- Fertilizer prices have been declining alongside food prices, but food prices are picking up.
- Fundamentals give downside protection with some risk coming from short term earnings.
- The long term outlook is positive with balanced markets and demand growth.
In agriculture and horticulture, potash is the common term for nutrient forms of the element potassium (K). It is used globally for increasing agricultural yields and is an essential fertilizer.
From an investing perspective potash has been beaten down alongside other commodities but seems to be close to its bottom. This article is going to elaborate on an investing thesis for potash producers.
Two supply contracts, between the Belarusian Potash Corporation and two major Asian consumers, China and India, are very important for potash prices. At the end of June, India signed on to buy potash at $227 a ton which is the lowest price in the last decade and China signed on to buy at $217 a ton which is 30% less than last year. The low prices are not good news for potash producers, but those prices usually establish a global price floor. Other potash miners typically settle prices with India and China at the same levels.
The low prices are a result of current low food prices after a few years of favorable weather. This resulted in farmers putting-off increased fertilization and $50 billion spent in investments for increased potash production in the last ten years making supply 10% higher than current demand and bringing prices to multi-year lows.
Figure 1: Potash prices. Source: PotashCorp.
As potash prices are currently 50% of what they were a few years ago, potash stocks are also down more than 50%. However, if prices have bottomed an opportunity might be developing in this slump.
Figure 2: Price movement of the Potash Corporation of Saskatchewan Inc. in the last 5 years. Source: Bloomberg.
Any improvements in the potash market would quickly give a boost to stocks of all potash producers.
Figure 3: Global potash producers. Source: K+S.
Before we look at the fundamentals of individual companies, we are going to elaborate on the short- and long-term market outlook.
PotashCorp CEO Jochen Tilk stated in his Goldman Sachs basic materials conference this May that potash prices have bottomed and gave a cautious but optimistic view for the future. The basic drivers for potash prices are not contract negotiations, but rather the weather and planting, thus in the short term we can expect potash prices to be correlated to food prices.
Figure 4: FAO food price index. Source: Food and Agriculture Organization of the United Nations.
Several agricultural commodities, such as sugar, soybeans, and coffee have seen significant increases in price this year after prolonged multi-year declines. This indicates that the bottom is likely in or near for most food based commodities. We therefore believe that fertilizer prices have also likely reached their bottom. As food prices increase, applying fertilizers becomes more attractive to farmers and demand increases.
Long Term Outlook
Food price correlations are also the main factor in long term potash prices forecasts. As the global population is expected to be around 10 billion in 2050, arable land is constantly decreasing while global calorie consumption is rising. Therefore, demand for both food and fertilizer should continually increase.
Figure 5: Less land, more demand for food. Source: K+S.
On the supply side there is current overproduction, but as potash is a pure cyclical play, with a turnaround in food prices—also cyclical,—a change in the current oversupply might soon be possible.
By 2020 PotashCorp expects supply and demand to level out as demand is expected to grow in line with demand for food at a few percentage points per year. The current weak demand is expected to normalize with higher food prices, lower inventories and some mine closures.
Figure 6: Potash outlook to 2020. Source: PotashCorp.
In a stable market environment, potash prices could pick up a bit which would be enough to significantly increase profits for producers, as most of them are profitable even with the current low prices and oversupply.
For a fundamental analysis of the Potash market we are going to use data from the Potash Corporation of Saskatchewan Inc. (NYSE: POT), Mosaic (NYSE: MOS) and Agrium (NYSE: AGU), which are more U.S. oriented.
If we are truly at the bottom of the potash cycle, then the above fundamentals actually look very intriguing. With an average trailing PE ratio of 13, potash producers are almost 50% cheaper than the S&P 500. The same holds for their book values and dividend yields, with an exceptionally high dividend yield from POT. It’s exceptionally high because the payout ratio is 120%. In order to sustain the payout ratio POT is taking on debt, however, management is confident that a bottom is in place.
The main risk is that potash prices further deteriorate, although this risk is minimal as the price floor has been set with the Asian contracts. A further decline in potash prices could be caused by benevolent weather conditions, crop yields remaining high without the need for fertilizer, or low food prices which don’t make it economical to use fertilizer. Seeing that food prices are increasing, this negative scenario seems unlikely, but investors need to be prepared for it. Another thing to be aware of is that none of the companies identified above are pure potash producers, so proper due diligence and specific risks should be assessed before investing.
The second risk may come from the upcoming earnings declines. As the current contracts are 30% lower than last year we can expect lower earnings for 2016. This could put pressure on stock prices even if it seems that the bottom in potash prices has been reached. However, the market may have already discounted any further decline in earnings. More aggressive investors could establish positions now, and more conservative investors could follow the earnings reports and if bad, with stock prices falling further, buy cheaper.
The potential rewards may outweigh any further downside risk since we have good companies with low PE ratios and high dividend yields, that are still profitable even at these low potash prices. They also have good supply chains in place and low cost production that creates an advantage in the market.
Investors should also remember that a drought in the U.S., or El Nino waking up and destabilizing global food production, would quickly increase food prices as well as the affordability of fertilizers, causing potash prices to rise.
An investment in potash looks like one with limited downside and huge upside potential with a nice dividend yield while you wait, which is something to think about during these long Summer days.
Disclaimer: Sven Carlin, the article’s author, is long K+S, AGU and The Mosaic Company, and may initiate a new position in any of the above mentioned companies in the next 72 hours.