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.
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.
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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