As you may know I’m always on the look out for commodity markets that have fallen out of favour. Ones that are hated by investors so such that any sense of fair value is so far down the list that they start to look like there is little in the way of downside risks. This brings out the potential for asymmetric returns for us as investors where the downside is limited, but the upside is potentially (but not always) very high.
One market that has been getting my attention recently has been the market for potash. Along with phosphorus and nitrogen, potash constitutes one of the three nutrients used in the production of fertilisers, and are used in varying proportions according to the nature of the crops and soil types. Essentially potash is used to strengthen plant roots and boost drought resistance.
The potash backstory
Potash prices began to rise in early 2007 from $172 per tonne to $875 per tonne by the end of the year. Prices were essentially driven up by a perfect storm, an extreme imbalance between tight supply and rapidly expanding demand. Increased demand for biofuels in the United States, Brazil, and Europe coupled with higher livestock production created still more demand for grain and thus for fertilisers. Grain reserves became historically low and prices rose sharply. Further worsening the situation were China’s imposition of high tariffs on fertiliser exports and the devaluation of the U.S. dollar in 2007 and 2008.
High fertiliser prices combined with the onset of recession resulted in rapid ‘demand destruction.’ While the price of phosphorus and nitrogen fell sharply potash prices remained relatively strong, buoyed by shortage and difficulties in transporting Russian potash as a result of an expanding sinkhole near its Silvinit mines (more on the importance of sinkholes later).
High prices attracted new businesses including mining companies such as BHP and other entrants with development projects to unearth new supplies of potash. Potash prices then fell back to around $300 per tonne two years later, and although a brief rebound saw prices rise to near $500 per tonne the price of potash has gradually declined to $200 per tonne, a level it has been stuck near for the past two years.
Weak crop prices have played a large part in the moribund price. Benign weather conditions and genetic engineering of crops have resulted in record yields causing global grain inventories to surge. Weak agricultural commodity prices reduce the need and the ability of farmers to pay for fertiliser. The exchange rate of large agricultural producers versus the US dollar has exacerbated the impact, i.e. the drop in the Brazilian real made it more expensive for farmers to import fertiliser.
Potash prices have also remained weak due to the breakdown of longstanding supply agreements. The potash market has long been characterised by cartel arrangements between major producing and exporting countries. In the early 20th Century Germany had a monopoly on the export market while restricting production along with its neighbour France. More recently the market has been dominated by a production agreement between Russia and Belarus. The Belarusian company, Belaruskali and the Russian group Uralkali, had formed a cartel known as the Belarusian Potash Company (BPC). This changed in mid-2013 with the end of the Russian-Belarusian agreement. The Russian contingent announced it was leaving the cartel in order to increase its market share. Perhaps predictably the Belarusian’s responded in kind embarking on an aggressive pricing strategy, signing deals with China and the US at levels that would penalise its competitors.
The buying power of the major consumers also needs to be factored in. India has to import all its potash while China imports about half its annual requirements of 10-11 million tonnes. China, which has 20% of the world’s population but only 10% of its arable land, has long been trying to bring potash prices down. As prices fell the market for potash became a buyers market. In 2012 China used its monopsony power to obtain potash price discounts after staging a buyer’s strike that lasted several months. The subsequent break-up of the BPC cartel gave these two major buyers of potash even more ammunition to demand hefty discounts.
All in all pretty depressing!
So why might now be the start of a recovery in potash prices? It revolves around the following five central themes.
– The short and long term outlook for protein based food.
– Agricultural commodity prices are unlikely to weaken further while supply prospects are due an upset.
– Signs of supply discipline in the potash market.
– Potential supply shortfall.
– Steepening production cost curve
As ever its always important to consider what milestones to look out for. As these milestones fall by an investor can become more confident that a particular narrative is taking hold. On the flip-side its important to consider where the thesis might be wrong. Not hitting these milestones is one such indicator, but there could be others.
The short and long term demand outlook for protein based foods is strong
A growing world population and increased demand for protein based food are the structural factors why potash prices could increase significantly over the coming decades. In most of the world outside of the United States, soybeans are the feed of choice for both pigs and poultry, two of the most popular protein sources in Asia. Although China’s soybean consumption over the last twenty years has exploded soybean demand is now surging across the rest of Asia, especially in emerging market economies like Indonesia, Thailand, India, and Vietnam.
Agricultural commodity prices are unlikely to weaken further while supply prospects are due an upset.
With global grain demand so strong, agricultural markets have come to rely on near-perfect global growing conditions to support record-breaking crops. If weather trends turn for the worse any resulting degradation in yields will have a huge impact on global inventories. Any adverse weather conditions in any of the world’s growing basins negatively impacting yields could cause global grain inventories to swing from record surpluses to huge deficits in a very short time with huge upward pressure on grain prices.
Signs of supply discipline
One of the best signs of a commodity market that is close to finding a floor is supply discipline, i.e. mothballing mines in a bid to take supply out of the market. We have seen it in other commodity markets in the past few years – Glencore’s decision to mothball a third of its zinc output in 2015 and Cameco’s more recent decision to shut their McArthur River and Key Lake uranium mines. We are starting to see that in the potash market now too. In late 2017 Canadian producer idled two of its mines for around two months while also running production at their most profitable mine (Bethune) around 400,000 tonnes lower than what the nameplate capacity would imply.
Supply shortfall
New projects delivering less than anticipated, and supply restraints (including idling and closures) have kept the market relatively tight. However, new capacity is coming online this year, notably in Canada and Russia, although the sector has a history of large greenfield projects typically taking much longer to commission and ramp up than advertised.
The risk of sudden supply shocks is always a feature of the potash market. In 2006, Uralkali lost a mine after a sinkhole wider than 100 meters opened above the site. In 2014, a flood at Uralkali boosted prices at a time when companies were curbing output following the breakup of the company’s sales alliance with Belarus. In March this year the ceiling of a potash mine in Belarus collapsed. Although the accident has not affected mine output, it reminded the market how vulnerable the industry is. According to Goldman Sachs the removal of just one of Belaruskali’s mines would take out about 2.5 million tons, or roughly 4% of global production.
Steepening production cost curve
Production costs have been driven down by the depreciation of key potash producing countries. Between 2013 and 2015 the cash cost for the lowest two potash producers halved as a result of currency depreciation. The increasing risk of protectionist measures by the US and retaliatory measures by many of its trading partners, a slew of bad news emanating out of many emerging economies and investors continued attraction to the dollar has led to the recent battering to emerging market currencies. Potash producing countries have not escaped the selloff suggesting that production costs at the low end of the cost curve are much lower than shown in the chart below. At the same time the production cost of marginal producers has risen sharply as energy, material and labour costs have increased. Together this has resulted in a gradual steeping in the potash production cost curve.
Chart 1: 2015 global cash costs (including royalties, SGA, excluding freight) FOB mine
The potash market is one of the most opaque commodity markets. The major producers publish little in the way of information about their activities. However, all commodity markets share some similarities. They all follow cycles of varying length and depth. Right now the potash market looks very depressed, but there are encouraging signs that the low is in, particularly evidence of supply discipline.
What is less clear is the extent to which buyers of potash are under pressure to pay higher prices. There are long term demand pressures of course, but in the short term, without a spark that leads to an increase in demand, its difficult to be clear when the market will be forced to move higher.
Early days for the potash market. One I will be keeping my radar on during the rest of the year.
You can listen to me talking about the potash market here with Mike Alkin.