Agricultural chemicals and fertilizer stocks had a good rally after the USDA November report projected a lower year end grain inventory. The iPath Dow Jones-AIG Grains Total Return Sub-Index ETN (JJG), Elements Rogers International Commodity Agriculture ETN (RJA), and Market Vectors Global Agribusiness ETF (MOO) all rose, some by more than 4% Tuesday.
The Agricultural Chemical and Fertilizer Stocks Index went up by 3% with top performers surging by 6% or more. SAFCO, IQ, Intrepid Potash (IPI), CF Industries Holdings (CF), Mosaic (MOS) and Yara International (OTCPK:YARIY) all are up. Chinese companies like China Agritech (OTCPK:CAGC) and Origin Agritech (SEED) had gains of more than 4% Tuesday.
It will be important to see where agricultural commodity prices and the fertilizer prices & utilization rates go from here. We think that this momentum is just the early stage of a bull cycle for agriculture and related stocks. We think they may keep their momentum until the middle of 2011. Urea prices have strengthened over the past four months in response to increasing demand during the spring sowing season of small grains and corn. Demand for urea is expected to remain strong into 2011 because of high grain prices caused by droughts, the heat waves in Russia and Central Asia, floods in Pakistan, South-East Asia and China (an estimated decline in grain yield by over 25%).
USDA November Assessment: The USDA report (November 9, 2010) projected a lower year end inventory which triggered a rally in fertilizer names. We have been recommending going long on fertilizer stocks since a brief correction in September 2010. USDA has projected a slightly positive picture for wheat supply from Argentina, Australia & Paraguay which may be revised downwards because of lower nutrient applications in Argentina & Paraguay. Also corn (-75 million bushels) & rice inventory estimates have been revised downwards.
China Export Ban: China currently imposes a 'high tax period' on Urea exporters during the key planting season to guarantee Urea supplies to the local market. China will potentially bring the period forward from 1st January next year to mid-November this year. This could remove all China Urea from the market in Q1 2011 because:
Chinese Urea becomes unaffordable to foreign buyers
Less bonded warehouse inventory to be shipped during high tax season
China was responsible for 14% of the global supply of urea in Q1 2010 - this measure could reduce supply by 10-15% during a time of high demand in Europe and America. Urea prices have run up recently on the back of strong demand / higher agricultural prices and a recent new Indian tender. Since this news has been around for a week or so and Urea's move has been pretty telegraphed by the market, by now the MENA [Middle East, North Africa] names that have benefited are Orascom Construction (OTC:ORSDF) and Qatar Industries.
Economics of Fertilizer Application: We calculate U.S. corn farmers are making 19% net profit margins on their crop at current commodity and nutrient prices, ahead of our subjective 10.0% breakeven threshold.
Ethanol Demand: Ethanol prices are higher with corn prices, providing good ROI for ethanol producers. Although small relative to domestic usage, higher ethanol exports and lower imports are also expected to add to corn use for ethanol- with high sugar prices limiting the availability of ethanol from Brazil. Ethanol is now blended into American petrol at a 10% ratio, also known as E10. We estimate that each 1% increase in the blending ratio requirement would draw down 370m bushels of corn, or 20% of the expected inventories. The U.S. EPA decided to approve a higher blend rate in September.
Floods & Drought: China / Pakistan have experienced both droughts and floods, which are hampering agricultural production in these countries. If China imports 3 million tons of corn from the U.S. to make up for lost domestic crops, U.S. inventories would fall by an additional 7%.
Lower Nutrients: Low fertilizer use in 2008 and 2009 may require farmers in the Americas to increase their usage to replenish soil nutrients in order to keep crop yields stable. Soaring U.S. wheat prices in August indicate farmers could convert some soybean acreage back to wheat, subsequently boosting demand for urea in 2011.
Barely Above Cost: Current prices for all three fertilizers, Nitrogen, Potash and Phosphate based, are barely above cost which is partially due to low natural gas prices. However, Urea prices usually move in tandem with grain prices which may provide an upside of around US$100 / ton to Urea and around US$120 per metric ton to Potash.
Inventory Liquidation: Wholesale fertilizer inventory liquidation in 2009 / 2010 may boost fertilizer demand in 2011 amongst the leading fertilizer consumers including Brazil, China, India and the United States.
Middle Eastern Fertilizer Producers: Middle Eastern producers are the lowest cost fertilizer producers in the world (natural gas at US$0.70 / MMBTU to US$1.5 / MMBTU). SAFCO, Arab Potash and IQCD will benefit from the increase in Urea demand and prices. SAFCO produces 2.4 MT of Urea and IQCD produces 3.8 MT of Urea annually. SAFCO is a pure play Urea manufacturer while the fertilizer segment comprises 38% of IQCD’s profit.
These companies traditionally have high dividend payouts and good dividend yields due to the high cash generative nature of the business model. Based on our estimates, SAFCO trades at 12.5x 2010 and 9.2x 2011 earnings and IQCD trades at 11.9x2010 and 8.5x 2011 earnings. The price to book ratio for SAFCO is 4.9 and 3.14 for IQCD. The dividend yield is attractive at 8.26% for SAFCO 6.5% for IQCD. As most regional stocks trade at a discount to their global peers, SAFCO and IQQCD trade at a 43% discount in terms of PE ratio, while paying higher dividends (global peer group average of 2.3%). The valuation discount coupled with earnings growth from expansion plans make SAFCO and IQCD attractive investment opportunities.
Disclosure: SAFCO, IQ, CF