Potash Industry Is Still Searching for Silver Lining

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Following the breakup of BPC and the breakdown in Uralkali supply discipline last year, potash spot prices have dropped by almost 28 percent to about $310 per metric CFR Brazil from $440 per metric ton. While following the Chinese contracts, global benchmarks are quickly approaching a price floor, and the underwhelming domestic and emerging markets demand combined with the incremental North American capacity additions will likely keep prices depressed for a longer term than the market optimism is currently suggesting.

Potash shipments rise, near-term data points positive

After a challenging second half of 2013, we recognize that near-term potash data points are likely to appear more positive in first-half 2014. Potash prices began to recover after China signed first-half 2014 contracts at a price of $305 per metric ton with a $20 per ton rebate. Inventory levels in China are believed to be around 2.5 million metric tons as compared to 4 million metric tons in third-quarter 2013. Following China, India is also likely to sign contract soon, with most analysts expecting a settlement in the range of $320-$325 per ton (Indian contract is usually signed at a premium to Chinese contract).

North America producer potash shipments increased 45 percent year over year and 31 percent month over month to 1.6 million tons in January. Domestic sales increased by 76 percent year over year to 833,000 tons while export sales rose by 22 percent to 803,000 tons, corroborating recent industry and company commentary during fourth-quarter 2013 results. January shipments represent the highest level of monthly sales post BPC breakup. The recent Chinese import contract should also improve price transparency and bring back some deferred second-half 2013 demand, notably in Southeast Asia, driving improved demand and export figures for North American producers in coming months.

Demand so far in 2014 has been strong, and producers remain focused on achieving higher prices in key markets including Southeast Asia and Brazil. However, the important thing for investors to note is that much of the positive news flow is already discounted in the shares of fertilizer companies like Potash Corp. of Saskatchewan (NYSE:POT), Mosaic Co. (NYSE:MOS), and Intrepid Potash (NYSE:IPI).

But what about long-term headwinds?

While the worst of the steep decline in potash pricing may be over, the potash market still faces significant secular challenges, and we think the market is under-appreciating the negative implications going forward. There is limited medium-term price upside for the industry. Announced capacity closures are largely confined to POT plant cuts and are relatively modest. Moreover, the announced closures are partially offset by brownfield capacity coming online over the next several years, with no major project cancelations amongst existing industry participants or new entrants. This whole situation is likely to result in only a limited improvement in 2014-2017 industry capacity utilization, with operating rates staying well below 2010-2011 levels.

Beyond the near-term positive signs, persistent and unresolved headwinds for the industry remain, including uncertainty surrounding the Indian import contract and Indian subsidy policies that limit visibility to a sharp uptick in global demand. 2014 is a year of general elections in India, and it is unlikely the subsidy issue will be resolved before the elections. In addition to the Indian subsidy, other challenges that the potash industry faces include elevated North American producer inventories and rising North American capacity that will increasingly pressure the large domestic price premium versus key international benchmarks.

Moreover, deteriorating crop economics will also pressure second-half 2014 and 2015 consumption. There is also a risk of potential emerging market FX depreciation as the U.S. Federal Reserve accelerates its tapering in the next several months.

Conclusion

Potash demand so far in 2014 has been strong, and producers remain focused on achieving higher prices in key markets, including Brazil and South East Asia. The recent Chinese import contract resolution for the first half of 14 is also likely to improve price transparency and bring back some deferred second-half 2013 demand. Moreover, India is also likely to settle its contract soon, with most market participants expecting a contract settlement in the range of $320-$325 per metric ton.

We acknowledge the fact that near-term news flow in the potash market has turned more positive, and expect indicators to appear more favorable in first-half 2014. However, medium- to long-term industry secular challenges remain and are unlikely to abate. As more favorable near-term data points become more widely understood, we expect investor focus to revert to these medium-term pressures and the implications for sector valuations.

In these challenging times, POT and IPI are both taking the necessary steps to offset industry headwinds. The decisions taken by both POT and IPI to reduce headcount and by POT to curtail supply were by no means easy; however, these decisions had become necessary to protect some shareholder value over the long-term. Going forward, investors should expect similar — maybe not as drastic — moves from competitors in the form of lower annualized operating rates, increased mine downtime, etc.

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