Potash And The Commodities Supercycle

 |  Includes: POT
by: Casey Hoerth

Potash, the common fertilizer form for the element potassium, is considered the highest-quality fertilizer there is. While it is the seventh most abundant mineral in the world, only a few areas are particularly blessed with deposits. Supply is constrained by two cartels from the richest areas. This keeps prices of the important fertilizer propped up.

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This year, commodities have been falling across the board: Silver has fallen steeply. Energy and metallurgical coal have dropped. Iron ore, base metals, aluminum, all down. Natural gas has been near rock bottom since 2009 and is only starting to recover. All of these commodities went parabolically higher between 2001 and 2010 due primarily to China and India's entrance into the global market. It seems this process has finally been cut short by new supply and the slowing of those two respective economies. Now all these commodities are following the "commodities supercycle" back down.

Click to enlargeA few such as oil and potash have managed to stay above the fray. Until recently. The breakup of the BPC cartel in Belarus two weeks ago has sent potash prices and potash stocks cratering.

Even though growing global population and declining amounts of arable land act to keep potash fundamentals strong, potash prices are higher than they should be. This article will focus on potash and how it is steadily joining the rest of the commodities crowd. For at least the last ten years potash has been more subject to politics than it has the marketplace, and I believe that trend will continue. Now, however, as new supply comes online from outside the cartels, the balance of power has shifted from supplier to consumer nations.

Defending The Turf

Potash prices are still higher than they should be in a more open market. A persistently high potash price has led to two important developments. First, it has encouraged new entrants to join despite the high cost of new, greenfield mines. Second, the high price has encouraged certain cartel member companies to "cheat" and sell extra tons of potash.

These two things are probably what caused Uralkali, the world's largest potash producer, to leave the two member Russo-Belarusian potash cartel BPC a couple weeks ago. This will achieve two things: It will punish fellow BPC member Belaruskali for selling above its set quota through other channels. It will also lower potash prices, thereby further raising the barrier for major new entrants such as BHP Billiton (NYSE:BHP), which is building a brand new mine in Saskatchewan. In this light, Uralkali's move is a very reactionary one. Uralkali may very well succeed in bringing Belaruskali in line and also in sinking BHP's Jansen mine prospect.

With Handful Of Grain, Hearts Do Not Panic

While the cartels may be good at blocking new private entrants, they won't be blocking Chinese capital from doing what it wants. Chinese firms, many of which the state has a majority interest in, will be investing in new potash production with self-sufficiency the priority.

In a government mandate no less, the Chinese government outlines here a plan to produce 80% of the country's potash needs within the country (a rough English translation is here). The reason? To reduce "monopoly risk," a clear reference to the Canadian and Russian cartels. As recently as 2010, China was importing 60-70 percent of its potash, so this is a big move. China, easily the biggest single importer and consumer of potash, sees fertilizer self-sufficiency as a matter of national security.

Companies like Sinochem will be building greenfield projects in Yunnan, Sichuan and Xinjiang provinces, all of which have been explored and have yielded potash discoveries. In addition, these firms will look to augment domestic production by opening new mines in countries swayed by China's influence such as Laos and Congo.

That the largest potash consumer is going from 40% to 80% self-sufficiency is a big deal. It will easily make China the third largest potash producer and will add substantial production which will work to drive prices down even further. Since China declared its desire to do this in 2010, its efforts have already been contributing to potash's steady price decline since 2011.

Turned On Its Head

These extraeconomic measures by China are beyond the reach of the cartels and they will add new capacity whether the cartels want it or not. A report by Rabobank stated that this factor, as well as the multitude of new projects by the world's largest, deep-pocketed mining companies, will ultimately turn the current situation on its head.

The Rabobank report added that China, India and Brazil in their "base-case scenario" ... "will tolerate and indeed contribute to overcapacity because of their desire to become self-sufficient in the mineral."

The ultimate result will certainly diminish Canpotex and Uralkali trading, but it will not kill the one cartel left standing. An analogy could be OPEC in the wake of the joint Prudhoe Bay/North Sea discoveries. That didn't break OPEC, but it sure did take power from it.

So it looks like potash will join the rest of its commodity brethren in going lower after all. It's not happening by clean market mechanisms, but rather by lumpy, politically-motivated moves.

Will we see potash move to a more free-market regime as a result of these new players? I doubt it, but control of supply will be less concentrated and production will be increasingly dictated by extraeconomic rationale. Both of these factors will contribute to lower potash prices.

PotashCorp A Buy Or Sell?

The investor must understand some key points here. This new reality does not mean potash should be categorically avoided. China's large-scale entry will not turn potash's prospects into something like that of steel's. The Chinese are merely attempting self-sufficiency, and a scenario where they would create oversupply and "dump" onto other markets as they do steel would be unthinkable.

Click to enlargeThe more likely scenario is that potash, at worst, will see margins compress to a level similar to where it was between 2001 and 2006, when potash averaged $140 per ton. Basically, treat potash as if it is another part of the commodities supercycle, because it ultimately is.

We can already see that margins for the most concentrated of Canadian suppliers, Potash Corp (NYSE:POT), are contracting. Potash Corp operated just fine in those sleepier times before the commodities boom, and it should still be profitable if prices returned to $100-200 per ton. However, the outsized profits obtained during the height of this cycle are over.

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FAST Graphs

At 8.4 times earnings and a dividend yield at 4.7%, Potash Corp seems cheap. But remember that the market can undershoot just as much as it does overshoot. I'd like to see a little more margin of safety before jumping in here, especially because this chart looks like a falling knife. If Potash prices return to their pre-boom stage supercycle levels, Potash Corp could easily drop another $5 per share, maybe even $10. There will come a time when this company is buyable, but right now it's probably best to stay on the sidelines.

Additional Sources

"EBIT Margin" from BHP Billiton Dec. 31, 2012 Interim Results Presentation.

"Quarterly Gross Margin Comparison" from Potash Q2 2013 Earnings Presentation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.