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By Jeffrey Stafford, CFA and Elizabeth Collins, CFA

With China and India back to buying potash after an extended hiatus in 2012 (global shipments were down 9% in 2012 from 2011), we expect demand growth of close to 10% in 2013. Potash prices should firm up from prevailing Saskatchewan spot levels around $420 per metric ton as the year progresses, although we don't expect a return to the heady levels of late 2011 ($550 per metric ton). Over the next five years, we still expect that supply will grow faster than demand, but the gap between the two has shrunk, given our expectation for strong near-term demand growth and some modifications to our supply forecast (projects shelved, longer ramp-up times, and so on).

Our long-term price forecast remains $375 per metric ton at the typical plant gate in Saskatchewan. Despite our expectation that prices will drop further, wide-moat Potash Corporation of Saskatchewan (NYSE:POT), which benefits from low-cost assets, looks moderately undervalued. PotashCorp's position on the cost curve delivers some downside protection if our price thesis turns out to be too bullish. Narrow-moat Intrepid Potash (NYSE:IPI), which has a geographic cost advantage, is the most undervalued producer, in our opinion. We think producers' stock prices could have more room to advance now that potash prices have dipped closer to what we see as a more sustainable level.

Farmers Need to Feed a Growing Population Using Fixed Land: Yields Must Improve
The world's population is growing. A United Nations study pegs average annual global population growth at about 1% through 2025, with faster growth in developing regions. With arable land per person decreasing as the population expands, more crops will need to be grown on less land. While many champion genetically modified crops as the magic bullet, optimal fertilizer application has proved to be a critical tool for improving crop yields, as farmers in much of the developed world have demonstrated. We think rising application rates in developing countries will support potash growth above gains in population.

Potash Demand Growth Higher in the Developing World: China, India, and Brazil Are Important
Like many other commodities, potash demand is an emerging-markets story. Brazil, India, and China accounted for nearly 50% of global potash demand in 2012. While we don't think farmers in China will come close to application rates used by their U.S. counterparts anytime soon, we do expect that long-term potash demand will receive a boost from higher application rates in China, India, and other emerging countries.

Any farmer will tell you that the correct balance of primary macronutrients--nitrogen (NYSE:N), phosphate (NYSE:P), and potassium (potash, K)--is essential to achieving the highest possible yields. However, compared with the U.S. and other parts of the developed world, China and India have underapplied potash relative to nitrogen for years. China's N:K ratio was especially high in the past, averaging 14.6 times over 1985-95 compared with an average of 2.2 in the U.S. over that same period. China and India have both improved N:K ratios substantially in recent years; potash consumption growth in those countries has been higher than the U.S., and the N:K ratio gap has narrowed. Over the past five years (2008-12), China's N:K ratio has averaged 6.3 times and India's 5.3 times. The N:K ratio in the U.S. has remained relatively stable through time, averaging 2.9 times over the past five years (the five-year average is higher than historical figures, given the precipitous drop in potash application rates in 2008). We think the gap between the U.S. and developing countries will continue to close. However, with large gains already made in China, we expect the rate of potash consumption growth in the country will slow compared with the period of robust growth before the global economic slowdown in 2008-09.

In addition, China’s and India's economies are growing much faster than the rest of the world, leading to rising incomes and increased food consumption. Meat consumption per capita has a multiplier effect on grain production: It takes roughly 7 kilograms of grain to produce 1 kilogram of beef; for pork and poultry, the multipliers are 4 and 2, respectively. Thus, as a population moves from eating mainly grain to consuming more meat, the level of grain production needed to support that population increases substantially. Applying more potash to crops boosts grain yields per acre.

While we expect continued growth in food consumption in China, rapid gains in caloric intake per capita compared with developed countries have already taken place, in our view. We agree with other commentators that China's population will eat more food, and importantly more meat, but the country is already bumping up against its wealthier Asian neighbors in terms of daily calories consumed. We think China's daily protein consumption from meat could increase, given continued middle-class development and a demand for higher-quality food, but we doubt it will ever reach the level seen in the U.S. due to cultural differences.

While the amount of meat consumed in China could have a significant impact on global potash demand, China's potash consumption profile is more influenced by fruits, vegetables, and rice than grains such as wheat and corn, which are more likely to be used in animal feed. According to a study by the International Fertilizer Industry Association, 50% of the potash used in China is applied to fruits and vegetables, with the next 28% applied to rice. Wheat, a more traditional livestock feed, accounts for only 4% of China's potash demand. Fruits and vegetables have grown substantially in China, in terms of both production and acreage, and these crops generally require more potash than grains.

India is another important market for potash. Similar to China, India uses most of its potash on fruits, vegetables, and rice, a combined 56%. Sugarcane, another potash-intensive crop, is important as well, accounting for 10% of the country's potash use. India still has a ways to go before it's eating as much as other countries, thus there is a significant runway for gains in caloric intake as incomes in the country improve. What has been more interesting and has had a big impact on potash consumption in recent years is the Indian government's fertilizer subsidy policy. Recently, the subsidy policy has favored the domestic nitrogen over imported potash, making potash much more expensive for farmers than in previous years. We view the pullback in potash demand as a temporary and unsustainable phenomenon. Food security is important to India, and we believe the country can only go so long before it changes its subsidy policy to make potash more affordable.

Finally, we highlight Brazil as an important emerging market for potash demand. Brazil consumes roughly 15% of the world's potash and, like the U.S., is a key crop exporter. The country has seen its production of soybeans and corn increase markedly over the past decade, as demand from China has soaked up new crops. China's soybean imports have climbed to nearly 60 million metric tons from just 4 million in 1998. In 2003, the USDA Foreign Agricultural Service estimated that over time, Brazil had the potential to add 420 million acres of crop production, an area much larger than U.S. acreage used for major crop production.

We're not expecting a big jump in Brazilian potash consumption driven by improving diets in the country. Similar to China, Brazil has made sizable gains relative to the U.S. in caloric intake. In fact, Brazil now consumes more calories per day per capita than Sweden, South Korea, South Africa, and the Netherlands. Further, we don't expect potash application rates relative to nitrogen to be a driver of growth in Brazilian demand. N:K ratios in the country have remained relatively stable over the years, and we expect that will continue to be the case. Rather, we think increased acreage will drive Brazil's potash consumption higher.

Farming Practices and Fertilizer Use in Developed Nations: U.S. Potash Use Flat to Negative
While the use of potash in the developing world is expected to increase, more advanced agricultural economies may in fact use less potash in the coming years. As farmers use more sophisticated farm management techniques (machinery, soil testing, and so on), they are able to use less fertilizer per acre to achieve the same yield. As such, we think growth in North American potash consumption will be relatively flat to even slightly negative after a return to more normal levels in 2013.

Could a Change in U.S. Ethanol Standards Dramatically Reduce Potash Demand?
The short answer: no. During the past decade, ethanol has emerged as a main driver of corn demand in the U.S., skyrocketing from about 6% of total U.S. corn demand in 2000 to about 40% currently (but only roughly 20% when the co-production of animal feed is taken into account). The U.S. government mandates the amount of ethanol used in gasoline with the Renewable Fuel Standard, which in 2013 calls for 13.8 billion gallons of corn ethanol, rising and leveling off at 15 billion gallons in 2015. We don't expect that Congress will throw out the standard. It doesn't directly cost the government anything, and there's enough support in the Senate from corn ethanol-heavy states that it would make repealing the standard difficult, in our opinion. Further, we think it is likely that a portion of U.S. corn ethanol production would remain in place based on the economics of production and the use of ethanol as oxygenate in gasoline.

Developed Potash Deposits Are Controlled by a Handful of Players: Rational Oligopoly
With potash deposits concentrated in only a handful of countries (mainly Canada, Russia, and Belarus), potash production is also highly concentrated. By our estimates, the top six potash makers control more than 80% of global production capacity, led by Potash Corp. On top of that, the top four producers belong to one of two large marketing organizations that negotiate contracts and pricing for their members, further consolidating the industry and decision making within it. The oligopolistic nature of the industry leads to more rational pricing and production decisions, in our opinion. As such, we think future potash brownfield supply will be utilized judiciously (similar to the situation in 2008 and 2009, when production was curtailed to support pricing), and we don't expect that the handful of companies that currently dominate the potash market will undercut each other on pricing.

Potash Corp estimates it takes seven years to fully develop and ramp up a greenfield potash project. Lengthy development runways give us visibility into future supply. Forgoing time-consuming and expensive greenfield projects, several of the top industry players have announced and are working through brownfield expansion projects. This includes Potash Corp and Mosaic (NYSE:MOS), the two largest North American producers; however, Mosaic has recently shelved plans for 2 million metric tons of capacity that was scheduled for the end of the decade. Additionally, the top two Eastern European producers, Belaruskali and Uralkali, have expansion plans on the docket. We estimate the bulk of planned brownfield expansions will start up between 2013 and 2017. Accounting solely for brownfield expansions, we think total potash supply will grow at a slower rate than demand through 2020. Thus, we believe the potash market would tighten without the addition of greenfield capacity.

Do Greenfield Projects by Outsiders Threaten the Current Oligopoly?
Given the oligopolistic nature of the industry, we think current players will utilize new supply judiciously, rather than flood the market with new potash, which would have a detrimental impact on pricing. However, the run up in potash prices in 2008 and again during 2011 has piqued the interest of firms outside the traditional circle. Namely, large global miners BHP Billiton (NYSE:BHP), Vale (NYSE:VALE) and Rio Tinto (NYSE:RIO) have shown an interest in potash. In 2010, BHP took a shot at acquiring Potash Corp in a hostile takeover, a bid that was ultimately struck down by the Canadian government. While we think Mosaic could be an attractive target for BHP, large miners will mainly look to develop their own potash projects through greenfield development, in our opinion. Notable greenfield projects include BHP's Jansen mine in Saskatchewan and EuroChem's projects in Russia. Each could eventually add 8 million metric tons to annual supply.

We estimate that about 24 million metric tons of greenfield capacity could be added by 2020, with the bulk of capacity coming on line in the back end of the decade. That said, it is unlikely that all of the projects announced will make it through to completion. And even if projects are completed on time, final figures for annual production capacity could fall short of initial estimates, especially for projects in the very early stages of development. As such, we have haircut our greenfield capacity numbers for selected projects. We have also toned down our expectations for how quickly BHP and EuroChem will be able to ramp up production at their new mines.

When BHP was engaged in its bid to take over Potash Corp, it said it would operate its potash assets similar to the overall philosophy deployed across all its businesses: Run assets at full capacity and take market prices (even during tough times). This strategy generally works for BHP because the company controls low-cost assets, and it would have been replicated by securing Potash Corp's cost-advantaged potash mines. Canpotex producers do not operate under a similar strategy. This was proved in 2009 when the companies drastically cut production in an effort to prop up prices and maintain margin. Industry operating rates plummeted to about 50% (thanks largely to Potash Corp), and prices found a bottom before reaching per unit costs of production for the lowest-cost producers.

Though BHP failed in its bid to acquire Potash Corp, it could make a play for another potash producer. We see Mosaic as the most likely target if BHP chooses to pursue another producer. As Mosaic is a U.S. company, we don't believe the Canadian government could block a bidder for Mosaic in the same way it killed the BHP-Potash Corp deal. If BHP were to acquire Mosaic, we think the deal would be bearish for potash prices, and we may lower our long-term potash forecast. One possible deterrent to BHP acquiring Mosaic is Mosaic's phosphate assets, which BHP and other miners have shown less interest in. Further, BHP's management has mentioned that it is more focused on generating free cash flow and returning cash to shareholders, and the company might not have the appetite for a large acquisition.

Strategic Investments by Importing Countries: China and India Could Throw 'Bad Money' at Projects
Outside of BHP, EuroChem, and established players, several junior potash companies control undeveloped greenfield assets around the world. While we think that many of these projects will have difficulty securing financing at current potash price levels, there is the possibility that China and India will make strategic investments in greenfield developers with little regard for project economics. China and India probably want to control more of their own potash assets rather than relying on the two large marketing organizations--Canpotex and BPC--for future supply. Examples of investments include Indian company Gujarat State Fertilizers & Chemicals' recent stake in the potash development project controlled by Karnalyte.

We believe these types of investments (especially since they may be made outside the scope of traditional return requirements) have the ability to shake up the potash industry over the long run. Big money funneled to greenfield projects would probably come with supply purchase agreements, taking away some of the open-market tons currently sold by Potash Corp and others. That said, a big impact from strategic investments is still years away--past 2020, in our opinion.

Potash Utility and the Impact of Crop Prices: Poor-K Soils Support Potash Purchasing Even at High Prices
In addition to the oligopolistic nature of the potash industry and the pricing support afforded by it, we think the marginal utility of applying potash will help prices stay above marginal costs of production. To help us better understand farmers' purchasing decisions, we use a matrix developed by Paul Fixen of the International Plant Nutrition Institute to estimate the economic implications of applying potash to U.S. Corn Belt fields at varying potash and corn price levels. A 2005 soil test summary by IPNI estimates about 45% of the soils in the major corn states have low to medium levels of potassium (under 160 parts per million). For growers planting on these fields, it still makes economic sense to buy potash at extremely high prices, even with low corn prices. For example, assuming $3 per bushel corn (current prices are in the $6-$7 range) and $1,000 per metric ton potash before freight, growers on low- to medium-potassium soils still receive a positive return per acre by buying and applying potash.

If all of the soils in the Corn Belt suffered from potassium deficiency, producers might be able to push long-term prices above $1,000 per metric ton. However, 55% of soils in major corn states have a high level of potassium. For farmers on these fields, the purchasing decision is not as clear. Growers with soils rich in potassium apply potash to replace the potassium taken out by corn, not necessarily to increase yield for that particular growing season. We have to believe these purchasers are much more price-sensitive, because delaying annual potash purchases by a year or two and waiting for a lower price would not have much (if any) impact on yield. The problem for potash producers is they are not able to price-discriminate between purchases of potash to boost yield and purchases to replace potash taken out of the growers' "bank." Therefore, we don't assume that prices can be totally predicted by utility to farmers without potash in the bank. Further, diminishing yield returns above certain potassium levels (depending on soil composition) puts a ceiling on potash demand no matter the corn price level. However, in our opinion, the utility of potash (ability to generate real gains in yield) should help support prices above the marginal costs of production.

The utility of potash for farmers depends not only on the price of potash, but also on the price of crops. As such, periods of elevated crop prices and ensuing high net returns to farmers give potash producers added leeway to keep prices high. With bad weather ravaging yields and production, crop supply has been under pressure over the past few growing seasons.

We think crop stocks will be rebuilt over the long term and the eventual dip in crop prices will put pressure on potash pricing. Crop prices should recede once stocks are rebuilt. Current stocks/use ratios for major crops are at or near historical lows in the U.S., pushing up prices and encouraging farmers to grow more. Acres planted in the U.S. are projected to be high again this year, but as we saw last growing season, Mother Nature is not obligated to comply with trend line yield estimates. It may not happen this year, but we expect global crop supplies will eventually be rebuilt. While we think crop prices will eventually fall, we don't think the days of sub-$3 corn will ever return for sustained periods, due to structurally higher levels of demand caused by growing populations, rising incomes in the developing world, and the use of certain crops (specifically corn and sugar) in biofuels.

Wide-Moat Potash Corporation of Saskatchewan Is the Highest-Quality Producer
Potash Corporation of Saskatchewan holds a wide moat in the growing fertilizer industry. The company is the world's largest producer of the fertilizer potash and gives investors a way to play the need to feed a growing population on a limited amount of arable land. Not only is Potash Corp the world's largest potash producer, but it also controls some of the lowest-cost potash assets in the business, and its position on the low end of the cost curve allows for attractive returns. For these reasons, we award the company a wide economic moat rating. Recently, results have been dented by slow buying from China and India, but volume is set to expand in 2013 with those buyers coming back to the market. Over the long run, we expect double-digit potash volume growth, as brownfield capacity expansions come on line. Potash prices have also come down recently with the signing of new contracts, but we think the China and India prices represent a near-term floor for potash pricing, and the lower price should help spur global demand, allowing producers to increase capacity utilization in 2013.

Pure-Play and Narrow-Moat Intrepid Potash Looks Undervalued, but Comes With Execution Risk
Investors searching for a better value opportunity, a potash pure-play, or smaller-cap name in fertilizer should take a look at Intrepid Potash. With mines close to its U.S. customers, Intrepid benefits from lower freight costs and higher realized sales prices compared with companies operating Canadian mines. Intrepid is a small player in the potash market, but that does not preclude it from benefiting from positive industry dynamics, including barriers to entry and oligopolistic pricing behavior. In fact, Intrepid can actually benefit as a smaller player. While Potash Corp and other large producers generally curtail production during periods of weak demand in an effort to preserve pricing, Intrepid can continue to run its mines at high operating rates because its production makes up such a small portion of global production. In this regard, Intrepid can be a sort of free rider. Intrepid's potash costs per ton should start to decline in 2014 with the ramp-up of production at the company's new solar solution facility. This new facility (and its ability to lower the company's production costs per ton) is the main driver of Intrepid's positive moat trend. However, the project also brings a substantial level of risk to an investment in Intrepid. The capital expenditures for the project could increase, and the new supply makes it more difficult to predict long-term operating costs for Intrepid.

- Jeffrey Stafford, CFA, is an equity analyst for Morningstar, covering agriculture and chemical companies.Elizabeth Collins, CFA, is a director of equity research with Morningstar.

Source: Potash Prices Have Come Down Near Our Long-Term Forecast, Eliminating A Potential Encumbrance To Equity Values