 | | Chris Mayer | People need food. Food needs fertilizer. One of the world's most important fertilizers is in short supply. That fertilizer is potash.
One of the first things people change as they emerge from poverty is their diet. They move toward more meat and a greater variety of fruits and vegetables. So while we may wonder about how many cars or toasters the brave new world's top consumers will want, we know for sure they'll eat more food.
But the web of food production shivers and shakes in the short term in response to economic pressures. Farmers cut back - like everybody else - in 2008 and 2009. One of the things they cut back on was fertilizer. They used 30-40% less potash than usual, for instance. Potash, a key fertilizer ingredient, saw six consecutive quarters of falling volumes.
Farmers ran down their inventories. All that deferred buying pushed North American potash inventories below their five-year averages - first time that's happened since November 2008. In some cases, farmers didn't apply potash at all. Potash stays in the soil for up to two years, so you can skip applications. But you can do that for only so long.
In any event, farmers are now returning to the market. PotashCorp (NYSE:POT) reported its highest potash volumes ever in the first quarter of 2010 - a fivefold increase, year over year. With corn at around $4, famers have every incentive to buy fertilizers. Grain prices support good returns for farmers at current fertilizer prices.
Longer term, there will be pressure to produce more food. In turn, farmers will seek to boost crop yields. Fertilizers are one way to get there. There is plenty of room for growth here, as application rates remain well below recommended rates.
Of all the nutrients, potash has the greatest potential for growth - a potential 298% increase to match that recommended rate of 66 pounds per acre.
One interesting piece of news from China in February was the government initiative to boost crop yields by sending out 100,000 agronomists to educate 160 million farmers about modern farming techniques. The goal is to boost fertilizer use and demonstrate the benefits by way of soil samples. China is the biggest fertilizer market in the world, but crucially, it lacks much in the way of potash. China must import most of its growing needs.
That's because potash is a rock and quality mines are scarce. It costs a lot of money and time to bring one online. A brand-new (or greenfield) 2 million-tonne potash mine will cost you a minimum of $2.2 billion - not including what it would cost for infrastructure such as rail, power, etc. It would also take seven years.
So the bigger-picture reasons for owning potash still make sense. More importantly, for our purposes, is the value of the stocks. We own the No. 1 and No. 2 producers of potash in PotashCorp and Mosaic (NYSE:MOS). They also produce the other nutrients, nitrogen and phosphate. PotashCorp is the second largest nitrogen producer and third largest phosphate producer. Mosaic has no nitrogen exposure, but is the second largest producer of phosphate. This latter nutrient is also a rock for which potential supply issues loom.
The April 20 edition of Foreign Policy included a story titled "Peak Phosphorous," with the subhead: "It's an essential, if underappreciated component of our daily lives, and a key link in the global food chain. And it's running out."
The story begins:
"From Kansas to China's Sichuan province, farmers treat their fields with phosphorus-rich fertilizer to increase the yield of their crops... Our dwindling supply of phosphorus, a primary component underlying the growth of global agricultural production, threatens to disrupt food security across the planet during the coming century. This is the gravest natural resource shortage you've never heard of."
You think OPEC is a force with 75% of the world's oil reserves? Well, just five countries control 90% of the world's phosphate reserves: Morocco, China, South Africa, Jordan and the United States.
The US has only 12 phosphate mines; nine belong to Mosaic. Two others belong to PotashCorp, including its facility in Aurora, N.C., the largest in the world. When food supply issues get hairy, countries essentially stop exporting phosphate. China did this in 2008. (China has the second largest reserves of phosphate, after Morocco.) I don't see a phosphate shortage as imminent, but it's a potential flash point that would surely light a fire under Mosaic's stock price in particular.
Either way, both of these stocks are potential monsters. Potash and Mosaic could double their output by 2015 and 2020, respectively. About 75% of new supply coming online till 2020 is from these two titans. This provides a powerful way to increase earnings even if potash prices go nowhere. If prices do climb, then earnings will jump sharply.
The value in these stocks, though, really comes from their huge net asset values (NAVs), as seen by looking at replacement values. In other words, let's answer the question, "What would it cost us to build these assets from scratch?"
If it is cheaper to buy the stocks than to build the assets, we have a promising situation. Think about that as if you were potash producer. If it cost you $1 billion to build a 1-million-tonne facility or $500 million to buy a ready-made potash mine in the stock market, what would you do?
All things being equal, you buy the stocks. In today's market, the stocks are cheaper than building new mines. A number of global mining giants get the attractive investment profile I've laid out for you. Vale and BHP have already made small purchases. Vale bought Bunge's phosphate mines and took a majority stake in Fosfertil, a Brazilian fertilizer company. In 2009, Vale also bought potash reserves in Argentina and Saskatchewan. BHP already owns reserves for a possible mine in Saskatchewan. All of these would be greenfield projects.
So given all the risks, expense and time... Why not just buy PotashCorp or Mosaic if they are cheaper? (Not only are they cheaper, but the assets are of a much-higher quality). In past issues, I've shown you my own conservative estimate of PotashCorp's and Mosaic's NAVs based on replacement value - $120 per share and $70 per share, respectively.
However, I could be way conservative. Morgan Stanley's estimates are much higher, to give one other estimate. They include an estimate for infrastructure. They also use average costs based on existing publicly disclosed greenfield projects. Morgan Stanley gets a sum-of-the-parts NAV of $158 per share for PotashCorp and $86 per share for Mosaic.
Therefore, both stocks are trading at substantial discounts to their NAVs. At $96 a share, Potash is selling 40% below its NAV. Mosaic is even cheaper. At the current quote of $45 per share, Mosaic would almost have to double, just to get to its NAV. And in past cycles, these stocks often traded for premiums to NAV.
The high cost of new assets also provides price support for fertilizer prices. To lay out all of that cash for a new potash mine and get just a 10% return on your investment, you'd need potash prices of $500 per ton to make it work. Currently, prices are around $350 per ton. Brownfield expansions - or additions to existing mines - are cheaper. Some can work at prices as low as $250 per ton. These brownfield expansions are what Potash and Mosaic are doing. But they've got the best assets.
All in all, I think the case for these stocks is still a good one. Earnings are highly uncertain, but the asset values are there. And we've got good catalysts going forward. The market is focused on the near-term record harvest, but I look to the long-term value in these stocks. If you don't own it already, I'd take advantage of the disparity and buy some Mosaic.
Chris Mayer,
for The Daily Reckoning
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