Fertilizer stocks ramped higher to start the new year after China settled on 2010 pricing for importing potash. The price level is set at $350 per metric ton which is within the range of expectations. While the $350 price point was largely anticipated, many related stocks traded higher simply due to the stability the decision added to the market. Now that the largest consumer of potash has settled on an attractive price, North American distributors can begin negotiating with other purchasers both domestically and abroad.
Typically, China receives a discount because of the large volume represented by the country. As such, most market participants now consider $350 the “floor” for pricing with marginally higher prices for other buyers. According to Credit Suisse, the economic dynamics favor a continually rising price for the next several years and they expect potash to sell for $550 per metric ton in 2017.
The supply / demand dynamics for fertilizer look especially attractive in North America today. Most farmers in North America dealt with a late harvest which meant that fertilizer could not be spread in the fall. This could lead to significant demand in the first and second quarter as farmers prepare the soil for the spring crops. Most of the potash dealers currently have extremely low levels of inventory which should lead to heavy buying pressure. Not only do these dealers need to buy enough potash to meet the demands of farmers in the spring, but they also need to replenish their inventory now that pricing visibility is in place.
The $350 per metric ton pricing is especially attractive to North America producers such as Intrepid Potash (IPI) and Potash Corp (POT) because of the low cost of production. It is estimated that these companies can mine potash at a cost of roughly $100 per metric ton, leading to a gross profit of $250 – an impressive margin. Normally when businesses have such a hefty multiple we would worry about competition, but global supplies of potash are limited and there are significant barriers to entry in this market.
The selling prices are now high enough to justify an increase in production for firms like POT. The company is well known for matching production with demand, and in the past year the company has reduced its production as the global recession caused demand to wane. But farmers cannot continue to grow crops much longer without replenishing the soil and demand for agriculture products is much more inelastic than other goods. With an aging population in North America (which means more resources used per capita) and a rapidly expanding middle class in developing nations (again – more resources per capita), the demand for agriculture products will likely only continue to grow.
Potash Corp (POT) is probably the most stable investment in this area as the firm holds the rights to a very wide range of potash properties. Intrepid Potash (IPI) on the other hand is a smaller and more nimble player and could theoretically grow at a more rapid rate than its competitor. Both companies appear to be trading in a strong trend and could lend significant investment returns.
Aggressive investors may want to own the individual stocks or potentially buy out of the money options on POT or IPI. A more conservative approach would be to own the stock and sell calls against the position. Currently the POT June 120’s appear to offer a strong annualized return while at least partially protecting investors from a pullback in the stock. Alternatively, one could own IPI and sell the March 32 calls for a bit over $2.30 per share. The option premium would protect against an 8% loss in the stock, and the return over the next three months would still be attractive if the stock was called away.
Regardless of how you play this area, it appears the opportunity is strong. An improving agricultural picture, visibility with pricing, and the fear of inflation could all help push fertilizer stocks higher to begin this new decade.
FD: Author has a position in Sound Counsel client portfolios
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