Following a year rebounding from the collapse of the Belarusian marketing arrangement, the potash stocks of Potash Corp. (NYSE:POT) and Mosaic (NYSE:MOS) sit in a precarious position. Investors are now bullish on the stocks, yet several market situations suggest the market doesn't have the long-term potential most continue to project.
The story continues to persist that emerging market consumers will demand better diets that require farmers to purchase more fertilizers, such as potash. The theory is logical considering the growing middle class in China and the potential in other parts of Asia, including primarily India. The reality so far appears far less than projections, while at the same time, new market entrants are lurking around waiting to pounce on any increases in demand. The data suggests investors need to focus more on the supply/demand equation and not the overly optimistic demand projections.
Last week's news that Rio Tinto (NYSE:RIO) plans to enter the potash market via a joint venture with Acron OAO from Russia is a large red flag for the sector. The news from Rio Tinto follows the previous intent of BHP Billiton (NYSE:BHP) to not only enter the potash market, but also to make the commodity a fifth pillar of long-term focus. In essence, the gross margins obtained by Potash Corp. from mining in Canada are drawing in a couple of the largest miners into the sector.
According to Acron, the Rio Tinto mine has 1.4 billion tonnes of inferred resources at an average grade of 31% potassium chloride (KCI). The company places the recoverable amount at 329 million tonnes of KCI.
The BHP Billiton Jansen mine has massive resources, with 5.3 million tons of inferred resources and 1.3 billion tonnes of recoverable resources. At the end of last year, BHP approved moving forward with the Jansen Project, and agreed to invest another $2.6 billion to finish construction of the mine to have it ready for production by 2017.
BHP recently pulled back from moving the mine into production, and further passed on a right to develop an export facility at the Port of Vancouver in Washington due to uncertainties about the timing of the development project. The intent now is to start production by 2020 and reach annual capacity of 10 million tonnes.
Anybody wanting a good summary of the potash market needs to look no further than the North American leader in that market - Potash Corp. The company produces monthly and quarterly market updates that provide all the data one needs. The primary concern investors should grasp is that the demand part of the equation isn't developing as expected, and Potash Corp brings that to light with several charts.
The first chart highlights the exports to the primary drivers of growing demand in the form of China and India. What was forecasted as robust demand isn't developing as projected. The below slide only shows modest growth over the last decade, especially from the level achieved during 2007.
The second chart highlights how the previously mentioned supply continues to outstrip demand. Without the Canpotex marketing arrangement in Canada and the previous Belarusian deal, the prices of potash would likely collapse even further. The below chart shows again a market that not only isn't growing all that meaningfully, but also one where the supply continues to quickly meet any increase in demand.
Once shipments hit 50 million tonnes in 2004, the market has mostly traded sideways. The chart again shows a bullish tilt towards solid growth throughout 2018, but the recent history suggests that the growth aspirations won't be met.
Unsustainable High Margins
The likes of Rio Tinto and BHP find the market attractive due to the high margins for potash partly propped up by the marketing arrangements.
For the first quarter of this year, Potash Corp. maintained gross margins on potash of over 44%, and had previously hit numbers around 57% prior to the breakdown of the Belarusian agreement that sent potash prices crashing.
Mosaic provides an even starker example of the discrepancies in the fertilizer markets. The miner gets a 29% gross margin from potash, but only 17% from the much larger phosphates division.
In the case of Rio Tinto in 2013, the large miner obtained margins after all operating costs of just below 30%. A solid consolidated number, but a number very indicative of several commodity segments that produce much lower margins than the exceptional ones from potash.
The long-term demand projections continue to miss actual usage trends that hardly improve each year, while the largest miners continue to push forward with plans to build new mines for entering the sector. Neither scenario paints a very attractive picture for the high valued commodity. Without fast growth in demand, it doesn't add up that the commodity would ever return to a position of higher prices, especially considering the forecasted high-demand areas of Asia can't afford those prices.
Investors are encouraged to use the recent run-up in stock prices to exit positions, or at the very least, keep a vigilant eye on the potash stocks. The willingness of Rio Tinto to enter the market and with BHP still lingering, sets up a tough equation for miners down the road.
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