Richard Kelertas: Economic Turmoil Creates Potash Values

Richard Kelertas Fertilizer companies have felt the pain of global monetary chaos, but as indicators lag, some potash equities are positioned ahead of the curve for big gains. Dundee Capital Markets Vice President and Senior Financial Analyst Richard Kelertas believes investors need to be sharpening their pencils and establishing positions. In this exclusive interview with The Energy Report, Kelertas shares his best names.

The Energy Report: There’s been damage done to potash stocks over the past six months. Why?
Richard Kelertas: Macro issues have hurt all commodities. When the world is worried about its next breath, all these stocks get hit very hard. We’ve had the Euro crisis and then the Greek debt crisis since these stocks peaked in summer. Also, I think there were expectations that North America and Europe would emerge from the last serious recession with half-decent growth going forward, and that recovery would be moderate, measured and continual from 2010 all the way up to 2013–2014. That’s now been interrupted by macro events, and the odds that they will be quickly resolved is almost nil. We are going to have to deal with slower economic growth worldwide, not just in the eurozone and North America, but also in China and all of Asia because it’s all interdependent.

We will also have to expect that the consumer will be drawn back a bit, both in Western societies where food is a necessity and a luxury, and in developing economies where it is a necessity. So, high-end food values, high-end organics and food stocks that are higher priced will be under pressure. That means lower requirements for meats, which means that the farmer may be cutting back on his crop output.

TER: Can you make a case for growth in potash consumption?

RK: For the next six months, I expect flat growth. Prices and volumes have retreated slightly. Inventories dropped in October. That’s good news. I expect prices will be flat to down.

However, if Europe’s debt crisis and low North American growth are resolved in the next 6–12 months, we could then see Asian export nations gear up again. That means that their diets will improve again, and crop prices and speculation in crop price increases going forward will pick up. That will happen sooner than six months in the futures market, but at the same time my expectation is that the next six months are going to be slow.

Within the next year, we should see some growth return. That will be composed of three components: Farmers will use potash at normal levels and growth will be reflected in shipments and prices. Lands that will be brought back into production will expand demand. This is fallow or abandoned agricultural land throughout the world, especially in Africa, that has been bought up by either investment pools or sovereign wealth funds or specialty farm land managers. In the grand scheme of things that doesn’t seem to be a lot in terms of the total farmland area throughout the world; however, potash application rates will be much higher than normal because you are bringing it from infertility to fertility levels. So, we could see a substantial push and it will show up in perhaps a 0.5–0.75% increase in potash demand worldwide.

TER: Are you able to venture a forecast on the price of potash?

RK: My international price forecast, the Vancouver export price, is about $450–465 per ton (/t) right now. For 2012 we expect an average price of $505/t and then moving to $520/t average price in 2013. The peak price in 2013 should be around $650/t, maybe $625/t. But, it won’t be as high as the $700-725/t that I thought may take place when I made that forecast a year ago.

TER: Are fertilizer prices leading or lagging economic indicators?

RK: They are lagging indicators. We need to see economic activity pickup first. The mood of farmers is always pretty gloomy, and getting them to change their view on world markets requires crop prices to move. But, crop prices won’t move really unless you see economic activity pickup.

TER: Is potash still low-hanging fruit? Or is it getting much more difficult to mine?

RK: That’s a good question. We just put on a seminar and heard from ERCOSPLAN, the German exploration consulting firm that has provided a lot of NI 43-101s for potash projects throughout the world. If you’re doing deep shaft, it is very expensive and time consuming, and there are long lead times. I would say that most of the best sites, except in Saskatchewan and Russia, are deep-shaft mines. There may be one or two open-pit opportunities in Ethiopia or in Utah where you’ve got very shallow deposits. Solution mining, though, provides you with the opportunity to get several large sites into production in a relatively short period of time.

But the limiting factor right now is financing, and that’s because you’re dealing with $800 million (M)–1 billion (B) for a 1–1.5 billion tons per year (tpa) equivalent of potash, even for a solution mine. The second limiting factor is cash balances. If we are going to have a long, drawn-out economic downturn here, which is quite possible, then very few of these projects will come to fruition and get into production. They will run out of cash before they can either get taken out or get the financing. So, there are only a couple of strong plays that have plenty of cash and, where cash-burn rates are low, can survive this downturn and lack of liquidity in the marketplace. The third thing is that we could possibly see some deep-shaft mines flood over the next 6, 12, or 24 months like we had in Russia with Sil’vinit (acquired by Uralkali OAO (URKA:RTS; URKA:MICEX; URKA:LSE). We could see something possibly happen in Saskatchewan or in other areas. And I don’t think it’s a question of “if”; I think it’s a question of “when”. Many deep-shaft mines are 2,200 meters down. A lot of money is being spent pumping out water, and you could see some production disruptions. If that’s the case then the market could get tighter very quickly.

TER: Limited access to financing could be a major problem for small companies, couldn’t it?

RK: Yes, absolutely. I think about 100 worldwide projects are being considered in potash, both public and private. I would say 10–15% of them have a hope of getting financing, and of that, I think perhaps three or four might actually get financing.

TER: From everything you’ve just said it sounds like margins are going to have to contract or that prices are going to have to go up. Where does this put the potash producers?

RK: Well, at the current pricing their margins are pretty good. For instance Potash Corp. (POT:TSX; POT:NYSE; Not Rated) is the most visible, and its operating margin, not gross margin, so we’re talking before interest, is about 40%–45%. Terra Nitrogen Co., L.P. (TNH:NYSE; Not Rated) is 65%. CF Industries Holdings Inc. (CF:NYSE; Not Rated) is 60%. Now CF is urea, and it’s a different kettle of fish, but Potash Corp. is about 40%. So, prices can come off quite a bit before they’re going to have any issues. However, I can tell you that any projects that are not in progress will be put on the back burner. You need to have potash pricing power. For instance, BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK; Not Rated) Jansen Project in Saskatchewan needs average long-term potash prices of about $500–550/t really to make a go of it, and from my work the long-term international price is about $410–425/t.

But to answer your question, in a lot of cases their cost inputs have gone up too. So, if they have the combination of prices falling while their cost inputs remain high for let’s say two, three or four quarters, their margins are going to get squeezed quite substantially. But there is no doubt about Q112 and Q212, so If this economic crisis settles down, they’re going to push for higher prices.

TER: The large-cap companies have so many advantages. It seems like there’s so much risk in the small-cap potash equities.

RK: Right: That’s why they’ve been hit very hard. The juniors are the most at risk.

TER: What regions are the most favorable for companies right now?

RK: I would say the best places are Saskatchewan, Utah, Arizona and Ethiopia in Africa.

TER: What specific companies are you telling your clients to invest in?

RK: We’ve been very consistent in the stocks we like since the economic crisis of 2008. On the large-cap side, Agrium Inc. (AGU:NYSE; Buy) has probably had the lowest margins of the big-cap names, but it tends to have the most diversity in its product mix. It has a wholesale nutrient division, a retail division and a specialty fertilizer division, which includes distribution. In a tough economic environment, we opt for diversification. In a very strong commodity market, it makes sense to go to single commodities or pure nutrient plays like Potash Corp., CF Industries, Terra, The Mosaic Company (MOS:NYSE; Not Rated) or Intrepid Potash Inc. (IPI:NYSE; Not Rated). Because we expected the economic recovery to be very difficult, we liked Agrium the best in the large-cap space, and we still feel that way. Until we see commodities fundamentals suggesting a speeding up of economic recovery, we’ll stick with Agrium on the large-cap side.

TER: What about small caps?

RK: On the small cap side our top picks continue to be Allana Potash Corp. (AAA:TSX; ALLRF:OTCQX; Buy) and Karnalyte Resources Inc. (KRN:TSX; Buy). They have the most cash, the lowest burn rate and they are the closest to production and financing. They have all the components in place, including their NI 43-101 resource estimates. But they both have different advantages and disadvantages. Allana has the possibility of being an open-pit mine, or open-pit/solution mine combination, or just a solution mine, which would be low cost because of the solar evaporation in Ethiopia.

Karnalyte is a solution mine, but it’s a gigantic deposit and will probably only need one cavern for 10 years. It does not have to do a lot of drilling. But if it does, the drilling will be horizontal. The key thing with Karnalyte is that it has boron-free magnesium chloride. That is attached to the potassium salt, KCL. The magnesium chloride comes out with the potassium. Thus, its extraction costs are not any different. Refining costs are going to be a little bit more expensive to separate the magnesium chloride, but that’s an extra revenue source.

TER: So, Allana is getting the magnesium chloride practically for free?

RK: That’s correct. Allana has not only the opportunity for MOP (muriate of potash), which is the standard potash, but also SOP (sulfate of potash), which sells at a premium. When the first million tons is fully operational, Allana will be able to produce 20–30% SOP.

TER: Karnalyte is up 31% over the past 12 weeks, and it’s the only one I see with its head above water over that period. Most others are the mirror image of that, down anywhere from 20–40%. Why such high relative strength?

RK: I think there are a few things: One, it has been getting its story out aggressively. Number two, it has been very close to getting the feasibility portion of its magnesium chloride production, and that will be ready by the end of November. I think that’s the most important thing, and it is just now starting to be understood by the market, which has been quite anticipatory of that. Three, there’s been some talk on the street that Karnalyte has worked a 30% contingency into its production costs, which is a lot higher than what it will actually work out to be. That means that its return on the project is much higher, we think, than what the company has been telling the street.

TER: How much per ton is the magnesium chloride right now?

RK: Well, it sells anywhere from $450–700/t depending on the end-product use and the purity levels. It will almost be a one for one. I think that Karnalyte will be able to get 600,000 tpa of magnesium product that they’ll be able to take out of the ground. That’s not factored into its numbers, but my NAV reflects that expectation to a small extent. So, it could be double the size in terms of profitability and revenue than the consensus on the street.

TER: Your target price on Allana is $3.05, which is an implied return of about 200% from current levels. I’m wondering about its preliminary economic assessment (PEA) due out before year-end. What is that going to tell investors?

RK: Well, I think it is going to solidify the resource in terms of measured/inferred. And of course, you’ll get a good idea of whether Allana can go to an open-pit or solution or both. More than everything else it’ll firm up the opex and capex. It will be quite clear that the area will support not just a million tons per year (Mtpa), but 2–2.5 Mtpa.

TER: If it is a solution mine, how much advantage will the solar heat evaporation be?

RK: If it’s open-pit, opex will be $40–50/t. If it is a solution mine it’ll be $65–70. A typical solution mine with natural gas or coal evaporation costs would be close to $90–100/t.

TER: What other companies are you talking to investors about?

RK: Well, at our conference we had nine presenters. Of course Allana and Karnalyte were there. We also had Passport Potash Inc. (PPI:TSX.V; PPRTF:OTCQX; Restricted). There were others at the conference that we have put on our watch list, and we are bringing them forward to investors as items of interest. We are looking at the resource and numbers on each one. They include Western Potash Corp. (WPX:TSX.V; Neutral), which just came out with a further update on its NI 43-101 and firmed up its resource estimate and capex/opex. We had IC Potash Corp. (ICP:TSX.V; ICPTF:OTCQX; Buy). We had Encanto Potash Corp. (EPO:TSX.V; Buy) and we also had ENP Minerals, which is hoping to get going in Utah. We had Rio Verde Minerals Development Corp. (RVD:TSX; Neutral), Epm Mining Ventures Inc. (EPK:TSX.V; Neutral) and Verde Potash (NPK:TSX.V; Neutral). So, we’re talking about those and getting up to speed as well on the numbers and the resource for each one of those companies. We’ve issued research on them and put them on our watch list, but we don’t have firm numbers or target prices for them yet. We will continue to speak with those companies.

TER: Western Potash CEO John Costigan noted that his company has the largest resource base of current junior potash explorers and developers. What does that mean to you?

RK: Well, there’s the old adage: It’s not necessarily how big it is but how low-cost it gets. To me, quality or concentration of the resource is number one. You have to take a lot of brine out before you get a half-decent concentration of potash. So, it is going to be all about costs. It seems to have fairly low opex costs, but I have to check into that and do more work on it. On the surface, costs seem to be a bit low compared with comparable projects. The initial capex of $2.5B to get it started sounds reasonable for a 2 Mta mine. I think it’s going to be a question of distance to market and ease of getting the mine up and running.

TER: Encanto was one of the presenters at your conference. How much can it expand its resource?

RK: From the information we have, we think the resource could be expanded quite significantly. With all the agreements Encanto has with native groups in Saskatchewan and its proximity to the Esterhazy deposit where Potash Corp., Agrium and Mosiac all operate, I think it has a good chance of expanding its resource anywhere from 25–50%. That is quite possible. But, again, before we make any pronouncements on it, we’re going to be speaking with management and talking with the engineers and geologists.

TER: Were there any other companies you wanted to mention?

RK: Not at this stage. We haven’t done enough work on, for instance, Ethiopian Potash Corp. (FED:TSX.V; FED.WT:TSX.V; Not Rated). We haven’t done enough work on IC Potash or EPM Minerals. So, we’ll reserve judgment on those for the time being.

TER: Richard, it was a great pleasure speaking with you once again.

RK: No problem, my pleasure as well.

Richard Kelertas has 25 years experience as a research analyst covering the forest products sector. He has been one of the top-ranked analysts in the sector over the years consistently, and was most recently ranked No. 1 by Brendan Woods. Kelertas has worked for a number of well-known brokerage firms, including ScotiaMcLeod, Deutsche Morgan Grenfell, UBS Warburg, and Desjardins Securities. He has a bachelor’s degree in forestry and a master’s degree in forestry and economics from the University of Toronto. Richard is also a Registered Professional Forester.

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