Mark Gulley: Potash Stuck in Neutral

September 14, 2012 08:08 AM

Mark Gulley is a principal at Gulley & Associates Llc, New York, and an Inputs Monitor contributor.

Potash prices have been roughly flat since November 2010. The Midwest potash price has round-tripped from $546/tonne in November 2010 to a peak of $626/tonne in October 2011, back to $541/tonne in August 2012. This is despite elevated crop prices, corn at $6.55/bu (Dec. ’13), soy at $13.54/bu (Nov. ’13), and wheat at $8.71 (Dec. ’13).

Two conditions must both be met for increased pricing flexibility - fertilizer affordability driven by supportive crop prices, and tight operating rates.

Outperformance is likely to be problematic. Since only one condition is being met over the next several years, and since pricing is a key driver of EPS and equity valuation, P&K equities are likely to struggle.
Nutrient affordability is satisfactory. At a long-term corn price of $5/bu, total fertilizer expense would account for 17% of corn revenues compared to a 10-year average of 19%. Of that 17%, potash would account for 3.5%, which is the 10-year average.
But operating rates continue to trend lower. I estimate the global potash operating rate could decline at 150 bps per year from the 98% peak in 2004 to the 80% trough in 2015E.

Potash Capacity
An inflection point in operating rates is tied to capacity growth. The global potash industry is at a crucial inflection point in 2012E. This is because capacity is set to grow at a much higher rate over the next several years (5%/yr) than in the past several years (2%/yr). Even if brownfield expansions don’t ramp-up quite as rapidly as expected during this period, it’s largely academic since the industry would need operating rates in the high 80’s to enjoy supplier-power pricing flexibility in any event.

I see three distinct periods in terms of capacity additions during the fifteen-year 2000-2015E period; stable capacity, moderate capacity increases, and excessive capacity increases. Over the 15-year period both demand and capacity grow 3%/year, but with variability intra-period.

2005-2011: An eventful period. The ethanol era began in 2005, there was the 2008 bubble, the great recession of 2009, and the recovery which began in 2010 and extended into 2011. PotashCorp began planning its brownfield expansion strategy in 2007. During this period, operational capacity grew at 2.6% per year, demand grew at 1.4% per year, but operating rates eased from a strong 95% in 2005 to 91% by 2011.

2012-2015E: Capacity overhang brewing. Our analysis suggests operating rates will plunge to 84% in 2012E from 91% in 2011, remain stuck in the low 80’s through 2015E. An operating rate of 84% in 2012E would be the lowest since 2002, except of course for the 51% in the great recession of 2009. Even if demand grows at a robust 3-4% per year during this period, it will not be enough to overcome 5% capacity growth.

2012E: The short-term issue is that capacity could be up 5%, 3.5 million tonnes, this year, which hits global operating rates by around 500 bps.

2012E-2015E: Capacity should be much more than adequate over the next five years. K+S Group (SDF.DE, Not Rated) has a recent view of supply-demand forecasts, having just updated its roadshow slide-deck. It forecasts that operational capacity will increase by 15 million tonnes, 5,000 tonnes/year-year, 5% per year, 2012E-2015E.

Brownfield Capacity

PotashCorp and Mosaic are the most aggressive in terms of adding brownfield potash capacity at each of their Canadian mines by the 2016-2017E time frame. PotashCorp is adding 5.6 million tonnes, Mosaic 3.3 million tonnes, Uralkali 3 million tonnes, China’s QSLI and Agrium roughly 1 million tonnes each, SQM, Israeli Chemicals Ltd, and Intrepid at 0.4-0.5 million tonnes. We don’t anticipate Mosaic backing off of its plans to execute on its brownfield expansion plans so as not to lose capacity share to its Saskatchewan rival.

Greenfield Capacity

A marker for an inflection point in a basic material is when greenfield capacity is being built because this implies that reinvestment economics has been achieved. This can occur even if larger incumbents insist that this hurdle has not been overcome because incumbents have the most to lose. This is especially the case in potash because it’s been fully 40 years since the last potash mine was built in Saskatchewan.

K+S. Moose Jaw, Saskatchewan - K+S is committed to its first N.A. potash mine, a solution mine to be built in three phases, located near Moose Jaw, Saskatchewan. K+S faces declining reserves and rising costs for environmental compliance at its conventional potash mines in Germany. It established a beach-head in Saskatchewan with its 2011 acquisition of a publicly traded company, PotashOne, for $0.4 billion. The announced capital investment for phases I & II is $3.25 billion . Initial capacity is 2 million tonnes/annum in 2017E and the date for ramp-up to begin is 2015E. K+S has said the final long-term capacity could be 2.86 million tonnes by 2023 and the ultimate capacity could be 4 million tonnes.

BHP. Jansen, Saskatchewan. - BHP appears to be slow-walking its entry into the global potash industry with a conventional shaft mine located at Jansen, SK. Investment to-date is $1.2 billion The projected on-stream date is late 2015 for first saleable product, which is not reflected in our 2015E capacity estimate due to project risk. Ultimate capacity is to be 8 million tonnes/year.

Potash Demand

Both potash and phosphate demand could falter for the upcoming 2013/14E crop due to the drought in the U.S. corn belt. To be conservative, I have not yet reflected this impact in my NA demand forecast. (P&K are usually applied together as the "dry" fertilizer every two years after soy harvest). Soil tests taken post-harvest will actually determine application rates. The U.S. accounts for a third of global P&K consumption.

Total crop production for the three major row crops (corn, soy, wheat) is estimated to be down 12% for the 2012/13E crop currently being harvested. Using this as a rough proxy for crop nutrient removal during this harvest, all else being equal, growers could cut-back on application rates for the 2013/14E crop due to lower crop uptake by the plants. Demand should presumably recover for the 2014/15E crop to reflect more normal growing conditions.

Investment Risks

Investment risk reflects the fact that the production agriculture business is subject to significant volatility owing to several factors that lie outside the control of the customer base. Millions of individual growers affect supply and demand for crop production, and therefore crop prices are subject to: (1) highly variable weather; (2) changing government policy; (3) highly varying crop yields (4) the relative value of the U.S. dollar; and (5) the recent spike in the corn price; and (6) resulting overhang in the U.S. ethanol mandate due to the prospect for high food inflation in a deflationary environment as evidenced by very low bond yields; and (7) the remote possibility that EPA could grant a waiver on the ethanol mandate due to the worst farm-belt drought since 1988.

My current 12-month price target of $120 for Buy-rated Agrium is based on 11x our current 2013E EPS estimate of $11 per share. This is based on an arithmetic average of four valuation approaches: DCF, EBITDA multiple, comparables, and sum-of-the-parts. Risk to my price target also reflect the fact that the production agriculture business is subject to significant volatility.

Until fertilizer affordability supported by crop prices merges with tighter operating rates, I expect potash to remain stagnant. I maintain a negative stance on P&K crop nutrient equities due to lack of pricing flexibility, despite elevated crop prices. The exception is Agrium (AGU, Buy), based on the potential for a break-up into retail and wholesale. Drought year corn prices support greater price flexibility, but I do not see this having any leverage on the market at large without operating rates first coming down amid strong grain prices.


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