The Energy Report: Potash prices and production collapsed in 2008. Why is Raymond James still bullish on potash?

Steve Hansen: It is a relatively simple supply-demand thesis. On the demand front, global food consumption is growing steadily alongside population growth, urbanization, rising disposable income and shifting dietary patterns—particularly in emerging markets. According to the FAO, global food production needs to increase by 70% by 2050 just to keep the world adequately fed. That’s an enormous uplift compared to current levels. We view higher rates of fertilizer application, especially potash, as one of the key factors in achieving these necessary production gains.

On the supply side, global potash reserves and production capacity are concentrated in the hands of just a few key players. The world’s top-five producers account for two-thirds of global potash capacity. The immense capital requirements needed to develop new mines present significant barriers to entry. This combination of concentration and capital creates an attractive supply-controlled environment; it allows the incumbent producers to extract favorable pricing.

TER: What countries are the major users and/or exporters of potash products? Which countries produce enough for their own consumption, and which are import dependent?

“There are three buckets of potash players in Saskatchewan: the incumbent producers, the ’super-major’ developers, and a handful of junior developers.” –Steve Hansen

SH: The largest exporters are Canada and Russia, where more than 70% of global potash reserves are concentrated and the largest incumbent producers are also based. The largest consuming nations are China, the U.S., Brazil and India, all of which have large, agriculturally influenced economies. The largest consumers are also the largest importers, although, in some instances, importers do have material amounts of domestic production. The obvious cases are the U.S. and China, both of which have fairly sizeable domestic potash industries that help reduce the amount of required imports. On the other end of the spectrum are Brazil and India. Because both have very little domestic production, they must rely almost entirely upon international imports.

TER: Saskatchewan holds 40% of the world’s potash reserves. Who are the major potash players in Saskatchewan? How have those firms been affected by the recessionary economic situation since 2008?

SH: From our perspective, there are three buckets of potash players in Saskatchewan. First are the incumbent producers, including the large-cap bellwether names, such as Potash Corp. (POT:TSX; POT:NYSE), The Mosaic Co. (MOS:NYSE) and Agrium Inc. (AGU:NYSE; AGU:TSX).

The second bucket is filled with what we call the “super-major” developers. These companies are relatively new players to the Saskatchewan basin, but they have very deep pockets and plentiful access to capital. These firms include BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK), Rio Tinto (RIO:NYSE; RIO:ASX) and Vale S.A. (VALE:NYSE). European producer K+S Aktiengesellschaft (SDFG:FSE), also entered Saskatchewan recently, as did a large Russian-backed player, ACRON Group (AKRN:LSE; AKRN:RTS).

The third bucket contains a handful of junior developers. These players are small-cap companies looking to advance their flagship greenfield projects through the traditional development milestones, typically with the goal of selling the asset and/or luring in a strategic partner. These juniors do not have the financial capability to advance a project beyond its initial development stages. A couple of the key players are Western Potash Corp. (WPX:TSX.V) and Encanto Potash Corp. (EPO:TSX.V).

TER: How did falling potash prices affect the industry during the past recession?

“There is an increasing risk that small firms working on good projects could be ‘left at the altar,’ with no partner to consummate the marriage. This is likely to trigger a wave of junior consolidation.” –Steve Hansen

SH: The effects have varied. The large incumbents were not impacted much. Their financial performance clearly suffered temporarily, as demand and pricing both fell precipitously during the downturn, but both have recovered handsomely since then, and these producers are now doing very well. There was also some industry consolidation in the east. Developers also fared reasonably well, buoyed by a few large takeouts in the space. Most have also made solid strides in advancing their flagship projects.

TER: Given that demand for potash is subject to large demand volume and market price fluctuations, what are the opportunities for potash juniors in Canada? What about juniors in other regions of the globe?

SH: Prior to 2007, the concept of a junior potash developer was pretty much nonexistent. Prices had dwindled below $200 per ton for the better part of three decades, and the major incumbent producers around the world had multiple decades of low-cost reserves. So there really was no economic incentive for junior developers to seek out new potash projects.

But as potash prices began to surge, post-2007, junior developers sprouted up all over the world, all racing to develop the next wave of greenfield potash mines, the likes of which had not been built since the 1970s.

Several early movers in the space have already played a major role in shaping the industry’s future. BHP acquired Anglo Potash Ltd. in May 2008, as well as Athabasca Potash Inc. in January 2010. K+S later acquired Potash One Inc. in November 2010. Most of these projects are now being advanced by their respective new owners with first production being discussed in the latter half of the decade.

TER: Can this trend continue?

SH: Looking forward, we believe it’s going to be more challenging. The new “super-majors,” which are the most likely players to construct new mines—BHP, Rio Tinto, Vale, ACRON, K+S—all appear to have made their beds at this point, each with substantial land positions and/or mega-scale projects already secured, thereby limiting the number of natural acquirers.

To be fair, we still believe there are reasonable prospects for large downstream players, the big consumers of potash, to step in and provide critical financing and/or offtake arrangements for junior developers. But there is an increasing risk that many small firms working on good projects could be “left at the altar,” with no partner to consummate the marriage. And as in most cycles of the commodities trade, this is likely to trigger a wave of junior consolidation over time.

TER: What is the potential for offtake contracts for junior potash players?

SH: That is the million-dollar question for the developers. The capital requirements are enormous for greenfield potash projects. A smaller niche project can require $750 million ($750M) in capital expenditures and a larger one can require $3–4 billion. Juniors just don’t have the financial resources to capitalize these large-scale projects.

There are, however, anecdotal stories of downstream Chinese and Indian parties preparing to step up. They’re doing a lot of due diligence. We know that. We just haven’t seen anything significant materialize yet.

The one exception is the recent offtake arrangement that IC Potash (ICP:TSX.V; ICPTF:OTCQX) struck with Yara International (YARIY:OTCPK). Yara is one of the world’s largest suppliers of fertilizers, and this specific deal entailed Yara taking roughly a 20% stake in IC Potash for $40M at a very nice 41% premium. Yara also entered into a 15-year offtake arrangement for 30% of all production out of IC Potash’s flagship Ochoa project.

There are opportunities for more offtakes, and I suspect we shall see more of them. But I do not expect a wave of them in the near-term future.

TER: Ethiopia has been a source of potash since the 14th century. In late 1960s, floods shut down potash production, and then war and internal strife kept the mines closed. How has this situation changed? Is the Ethiopian government friendly to foreign mining investment? Is it stable?

“Developers in [Ethiopia and Brazil] are likely to have access to capital from nontraditional sources, such as the International Finance Corporation and World Bank.” –Steve Hansen

SH: Ethiopia is blessed with a high-grade, relatively shallow, world-class potash deposit in the Danakil basin, which is located in the northeast near the Eritrean border. It’s very well positioned geographically to service some of the world’s highest-growth markets for potash, with relatively short shipping distances from Africa’s eastern coast. However, from our perspective, the principal challenge for the basin pertains to the country’s relatively undeveloped infrastructure. It’s still lacking in a lot of key roadways, rail, and power infrastructure. There are also key technical issues around water availability that still need to be addressed. The Ethiopian government has made significant progress on road development, however, having paved a large roadway into the southern side of the Danakil basin. The government has also contracted a Chinese state-owned railway group to build out the rail infrastructure. The early stages of this rail infrastructure are not headed into the Danakil, but there is the potential to extend rail there, which would be a huge win for the basin. Other large parties—Yara being a key example—are also making additional investments in the basin.

So the short answer is that Ethiopia still has clear challenges to overcome. But the quality and size of the resource is not to be ignored. Over time, the Danakil will certainly be developed, but a few more things need to fall into place before large-scale development can take off.

The one counterintuitive advantage Ethiopia has going for it is that developers in the country likely have access to capital from nontraditional sources, such as the International Finance Corporation and World Bank. Developers with projects in advanced countries, such as Canada, cannot access this type of capital. There are good examples of infrastructure-related projects—wind in particular—where the IFC and World Bank are already providing attractive financing terms to advance the economic development of Ethiopia. And we expect that potash developers in the Danakil basin likely have access to similar sources of capital. For example, Allana Potash Corp. (AAA:TSX; ALLRF:OTCQX) has already struck very good financing arrangements on both the commercial and international banking fronts.

TER: Who has Allana partnered with?

SH: On the equity side, Allana has received equity financing from Liberty Metals & Mining Holdings LLC. (a subsidiary of Liberty Mutual Insurance). Liberty is a large, sophisticated group with a great deal of mining interests around the world. The World Bank-affiliated International Finance Corp. has also taken an equity stake in Allana. This was a critical accomplishment for the company’s credibility. Thanks to a recent equity raise, it is now fully funded through its definitive feasibility study (DFS). The one key piece of the financing puzzle still to be completed is on the debt side, but this likely won’t occur until the project’s DFS is completed later this year. At that point, presuming everything goes to plan, the company will need to raise one last tranche of equity to finance construction. The big question for Allana is what percentage will go into debt versus equity? Typically, it’s a 60/40 or 70/30 split. But Allana may be able to raise the ratio even higher, perhaps even 80% debt, given its access to development agency financing. It just needs to address key technical issues that are still outstanding.

TER: Are there other players operating in the Danakil basin?

Yara has a partnership in the basin. South Boulder Mines Ltd. (STB:ASX) is on the Eritrean side of the border. And Ethiopian Potash Corp. (FED:TSX.V; FED.WT:TSX.V) has a deposit. BHP also has a large concession in the basin, although it hasn’t been too active there of late.

The Danakil footprint is well mapped out. It is a world-class deposit, with attractive attributes. Multiple parties are expressing interest in it. The big question remains: Is it the easiest deposit to develop in the current context, versus other opportunities?

TER: What other regions are you looking at for potash?

SH: On the incumbent producers’ side, we favor Canada. But in terms of the developing opportunities, we really like Brazil for junior developers. There are some very large potash deposits in the Amazon basin, but they’re not easy to get at. There are complexities around climate, humidity, access and infrastructure. A benefit is that Brazilian firms do have access to some of the same nontraditional funding I mentioned earlier, including the International Finance Corporation. Furthermore, the Brazilian Development Bank has already expressed definitive support toward other fertilizer projects, including one controlled by MBAC Fertilizer Corp. (MBC:TSX).

Brazil has become an agricultural powerhouse in recent decades. But the challenge is that it needs to import up to 90% of its potash. The government views this as a strategic issue, and it is working toward self-sufficiency in potash by 2020. That timeframe may be a bit ambitious, but at least it has outlined a goal.

TER: What are investors looking for in a potash company?

SH: Overall, from a financial constraints perspective, potash investors looking at junior developer opportunities seem to prefer smaller, bite-size capital projects, given the significant challenges around raising capital. Investors also prefer that production come online sooner rather than later, which is one of the reasons we suspect many projects are steering toward solution mining, versus traditional underground mining techniques.

TER: How do you determine a target price for your stock picks?

SH: For the large incumbents, we apply a target multiple to the company’s forward projected earnings. Flexibility in this target multiple, at least compared to its historical range, allows us to capture a wide array of potential factors that may also influence the share price and outlook. For the developers, our target prices are generally derived using a risk-adjusted, net asset-value (NAV) approach. Most of the junior potash developers do not have cash flows today. So, in simplistic terms, we forecast a company’s future cash flows based upon its development project attributes, and then discount it back to present day to derive a NAV. Finally, once we’ve got the aggregate NAV figure, we risk-adjust it for various factors, such as stage of development and geopolitical and technical risk. Handicapping is more of an art than a science, particularly for the earlier-stage developers when the cash flows are years away.

TER: Do you prefer any particular potash players?

SH: Our two favorite names are Potash Corp., which we rate as an Outperform with a $60/share target price, and MBAC, which is Outperform with a $4.50 target price. In the current environment, we generally prefer the larger companies with current cash flow. Potash Corp is the bellwether in this space. It is the world’s largest fertilizer enterprise with the number-one ranking in potash capacity. It is number three in phosphate and nitrogen. Potash Corp is in the final stages of a decade-long capacity expansion program, whereas many of its large competitors are just getting started with expansion programs. And at the same time, as its capital expenditure winds down, its free cash flow is set to balloon. That should facilitate stock buybacks, dividend increases and further strategic investments. Given its share price retreat in recent months, it’s now trading at ultra-low levels.

MBAC is a unique story. It is phosphate focused and it is Brazilian. Its flagship Itafós Arraias SSP project is fully funded and poised to go into production later this year. The potash industry today is a barbell. On one end are the big, incumbent producers and clustered at the other end are the small developers. MBAC is a junior developer that is going to migrate into the big production bell. We see that as a rerating opportunity for the company. We also see it as an opportunity for MBAC to develop as a large fertilizer enterprise, because it has a number of very attractive assets in its pipeline. MBAC is our second favorite name. The other developer that we are positive on is Western Potash. It has a very attractive property in the Milestone project in southeast Saskatchewan.

TER: Thanks for talking to us today, Steve.

SH: It was a pleasure.

Steve Hansen joined the Raymond James investment firm in October 2005 as an associate equity analyst covering the industrial sector. He was promoted to equity analyst in April 2007. Prior to joining the firm, Hansen worked as a stock analyst with Morningstar, covering the forest products sector. Hansen holds a Master of Business Administration from the Ivey School of Business at the University of Western Ontario and a Bachelor of Science in forestry from the University of British Columbia. Steve also holds a CMA designation and is a CFA Charter holder.