Agriculture & Fertilizer Stocks

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Monday, September 1, 2008

Oil/Fertilizer Two-Step At An End (POT, MOS)

Most of the big names within the agriculture chemicals industry have pulled back considerably from the multi-year highs clocked early this summer. Fair or not, they have moved nearly lockstep with the falling price of oil and other major commodity groups such as metals, coal and soft commodities like corn, wheat and soybeans.

While the price of the food commodities is indeed instrumental in setting prices on fertilizers, feedstocks and the like, I think the tie between the price of oil and industry leaders like Potash Corp. of Saskatchewan (NYSE:POT), Mosiac (NYSE:MOS) and Agrium (NYSE:AGU) will begin to break down. And this could have big implications for long-term investors.

Don't be misled about the power of the price of oil: it has a profound effect on the global economy. It affects transportation costs, energy costs and the cost of thousands of derivative products that have oil-based products as a key ingredient. But it is not the end all be all for commodities, as pointed out recently by Citigroup analyst Brian Yu: "…the market has failed to recognize that demand for grains rarely cycle (supply cycles though) and has shown little historical correlation with economic activity. The last time we checked, fertilizers and grains are not industrial metals."

First Things First, What's Potash?
Potash is a mineral (potassium carbonate) hidden deep within the ground, and despite what you might think, it's actually a highly-sought after commodity, and more importantly, it's in very limited supply. Potash, along with nitrogen and phosphate, are key ingredients in the fertilizers that are necessary to increase crop yields.

Global demand for food is obviously on the rise, as is the need for increasing crop yields because the per capita land available for farming is falling. However, the trends are more than linear with regard to world population growth or even income growth, because as millions of people in developing nations make income and wealth gains, they increasingly seek to switch from starch-based diets to protein-based diets. And these diets require between two-to-seven kilos of grain to produce just one kilo of beef, pork and poultry. (Read Harvesting Crop Production Reports to learn more about what grain investors need to know before jumping in to this sector.)

Article Highlights Industry Explosion
S&P analyst Richard O'Reilly wrote up an excellent piece on Potash Corp. that highlights many of the exciting metrics being thrown out by the agricultural suppliers. Here are some of the quick highlights from the report, specific to global leader Potash Corp:

Twenty-two percent of global potash capacity; over 10 million tonnes will be delivered in 2008.

Average contracted rates in North America will likely hit over $700 per tonne later this year, up from $182/tonne in 2007.

Recently signed contracts in Asia & South America have hit over $1,000/tonne.

China - the world's largest single buyer - has depleted nearly all its inventories, and will be forced to renew a record supply later this year. Its 2008 contract was priced at $576/tonne.

Similar price trends are in place for the company's two segments, nitrogen and phosphate-based fertilizers and feedstocks.

2008 expected EPS at $12.50, up nearly 400% from 2007. Forecasts for 2009 are in the range of $17.80 per share

Thoughts on Supply, Ethanol

Much has been made about the short-term effect of ethanol production on the price of corn and related commodities like wheat and soybeans. There seems to be a prevailing thought that the switch to ethanol has artificially raised the prices of these commodities.

If you are in the camp that believes ethanol (as we know it now) is not a viable long-term solution to our energy problems, you may be right. It's quite likely that interest in corn-based ethanol has peaked. Frankly, I don't care. Its recent adoption - along with constant growth in worldwide food demand - has served to nearly wipe out the world's grain inventories. According to the USDA the stock-to-use ratio of worldwide inventories is the lowest on record at less than 16%. Nations will need to build up these inventories, which will only add to the demand push in the coming years. (For more on this issue, read The Biofuels Debate Heats Up and Peak Oil: Problems And Possibilities.)

Demand Can't Create Supply
One of the core tenets of capitalism is that when a commodity's price heads towards the moon, greater resource are put towards finding more, even at previously prohibitive costs. Most analysts agree that it can take up to five years to get a new mine up and running before the first pound is extracted. As for right now, demand for potash and other nutrients will outstrip supply this year and in the foreseeable future. Potash Corp. and Mosiac, for their part, are each investing in large capacity upgrades over the next several years, with Potash Corp's capacity growth equal or greater to what the rest of the industry combined will be able to bring on-line by 2013.

A rising dollar could hurt the profits of this group, as the majority of sales are overseas. I strongly believe, however, that any incremental losses will be overridden by the incremental income and wealth gains happening in the BRIC nations and elsewhere in the developing world, and the resulting demand for grain-based foods.

Consider this powerful statistic. In the United States, roughly 15% of every incremental dollar earned - whether through income gains, wealth gains, or via deflation - is spent on food. In China, however, where the majority of the population is below middle-class level, 40% of every incremental dollar is spent on food. In India, the rate is nearly 70%.

Parting Thoughts
I like all three of the major suppliers of fertilizers and feedstocks, and believe all have compelling valuations: all three trade for less than 10-times 2009 estimated earnings, and all three have PEGs much lower than 1.

I prefer Potash Corp. of Saskatchewan because it holds more than $11 billion in equity interests (as of June 30) in its foreign rivals, most of them geographically nested next to the largest growth markets of the world. This provides a nice semi-hedge against rising transportation costs and will add juice to the bottom line that its rivals can't match.

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