A recent announcement by Russian potash producer Uralkali that it is exiting from Belarusian Potash Company, or BPC, joint venture has caused a significant correction in fertilizer stocks across the globe. Uralkali is the world’s largest potash supplier with ~10.5 mt estimated sales for 2013. Until now, potash exports were dominated by Eastern European and North American companies, and their export joint ventures BPC and Canpotex were main parties in negotiating contracts with the buyers. This created a pricing discipline in the potash market, which made these companies a favorite for investors in agriculture space.
However, Uralkali’s decision changes this dynamic. Uralkali was upset by its partner Belaruskali (the third largest potash supplier) due to announcement by Belarus’ president in December last year that Belaruskali can sell products outside of BPC. Uralkali was also under pressure by the Chinese government, the largest buyer of potash fertilizers and a tough negotiator. Uralkali expects potash price to correct from current $400 per ton to $300 per ton in the near future. It plans to increase its sales volume from the current 10.5 mt to 13.5 mt by the next year to make up for some of the pricing loss.
North American export company Canpotex is unlikely to remain immune from breakdown of BPC and has little choice other than to lower its prices. Canpotex is a joint venture owned by Potash Corp./Saskatchewan (USA) (NYSE:POT), Agrium Inc. (USA) (NYSE:AGU) and Mosaic Co (NYSE:MOS), and all exports from these companies are routed through Canpotex. Other than pricing pressure, sales volume at these companies is also likely to suffer if there is any delay by these companies in lowering prices. Unlike nitrogen based fertilizers, which are washed away by water and have to be applied every year, potash fertilizers can remain in the soil for two to three years. So, even if farmers skip a season or two and do not apply potash fertilizers, the crop yield won’t suffer much.
A similar thing happened during the 2008 financial crisis when many commodities, including crude oil and base metals, corrected significantly. Potash Corp./Saskatchewan (USA) (NYSE:POT) companies were not ready to lower their prices, and farmers postponed their buying in anticipation of lower prices. This led to a stand still situation, and the complete supply chain froze, with dealers ending up with excess inventory.
I believe the current situation might be worse, as Uralkali has given clear indication that it is willing to sell Potash Corp./Saskatchewan (USA) (NYSE:POT) at $300 per ton or lower. The price correction in this case might be much faster. To put this number in perspective, Mosaic Co (NYSE:MOS)’s current marginal cost of production is ~$250 per ton. In case there is any over-correction and potash price goes closer to marginal cost of production, the stock price of these companies will end up trading near their book values, implying significant downside to the current stock prices.
So, how to trade these stocks now? First, Mosaic Co (NYSE:MOS) and Potash Corp./Saskatchewan (USA) (NYSE:POT) are the companies you must avoid. Potash Corp derives 60% of its sales from potash-based fertilizers, while Mosaic has this number closer to 50%. Both these companies are still trading at a premium to Agrium Inc. (USA) (NYSE:AGU), which derives just 7% of its sales from potash-based fertilizers. Historically, the premium for potash companies was justified due to pricing discipline. But now with the cartels getting broken, they might end up trading at a discount. In fact a pair trade by going long Agrium which is trading at nine times forward earnings and shorting Potash Corp and/or Mosaic, which are trading around eleven times forward earnings may be a good idea.
Even better will be going long on a non-fertilizer agriculture company like Monsanto Company (NYSE:MON). Monsanto’s stock price has corrected ~10% since mid-May, mostly due to short term concerns surrounding corn seed margins. Due to the 2012 drought, seed production costs were higher this year leading to margin compression. With favorable growing conditions this year, I believe this won’t be an issue in 2014 and the company is likely to see some margin improvement next year.