Since September 2012, the prices of commodities, whether base metals like copper and iron ore, or precious metals like gold and silver, or agriculture commodities like fertilizers and grains all went down. CRB index has lost 10% since September 2012. Potash (POT) Corp. has underperformed the market like other commodity companies. But there is a silver lining in lower commodity prices for Potash.
For long term investors, whether China or India signs a contract for purchasing potash at $400/t or $450/t is of little significance. The biggest concern is the long term trend of supply and demand balance. Due to the growing population and improved living standard in populous countries like China and India, potash demand will be stable. Global shipments of the fertilizer are expected to be 57 million tonnes this year, and demand will increase by 3-5% annually over next decade. Global operational supply capacity is about 62 million tonnes in 2013 and will grow to about 70 million tonnes in 2016 according to Potash Corp forecast.
A significant number of potash exploration projects have been announced in various parts of the world; however, most of them are still at very preliminary stages of evaluation. High-quality, economically viable potash deposits are geographically concentrated in Canada, Russia and Belarus. K+S Inc. has received approval in 2012 for its Legacy project in Saskatchewan and is in the early stage of development. Eurochem has started two projects in Russia but encountered some delays. Vale recently suspended work on its project in Argentina due to escalating costs. BHP (BHP) continues to perform development work at its Jansen site in Saskatchewan but has yet to make a final decision to go ahead with the project. Among all these projects, only BHP's Jansen project will have a significant impact on the global potash supply. It is estimated to cost BHP $12 billion to build the mine and will haul 9 million tonnes a year at peak production in 2026. If BHP goes ahead with Jansen project, then the over-supply of potash will be a problem in about a decade. It will depress potash price to $300-400/tonne.
Up until the end of last year, BHP was pushing the project. "We intend to build the world's largest potash mine," said Bronwyn Wilkinson, a spokesperson from BHP. "We see Jansen as the first project in what will eventually become a large business for BHP in Saskatchewan." Since then, however, the situation has changed. Based on my analysis, there is a 50% probability that BHP may delay or even cancel the project. The reasons are as follows:
- Lower commodity prices. As a global resources company, BHP has been ranked as one of the largest producers of major commodities, including aluminum, copper, energy coal, iron ore, manganese, metallurgical coal, nickel, silver and uranium along with substantial interests in oil and gas. In last 12 months, most of these commodities are trending lower. BHP's operating cash flow has dropped 25% from 2011 to 2012 and is expected to continue to drop. If BHP goes ahead with Jansen project, it is unlikely it can fund the project through internal operating cash flow. The project has to be funded either by external debt or by third party partnership. Given the lackluster pricing environment in commodities, debt holders may start to worry about the rating and will demand a high yield. The best case scenario for BHP is to convince China or Indian to step in to provide financing or take a stake in the project.
- Adequate potash supply. For the next 20 years, the supply and demand for potash are well balanced. If additional 9 million tonnes potash comes into market in 10 years, the price is expected to be depressed to around $350/tonne. Currently the marginal cost of producing potash is around $250/tonne in Canada. After adding royalty payment to the government, costs of storage/shipping / handling, and inflation, the production cost can easily be increased to $300/tonne in 5 to 10 years. The targeted capacity for BHP is to produce 9 million tonnes potash annually. Therefore, the gross profit would be around 450 [9x (350-300)] million dollars and net profit around 300 million dollars after taxes. Given the project cost at 12 billion dollars, the IRR is too low.
- Investors' impatience with mining companies. The performances of mining companies over last two years were very poor and investors are losing patience. They started to demand return of capital through dividends or share buybacks. Most mining companies are retreating from their expansion plans. For new projects, the hurdle rates are high. The expectations for commodity prices are becoming more reasonable which make many projected IRR unattainable. In addition, BHP has just changed its CEO. The most important task for the new CEO is to evaluate the risks of long term projects like Jansen mining and the prudent decision is to postpone the project.
In summary, unless there is a third party willing to finance or take a stake in the project, Jensen project is likely to be postponed. If this is the case, it will benefit Potash Corp greatly. The pricing environment will be stable and earnings will grow slowly with less volatility. For long term investors, keep your fingers crossed that commodity prices, especially potash price will continue to be sluggish for a while.