The nitrogen fertilizer market over the past several years has not been too kind to Terra Nitrogen Company (NYSE: TNH). Since 2011, the price of ammonia and urea ammonium nitrate (UAN) have slowly been sliding thanks to the aftershock of the Chinese commodity boom. Despite the troubles of the market, the company has been able to still generate strong margins and return cash to its investors. This quarter was particularly tough in that regard because fertilizer prices were so low, but according to the management team at Terra Nitrogen's parent company, CF Industries (NYSE:CF), the worst of the market may be behind us. Let's take a quick look at Terra Nitrogen's results as well as what CF Industries is seeing in the future of the fertilizer market that should leave investors encouraged.
By the numbers
|Results*||Q3 2016||Q2 2016||Q3 2015|
|Earnings per unit||$1.04||$3.22||$2.23|
|Distributions per unit||$1.77||$2.58||$2.81|
The largest driving factor in Terra Nitrogen's sales decline came from the falling prices of both ammonia and UAN. Prices for these two products are typically lower in the third quarter because of seasonal cycles in the agricultural market, but this year's lows have been particularly noticeable because of a global oversupply of nitrogen based fertilizer production. The company was able to offset some of these weaknesses by shifting more of its production toward ammonia versus UAN since ammonia prices are that much higher, but it can only do so much in this regard.
The thing that does stand out, though, is that earnings appear to have dropped rather significantly compared to the prior quarter. That's because the company reported an unrealized net mark-to-market gain on natural gas derivatives of $27.3 million, which artificially lowered costs of goods sold for the quarter.
From a cash flow perspective. This quarter was obviously hurt by lower realized prices, but it also helps that capital spending this year is significantly lower than in 2015. Last year, Terra Nitrogen's' facility went through a large turnaround that cost $82 million over the first 9 months of the year. In 2016, though, capital spending has been just $25 million, so a little more cash is flowing out to investors.
What management had to say
Terra Nitrogen doesn't hold its own conference call to discuss its results because it is a subsidiary of CF Industries. On the CF Industries call, Bert Frost, SVP of Sales, Market Development, and Supply Chain at CF Industries, gave a pretty extensive outlook for the nitrogen fertilizer market that is very pertinent to the future prospects of Terra Nitrogen.
The global oversupply of nitrogen and its pressure on prices is not a new story. As we have said before, we believe 2016 represents the high watermark for urea capacity additions globally, with capacity additions projected to drop off sharply after mid-2017. As an industry, we have yet to see the full impact of the new North American production capacity, but that which has come online has begun to displace imports.
The low global prices have challenged the ability of high-cost producers to operate. The marginal producer, which remains Chinese anthracite coal plants, have also seen production and transportation costs rise. Rail and trucking costs in China have increased, and electricity subsidies for small urea producers were eliminated in April. Additionally, coal prices have increased due to government-imposed mining restrictions.
Anthracite lump coal prices in China had been flat for most of the third quarter, but recent published reports suggest that prices have increased 20% to 30%. This has translated to additional plants in China shutting down and fewer Chinese product being offered in the international marketplace via exports. Through the end of the quarter, approximately 8 million metric tons of annual urea capacity has been shut down in China, and we anticipate that number to continue to increase.
This fundamental economic pressure is affecting pricing. The Chinese port price per metric ton for urea had risen to about $220 as we enter November, up from $194 per metric ton at the end of September. Also, the average U.S. Gulf price for urea barged product was approximately $180 per short ton for the third quarter, and today, it is $30 to $40 higher. We anticipate that prices in the coming quarters will also be supported by stronger demand.
During the low price environment of the third quarter, customers took a new approach to purchases. While the third quarter typically has the lowest prices and lowest volumes in North America, demand was pressured more than normal. The trend of lower prices over the last 18 months has increased inventory risk in the mind of the purchaser. Over the last 10 years, customers have purchased forward, received the product out of season as inventory and then delivered the product to their customers for either fall or spring applications.
Today, this is much less the case. Many domestic customers told us they did not want to purchase product in the third quarter, preferring instead to take a wait-and-see approach to understand how the market will develop, particularly with new capacity expected to come online in North America. This approach was a deviation from historical purchasing patterns, but we responded to this environment in a few specific ways.
What a Fool believes
This was one of the tougher quarters for Terra Nitrogen as fertilizer prices were very weak. Still, the company was able to produce net income margins greater than 30% and return a pretty hefty amount of cash to unitholders in what is traditionally the low point in the company's earnings cycle.
Based on the outlook from CF Industries execs, investors in Terra Nitrogen should expect this year and possibly 2017 to be so-so years as the glut of nitrogen fertilizer production will still be high, but eventually rising demand and the shut down of marginal cost players should bring prices back up again. This should set up Terra Nitrogen rather nicely to pay out hefty distributions to shareholders for many years to come.