The shale gas boom in the U.S. has benefited many industries. Where some companies have found an incremental demand for their products like Westport Innovations (WPRT), a natural gas engine manufacturer, others have found a cheap raw material in the form of natural gas to be used in the production process. In this context, the fertilizer industry deserves a special mention. In this piece we will analyze which players in the fertilizer industry are expected to be the main beneficiaries of the shale gas boom.
The Fertilizer Industry and the Shale Gas Boom
Natural gas is an important raw material for the production of ammonia and nitrogen which in turn are used to produce fertilizers. The shale gas boom has led to a sharp decline in the natural gas prices which has significantly slashed the production costs for nitrogen.
It would not be wrong to say that not even a single U.S. fertilizer player has lost anything from the shale gas boom. All fertilizer companies have been winners. Before the shale gas boom, the North American producers were the marginal cost producers. Currently, the shale gas boom has reduced the production costs to such low levels that the North American fertilizer companies are operating in the lowest quartile of production costs (since their inception!).
The costs have declined but the prices have remained stable therefore improving the margins for the North American fertilizer companies. A price floor has been set by high cost producers in China and Ukraine. The current price hovers around $400/ton. A natural gas price of $3/MMBtu has restricted the granular production cost to $115/ton in the U.S.
Unquestionably, the strong margins in the North American nitrogen industry are attracting significant investments while the new capacity expansion projects in the Middle East have dried up.
Winners of the industry
I have already mentioned that every company in this industry has benefited from the shale gas boom. However, we need to pick out the top winners in this industry that are expected to benefit the most from the shale gas boom in the future.
We have four main players in the U.S. fertilizer industry: Agrium (AGU), CF Industries (CF), Mosaic (MOS) and Potash (POT).
I believe that AGU and CF are the top picks to benefit from the shale gas boom. There are two reasons to back my claim:
1. Fertilizers are made up of different chemical compositions. The following six ingredients vary in different proportions: a) Nitrogen b) Phosphorous c) Potassium d) Calcium e) Magnesium f) Sulfur
We have already discussed that nitrogen can be produced extremely cheaply using natural gas. Therefore, automatically, the companies that have a high exposure in nitrogen-based fertilizers will be the main beneficiaries from the shale gas boom. In this regard, AGU and CF come at the top of the list.
2. This year, various companies have announced different plans to develop new urea capacity in North America. These plants are expected to start their operations from 2016 onwards. The addition of the new capacity is expected to bring an additional 9 million tons of fertilizer annually from 2016 onwards. In this case, AGU and CF have solid expansion plans.
Agrium
The company is one of the largest producers of agricultural nutrients in the world. The company is one of the very few that possess the unique feature of crossing the entire agricultural value chain. Not only this, the company is also the world's third-largest global nitrogen producer. It generates more than half of its profits from the nitrogen segment. This is why I believe that the company is expected to see a marked improvement in its bottom-line after benefiting from the shale gas boom. The company has announced a two year plan to increase its North American urea capacity by 2.6 million starting in 2014.
CF Industries
CF Industries is the second largest nitrogen fertilizer producer in the world. The low cost natural gas has moved CF to the low end of the global industry cost curve. In the long-run, the company intends to continue leveraging its cost advantage through a recently announced $3.8 million nitrogen capacity expansion. The following charts show how gross margins of CF's nitrogen segment are negatively correlated to the natural gas price.
(click to enlarge)
Source: 10Q
Valuations
Agrium (AGU) | CF (CF) | Potash (POT) | Mosaic (MOS) | |
Gross margins | 27% | 52.30% | 45% | 28.34% |
Operating margins | 12% | 50% | 42% | 23.66% |
Dividend yield | 2.04% | 0.80% | 2.10% | 1.79% |
YTD performance | 46% | 40% | -1.84% | 12.50% |
Forward P/E | 10x | 8x | 12x | 11x |
Clearly, CF has the highest margins in the industry. On the other hand, AGU is also expected to witness a rise in the margins after the enhancement of its urea capacity. Also, both AGU and CF have cheaper forward multiples than their peers.
Corn, the world's largest cash crop, has heavy fertilizer requirements with a particular reliance on nitrogen. I expect high application levels for CF's and AGU's nitrogen products in 2013 as farmers seek to maximize production to take advantage of the elevated corn pricing environment resulting from the severe U.S. drought that has left crop supplies tight. As we approach the primary U.S. application season this spring, I expect the fertilizer demand to be strong in terms of both volume and pricing.
Both AGU and CF have their strong points. Where AGU offers an attractive dividend yield, CF has attractive margins. Both companies have a solid liquidity position which means that they are in an ideal position to invest in infrastructural development to benefit from the shale gas boom. I recommend investors take a long position in both stocks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
