Bright Spots in the Fertilizer Market: Robert Winslow

Global population growth and escalating food demand underpins long-term upside for potash, phosphate and nitrogen producers, but fertilizer oligopolies may have jumped the gun last year with aggressive rates that priced farmers out of the market. As farmers expand acreage rather than boost yields in now-tired fields, grain prices have backed off recent highs. That’s why Robert Winslow, agriculture research analyst and director at National Bank Financial, is picking his stocks with care. In this interview with The Energy Report, he shares where he sees strengths and weaknesses in the industry and names some interesting contrarian plays.

The Energy Report: Your last interview took place in April of 2011. What have been the major developments on the agricultural front impacting the fertilizer markets since then?

Robert Winslow: Increased weather volatility, like last summer’s drought in the U.S., which led to modern-era highs in corn, wheat and soybean prices, have had a significant impact on the market. Although grain prices have softened of late, I believe you’re likely to see somewhat higher-than-usual grain prices through at least the first half of 2013, given the persistent dryness in the U.S. corn belt and wheat-growing regions. Grain prices drive farmer sentiment and buying, and therefore the price and the demand for fertilizer.

We’ve seen some disconnects when it comes to potash, such as in India: Because the rupee was devalued about 20% through 2012, Indian farmers can’t afford to pay the prices that the potash companies would charge, and this resulted in subdued demand. Chinese demand has been somewhat subdued as well. Globally, we’ve had this really interesting dichotomy with high grain prices buoying larger demand in places like North America and even Brazil, but softening demand in yet other parts of the world with country-specific issues. In total, we haven’t seen the demand strength in potash that you might have otherwise expected with this high grain-price environment.

Some would say it’s partly because grain prices are not sustainable at these high levels. We are actually of that view. Like any commodity, when the price gets too high, two very simple things play out: demand destruction and supply response. You’ve seen demand destruction over the last 3–6 months. For example, high-cost ethanol plants have been shuttering production. High-cost producers of cattle, pigs and chickens have been culling their herds because they can’t afford the feed costs unless meat prices rise in conjunction, which they have not.

Then there’s supply response. Farmers are expanding acreage by moving into marginal land. You may not get robust yield on that land, but you can still increase production, which we’re seeing play out now. Brazil is expected to increase soybean acreage by 8–10% this year. With these dynamics playing out, the grain prices are beginning to come down. We expect that by the second half of 2013 you should start to see lower fertilizer demand reflected in pricing, even in the U.S. and Brazil. That is why we maintain a fairly cautious view on the fertilizer sector at this stage.

TER: How might continuing climate change and severe weather affect grain prices and fertilizer demand?

RW: Nobody really knows the answer. I don’t pretend to, but I will say that the stocks-to-use ratio for grains right now, globally, is about 68–69 days of supply. It’s relatively tight compared to the last 30 years or so, and it doesn’t take much to tip over and get a real spike—or falloff—in grain prices. When you do get these supply shocks through floods or droughts, the relatively tight supply situation can move prices quite dramatically, which we saw just this past year.

Many investors don’t believe such price spikes are sustainable and they aren’t going to pay for them. We’re probably at least two years away from where we have a bit more of a buffer in the stocks-use ratio to get us away from this tightness that is causing more volatility in the grain price. In the meantime, we can expect continued volatility in both grains and fertilizer equities.

TER: How have the various segments of the fertilizer industry performed in the last year and a half?

RW: Potash has been the commodity with the most interest. We’ve been a bit of an outlier in the investment community, with a rather bearish view on both the commodity itself and on some of the senior potash producer equities. We are of the view that the potash oligopolies (and we all know who they are) have been rather aggressive with their pricing. In a perfect world, you might be able to raise your prices every year, but we don’t live in a perfect world. Places like India just couldn’t afford the higher prices, so they bought less. The oligopolies and agronomists are right in saying that parts of the world, like India and China, need more potash in the soil, but ultimately, demand is price dependent.

In 2012, global potash demand looked to be in the neighborhood of 50 million tonnes (50 Mmt), which is below the levels we saw back in 2004. Thus, the commodity usage has been basically flat to down over the last 7–8 years—not a compelling investment theme. But the potash price more than tripled over that period. This aggressive pricing has since come back to bite the oligopolies. I expect a demand recovery in 2013 because India has been under-applying fertilizer, and it will need to make up for that at some point. I doubt India would purchase its full allocation, which would be 6–7 Mmt, unless it can buy potash near or below $400/Mmt. And if it does buy the 6-7 Mmt, then there’s a good chance India might buy less again in 2014, with Indian farmers trying to mine the soil. Of course, if the rupee comes back with vigor, India would have more buying power.

On the supply side, there’s tremendous brownfield supply expected over the next three to four years. Most of it is coming from the oligopolies themselves. It looks like the global supply will be growing about 4% per year, on average, over the next four years. So if your demand is flat and supply is up 4% per year, it doesn’t bode well for potash prices. That doesn’t include the greenfield supply that could come on from BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK), K+S Potash Canada (SDFG:FSE) or any of the juniors that are working to build mines. So the supply/demand dynamics are not, in our view, compelling for potash over the next two years, particularly if we get less volatile global weather patterns and grain prices trend down.

TER: How do the prospects look in the other fertilizer segments?

RW: Phosphate is looking rather interesting here. Not unlike potash, there’s a bit of an oligopoly situation, with Morocco controlling half or so of the global phosphate rock market. It appears that Moroccans really want to move more into the higher-margin business. Instead of just selling rock to the world, they figure they can make monoammonium phosphate and diammonium phosphate, which are finished fertilizer products. This will make it rather challenging for the non-integrated phosphate producers and/or companies that still rely on imported rock. U.S. phosphate producers like The Mosaic Co. (MOS:NYSE) and Agrium Inc. (AGU:NYSE; AGU:TSX), for example, rely or expect to rely to some extent on Moroccan rock.

On the other hand, that should provide some interesting opportunities for the greenfield phosphate companies, certainly in North America, that are developing phosphate deposits. There are a couple of companies in particular that you might want to keep an eye on. One is d’Arianne Resources Inc. (DAN:TSX.V; DRRSF:OTCBB; JE9N:FSE) and the other is Stonegate Agricom Ltd. (ST:TSX, SNRCF:OTCPK). Both are working on projects here in North America. The next few years could be interesting for them.

TER: Then how about the nitrogen products?

RW: Unlike potash and phosphate, nitrogen isn’t reliant on ore bodies. It’s produced all over the world, so you don’t get the sort of concentration you get in potash and phosphate. If you’re investing in that sector, you have to be a little careful, because we believe that nitrogen producers in North America, in particular, are near peak margins due to the low price of natural gas, which is a big input component. In our view, you shouldn’t generally buy equities that are about to post peak earnings and peak margins, especially when the market already expects those peak results.

Two companies in particular, Agrium Inc. (AGU:NYSE; AGU:TSX) and CF Industries Holdings Inc. (CF:NYSE), have share prices near their all-time highs, and the market’s already valuing some pretty robust results for them. We would be very cautious, and, in fact, we have an Underperform rating on Agrium. That stock’s trading a little over $102 today, and we have an $87.50 target on it.

TER: How are current commodity and financial market conditions affecting plans for junior mining companies in the project development stage?

RW: It’s a challenging time. Finance risk is the key challenge for a lot of these junior companies, whether it’s potash or phosphate. That means that if you have an ore body or an asset, it needs to have some competitive advantages, for example by being a low-cost operation either at the mine level or through low distribution costs. We look at projects like Allana Potash Corp. (AAA:TSX; ALLRF:OTCQX) in Ethiopia, for example, which looks to be well positioned as a low-cost operation at the mine gate and could be one of the lowest-cost delivered potash suppliers into India, which has no domestic potash. Companies are better off when they have these types of strategic advantages, but at the end of the day, the finance risk is still an overwhelming one today.

There is one development stage fertilizer company that we’re most intrigued by, and that’s MBAC Fertilizer Corp. (MBC:TSX; MBCFFOTCQX), because its finance risk is now largely behind it—it is about to move into production in the next few months or so. It has a phase one phosphate project in Brazil called Itafos, right in the Cerrado, which is the breadbasket of Brazil. It also has another phosphate asset to the north of the Cerrado. This company has a logistic advantage because half of the phosphate fertilizer manufactured in Brazil uses imported rock from Africa. We are extremely interested in this stock and it has our Top Pick rating in the sector. We have a $5.25 target on the stock with an Outperform rating. Frankly, the company is a potential acquisition target because there are parties that appear to be aiming to consolidate the phosphate fertilizer sector in Brazil. We believe MBAC Fertilizer is one to own for 2013.

TER: It’s nice to see some blue sky on the horizon.

RW: I’m not a complete bear on the sector. There are some bright spots in my coverage list.

TER: Do you expect any other interesting M&A activity in this industry due to current market conditions?

RW: I don’t see much particularly different about 2013 versus 2012 as far as the macro call goes. There’s been expectation for some time that the Indians and/or Chinese would come in and buy up more of the junior fertilizer companies to help secure supply, particularly in the potash sector. That just hasn’t happened yet. One thing that’s different about 2013 is that there should be a number of bankable feasibility studies completed this year, which will help derisk a number of the early-stage projects. It looks like Allana Potash is expecting its bankable feasibility any day now and d’Arianne Resources is expecting a bankable feasibility mid-year. Elemental Minerals Ltd. (ELM:TSX; ELM:ASX; EMINF:OTCPK) has a bankable study expected in the second half of 2013 on its potash project in the Republic of the Congo. Even IC Potash Corp. (ICP:TSX; ICPTF:OTCQX), which is a company looking to develop a sulfate of potash fertilizer project in the U.S., expects a bankable study in mid- to late 2013 as well.

There are number of bankable feasibility studies coming, which will help derisk these projects and could spur some investment by the likes of the Indians, the Chinese and even the Brazilians as they look to secure fertilizer, but time will tell. Because finance risk is quite significant for these companies, they ultimately need strategic partnerships and/or offtake agreements to help mitigate that risk. So as these studies come out in the next 6–12 months, that could change the equation for many of them. We’ll have to wait and see how that plays out.

TER: You talked about MBAC, which you like. What’s the situation with PotashCorp. (POT:TSX; POT:NYSE)?

RW: We’re bearish on that one. I believe we have the only Sell rating for that stock on Bay Street and Wall Street. So if you like contrarian views, that’s us. The potash commodity supply/demand situation is not particularly compelling. In terms of valuation, we look at that company as having mid-cycle earnings around $3.05 a share in our 2014 estimate. A typical multiple on mid-cycle earnings tells us this stock is overvalued at $41–42. The Street and most analysts seem to love it. They believe it’s worth $50+. Considering the cyclical downside potential for grain, we’re not of that view. We had a sell on it for most of 2012 and it’s been the right call. We’ll have to see how 2013 plays out.

TER: What do you see ahead for fertilizer producers and how can investors position themselves in this industry, if they like the future prospects?

RW: It’s as simple as this: The correlation between grain prices and agricultural equities, particularly the fertilizers, is quite high. Grain prices have retreated of late but still appear to have more downside risk than upside and we would argue over the next year or so, barring unforeseen supply shocks, the trend for grain prices is for further downside. If you’re of that view, then the bias for the agricultural equities would be down as well. So we’re pretty cautious here. We’d be inclined to sell into strength, if these agricultural equities rally, and focus more on the supply/demand fundamentals for grains. With that view, we have only a select few buys and we’re more cautious with a number of sells in our universe.

TER: And there’s a little bit of news on the horizon for mid-year with some of the smaller companies if they can get their act together.

RW: That’s correct, on the bankable feasibility studies coming out.

TER: We greatly appreciate your time and input today, Robert.

RW: Thank you very much.

Robert Winslow is an agriculture research analyst and director at National Bank Financial (NBF). Prior to joining NBF, Robert was an analyst, managing director, and the head of research at Wellington West Capital Markets Inc. (WWCM). Prior to WWCM, Winslow was a special situations analyst at Orion Securities. Winslow began his career at Solar Turbines Inc. (a Caterpillar company) in Dallas, TX, where he was a senior product engineer. He has a Bachelor of Science in mechanical engineering from Queen’s University, a Master of Science in mechanical engineering from Texas A&M University, and a Master of Business Administration from Cornell University. He also holds the Chartered Financial Analyst (CFA) designation.

Biggest Value for Agricultural Investors Revealed: Steve Hansen

Steve Hansen Steve Hansen of Raymond James sees the potash market as a barbell, with a handful of large incumbent producers on one end and dozens of junior miners clustered at the other. In this exclusive interview with The Energy Report, Hansen discusses which juniors may migrate to the mid-cap arena and why current share price weakness does not dampen Raymond James’ bullish sentiment on the sector, from Canada to Ethiopia.

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.

Brazil's Biofuel Boom: Mark McHugh

Mark McHugh Believe it or not, industry experts see biofuels accounting for up to 25% of global energy consumption by 2050. With this long-term vision in mind, Mark McHugh, president and CEO of consultancy firm CenAm Energy Partners SA, assesses the current biofuel industry from his base in Brazil, the seat of the growing industry. In this exclusive interview with The Energy Report, McHugh explains why specialized energy feedstocks are the solution to current technological and political growth constraints, predicting that biofuel investment returns may rival historic fossil fuel profit ratios.

The Energy Report: The biofuels sector encompasses a range of products. Can you give us an overview of this commodity space and how production processes differ?
Mark McHugh: Biofuels are derived from agricultural commodities. There are three types of “first-generation” biofuels, two liquids and one solid. Bioethanol is added to gasoline. It is produced largely from corn grown in the U.S., sugar beets grown in Europe and sugar cane grown in Brazil. Biodiesel is produced from vegetable oils and/or animal fats. The third biofuel is biomass or biomass pellets, which are used in electricity generation to replace coal. The pellets are produced from wood chips or renewable energy crops.

TER: With traditional fossil fuel prices ever steeper, is it possible that biofuels could take over a significant share of that market?

MM: Energy scenarios produced by Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) and the World Energy Council project that by the year 2050, biofuels will source 15–25% of global energy consumption. The biofuel industry will be the same size the oil industry is today. Whether you believe or disbelieve that, it’s what energy analysts are projecting.

TER: Many industry players are involved in biofuel research and development. What state-of-the-art technologies are changing the landscape in this space?

MM: First-generation transportation biofuels, such as corn-based ethanol, are mature technologies. Unlike energy sources for hydrogen or electric cars, no major infrastructure investments are required to accommodate them. Corn ethanol is about 1.3 times more efficient than fossil fuel and has little or no benefit in reducing carbon emissions. Brazilian sugar cane-derived ethanol is 8–10 times more energy efficient, and it is lower in carbon than the fossil fuel equivalent.

However, corn and sugar cane are also food crops, and that presents sustainability challenges. The next generation of biofuels is not produced from food crops; it is more environmentally sustainable. While second-generation biofuel production costs are not yet competitive with first-generation costs, renewable fuel standards are friendly to non-food biofuels. In the U.S., governmental mandates require that 10 years from now, $16 billion gallons (Bgal) of second-generation lignocellulosic biofuels must be produced. The mandates allow for the production of $15 Bgal of conventional biofuels, which includes corn-based ethanol. It’s going to take 10 years for the lignocellulosic biofuels’ volume to equilibrate with first-generation volumes.

TER: What are lignocellulosic biofuels?

MM: Wood or cellulose is the main component of lignocellulosic materials. I am a strong believer in lignocellulosic energy crops, particularly elephant grass, switch grass, or the generic name, miscanthus. Miscanthus is among the most efficient and most sustainable of the second-generation feedstocks.

TER: Who are some of the major players developing miscanthus?

MM: It’s very patchy. There are some plantations in Europe and the U.S. Developmentally, miscanthus is in the early stages. In Brazil, Embrapa, the agricultural research institute, is developing new strains of miscanthus to obtain optimum yields. New Energy Farms (private) is a key developer of miscanthus as a feedstock for second-generation biofuels in the U.S., Canada and the U.K. However, nobody is a significant player yet.

TER: What level of demand currently exists for second-generation biofuels?

MM: Supply is constrained, but there is a substantial demand. Europeans are converting existing coal-fired plants to burn biomass pellets. There just isn’t enough agricultural land available in Europe to produce a sufficient quantity. Brazil is a prime candidate for growing exactly the type of energy crop to produce biomass pellets from miscanthus, but substantial investment is needed to kick this off.

Demand in Europe for biomass pellets is about 10 million tons (Mt) today, and that figure is projected to climb as high as 50 Mt within the next 10 years. But producing 5 Mt requires a plantation of 200,000 hectares, whereas the lignocellulosic plantations today are still small in Brazil, in the range of 1,000 hectares. So it’s a question of scale. Some of the Brazilian timber companies are growing eucalyptus and other fast-growing wood products, and a Brazilian company called Suzano Papel e Celulose S.A. (SUZb5:BOVESPA) has the potential to produce 2 Mt biomass pellets from wood chips. But miscanthus has a key advantage in that it delivers two crops annually, whereas it takes four to five years to get maturity on timber-based products.

TER: What are the technological impediments to developing miscanthus?

MM: There are a couple of methods of converting lignocellulosic material into biofuel. One is a thermal cracking process. The other involves using enzymes to convert the cellulose into sugar and then fermenting the sugar into alcohol. Companies, including Dow Chemical Co. (DOW:NYSE), are investing in this route. Yet individual industries are all trying to develop their own proprietary methods. That’s the main factor that’s stalling it.

TER: Does miscanthus serve all three types of biofuel?

MM: That’s its key advantage. I’ve been having discussions with large investors, still very much at the idea stage, but that’s exactly the issue. If you’re considering a position in the second-generation biofuels business, miscanthus is a very good starting point. If you accept the hypothesis that the biofuels or bioenergy business is going to be as large as the oil business in about 40 years, then you want to control supply. The demand is already there. It’s a bit like the growth of the original oil industry in that the biofuels industry will be driven by supply considerations, certainly for the first 20–30 years.

TER: You mentioned earlier that allocating land for biofuel feedstocks presents a challenge. Where are the potential feedstock hot spots?

MM: There are suitable locations in South America, specifically in Brazil. Sub-Saharan Africa is ideally suited. Miscanthus grows best in a tropical zone within eight degrees north or south of the equator, but it doesn’t mean that there aren’t opportunities for North American production. Large plants in the U.S. and Canada are producing biomass pellets from wood fiber.

TER: In light of the fact that biofuels are in part encouraged by sustainability-focused government regulations, what is the carbon footprint of miscanthus?

MM: As miscanthus grows, it absorbs carbon dioxide from the atmosphere. When it’s burned, it gives out the same amount of carbon dioxide, so in theory it is carbon neutral. However, it is important to factor in what we call a “land use penalty.” If we convert existing land to plant corn or sugar cane for biofuels, we have to keep replanting it, thereby repeatedly creating carbon emissions. Miscanthus, on the other hand, only needs to be planted once. After it is cut, it grows again and again. And while it’s not strictly carbon neutral, the land use penalty for miscanthus is among the lowest of the second-generation feedstocks.

TER: Are there any major players getting involved in Brazilian feedstocks?

MM: There are some small players in biomass pellets, but that’s a side show. Brazil is the second-largest market in the world for bioethanol. The U.S. is the largest market. Brazil and the U.S. supply 75% of the world market for biofuels. In the Brazilian market, about 400 sugar mills produce ethanol. About 10 large players control 50% of the total capacity. About 150 smaller players own single mills.

TER: These are all local firms?

MM: They all started out as local firms, but multinational players are entering as Brazil’s ethanol industry consolidates. The only significant vertically integrated company, Raizen S.A., is a recent joint venture between Royal Dutch Shell and Cosan S.A. (CSAN3.SA:BOVESPA). Cosan was an ethanol producer that acquired Esso’s, or Exxon Mobil Corp.’s (XOM:NYSE), downstream assets in Brazil three years ago. Another big producer is ETH Bioenergia (private), which in its formation included a takeover of Brenco Holding S.A. by Odebrecht S.A., a Brazilian construction and engineering company. The larger players have multiple mills in states surrounding Sao Paolo. They typically enjoy efficient agricultural yields. Such producers build two capacities into their sugar mills that are key to its profitability: One is the ability to switch production from sugar to ethanol and vice versa, depending on market prices for sugar. The other capacity is co-generation. These plants generate electricity using biogas, or sugar cane waste, as fuel. The company sells that power to the grid in Brazil at a preferential price for renewable fuels-produced electricity.

Then there are about 150 sugar mills that are smaller in terms of size and production capacity. Traditionally, they were financed with soft loans from government banks in the early days of the Brazilian ethanol Pro-Alcohol program. They don’t typically have the capacity to switch from ethanol to sugar, and they don’t have co-generation. Because they’re smaller, their yields are typically lower. So a number of them are struggling and bigger players are buying them up.

On the distribution side, there is one big vertically integrated player: Raizen. It manages the Shell and the Esso retail sites throughout Brazil. It is the third player in the retail fuels market behind Petrobras (PBR:NYSE; PETR3:BOVESPA), or Petróleo Brasileiro, and Empresas Petróleo Ipiranga (state-owned). But it also produces biofuels. And because it is vertically integrated, Raizen can see the whole value chain and price accordingly. That allows it to be more competitive, because the gasoline sold at the pump in Brazil contains 25% ethanol. Fossil fuels are only refined by Petrobras in Brazil. The Shell and Esso brands buy fuel from Petrobras and blend in the ethanol before they sell the grade at the pump.

TER: Is consolidation the name of the game in Brazil?

MM: There are a lot of family businesses for sale. And the industry in Brazil is not currently expanding capacity. Brazil is inwardly focused at the moment, trying to improve efficiencies with consolidation. This business is very much defined by national boundaries.

Brazil used to export 30% of its ethanol production, after accounting for domestic consumption. For years, the Brazilian biofuel industry had been hammering at tariff barriers in the U.S. to develop the biofuel export business. But when the price of sugar went up a while ago, Brazilian ethanol producers switched into sugar production. Ironically, due to a poor harvest last year, Brazil had to import corn-based ethanol from the U.S. in order to make up for its domestic shortfall in biofuel.

TER: How do governmental policies affect the development of biofuels?

MM: The evolution of this business is being driven by regulatory incentives, such as the Blender’s Tax Credit in the U.S. and public subsidies for renewable fuels. But a mature industry will not need subsidies. There needs to be healthy international trade in biofuels, just as there is in oil. And if biofuels are going to generate 15–25% of global energy consumption, the industry needs to focus on developing miscanthus and other energy crops. Sustainability is a key to this business.

TER: What companies do you recommend for investors interested in second-generation biofuels?

MM: Dow Chemical is leading the pack with work on enzyme technology. It’s a good pick.

In the biodiesel business, there are some good export markets. Argentina is a key exporter of biodiesel to Europe. I’ve been working with a company called Incoming Inc. (ICNN:OTCBB), which is a U.S. company that is looking to build a transnational biodiesel business with a position in Brazil, exporting to the U.S. In the U.S., biodiesel has been subject to major ups and downs as government subsidies have been set and removed and then replaced. It makes sense to hedge regulatory risk by having a position in more than one export market.

The Brazilian biodiesel market is booming at the moment. That’s also driven by policy mandates. The current blending target for biodiesel is 5%. There is talk of that going up to 7%. Margins are profitable for efficient local Brazilian players in that market.

TER: Thank you for speaking with us today.

MM: My pleasure.

Mark McHugh is president and CEO of CenAm Energy Partners SA, an independent professional consultancy and investment advisory partnership focused on the oil and renewable energy industry in Latin America and Africa. He is based in Brazil and has experience in the international oil industry in marketing, sales, strategy consulting and general management. He spent 26 years with Royal Dutch Shell and reached the level of vice president of regional marketing based in the U.S. He is experienced in leading new business development and M&A initiatives and managing new business start-ups.

The resource curse of land ownership

Land ownership in pre-modern India

In India, 50 or 100 years ago, land was a defining feature of wealth. The stock of land generated a flow of income. The landless were low-paid agricultural labour. The landed gentry of rural India were the kings of their heap. They had power, prestige, position, prosperity.

In the eyes of many, the initial conditions of high inequality of land ownership were a key barrier that held India back. It was argued
that a one-time bout of bloodshed was essential, to expropriate the rich, and to transfer land ownership in a more equitable fashion. In India, this capacity for State-inflicted bloodshed was present in some places only. In much of India, the unequal distribution of land ownership found in 1947 was left intact.

Fast forwarding into the present, there has been a sea change in the fortunes of the owners of agricultural land.

Agriculture is less important

Particularly after we escaped from the Hindu rate of growth (3.5%) in 1979, the share of agriculture in GDP has dropped sharply. In
relative terms, the wealth created through firms in industry and services has dwarfed the wealth of the landed gentry. The richest man in India is born of one who started out with no land. Government interventions continued to stifle agriculture, but shifted to a
greater laissez faire approach in industry and services; this helped accelerate the decline of agriculture.

The plight of those who stayed back

Rural to urban migration has unleashed new forces on the role and status of the landed lords. Within rich families, high IQ children may be going off to the city to a greater extent, e.g. based on the filtration by competitive examinations where outcomes are correlated with IQ. To the extent that such a process has been afoot, it has given a selection bias where the low IQ children were the ones more likely to stay back in the `idiocy of rural life’ (as Marx characterised it).

That there was an easy option – to live off the land – was a `resource curse’ which afflicted the households who had land. In
contrast, for landless households, there was no conflict of interest in moving to cities (other than the recently introduced NREG, which tries to perpetuate poverty by hindering rural to urban migration).

The power and status of the landed lords was now twice undermined. Their quick-witted cousins who established themselves in
the cities were connected into capitalism and getting ahead. Families of the landless have tended to move to cities and connect into
capitalism and get ahead. The erstwhile lords have started looking nervously at both groups of escapees, wondering whether land ownership was such a nice initial condition.

In a fascinating recent article, Devesh Kapur, Chandra Bhan Prasad, Lant Pritchett and D. Shyam Babu gave us some insights into these changing social structures. In their survey data, in 2007, 98.3 per cent of Harijans were contracting-out the work of tilling their fields to their erstwhile lords, the upper-caste men who owned and operated tractors. The upper tail of the Indian income distribution has, in a few generations, been reduced to operators of agricultural equipment.

The importance of engaging with the market

A defining issue of modern times, for an individual, is a continued and deep engagement with the market. For insights into this idea, see this interview with Tom Sargent. The Ljungqvist/Sargent story matters even more in India, when compared with what has happened in the West. At 7 per cent GDP growth, every few years, far-reaching change comes about in technology and processes. Each individual builds knowledge and human networks by continually engaging with the market. If a person is cut off from engagement with capitalism for even a few years, this generates a lot of damage to the human capital. At that reduced human
capital, the person has to either accept an offer at a much reduced wage, or stay unemployed (which further undermines human capital).

In this setting, consider the plight of a land owner, who has been living off the land, and has never engaged with modern India. Particularly in the post-1979 period, when India has experienced relatively rapid growth, each year of being a country hick owning land meant being further away from the skills required to participate in the contemporary Indian economy.

We see the plight of adivasis in India, who have been away from the market economy, and are unable to plunge into it. We see the plight of the unemployed of Europe: the welfare state pays them dole to stay warm and well fed for many years of unemployment, but after this they are unable to come back into the labour market.

We see a similar problem with the landed gentry of India. They lack the skills to participate in the market economy. Income from the land, their resource curse, dulls their incentive to overcome the barriers. They are often too proud to accept low wage assignments
which are the starting point through which the unskilled connect to capitalism. These problems have come together to give a unique vicious cycle of dis-engagement with modern India that now afflicts the rural landed gentry.

Sale of land in the outskirts of cities

At the edges of all cities, urbanisation is proceeding through developers buying land from the local landed rich and transforming it
into the endless suburbs. In the short term, this has generated immense windfalls of wealth for the landed rich. But in some ways,
this is a bit of a disaster for many of them. Lacking in knowledge about the market economy, they are scammed by insurance salesmen and such like. Much of this newfound wealth tends to get dissipated in a few years.

Urbanisation and land development throws open vast opportunities for trade and industry. But the erstwhile landed rich tend to be
uniquely ill equipped at harnessing these opportunities. They tend to be too proud to work for someone else, and inadequately equipped to stake out on their own. They experience a brief blaze of glory when paid fabulous prices for their land, and then fade away into insignificance.

Some politicians have been moved to advocate special legal protections for the hapless rural rich who sell land to the modern
sector. It’s quite a turnabout within a few generations: from landed elite that oppress the others, to witless folk who need to be
protected by special laws that inhibit the sale of land.

The curse of land

A few decades ago, the left-of-centre view dominated the thinking in India. It was felt that inequality of land was a major bottleneck
that held India back. Many argued that the failure of Indian democracy to engage in a one-time bout of class warfare was a major mistake that was holding India back. It was argued that the Chinese path was the right one: to expropriate the landowners and then start a capitalist economy where everyone is equal.

With the benefit of hindsight, things look different. I think this story reiterates the dangers of social engineering. We are dealing
with enormously complex systems that we only dimly understand. As far as possible, it is wise on our part to use the force of the State as little as we can, and to always avoid treading on fundamental human rights such as property rights.

Acknowledgments

I am grateful to K. P. Krishnan , Suyash Rai and Mihir Thaker and for insightful conversations.

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.

Bruno del Ama: Fertilizer Is a Growing Business

Bruno  del Ama It may not sparkle or shine, but fertilizer has a bright future. In this exclusive interview with The Energy Report, Bruno del Ama, CEO of Global X Funds, tells us why investors should be looking at this “growing” industry and how his company’s new global fertilizer and potash ETF (NYSE:SOIL) provides a great vehicle for profit. He also tells us why his company’s gold and silver mining ETFs are poised to catch up with precious metal market performance.

The Energy Report: Thank you for joining us this morning, Bruno. Before we get into the details of Global X Fertilizers/Potash ETF (SOIL:NYSE), let’s discuss ETF basics and how they operate.
Bruno del Ama: Certainly. Exchange traded funds (ETFs) are fairly similar to traditional mutual funds. Their name indicates their main difference—they actually trade on an exchange like any other stock. ETFs have been one of the fastest-growing segments in the financial services industry. That’s due to many of the benefits ETFs offer, such as low cost, transparency and tax efficiency.

TER: This really is a proliferating field. It seems like every time we turn around there’s a new ETF. What factors does Global X Funds consider when developing an ETF for a particular sector?

BdA: We focus on three very important factors when we decide to bring new products to market. The first starts with the global macro trends. What are the big themes that are shaping the world? Our products have to fit into those very long-term secular trends that will continue to drive performance.

The second one is that it has to be unique and differentiated. So, if you look at the lineup of Global X Funds, there are essentially no products like them. And thirdly, the products in the ETF package must make sense and provide good access to the type of market that we’re considering.

TER: How long has Global been managing ETFs?

BdA: We brought our first ETF to market in February 2009, and we have been ranked by BlackRock as one of the fastest-growing ETF companies in the world. We currently have about $1.5 billion (B) in assets under management and have been ranked by our peers both in Europe and the U.S. as the most innovative ETF company in North America.

TER: What are the advantages for investors buying an ETF versus other investment vehicles?

BdA: The main reason why ETFs have been very popular is their low cost. Their management fees are much lower than those of comparable mutual funds. ETFs also don’t have the loads, distribution and short-term redemption charges that mutual funds typically incur. They’re very cost efficient. Essentially, what ETFs do is bring institutional-like expense ratios to the retail investor. However, about half of the user base for ETFs is institutional so these products have to work well for both investor classes. The retail investor can essentially piggyback off the institutional investor and get access to the exact same expense loads. That has been a huge driver of growth.

Innovation, as you point out, has been another driver of growth. The fact that you can get access to areas of the world that were very difficult to access before is a huge benefit. For example, we have a whole suite of China sector funds. So, if you have a particular view on the China consumer segment, that’s something that you can now place targeted bets on, which was very difficult, if not impossible before ETFs emerged.

The third benefit of ETFs is their tax efficiency. Additionally, market volatility has made the liquidity ETFs offer very appealing. If you have the market swinging up or down 300 basis points on any given day, you can come in at 11:00 a.m. and you then sell your shares at 3:00 p.m.

Transparency is yet another benefit of ETF investment. One of the problems in the market in 2008 was that a lot of investors in mutual funds didn’t know exactly what they owned. In our case, as well as with most ETFs, you can go into our website and see all of the holdings updated daily for any particular ETF.

TER: Typically, how much trading occurs in these funds?

BdA: Essentially 90%–95% of ETFs are what’s called passive funds. They track indexes developed and maintained by a third-party, such as Standard & Poor’s, Dow Jones, FTSE, etcetera, and those indexes don’t change very often. They’re typically rebalanced two or four times a year. There’s not a lot of trading that takes place. Of course, you could have corporate actions within a quarter where a couple of companies within the index merge or there’s a spinoff. There’s some amount of trading that happens inter-quarter between rebalance dates, but these funds provide exposure to a complete market in a passive way.

TER: So why did you start this particular potash and fertilizer ETF?

BdA: The only way to invest in the fertilizers/potash market is to buy individual stocks, most of which actually trade on foreign exchanges. This ETF allows investors to get diversified exposure to the whole fertilizers/potash sector, including stocks from 15 different markets, including Israel, Australia and China, to name a few. We had received inquiries from institutional investors looking for a simple and cost-effective vehicle to invest in the fertilizer/potash market. These investors are driven by the significant growth in the food and agro business market. Fertilizers are the nutrients that farmers require to increase crop yields, and as such, they are the first link in the global food supply chain.

TER: What are your growth expectations for this sector?

BdA: The prospects for continued growth in the fertilizer/potash business are very compelling. Purchasing power growth and the result of diet shifts in emerging markets are driving crop usage from grains toward high-protein feed, fruits and vegetables, which require about double the average application rate of fertilizers. The resulting growth in crop yields is enormous. For example, grain yields in India are less than one-half of those in the U.S., with lack of proper fertilization being the key reason.

TER: So the big markets are overseas. Is the North American market relatively saturated in terms of fertilizer usage?

BdA: Yes and no. I wouldn’t call it saturation, because the U.S. is a big farming country and you continue to see growth in farming. But, certainly from a fertilizer use perspective, the U.S. is a much more efficient market and so the penetration of fertilizer is very high. Emerging markets such as India have low penetration of fertilizer, so there’s a lot of catching-up that has to take place.

TER: Can you give us a little more of the specifics on your new Global X Fertilizers/Potash ETF?

BdA: Our Fertilizer/Potash ETF invests in the largest and most liquid companies involved in the fertilizer sector globally. It currently includes 29 companies from 15 different countries. What’s unique about this sector is that it sits at the intersection of commodities and agro business—probably two of the most significant bull markets currently taking place.

TER: Are there any other similar funds out there at this point?

BdA: There is nothing else focused on these markets specifically. There is a fund that invests in the broader agro business market. They may have a quarter of their exposure to the fertilizers market but it’s more diversified and includes farming operation and equipment. Ours is the only fund that has focused exposure on just the commodity/fertilizer aspect of the agro business market.

TER: You have a very geographically diverse group of stocks and most of them are companies that most investors have never heard of. Are there certain countries and regions that appear to be performing better at this point than others?

BdA: The emerging markets will clearly be the key engine of growth. Asia and Latin America already account for about two-thirds of global consumption of fertilizers to support food production for their large, growing populations. Global fertilizer consumption is growing fastest in these emerging markets with historical annual growth rates of more than 3% over the last 15 years. China and India specifically will be the key engines of growth. Annual consumption in China, for example, is expected to return to their pre-2008 growth levels of nearly 10% per year. Major growth has been taking place and will continue to take place in emerging markets.

TER: Are companies based outside of emerging markets included to provide geographical balance?

BdA: The fund represents the full fertilizer market, wherever those companies are located. China imports about 70% of the fertilizer they use. So, when you look at some of the names of companies in the U.S. or Israel, you know that some of their production is consumed at home but a big percentage of it is exported, primarily to emerging markets. There is a tremendous amount of trade and export taking place. Even by investing in some of the Australian or U.S. names, you will get access to the emerging markets. Obviously, when you invest in some of the fertilizer companies that are physically located in places like China, they’re expected to generate outsized growth because their local market is growing the fastest.

TER: What are some stocks our readers might find interesting on an individual basis?

BdA: As a fund manager, we don’t necessarily provide recommendations on single names. Most of these stocks are in foreign markets, but there are a handful of stocks that can be bought on U.S. exchanges, including CF Industries Holdings Inc. (CF:NYSE), Intrepid Potash, Inc. (IPI:NYSE), The Mosaic Company (MOS:NYSE), Scotts Miracle-Gro Co. (SMG:NYSE) and Terra Nitrogen Co., L.P. (TNH:NYSE). There’s also one Chilean fertilizer company that can be bought as an ADR, Sociedad Química y Minera de Chile S.A. (SQM:NYSE; SQM-B:SSX; SQM-A).

As a whole, this is clearly a growth market, and valuations will reflect the growth dynamics that are taking place. We certainly believe that this is a great market to be in going forward.

TER: What are some of the other ETFs that Global X Funds manages?

BdA: Global X Funds operates, perhaps, the broadest suite of commodity producer ETFs across a number of markets, including gold, silver, copper, aluminum, lithium, uranium and oil. The best performing of our funds has been the Global X Pure Gold Miners ETF (GGGG:NYSE), which is a relatively new fund launched in March of this year. It tracks the Solactive Global Pure Gold Miners Index and provides exposure to companies that generate the vast majority of their revenues from gold mining. The other fund that has performed well is the Global X Silver Miners ETF (SIL:NYSE), which tracks the Solactive Global Silver Miners Index and is currently our largest fund with around $500M in assets under management.

TER: Do you have any other food for thought for our readers?

BdA: The one observation I would make is that when considering investing in the commodities space and precious metals miners in particular, you have seen relative underperformance for the miners relative to the physical metal. We are big believers in investing in the commodities markets through mining stocks and producers for a number of reasons. Reason number one is that these are operating companies, and even in an environment where commodity prices are flat, they’re still generating revenues, earnings and growth. They’re paying dividends so they’re income-producing, as opposed to the metal itself, which doesn’t pay any dividends. We see an opportunity in this relatively underperforming market for the miners. Gold and silver miners have done pretty well, but not as well as gold or silver itself. A lot of it is driven by the analysts not factoring in the current high gold and silver prices into the earnings forecasts of these companies because they do not expect them to remain at those levels.

If you think about that dynamic, three things can happen: If the price of gold remains at the level where it is, a fund that invests in physical gold wouldn’t go anywhere because the price is not going up. But as the price stays at that level, the analysts are going to start factoring in those price levels into their earnings forecasts, so the price of the miners should go up while the prices of the physical gold stays flat. In an environment where the price of gold itself goes down, the physical gold ETF performance will be down. At that point, the miners have an advantage because they haven’t factored in that higher gold price into the expectations so they should perform relatively better.

If the price of gold goes up, the physical gold ETF should go up. But that should also factor into the miners, who typically have had an exponential return relative to the price of gold because their costs remain relatively flat while their earnings go up. They have a leveraged return versus the physical metal, and this is a good time to look at the metal producers as opposed to the physical metal as an investment. Our clients are very well positioned to benefit from that exposure.

TER: We appreciate your time and insights today.

BdA: Thank you for having me.

Bruno del Ama is the cofounder and CEO of New York-based asset manager Global X Funds, which has $1.5 billion in assets under management. Previously, he served as head of operations in the structured products business at Radian Asset Assurance, and was a senior consultant at Oliver Wyman. He is a CFA charter holder and received his MBA from the Wharton Business School.

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Interesting readings

A nice story about UIDAI, by Lydia Polgreen, in the New York Times.

A new insight into India’s north-east states: they are part of a region provisionally named Zomia. An interesting article in the Chronicle of Higher Education by Ruth Hammond. The book.

On 21 April 1956, Jawaharlal Nehru did the first convocation address at IIT, Kharagpur. It’s a good read, and it’s surprising how much of it makes sense in 2011. E.g.: in the larger context of history, and looking at it in this way it seems to me that at the present moment there is no more exciting place to live in than India. Mind you, I use the word exciting. I did not use the word comfortable or any other soothing word, because India is going to be a hard place to live in. Let there be no mistake about it; there is no room for soft living in India, not much room for leisure, although leisure, occasional leisure is good. But there is any amount of room in India for living the hard, exciting, creative adventure of life. In case you have not yet seen the Steve Jobs commencement speech, it is worth watching.

How civilised: Literature festivals in India, by Abhilasha Ojha in Mint.

A fascinating story from rural India about the differences between boys and girls on mathematics, by Maia Szalavitz in Time magazine.

Who’s to blame for India’s inflation and India’s Inflation Is a Lesson for Fast-Growing Economies by Alex Frangos in the Wall Street Journal.

When do stock futures dominate price discovery? by Nidhi Aggarwal and Susan Thomas, IGIDR working paper, has some surprising results.

Anupama Chandrasekaran and Vidya Padmanabhan, in Mint, on Indian ventures into farming in Ethiopia.

Raghu Dayal in the Business Standard on the huge opportunities in better India-Bangladesh relations.

Mobis Philipose in Mint, on recent developments in SEBI and on currency derivatives trading.

We need a Hazare in the financial sector by Tamal Bandyopadhyay in Mint. N. Sundaresha Subramanian in the Business Standard. Ex-SEBI member to PM: ID leaked, family at grave risk by P. Vaidyanathan Iyer in the Indian Express. CVC to Fin Min: Probe both sides’ complaints by Ritu Sarin in the Financial Express. And, reportage in India Today. Spat between Abraham, SEBI, finance ministry gets murkier by Appu Esthose Suresh in Mint. Supreme Court wants petition on SEBI refiled by Nikhil Kanekal and Appu Esthose Suresh in Mint. A first and then a second article on these issues, by R. Jagannathan, on FirstPost. An editorial in the Business Standard. Subhomoy Bhattacharjee in the Financial Express.

R. Jagannathan on post offices as banks (on firstpost). And, you might like this related document.

China’s A. Q. Khan problem: an article by Michael Wines in the New York Times.

A great story by Anthony Shadid in the New York Times about being on the run in Syria.

A great article by Paul Berman, in the New Republic, about Islamism.

Why is it so hard to find a suicide bomber these days by Charles Kurzman, in Foreign Policy.

Love and war, by Janine di Giovanni, in the New York Times.

What’s next for the dollar? by Martin Feldstein.

Sussane Craig has a great profile, in the New York Times, of how Howard W. Lutnick brought Cantor Fitzgerald back to life after the
firm was savaged in the 9/11 attacks.

Charles Neivert: Fertilizer Companies with Value

Charles Neivert The recent tumultuous downturn in stocks has created deeper values and new opportunity in the agricultural space. Dahlman Rose & Co. Managing Director Charles Neivert is a near-term bull on fertilizer companies, but the window could close and diminish prospects in the not too distant future. In this exclusive interview with The Energy Report, Charles talks about the complex dynamics that affect the farming and fertilizer industries, and reveals his best pick for a core holding.

The Energy Report: Charles, I was looking at an un-weighted basket of fertilizer stocks, and they were down about 23-24% for the last week of July through the first six trading days of August. Has this opened up some tremendous value for investors? Or is this downturn signaling a commensurate slowdown in agriculture along with the general economy?
Charles Neivert: I think that as a group this is probably more of a signal of a very strong value for investors over the next three to six months—possibly longer than that depending on the company. We don’t see a great change in the agricultural landscape due to the changing economy. It is certainly part of the things going on, but it may have less bearing on the fertilizer names than some other material spaces. That’s simply because food is involved and the grain crop out there that may have been damaged in some ways—though possibly not quite as definitive as we might see in other products. As a result, we think there is a lot of value in the fertilizers.

TER: The key difference is that it’s food?

CN: Yes. The demand for food is less elastic. Certain amounts of food are needed to keep going and global inventory is limited. This year, a number of grain crops were not exceptionally large. As a result, we don’t see a big rebuilding of inventories. The potential is that the price of some of these grains could continue to go up if the harvest does not come up. So, you could see things going up even though the economy is backing off simply because supply is being cut away.

TER: It sounds like you are near-term bullish on some fertilizer names, but that you have longer-term fundamental concerns.

CN: Yes, that is the case. Company prospects really depend on which nutrient is involved during which timeframe. The near-term is very good, I think, for any nutrient given the food and grain situation. However, as you mentioned, fundamentals for some of these products could potentially deteriorate over time while others are likely to be stronger for a little bit longer.

Again, given the nature of the agriculture business, it is really difficult to have a very long-term outlook within the context of a potentially extremely volatile production range, meaning grains. That is because the grains can go anywhere from very, very large harvest years to rather challenged times without any real rhyme or reason. There are no traditional business cycles. The agricultural cycles are all based on weather. If weather is extremely cooperative across a broad range of geographies, you could have an enormously large crop at a time when you don’t really want an enormously large crop. You may already have inventories, but there is not much you can do about it.

You might also get a small crop on top of small inventories, or something in-between. You don’t have the same control, particularly on the supply side, as you do with a manufacturing operation that can back off production when inventories are long. For the most part, the rules that governments have put into place to enforce land set-asides to help control production, have largely been abandoned. Those policies are no longer used, particularly in the U.S. and even in some other areas. So, you can get large or small crops completely opposite of what you might want or need at that time.

TER: Let me just flip here to the macro-economy for a moment. In a detailed statement following a meeting of the Federal Open Market Committee on August 9, the Fed signaled a prolonged period of slow growth and, in an extraordinary comment, said that interest rates are expected to remain low until mid-2013. How does this affect the agricultural universe?

CN: Well, those rates are pretty much focused on the United States. So, I don’t think it really has that much of an impact on the Ag space. In fact, it may have none. Low interest rates, to the extent that they affect the dollar could present some potential challenges because the dollar is weak or because the dollar is strong. That does have a lot to do with corn or soybean costs to potential importers of U.S. products versus some competitors. But, it will have nothing or little to do with what the farmer is going to plant in any given year.

TER: Charles, what are your institutional investor clients telling you now during this selloff? Are they holding off on buying stocks for fear of needing cash for redemptions at this point?

CN: Each portfolio manager may take a different tack, so really this one is a little hard to answer. My guess is that now people are moving and seem to like the Ag space for the time being. We are seeing good activity. A lot of it is to the buy side where activity levels are good.

TER: Can a case be made that some of these plant nutrient producers are defensive stocks?

CN: In the current environment, you can make that argument. They are not typically defensive in the way you think of a food stock in a recession. In a recession, these guys get hit. When grain production is being challenged, they become defensive opportunities.

TER: Potash is traded in a negotiated market, not a globally efficient and tight market. But we have seen some transactions of $490/ton in India. Could this represent an upward trend?

CN: Well, the price of this product has been coming up for over a year now as demand has come back from the trough of 2009. I won’t say it’s impinging on capacity, but it starts to be a snug market because we have run through a fair amount of inventory over the last year to a year-and-a-half. That is what ultimately justifies the fertilizer price. For the sake of argument, if this year’s crop turned out to be extremely large and we rebuilt inventories substantially, fertilizer pricing would have a very tough time going up from here. By the same token, if the crop comes in short, and the way it’s looking, it would increase the price of grains and therefore be a bit supportive of a price increase in potash. What we found in 2008 was that crop price is a very important determinant in what the fertilizer price can ultimately do.

TER: Are you currently bullish on potash as a commodity?

CN: No. Near term I like all the names and products, but on a longer-term basis, I’m not as bullish. I see an awful lot of capacity on the horizon. Some has begun to come up and more is coming over the next few years. It will be a pretty steady stream from a very wide variety of potential producers and some new entrants.

TER: At what price-per-ton would you be bullish on potash equities generally?

CN: I don’t look at the price of the product as a sign at all. I look at the price and prospect for the grains and consider what needs to happen from that point. So, when grains are at low prices and the crop is looking strong, I’m not going to be bullish.

TER: Is the extraordinary heat wave in the U.S. affecting crops?

CN: It’s definitely affecting crops. The timing of the heat wave is also an issue. If you get periodic rain, it reduces that impact. But, there are times where heat can be extremely damaging and other times when it’s less damaging. If heat hits at certain points of the growth cycle, plants can be far more damaged than at other stages of their growth. The heat that came through the Midwest earlier in the year hit around a time when certain plants were going through a key stage maturation, and that can be a problem.

TER: Is there a play for investors on drought-resistant crops?

CN: Seeds haven’t yet gotten there. There is no seed out with the label of drought-tolerant. It’s hard to say resistant. It’s really a matter of degrees. If you get no water, nothing will help you. But, if you get smaller amounts than normal, some seeds under development will still produce near- or full-yields under less-than-ideal conditions, but they are not in the market yet. They are within a few years, so the claim goes, and we will see when they make it. All the major seed players are working on that particular trait. You can get into the companies that would provide that pipeline by looking at the typical seed names of the world—du Pont de Nemours & Company (NYSE:DD) and Monsanto Company (NYSE:MON).

TER: Low equity prices have left a lot of companies with cash on their balance sheets. What does this bode for M&A activity?

CN: It’s a tough call. It depends on the product because some of the markets may be so consolidated already that it will be difficult to get anything by the antitrust people. Cheap prices may or may not allow for acquisition because people will look at the price from six weeks ago for comparison. A perfect example is what PotashCorp (TSX:POT; NYSE:POT) went through when BHP Billiton Ltd. (NYSE:BHP; OTCPK:BHPLF) took a run at them. The stock was down in the high ’80s to low ’90s for a long time. BHP was thinking it could get the company for $130, but just before the offer, PotashCorp’s share price went up to $106 because the wheat market in Russia started to give way. Russia was experiencing a serious drought. The prices started to move up, and even though the $130 offer was actually still a pretty substantial premium, it was not accepted. Not only was it not accepted by the company, but, as conditions in the grain marketplace worsened with stress from the U.S. corn crop, that price got even higher. So, it easily surpassed the offer number. Either people were expecting a much higher bid, or something is going on that makes the stock just worth more—like getting another bid. When the BHP bid was pulled, the stock didn’t drop.

TER: What are you telling your clients right now Charles? Where are the value and the growth stories?

CN: The name we like the most in the group is CF Industries Holdings Inc. (NYSE:CF) because we see the pressure on the corn crop in particular leading to a very positive, constructive situation for corn into 2012. The biggest beneficiary of a corn crop that needs to have a very large planting is more likely to be a name that is heavy in nitrogen, as opposed to one heavy in potash and phosphate.

We think there is going to be a fairly significant increase in corn acres planted next year, and if you need acres in corn, the U.S. doesn’t have a lot of new, unplanted acres to go after and would have to probably use acres currently in another crop. Often that tradeoff is in soybeans, which would result in an increase in the application of nitrogen.

TER: Even in this downturn, CF Industries is still up 82% over the past 12 months and it’s flat over the past month. So, it’s held up pretty well under this pressure.

CN: CF Industries is our only straight-out buy. We’ve been recommending this stock for a long time. Even when I was less constructive on the industry, this was the name we liked the best.

TER: Even though CF Industries is your only straight out buy-rated stock, you still recommend that money managers create a basket of these stocks, do you not?

CN: Right.

TER: And, what would that basket include?

CN: We are sort of constructive on all the fertilizer names, at least through the fall application season and possibly a bit beyond. CF is only in nitrogen with some phosphate exposure and no potash exposure. So, we would tell people to get some potash exposure, but pick your name carefully. We lean toward PotashCorp as a name, but you have to look at it at that moment in time and see how the company is performing against The Mosaic Company (NYSE:MOS) or Intrepid Potash Inc. (NYSE:IPI). It’s really a close call based on a lot of different metrics. That is why we recommend a basket within the group to your preferred weighting. You have to own some of everything, but include some of all of the nutrients. You could cover it all with two or three stocks in the basket.

We have upgraded the entire industry to an attractive level, and in a strong agricultural situation, you don’t want to be left completely unexposed to one particular nutrient because they will all move well and you want to catch some of that. It’s always hard to tell which one will be the best of the group.

TER: These companies are all mid- and large-cap. Are there any small- or smaller caps under a billion dollars where investors might be able to get a little more leverage?

CN: The only one that I deal with that gets down close to that range is CVR Partners LP (NYSE:UAN). It is a pure play on the nitrogen side structures as an MLP (Master Limited Partnership). It features a good payout, but tends to mute the share price a bit.

TER: Want to mention any other phosphate, potash or nitrogen companies?

CN: The only company I haven’t mentioned in the universe is Agrium Inc. (NYSE:AGU). I hesitate to use the word defensive play, but it has a big retail operation that it uses very effectively to move an awful lot of product. It does very nicely in that business. It is also spread across all the nutrients. It has nitrogen, potash and phosphate exposure. It also happens to be based-in and sell a lot of product in Canada, which means that it is a bit isolated from the rest of the market. That actually gives the company a pricing advantage because the market up there is a bit higher-priced. Its big retail exposure is sometimes a little bit of a turnoff if what you are trying to do is play the fertilizer space in a pure way. It’s a good company and well run. But, people tend to look at it and say it’s not exactly what they are after.

TER: Charles, thank you very much for your time today.

CN: Thank you.

In May 2009, Charles Neivert joined investment bank Dahlman Rose & Company LLC as managing director to head the firm’s new Agriculture and Chemicals Research division. Prior to Dahlman, Charles was an executive director at Morgan Stanley where he re-launched the firm’s commodity, specialty and fertilizer chemical equity research practice. He was also co-founder and president of New Vernon Associates, an equity research boutique specializing in global chemicals, which was awarded Institutional Investor’s “Best of the Boutiques and Regionals—Commodity Chemicals” honor for nine consecutive years. At New Vernon, Charles conducted all fundamental industry research on a global level, including analysis and forecasting of 50 distinct chemicals. He earned his Bachelor of Arts degrees in chemistry and economics from the University of Pennsylvania.

Interesting readings

The Anna Hazare silliness is depressing. Writing in the Indian Express, Shekhar Gupta has an interesting angle on why there is so much interest in this snake oil.

India’s $2 trillion economy means we have to reform faster by R. Jagannathan on FirstPost.

Meera Subramanian has a beautiful story about how Diclofenac, fed to cows, is killing off India’s vultures. We’re down from 50M vultures to 60k. The consequences are bigger than we think.

Former Sebi member Abraham?s claims under CVC lens by Appu Esthose Suresh in Mint.

China’s port in Pakistan?, by Robert D. Kaplan, in Foreign Policy.

The 10 most corrupt Indian politicians.

A promising band: Menwhopause. Listen.

The decline of Asian marriage, in the Economist.

Vinayak Chatterjee on ten projects that matter in India today.

The new draft Microfinance Bill. Back story.

Nirvikar Singh in the Financial Express on the CCI order about NSE.

Think again: War by Joshua S. Goldstein in Foreign Policy.

Hegemony with Chinese characteristics by Aaron L. Friedberg, in the National Interest. Arab Spring, Chinese Winter by James Fallows, in the Atlantic. The South China Sea is the future of conflict by Robert D. Kaplan, in Foreign Policy.

The problems of dogs in Iran.

Richard Kelertas: Corn Report Pushes Potash Prices

Richard Kelertas Rising corn production acreage highlighted in the latest USDA crop report could lead to increased fertilizer demand and prices, says Richard Kelertas, a senior analyst at Dundee Securities. In this exclusive interview with The Energy Report, he points to which potash juniors could hit the market while demand is still high.

The Energy Report: U.S. corn production is up 4% from last year, according to a new Crop Production Report released this month by the National Agricultural Statistics Service. The August 11 report forecast a 12.9 billion bushel harvest. “If realized, this will be the third largest production total on record for the United States,” the report stated. Will this result in an increase in domestic demand and prices for fertilizer, particularly potash?

Richard Kelertas: Yes. We expect a gradual, but steady increase in crop and fertilizer prices going forward.

TER: Last May you predicted potash prices of $750/ton. When might that occur and what countries are the main drivers for this?

RK: A peak could come anywhere from 18–24 months from now. Our thoughts are as follows: We are seeing very tight potash markets. The Chinese have been asking for more. The Indians have now settled a contract for significantly higher than what they wanted to pay. Farmers have been pressuring the government to make sure there is plenty of fertilizer—especially potash and urea—in the fields, but they also want to make sure it’s at a half-decent price.

The supply is now getting out to the fields, but the price has gone up simply because there is a bit of a monopoly, with the major producers represented by Canpotex Ltd. Our view is that the price pressure will continue for the next 12–24 months. No major new capacity additions—brownfield or greenfield—are planned for the next two to three years. Really, the new capacity doesn’t kick in until 2014–2015. So 2011, 2012 and 2013 are going to be very tight markets. That’s on the fertilizer side.

On the food side, we have stock:use ratios that are very low. Crop prices are starting to recover although the second economic crisis we are going through now may cause those prices to ease off a little bit. Some crop harvests are going to be low throughout the world. The stocks of various staples will be tight for the next one to two years. So we think this is a perfect storm for fertilizer prices to continue to run up. It won’t reach the level of the last run up in 2008–2009, but it is certainly a very buoyant market.

TER: What impact do short-term stock fluctuations and economic challenges have on both food prices and fertilizer prices? What about the prospect of a weaker dollar?

RK: As you’ve seen in the past, it has had a short-term impact. If the fundamentals were weak to begin with—meaning crop stocks were high, harvests were very, very good throughout the world and inventories of nutrients were either at their 5–10 year averages or above—then you saw a significant downturn in nutrient and crop pricing along with usage. Farmers back off if crop prices aren’t high enough because they won’t get enough per-acre to justify putting in more nutrients. Plus, the bounce back in 2009–2010 and the beginning of 2011 was because of both strong fundamentals for fertilizers and crops and a tremendous amount of stimulus from governments that were pumped into the market. It remains to be seen whether governments still have those arrows in their quivers. I would suspect that this is going to be a little more drawn out.

Several governments are near crisis situations. The European Central Bank has said it will buy Spanish and Italian bonds; that will certainly help for the time being. The real question is: Are international consumers going to back off on buying feedstuff for cattle, poultry and their own diets? Will the middle class throughout the world continue to demand better nutrition? If that’s the case, even with an economic crisis, you will still see crop prices hold up fairly well. If everyone goes into a cocoon and cuts back on everything, then we could see prices fall back and the recovery will be that much longer. So it does have an impact. In this particular case, we think it is going to be short lived. We think it is going to be a couple of months where everyone steps back and commodity prices generally step back along with that. Nutrients and fertilizers are like any other commodity. They react to the individual fear factors going on in world markets.

As the U.S. dollar continues to weaken over time compared to other major currencies, potash prices in U.S. dollar terms will strengthen alongside the strong fundamentals.

TER: You mentioned some new capacity that might be coming on in 2015. Where is that and what companies are going to be behind it?

RK: PotashCorp (TSX:POT; NYSE:POT; Not Rated*) and Agrium Inc. (NYSE:AGU; Buy Rated) have some new plants. Those are brownfields. We also have the possibility of a couple of larger mines. Allana Potash (TSX.V:AAA; OTCQX:ALLRF; Buy Rated), for instance, may have its open-pit mine in Ethiopia up and running in early 2014. You will probably see only 300–500 thousand tons of potash come out of that operation in 2014, and it probably won’t be fully ramped up for 1 million tons (Mts.) until 2015–2016. We may have some more brownfield projects, but if they are deep shaft, those are going to take a heck of a long time. So, the most we are going to see is probably 2–3 Mts. with some brownfield plant expansions coming on by 2014–2015. Allana, which would probably be the first greenfield operation to come on-line, could be producing by sometime in 2014.

TER: Are fertilizer company stock prices going up along with food prices?

RK: No, they haven’t. Q211 results for most of the major players—The Mosaic Co. (NYSE:MOS; Not Rated), PotashCorp and Agrium—showed a bit of a perk up, but just as some real traction was starting to develop again, the debt ceiling issue put a stop to all upward momentum. Then we had the debt downgrade. That is going to put us on ice for the time being. Stock prices for all commodities will be off. If the U.S. dollar weakens enough, which we think it probably will over the next several weeks, then you may get a pickup in commodity prices as international buyers find it cheaper to come into the marketplace and any commodity priced in U.S. dollars tends to perk up. The light at the end of the tunnel could be negotiations with the European banks and U.S tax and spending reform.

TER: Let’s talk about what companies are going to be in a good position to capitalize on global demand when stock prices do come back.

RK: There will be, we believe, another run up going into 2012–2013 on stock prices. A prevailing fear factor will position well-established producers as the first ones to benefit when the market recovers. So Agrium, Potash, Mosaic—those are the key ones along with CF Industries Holdings Inc. (NYSE:CF; Not Rated) and Terra Nitrogen Corp. (NYSE:TNH; Not Rated). Those are the companies that have been around, have established solid earnings growth, have upped their guidance for 2011–2012 and have the volume and the staying power in this particular market. They have clean balance sheets, are well run and have some new capacity in brownfield tonnage coming into 2013–2014. So they are in good shape. Those are the ones we think will recover first.

The juniors will follow if there is a sustained market recovery. That includes Allana, PotashCorp, Karnalyte Resources Inc. (TSX:KRN; Not Rated), Passport Potash Inc. (TSX.V:PPI, OTCQX:PPRTF; Watchlist Buy Rated) and IC Potash Corp. (TSX.V:ICP; OTCQX:ICPTF; Not Rated). We could see Ethiopian Potash (TSX.V:FED TSX.V:FED.WT; Not Rated) and Encanto Potash Corp. (TSX.V:EPO; Not Rated) move as well. It all depends, however, on how far along these companies are in their development and the results of either updated resource reports or first-time NI 43-101s.

These things will all depend on how strong the potash market has remained even though the stock market has fallen off. So in the next three to six months, if the economy is actually in the dumps and all these potash prices have come off, then these juniors will basically go nowhere. Farmers are a pretty fickle bunch. If they smell that there is going to be any weakness in the overall economy or in crop prices and their returns, they will step back. And they can step back fairly quickly.

If, on the other hand, potash prices hold up at the $474.90/ton price recently signed by the Indians, then you are going to see these juniors perk up. As it stands right now, the fundamentals are still extremely strong—they haven’t deteriorated at all. Demand is high worldwide for crops, the stock:use ratios are very low and farmers have lots of money in their pockets. They are feeling pretty good about the next harvest. This is important because right now they are making decisions about the spring plant for next year. We expect crop prices to be very good and that application rates will actually be higher in 2012 because farmers are planting more and trying to bring back drought and floodplain areas with extra fertilizer applications where nutrients have been washed out of the soil.

TER: You mentioned some of the catalysts that would be necessary for the junior stocks to start appreciating. Do you want to go through a few of those, starting with Allana?

RK: We expect Allana to go ahead with its plan to get an open-pit operation in Ethiopia up and running by 2014. Additionally, Allana could be a takeover target for the Indian government, which is still bristling about signing a higher-priced contract for 2011 and 2012 delivery. Along with the Chinese government, the Indians have been very active in Ethiopia, delivering foodstuffs to drought victims and committing $300 million to a major railway infrastructure project. They may be looking to sign either long-term contracts or purchase a producer or an up-and-coming junior to deliver 2–3 Mts./year reliably. That makes a lot of sense long term. So, it is quite possible that someone like Allana or Ethiopian Potash—although it doesn’t even have drills in the ground yet—may have several suitors come calling. That is one catalyst.

We also believe Allana is talking to several banks to act as a project finance lead bank. When that is announced and the market sees that Allana is serious about going forward with production plans in 2014, we think that will perk up the stock. That is catalyst number two.

Catalyst number three will be the updated resource report coming out toward the end of the year and the bankable feasibility report coming out in February or March of 2012. That will show quite clearly the low open pit mining and extraction costs predicted. We believe it will be the lowest-cost operation and the first to production in the world. Once that becomes clear, it will be a catalyst for the stock price. So we have three events coming up in addition to the extra drilling in the Danakil Depression deposit. Those will be smaller catalysts that continue to show 25%+ potassium chloride (KCI) at very shallow depths and significant thicknesses.

TER: Another one you mentioned was Karnalyte?

RK: It is a solution-mine potential operation in Saskatchewan so you don’t have any of the country or transportation risks that you might have in Ethiopia. Investors who want to stick close to home during an uncertain market might like Karnalyte. It is a contiguous, large-scale deposit. There could be anywhere from 2–3 Bts. of potash there. The company has come out with its NI 43-101 and an updated resource report will be out at the end of the year. It believes it can get up to 3 Mts. in the next five years quite easily. This would be a solution mine with high capital costs to start up, but it is not a deep-shaft mine, which is five to six times the cost. It will be very low extraction costs, $100–$120/ton delivered to British Columbia seaports. The added benefit here is the extent of the magnesium-oxide deposits along with the KCl. Magnesium oxide is used for many applications, including as liners for arc furnaces in steel manufacturing. Manufacturers are willing to pay more for secure, zero-boron content magnesium oxide. That is another revenue stream that has not been factored in by the markets. The company has hired a specialist in magnesium oxide extraction and end-use processing to capitalize on that opportunity. It will issue a report in the next six months on the conclusions. That could be the catalyst that drives Karnalyte to new heights.

TER: Very impressive. How about Passport Potash?

RK: Passport is coming out with its NI 43-101 in September, so that will be the first catalyst. It is not as great a deposit as Allana or Karnalyte, but it is located right smack dab in the middle of Arizona with all the infrastructure in place—road, rail, power and water; it has everything there. There are no environmental issues to deal with and all state, federal and local governments, including the Native American community, are on the company’s side. They all want this thing to be developed. The area is economically depressed and this project will employ 300–400 full- and part-time workers. So the catalyst here is the NI 43-101, that is number one. Number two is that the deposit could be big, although with not as high a KCl content as Karnalyte and extraction costs may be a little bit higher as well. To get the concentration of KCl that it needs to produce a good, modern organic product, it is probably going to have to extract more slurry than some of the other producers. However, this deposit could be 2–2.5 Bts. and there are other interested parties. A large oil company just to the south of Passport Potash’s concessions is looking to diversify its product mix. So it is quite possible that we could see Passport Potash have a suitor or two come calling.

TER: Interesting. IC Potash?

RK: IC Potash has a very interesting story. It is a little bit further behind everyone else in terms of getting its project up and running. We will probably have more information for you in the next call.

TER: The last one you mentioned was Encanto?

RK: Encanto is, again, in Saskatchewan. It has all the native groups on its side. It has a substantial resource, but will come online later than some of the others. We don’t expect it to be up and running until 2015–2016. It is a solution mine with a good management team and a fairly contiguous deposit. We wouldn’t rank it at the top of our list. Allana is No. 1, Karnalyte No. 2, Passport No. 3. Encanto is in the middle third of the juniors we watch.

TER: Anything else that our readers should be watching out for in the potash space in the next six months?

RK: I think you will find that there is going to be a race to get things up and running as quickly as possible. The savvy investor should get into the space now. By 2015–2016, you will have a lot of projects, and if any of these juniors come online, which two or three of them certainly will, you are going to have enough potash coming on market to supply all demand through 2017–2018. That could lead to a pullback in these stocks from 2014–2015. So you have two-and-a-half years of good market returns coming. To take advantage of that window, get involved with potash players that are established—Agrium, PotashCorp. or Mosaic, and Agrium is our favorite of those three. But also play the select juniors that have a good chance of getting up-and-running with a better-than-even chance of getting linked up in a large offtake agreement or having a suitor come calling. Those would be Allana, Karnalyte and Passport Potash.

TER: Thank you so much for your time today. It has been very enlightening.

RK: Thank you.

*Dundee Securities rating

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. Richard 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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