Late in 2003 I became acquainted with the idea of a commodity super-cycle. I decided that a good way to participate in the cycle would be through investments in stocks of copper producers. To understand the fundamentals of these stocks I read brokerage reports that evaluated the earnings expectations and valuations. ; The conclusion I drew from such analysis were that the stocks were too risky. They were simply trading at multiples that were too high. 25x earnings! 30x earnings! Too expensive, regardless of the potential.
It took me about 6 months to realize the problem with this sort of thinking. The problem was that the analysts were basing their estimates on copper prices of less then $1.00 per pound. While such prices were consistent with the cyclical price of copper over the past 15 years, they were not necessarily reflecting the forward price potential of copper. If you evaluated earnings based on copper prices reflecting current conditions and future potential you quickly found that the stocks were actually trading at extremely low multiples, in the low to mid single digits.
Well, over time the estimates were revised, and the revisions were evidenced in the rise in the stock prices of copper producers, which in many cases quadrupled or better over the next 3 years.
The Same Theme Being Played out with Potash
Analysts are now making the same mistake with potash producers that they did with copper producers. The estimates of forward earnings have been and continue to be based on a price of the commodity that is not reflective of the pricing reality. In June of 2007 I wrote the following on the InvestorsVillage VT.TO board, a hub for agricultural investors:
BMO is predicting earnings for Potash Corp. (POT) that puts their 2008 multiple at about 25x earnings. Sounds expensive right? But here's the catch. That estimate is based on $188/t potash (after shipping costs). [Yet] some of the settlements for potash of late are well into the $200's."
The opportunity then was that analysts were basing their earnings estimates on $190 per tonne potash, yet it was clear that prices were moving quickly towards $300 per tonne. The opportunity now is the same, the only difference being that the numbers are higher. $300 per tonne potash has now been priced in. Yet the price of potash contracts being agreed to today are much higher then $300 per tonne.
To continue to use BMO as an example, the firm is forecasting potash prices of $317 per tonne for 2008 and $369 per tonne for 2009 (all estimates are net of freight costs unless noted). Canpotex, a consortium of potash producers of which PotashCorp is one, recently settled a year long contract for 1,325,000 tonnes with Indian Potash Limited and two Indian private sector contract buyers, TCL and CFL. According to Canpotex, "all contracts are at a delivered price of $625 per tonne." Scotia Bank has suggested freight charges to India will be around $125 per tonne, which means the realized price net of freight is $500 per tonne.
Similarly, Scotia Bank has reported that spot prices to Asia are in excess of $600 per tonne on delivered basis. Thomson Financial reported that Uralkali, a Russian potash producer,
has increased prices in Brazil for all deliveries of granular muriate of potash [MOP] from April 1 due to further tightening of supply and continuous strong demand in global markets… The new price level will be $600-$610 per tonneAgain, in both these cases the realized price is north of $500 per tonne net of freight.
The largest potash consumer is China, which imported around 9 million tonnes of potash in 2007. 2008 potash negotiations with China are ongoing, but analysts are slowly becoming more bullish about the outcome. They have to be. Even after accounting for the discount China will receive for being the biggest player in the market, it is difficult to see a contract settlement for less then $400 per tonne.
Why Prices will be Sticky to the Upside
As James Prokopanko, CEO of Mosaic recently pointed out, "the rally [in agriculture] is fundamentally different because it is being driven by demand, not by supply shortages."
I have described as much in my previous post, 'Agriculture: A Tale of Human Development'. The demand for grains is being driven by the development story that is taking place in China and India. These countries are moving to higher protein diets which require a greater grain input for the same caloric intake. The increase in demand has resulted in world grain inventories that are at their lowest carryover in over 20 years. As Prokopanko points out, "inventories will likely decline again this year despite record planting."
To meet the demand, proper fertilizer application will become a necessity. Bill Doyle, the CEO of Potash Corp., has pointed out that the application cost of each $100 per tonne increase in the price of potash is about 3 cents per bushel of corn, less then the daily noise of the corn futures market. A recent International Plant Nutrition Institute [IPNI] survey showed that "a wide range of global crops achieve a net return of over $3 for every $1 invested in fertilization." The lesson is clear: the incremental cost of an application of potash fertilizer is not significant enough to significantly deter demand.
Just as the supply response of base metals production was slow to materialize, the same should be expected for potash. Doyle has explained that there are no easily accessible sources of potash that can be brought on-stream quickly. Moreover, new potash mines take 5-7 years and require billions of dollars of upfront capital. The cost of a 2 million tonne per year greenfield mine in Saskatchewan, Canada is estimated to be at least $2.5 billion. Yet with analysts not yet convinced that potash prices are sustainable at today's prices, will banks be willing to finance based on those prices 5-7 years in the future?
The Bottom line
The problem is not that analyst estimates have been static. It is that they have been too slow to catch up with the faster changing reality. As recently as January BMO was predicting potash prices at $265.00 per tonne in 2008 and $300 per tonne in 2009. Since that time they have raised their estimates almost 20%. The problem is that the new estimate is still not high enough.
RBC Capital analyst Fai Lee has pointed out that the recent potash contract settlements "are significantly higher than our current realized potash price assumption for PotashCorp of US$350 per tonne for 2009." Lee goes on to note that "a US$10 per tonne change in our realized price assumption has an estimated impact to our 2009 earnings per share estimate of approximately 20¢."
Similarly, Morningstar analyst Ben Johnson has explained that "global potash supplies are tight, and rather than setting prices to a level approximating the marginal cost of production at some spot on the globe, potash producers seem to be simply fetching an ever-increasing scarcity premium for their product…This price signal indicates that our near-term average selling price projections for potash are far too conservative."
Such was the case with copper. The expectation that prices will revert to their marginal cost goes out the window when the commodity becomes in scarce supply. This has been proven with oil, with copper, and with the grains themselves. The same is true of potash.
Clearly, the analysts have been and continue to be behind this curve. Now, some are beginning to re-evaluate their position. Recently, there have been upgrades of PotashCorp and other potash producers by some investment houses. This will undoubtedly continue. As they do, the price of the stocks will rise. The real question is whether this will be the last time such revaluation occurs. Given the long term factors that are at play, I suspect it won't.