The Saudi Arabia of Fertilizer?

In the past several issues of StockInvestor, I have discussed agriculture and fertilizer, areas that have seen a dramatic increase in prices (and profits) in recent years. After taking a closer look at the industry, we decided to upgrade the moat rating of  Potash Corporation of Saskatchewan (POT). I sat down to talk about the company with Ben Johnson, who has covered the industry for about two years. (For more on Potash Corp., see my recent video report.)

Paul Larson: Ben, set the stage for us. How does Potash Corp. (PCS) make money?

Ben Johnson: Potash Corp. is the world's largest fertilizer producer. It produces all three of the essential plant macronutrients: nitrogen, phosphate, and potash. The bulk of the firm's production is sold into the fertilizer market, while the remainder is sold for use in animal feed and various industrial (mostly food-related) applications. PCS sells its products in more than 50 countries worldwide, and in 2007, about 30% of the company's sales were to customers outside of North America.

PCS is the world's largest potash producer, with 22% of world capacity. The potash segment accounted for 48% of consolidated gross profit in 2007. In 2007, the segment's gross profit increased by nearly 63% on an absolute basis versus 2006. PCS is also the world's second-largest nitrogen producer by volume (with 2% of world capacity). The nitrogen segment accounted for 28% of consolidated gross profit in 2007 and increased gross profit by nearly 70% on a year-over-year basis. Finally, PCS is the world's third-largest phosphate producer (with 6% of world capacity). The phosphate segment accounted for 24% of consolidated gross profit in 2007 and increased gross profit to a level nearly 3.5 times its 2006 result.

PL: Compass Minerals (CMP)--a longtime holding of the Hare Portfolio inside StockInvestor--makes sulfate of potash (SOP). What is the difference between that and muriate of potash (MOP)?

BJ: Sulfate of potash is a better means of delivering potassium (the key nutritional component of any variety of potash) to higher-value crops, such as fruits and vegetables, which can be harmed by the chlorine component of the more broadly available and more widely used muriate of potash (the variety that PCS produces). Because it is more specialized in its application, as well as more scarce than muriate of potash (potassium chloride), SOP tends to garner a price premium to MOP of historically near 50%.

PL: The stock of PCS has appreciated by more than 10 times over the past four years. What is going on?

Price, price, and price would be the short of it. The prices for all three nutrients have been rising at a meteoric rate over this span--well outpacing the rate of growth in the firm's production costs. For instance, from 2004 to 2007 the firm's average selling price per metric ton of potash increased at an annually compounded rate of 10.5%, while the average unit cost rose at a compounded annual rate of just 5.6%. As a result, gross profit per metric ton of potash sold nearly doubled to $97 in 2007 from $51 in 2004. And there will be more to come. Given recent price announcements for potash, average selling prices will easily double from 2007 levels in the coming quarters.

Pricing gains have had an even more dramatic effect on profitability in the nitrogen and phosphate segments. Unit gross profit in nitrogen has more than doubled from $45 to $94 over this same span, and phosphate unit margins have compounded an eye-popping 14 times from $4 in 2004 to $57 in 2007.

PL: What caused this strong pricing environment?

BJ: Put simply, strong demand and tight supplies. The bulk of incremental demand for potash and phosphate in particular is coming from Brazil, India, and China, where these two nutrients have historically been applied at rates far below scientifically recommended levels. As per capita incomes rise in these economies, they have seen dramatic shifts in dietary preferences, most notably in the form of increased protein consumption. When people eat more meat, it has a multiplier effect on the demand for grains because every pound of meat we produce requires about 10 pounds of grain. (It varies by the type of protein; for example, cows eat more than chickens.) This has put tremendous stress on global grain supplies, and global grain production has lagged consumption in seven of the last eight years. One of the simplest ways for growers in the developing world to boost their grain production in order to meet surging demand is to make better use of fertilizer.

Adding fuel to the fire has been the dramatic increase in biofuel production around the globe. While the story of corn ethanol in the United States is familiar to most of us by now, less than half of current biofuel production is in the U.S. This additional strain on global agricultural production has served to further accelerate grain demand.

For the most part, the fertilizer world was ill-prepared for such a dramatic surge in demand. And while demand growth has been robust, supply is whip tight. PCS happens to be an exception to this rule, which is a large reason why we think it has a wide economic moat. With the bulk of the world's excess capacity, the firm stands to capture the lion's share of incremental demand for potash over the coming years. New supplies of all three nutrients require large investments and long lead times. As long as demand growth outstrips the rate of growth in new supplies, pricing should remain strong.

PL: With its massive share of production and reserves of a critical world commodity, is it fair to call PCS the "Saudi Arabia of Potash"?

BJ: I feel a more apt analogy would be to call PCS the Saudi Arabia of the "other OPEC"--Organization of Potash Exporting Countries! But yes, I think that this is a fair comparison. PCS owns 22% of the world's potash production capacity, while Saudi Arabia accounts for roughly 13% of global oil production. Both enjoy low-cost positions in their particular markets, thanks to scale and the attractive natural resources they control. The Middle East has more than 60% of the world's proven oil reserves, while Canada sits on about 57% of the world's potash reserve base, according to the U.S. Geological Survey.

PL: Who are the closest competitors to PCS, and how close are they on a marginal cost basis?

BJ: The two closest competitors in terms of potash production capacity are Belaruskali and  Mosaic . There are no good public data to pinpoint what Belaruskali's costs look like, and PCS has a marginal cash cost advantage--less than 5% on a unit basis--over Mosaic.

PL: Do you think prices are sustainable?

BJ: Yes. The supply and demand balance within the potash market is extremely tight and will likely remain so for at least the next five years or so until either the bulk of the incremental demand from the developing world has been met or new supplies make some slack in the market. Second, growers' purchasing power, which is ultimately a factor of global grain prices, will also likely remain high for several years as global grain inventories remain at or near historical lows. High grain prices provide both the means and the incentive for farmers to use more fertilizer.

PL: How does the worldwide supply of arable land look? Beyond increased efficiency with fertilizer, another solution would be to simply farm more land.

BJ: According to the United Nations Food and Agriculture Organization, on a global basis, the amount of arable land per capita is currently less than half what it was in the 1950s. Urbanization, desertification, and continued population growth could place further downward pressure on this figure over the long term. While there are idle acres out there (there are currently about 36 million acres in the USDA's Conservation reserve program and a good chunk of untapped land in South America), a substantial portion of this land is either extremely environmentally sensitive, inherently less productive, or simply cut off from global markets by lack of infrastructure. In my opinion, making more efficient use of the land we have is going to be the key to long-term sustainability. 

This article originally appeared in the April issue ofStockInvestor.

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