Natural gas prices, which have generally been trending lower since the beginning of 2010, continued to slide over the last few months, dropping from an average spot price at the beginning of FY 12 (July 1, 2011) of $4.50 per MMBtu’s to a spot price the first week of January of just below the $3.00 mark.
The key reason in the decline has been the continued growth in U.S. on-shore production. Due mostly to the shift in hydraulic fracturing in shale formations, U.S. monthly production has steadily increased from an average of 1.5 Tcf per month in 2006 to an average over the last few months of just over 2.0 Tcf.
The general consensus is that natural gas prices will trend somewhat higher through the end of 2012, but remain below the averages of the last few years. This is also backed up by the latest NYMEX numbers which show natural gas prices trading below $3.50 through most of the year and, then, moving up toward the $4.00 level at the end of the year.
So what does this mean for nitrogen fertilizer prices? Absolutely nothing. While nitrogen fertilizer prices historically followed natural gas prices, the link between the two started to become disconnected in 2007. The main reason – supply/demand. First, nitrogen fertilizers are a commodity product where price is set by supply and demand of ammonia. Through most of the 1980s, 1990s and up until the last 4-5 years, the U.S. and world nitrogen balances were mostly in a surplus position. As a result, prices were driven down to the point where the high cost producers were forced to shut down production. Since natural gas accounts for roughly 90 percent of cash production costs, nitrogen prices mirrored natural gas prices.
The balances started to shift in the middle of the last decade when increases in demand started to outpace additions to capacity. The net impact was an overall tightening in the world nitrogen balance with prices escalating well above industry production costs. The disconnect has certainly been evident over the last two years. As shown in the chart above, MW wholesale prices roughly doubled during the period while the Midwest delivered production costs remained flat to slightly lower. The disconnect is even more evident when looking at producer margins. While historical margins typically averaged in the $30-$60 range, margins climbed from roughly $100 per ton at the beginning of 2010 to an average of over $500 per ton during the second half of CY2011.
The other key factor for the disconnect is the fact that the U.S. is no longer the world’s swing supplier. As a result of the downward trend in U.S. natural gas prices and the sharp escalation in both Eastern and Western Europe prices, U.S. production costs are now well below the "floor" price of European producers.
The good news in all of this from a buyer’s perspective is that the world nitrogen supply/demand balance is expected to move back into more of a balanced position over the next couple of years as new off-shore capacity, combined with some additional expansions/restarts in the U.S., start to come on stream. This should help put some downward pressure on the nitrogen markets. We don’t, however, expect prices to "re-connect" with natural gas prices anytime soon.