/story/russia-frees-the-potash-mar...

  • Report this Comment On September 24, 2013, at 4:23 AM, johnasle wrote:

    The Norwegian Company Yara could be a good long term Investment.

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