The agriculture boom is in full swing. Ag commodity prices remain high. A worldwide race to buy up farms in far off lands is in full swing. And fertilizer stocks have been the top performers during the whole downturn.
Fertilizer stocks like Potash Corp (POT), Mosaic (MOS), and Agrium (AGU) have had stellar runs. But over the last few months, fertilizer stocks have been very volatilite.
I’ve got good news though. For anyone that missed out on the first run-up in fertilizer stocks and has been waiting for a dip, a chance to buy could be days away. A few top fertilizer stocks have the potential to get crushed in the next few days. The combination of lofty valuations, high expectations, and soaring costs could spark it all.
Input Costs Soar
On page 29, Mosaic said it all:
A significant increase in the price of natural gas, ammonia, sulfur, or energy costs, that is not recovered through an increase in price or our related crop nutrients products could have a material impact on our business.
Over the past few months, natural gas, ammonia, and sulfur prices have risen sharply. Ammonia prices are up 140% in 2008. Sulfur prices have skyrocketed too.A ton of sulfur cost $30 a ton in 2000. It climbed to $450 a ton at the start of the year. The last sale I saw was at $800 a ton.
Sulfur and ammonia are traded between privately and prices are set by private contract, much like uranium. So it’s tough to get exact pricing data from day to day. However, prices are going up. And the rise in the first half of the year has been very strong.
Sulfur and ammonia price increases aren’t good for fertilizer producers. That’s not the biggest factor here though. The largest impact on fertilizer producers’ profits will be natural gas.
Natural Gas and Fertilizer
According to Mosaic’s most recent annual report, the company has a lot of exposure to natural gas prices. Mosaic states, ‘Natural Gas is the primary raw material used in nitrogen production and may represent as much as 90% of a ton of nitrogen-based fertilizer.”
That’s huge exposure. 90% of costs!
Of course, that’s just for nitrogen-based fertilizer. It takes a lot of natural gas to make other types of fertilizer.
Natural gas costs account for as much as 85% of ammonia-based fertilizer. And solution mining of potash, which Mosaic owns the largest potash solution mine in the world, uses a lot of natural gas. Mosaic estimates 14% of its potash production costs go to pay the gas bill.
When it comes to fertilizer, natural gas is very, very important. During the 2nd quarter of 2008, natural gas prices climbed about 40%. Mosaic admits only “a portion” of its natural gas consumption is hedged. As a result, I expect high natural gas prices to have a big impact on profits.
Not all Fertilizer Companies Created Equal
Not all fertilizer companies are the same though. Only a few produce highly sought after and monopoly protected potash. They are the only ones that really benefit from soaring potash prices. Other fertilizer companies, which have to buy potash, ammonia, etc. don’t enjoy being able to pass on higher costs forever.
Sure, they can pass on the higher costs to customers for a while, but that will only work for so long. Reuters published the headline, “New threat to food system: pricey fertilizer.” High prices will reduce total fertilizer used.
It’s simple economics. Fertilizer prices are not inelastic. High prices are reducing total fertilizer use around the world. We could see a big impact on reduced consumption when the Q2 numbers come out in the next few days.
It’s Happened Before
This wouldn’t be the first time high costs wrecked fertilizer stocks though. Back in 2005, when hurricanes sent natural gas prices soaring, fertilizer stocks were hit hard. In the two months that followed Hurricane Katrina, fertilizer industry stocks fell 25% on average.
Among the hardest hit were Mosaic, Terra Industries (TRA), and CF Industries (CF). They are all diversified fertilizer producers.
This time, it’s not going to be a sudden price shock. It’s been building for a long time. And when you consider the run fertilizer stocks have had, a sharp sell-off could be on the way.
Fertilizer Takes Center Stage
The catalyst for the sell-off is probably going to be earnings reports. Although it’s tough to ever predict earnings down to the penny, there’s a lot going against the fertilizer sector.
After huge run-ups, they are at some of the highest valuations they’ve been at in years. And Wall Street is expecting a lot from this sector to justify those high prices. In just the past two months, consensus estimates for Mosaic’s profits have risen 40%. Even missing by a penny or two could send these high-flyers down another 10% or more.
Monsanto (MON) is the perfect example of what can happen when news isn’t good enough in the agriculture sector. Monsanto reported earnings in June. The results were good. Wall Street was expecting earnings per share of $1.34. Monsanto booked profits of $1.45 per share.
Everything should be good, right?
Wrong. Earnings were strong, but they weren’t strong enough. Monsanto’s shares fell 8% right away. Sine then, the downtrend has continued. Monsanto is a diversified agricultural company and is not a pure fertilizer play. It does, however, show what can happen when expectations aren’t met…regardless of the long-term outlook.
Now, with earnings reports coming in just a few days, I expect more downswings to come. The three stocks I expect to get hit the hardest are the most diverse fertilizer producers. They all report earnings within the next 10 days.
Terra Industries reports on July 24, Mosaic on July 28, and CF Industries on July 29.
Buy on Weakness
There are a lot of considerations to make when it comes fertilizer stocks. As we’ve seen many times in the past, the combination of extremely lofty valuations, high expectations, and missing the quarterly numbers or cutting the outlook for the future can send share prices plummeting.
In this case, it still doesn’t look like too many traders have accounted for the impact of natural gas prices on fertilizer company profits.
Over the long-term agriculture is set to be a secular bull market. For now though, it comes down to a risk/reward proposition. If a fertilizer company beats estimates…it might get a small spike. But if they miss…they sell-off will surely come.
There’s not much upside and a lot of downside. So many things are going well for the agriculture sector for the long term. For now though, I’m afraid that could be what spells a big correction in agriculture stocks.
At Q1 Publishing we always focus on risk/reward. And when it comes to agriculture stocks and the upcoming earnings, the risk certainly appears to outweigh any potential reward.
Disclosure: Currently, I am not short or long any of the stocks listed in this article. But if Mosaic shares climb back to the $145 level this week or we see a 10% rally in Terra Industries or CF Industries, I will be.
