When oil was in the limelight, Sprott’s Bambrough and Dimitriadis went for wallflower companies in beaten-down sectors. Since 2007, the pair has seen striking highs and lows in natural gas, coal and potash and invested accordingly, infusing companies with much-needed capital and creating startling profits during sector upswings. Read on to benefit from the wisdom these two successful fund managers share in this Energy Report interview and find out where the duo is looking next for major growth.
The Energy Report: Much has happened on the economic, political and financial fronts since your last interview in February 2011. Obama has been reelected, oil is now at $87 a barrel (bbl) and quantitative easing is the new normal. Have any of these developments changed your investment perspective?
Kevin Bambrough: They haven’t changed our perspective because we’ve been prepared for these events for some time. We view this as a 15- to 20-year trend where runaway deficits and printing money is the chosen solution central bankers will provide to the markets. It will ultimately result in the U.S. dollar losing its reserve currency status and paper money, as we know it, becoming essentially worthless over time. Real businesses and real assets are what you should own.
We focus solely on resources at Sprott Resource Corp. (SCP:TSX) and Sprott Inc. (SII:TSX) focuses primarily on resource-related investments. Our long-term strategy is to sell businesses with strong margins in fairly buoyant sectors that could become unsustainable and depressed in value over time. We then recycle those investments into areas of the resource sector that are quite depressed and have an upside in valuation and margins. At the same time, we focus on building solid businesses in jurisdictions where we can develop our assets and create value.
Paul Dimitriadis: We started out in September 2007 with roughly $70 million ($70M) of capital with the idea of building a publicly traded private equity firm. Over five years, we’ve compounded capital, net of fees, at roughly 28% annually, growing the net assets to over $450M during a period when the resource sector has been extremely volatile and most resource stocks and the major indexes are down. We’re quite proud of that record. We’ve also been very active in buying back our shares to increase the net asset value per share, and have bought back a little over $70M worth over the last five years, which we’re committed to continue doing.
TER: In the broad economic/financial picture, how far down the road can governments keep kicking this can?
KB: I think the printing is going to continue out of necessity because governments need to provide funding for their operations. When governments issue bonds, central banks are the ultimate backstop for buying them. This process will continue on until investors around the world stop holding onto bonds or currency as a store of value and decide to own something more concrete than a promise from a bank or a government institution.
PD: To follow up on that, over the past 5–10 years, there’s been a lifestyle adjustment taking place globally that’s being reflected in the price of real assets. The emerging markets are getting wealthier and competing for real assets with the developed economies. We’re going to continue seeing the pressure on the EU and North American economies as the middle class gets squeezed further, while the emerging economies continue to progress and consume more, putting additional pressure on the resource pricing.
TER: Maybe we can talk about the individual resource segments you’re interested in at Sprott, starting with the oil market.
KB: In 2007, when everybody was loving oil at $140/bbl and gas at $10 per thousand cubic feet (Mcf), most resource funds were very heavy in oil and gas. We went to investing in coal, phosphate and potash. Nobody was really even looking at phosphate and potash at that time and the coal market was facing bankruptcy. Sprott Resource stepped in and gave capital to a company called PBS Coals Ltd. during a very weak time in the market when we saw a rebound coming. When that rebound came with very high coal prices in 2008, we took the company public and ultimately sold it. It’s now fully owned by Severstal Russian Steel (SVST:LSE).
Similarly, we monetized some of our potash and phosphate investments during a lofty period in that sector during 2009 and reloaded most of our capital into oil and gas.
TER: What’s your view of the oil market now, considering all the development going on all over the world with new offshore reserves that are fairly substantial?
PD: There’s been a lot of development in unconventional drilling and development of offshore reserves that were previously difficult to produce economically. Much of this new production is relatively short life and expensive, and is putting us on a treadmill just to maintain current global production rates. Bakken marginal production is over $80/bbl. Offshore is very expensive, so we’re putting a floor under oil prices at around $80/bbl West Texas Intermediate. It’s going to be difficult to sustain production with these unconventional barrels that have steep decline rates.
KB: To continue on Paul’s point, when the marginal price goes below that $80/bbl, we’ll be buyers because that price is unsustainable and oftentimes companies will be trading at very low values to a low oil price. When the price gets high and multiples tend to expand on optimism, we’ll be looking to monetize again. We’ve been continually adding to our oil and gas position. We’ve managed to merge Orion Oil & Gas Corp. with a company called WestFire Energy Ltd., and another company we invested in called Galleon Energy Inc., which became Guide Exploration Inc. They all came together and now it’s called Long Run Exploration Ltd. (LRE:TSX). It’s a very large oil and gas producer with significant upside.
PD: Long Run is currently producing around 23,000 barrels of oil equivalent per day, at a roughly 50/50 ratio of oil to gas. It has an incredible land package of around 600,000 net acres in northern Alberta and over a billion dollars in tax pools. We’re excited about this because it’s incredibly undervalued relative to its peers—probably 30–50% lower than companies of its size. Also, with its huge land package, we think that the company will be able to grow successfully over the next few years, principally in the Viking and the Montney. We’re buying the cheap of the cheap and it’s a core holding for us.
TER: Are you going to continue to grow Long Run or is it going to be taken out at some point by somebody larger?
PD: With sovereign funds and state oil companies, you never know where a bid might come from. But our focus is on building the company and developing its land position.
KB: An asset needs to be fully valued before we even consider parting with it because we’re very patient, long-term oriented investors and we can afford to take our time to advance it.
TER: What are your thoughts on natural gas?
KB: The conventional wisdom in 2007 was that the gas price was going to stay above $10/Mcf. That winter everyone was concerned that we’d run out of natural gas. Fast-forward to 2011, when natural gas plummeted to $2/Mcf, and people were saying it was going to zero because the storage was going to fill and we wouldn’t be able to deal with it. Finally, we had a big rinse-out in the sector. We continued to invest capital to build a bigger, stronger company that would be positioned for the rebound. Now we have a more positive market, and we think it’s going to continue to improve. In 2007, the question was whether we could build enough terminals to import enough gas quickly enough. Now everyone’s talking about exporting it—it’s a complete mirror opposite.
TER: What are your expectations for the coal market?
KB: The coal sector is looking a lot like it did in 2007, when we were buying PBS Coals. It’s a very depressed sector and we haven’t begun to see a strong rebound yet. Almost every coal stock has been crushed back to lows they hadn’t seen in years, and we’re looking to put capital to work. We’re trying to find the right opportunity, although it may still be a little early. We’re focusing on emerging markets, where we would like to make long-term investments, buy assets or partner with foreign entities that want to access fuel sources for their own country. The main key is to be in a country where we don’t have to worry about expropriation or excessive taxation. That’s becoming more difficult, considering all of the government budget problems all over the world.
TER: Uranium appears to be coming out of the doldrums. What’s your take on the sector?
KB: Despite Fukushima, many large utilities are seeking to build new nuclear facilities, especially in emerging markets and the Middle East. It’s becoming increasingly evident that there’s going to be a shortfall of uranium production in the coming years as some of the old mines are depleted. The depressed price doesn’t make most new mines attractive investments, so the sector has been starved for capital for a few years now. We expect that higher prices will inevitably attract capital to the sector. The new facilities under construction are going to have to pay up to secure supply and they’re going to have to fund mining projects, which is something we’re actually looking at. We’re working with some parties now that want to fund development projects in order to get offtake agreements in place.
TER: What uranium price would make uranium mining projects more economic?
KB: Investment would be much more attractive with uranium nearer the $75 per pound level. It may take a couple of years to get there.
TER: How are you playing that market?
PD: Our principal investment in the uranium sector right now is Virginia Energy Resources Inc. (VUI:TSX.V), which owns the Coles Hill deposit in Virginia. It’s the largest untapped deposit in the U.S. and it would be an economic boon to the area, if developed. The big issue is the moratorium on uranium mining in Virginia, which explains why the stock is so cheap relative to the project size and economic value. The legislature is going to consider a new mining law in the near future and we’re hopeful it will pass. If it does, that would obviously revalue this investment, probably making it worth multiples of what it is right now.
TER: When do you expect to see a legislative decision on this?
PD: The matter should be examined in the 2013 legislative session.
TER: Are there any private equity deals you’re involved in that will soon be going public?
PD: We don’t have any that we’re going to be taking public soon. We just monetized an oil and gas investment called Waseca Energy for a large win. We’re sitting at roughly $115M in gold bullion and $25M in cash.
KB: Right now we’re very focused on getting Sprott Resource’s stock trading much closer to its net asset value. It traded at two times net asset value when we first started the business, and as low as $0.50 on the dollar during bad times in early 2009. We’ve been buying back stock aggressively. We just announced a four million-share block purchase. We’re going to keep doing whatever it takes to tell our story and attract investors that are interested in sticking with us for the long run.
TER: What do you see ahead in 2013, and how can investors profit or protect their assets?
KB: I see more of the same—more deficits, more printing, more bailing and more volatility. We think that precious metals are going to do very well in this environment and that investment demand is going to eventually overwhelm the paper market. In the 1970s, gold went from around $35 per ounce (oz) up to $850/oz in 1980. That was a 25-fold increase within 10 years. This gold bull market started at around $250/oz in 2002 and I’m convinced that this run will carry a larger magnitude at a higher multiple because there isn’t as much physical gold held by central banks.
The seventies boom was ended in part by central banks dumping gold onto the market and leasing out their gold to bullion banks to flood the market in order to regain stability in the currencies, versus gold. That took interest rates to double digits all around the world. Now, no government can afford to raise interest rates because they’re already at huge deficits and raising them would make deficits even larger. Gold’s been up every year for the last 10 years but, at some point the doors are going to blow open.
TER: When do you expect mining stocks to perform more in step with the metals themselves?
KB: I think there’s going to be a continued separation between quality stocks and the more speculative ones. In the early boom in the gold stocks, almost any stock went up 10- to 20-fold over a period of 10 years. Some of the bigger ones that had hedges didn’t. The unhedged gold juniors and the exploration companies were awarded capital with very little discrimination by the investment community. Now we’re starting to see more emphasis on the companies that could actually produce gold profitably and be free cash flow generators that become dividend-payers. They make money the old-fashioned way—they mine it.
TER: Let’s end on that positive note. Thanks for speaking with us today.
KB: Thanks for having us.
PD: Thanks for the opportunity.
Kevin Bambrough founded Sprott Resource Corp. in September 2007. He is a seasoned financial executive with more than a decade of investment industry experience and is a recognized leader in the commodity investing space. Since 2009, he also has served as president of Sprott Inc., one of Canada’s leading asset managers, which has more than $8 billion in assets under management. Between 2003 and 2009, he held a number of positions with Sprott Asset Management, including market strategist, a role in which he devoted a significant portion of his time to examining global economic activity, geopolitics and commodity markets in order to identify new trends and investment opportunities for Sprott Asset Management’s team of portfolio managers.
Paul Dimitriadis is Chief Operating Officer for Sprott Consulting and Sprott Resource Corp. He has been with Sprott since 2007. Dimitriadis evaluates and structures transactions, coordinates and conducts due diligence and is involved in the oversight of subsidiaries and managed companies. He serves on the board of directors of two of Sprott Resource Corp.’s subsidiaries, Stonegate Agricom Ltd. and Long Run Exploration Ltd. Prior to joining the Sprott group of companies, he practiced law at Blake, Cassels & Graydon LLP. Dimitriadis holds a Bachelor of Laws degree from the University of British Columbia and a Bachelor of Arts degree from Concordia University.
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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.
China and India have returned to the potash markets, stabilizing current prices as long-term demand continues to grow. In this exclusive interview with The Energy Report, Corey Dias, who covers the industry for MGI Securities, brings us up to date on industry developments and shares why Brazil-based companies offer huge potential for prudent investors.
The Energy Report: Have there been any significant developments in the potash industry since you last spoke with us in January?
Corey Dias: The biggest change has been that China has actually come back to the market and is buying potash. Earlier this year, neither China nor India were buying, hoping to see a price decline. China has since agreed to purchase about 550,000 tons (t) at $470/t from Israeli potash company ICL Fertilizers (ICL:TASE). Canpotex Ltd. (private) signed a similar-sized agreement with China’s Sinofert Holdings Ltd. (297:SEHK) for Q2/12 delivery priced at $470/t. Finally, the Belarusian Potash Company (BPC), the other major potash consortium in the business, signed an agreement with Sinochem International Ltd. (600500:SSE) and CNAMPGC Shanghai Corp. (private) for a price of $470/t. Those buys are underpinning the price as it stands today, slightly below the $500/t spot. It seemed China wanted to hold out for better pricing, but it was inevitable that it would have to come back to the market. India will likely have to do the same soon.
TER: Have your views of the industry’s potential changed as a result?
CD: No, nothing has fundamentally changed. This just reinforces my view that fertilizers remain essential to the global agriculture market in order to facilitate growth, improve yields and provide food for burgeoning middle classes throughout the world.
TER: Do you see anything on the horizon that might have a major effect on the market or the prices, either positively or negatively?
CD: I expect some short-term impacts. Both the U.S. and Europe are obviously still facing economic headwinds, which can impact the fertilizer-buying patterns of those regions. That said, I am still bullish on the industry’s longer-term prospects. At the end of the day, populations will continue to grow, as will the middle class. Diets will continue to change, and therefore increased fertilizer use is inevitable. I expect the market opportunity for fertilizers such as potash to remain attractive going forward. There still seems to be a lot of positive sentiment out there.
TER: Do you expect any major changes in the number of companies entering into the business in the next 5–10 years?
CD: There will probably be a number of new entrants into the marketplace, especially given how topical potash is at the moment. However, as these projects attempt to advance towards production, many will fall by the wayside due to the difficulty of securing financing for these multibillion-dollar projects. I would assume that the first step of financing a major potash project would involve signing a long-term offtake agreement with a third party looking to secure supply in exchange for an upfront equity investment in a project. This offtake agreement, in turn, could be used as a form of collateral for project debt. Furthermore, not all of the output from these potash projects is going to be necessary from a demand point of view. A number of potash producers have new Brownfield projects that could help meet a significant portion of the expected increased demand for potash. That may not leave a lot of room for new entrants.
TER: Do you expect bigger companies to take over smaller projects that can’t finance themselves?
CD: I would think so, assuming that the smaller projects provide some kind of strategic value to the acquirer. That said, many large producers already have an inventory of deposits or projects they can use to expand production without seeking other acquisitions.
TER: Is location the primary factor in determining which projects are “strategic?”
CD: Yes. If one is operating a potash mine in Brazil, one has an internal market that could absorb one’s entire potash output. A company that wants to enter the potash market in a cost-effective manner would certainly aim to buy an asset in Brazil in order to benefit from the significant transportation price advantage expected to be enjoyed by the local potash producers. Moreover, Brazil imports over 90% of its current potash needs and, therefore, the Brazilian government is encouraging local projects to be built in order for the country to reach fertilizer independence by 2020.
TER: How have the major players performed during the first quarter of this year?
CD: Mosaic reported significantly lower sales numbers year over year, as did Potash Corp. This is unsurprising, given that China and India were not participating. Unsurprisingly, both Potash Corp. (POT:TSX; POT:NYSE) and The Mosaic Company (MOS:NYSE) have reduced production twice recently. In Eastern Europe, Uralkali (URKA:RTS; URKA:MCX; URKA:LSE) also reduced its production forecast. These companies are likely reducing production to preserve the current $500/t spot price and will probably continue to do so in order to avoid another price collapse similar to what took place a few years ago. Remember that Potash Corp., Uralkali and Mosaic are each tied to regional consortiums—Canpotex and BPC—and probably represent between 60% and 70% of the supply side of the market, so their actions are quite influential with regard to the rest of the market.
TER: What’s been going on with the smaller companies you cover in the last three months?
CD: The only junior potash company I was covering when we first spoke was Passport Potash Inc. (PPI:TSX.V; PPRTF:OTCQX). Since then I’ve added five other names. Passport released an NI 43-101 resource estimate for its Holbrook Basin potash deposit, which officially confirmed the existence of potash on its property. While the deposit is relatively low-grade when compared to Saskatchewan deposits, it is also quite shallow, which lends itself to conventional mining methods. This is the first of many milestones that will move the Passport story forward. I expect more and more positive news to come from the company in the next few months, including the release of a Preliminary Economic Assessment (PEA) by the end of 2012 that should provide a boost to the stock price.
Karnalyte Resources Inc. (KRN:TSX) had to provide clarification to the Alberta Securities Commission over a filing it made related to its updated technical report before Christmas. There was supposed to be an equity financing around the time of the report release, which subsequently didn’t take place due to delays related to the technical report. In the absence of clear information with regard to the delay, the market assumed the worst, so the stock price started to slide. Fortunately, the updated technical report was finally released at the end of March and, in fact, some of the numbers were an improvement over the previous technical report.
We still really like Karnalyte. The fact that it is planning to go into production in 2014 – ahead of a number of its peers – puts it in a great position to attract strategic investors interested in an offtake agreement which, in turn, could facilitate debt financing for plant construction.
CD: I also cover Western Potash Corp. (WPX:TSX.V). Western has one of the largest recoverable potash resources in the junior potash developer universe, and three other companies with deposits of similar size in Saskatchewan have been bought by larger entities such as BHP Billiton and K+S Aktiengesellschaft. This could make Western an acquisition target. The Company is currently in discussions with overseas potash buyers with regard to securing an offtake agreement. If Western is successful, the effect on the stock price would be extremely positive.
TER: How about Rio Verde Minerals Development Corp. (RVD:TSX)?
CD: I visited the Company’s assets in Brazil a couple of weeks ago. It’s a very interesting company aiming to produce both phosphate and potash. In the short term, the Company’s first phosphate project is expected to commence production in Q113, thereby providing some cash flow to somewhat mitigate share dilution as it moves its first potash project forward. The important thing about Rio Verde is that it’s operating in a market that has significant potash demand with very little domestic supply. The only potash mine currently operating in Brazil is run by Vale S.A. (VALE:NYSE) and produces less than one million tons a year (Mt/y). Demand for potash in Brazil in 2011 was over 7 Mt/y. So there’s a significant gap that needs to be filled. In addition, shipping from North America to the Brazilian fertilizer markets adds another $150–200/t in costs. A domestic producer could clearly save buyers a lot of money and improve its own the bottom line.
TER: Could Brazil be the next China or India in terms of potash demand?
CD: Brazil is already bigger than India when it comes to potash demand, and not far behind China. Its combination of fertilizer-intensive crops, low fertilizer application rates and little domestic potash supply makes it an ideal market for potash suppliers. Moreover, Brazil probably has the highest amount of available arable land in the world and the water necessary to irrigate it, which means that it has an opportunity to become an even greater agricultural powerhouse.
TER: What about Encanto Potash Corp. (EPO:TSX.V)?
CD: Encanto is another appealing company. It’s an interesting potash play because it involves a First Nations group called the Muskowekwan. Encanto has increased the size of its land package by more than threefold recently, which resulted in an increased potash resource estimate announced in an updated report released in March. The Company has two memorandums of understanding (MOUs) signed with other First Nations groups within Saskatchewan, which means that it could potentially replicate its Muskowekwan junior venture (JV) with these other two groups. That could make the company significantly larger than it is today. Encanto’s PEA states that it is aiming to produce 2.5 Mt/y and has alluded to the potential of doubling that output, based solely on its Muskowekwan JV. Output could be significantly higher should either or both of Encanto’s MOUs be successful.
TER: Looking at the projected price-to-earnings ratios on smaller companies that are planning to be in production in the next two to five years, it seems the markets are not giving them enough credit at this point. Are investors just waiting to see whether things turn out as expected?
CD: As we discussed earlier, not all of these potash projects will reach the production stage. So the market is taking a wait-and-see approach until project financing is secured and construction and production actually starts. Right now the companies basically trade based on the milestones that they’ve reached. A company will start with an NI 43-101 resource estimate and then it will perform an economic analysis on the project in order to determine the project’s viability, whether it’s a PEA or a prefeasibility study (PFS). Even when an economic assessment is completed, the project will still have to be constructed. At that point, the ability to finance the cost of building a production plant becomes a big question.
TER: You just initiated coverage on March 2nd on Verde Potash (NPK:TSX.V). What’s going on with that one?
CD: Verde is another junior potash developer with assets in Brazil. The company plans to produce conventional potash using glauconite, which is a green rock that can be found on the surface of Verde’s property. The company is planning to use a method called the Cambridge process, which was developed as a collaboration between Verde and a professor at the University of Cambridge in the U.K. The company recently released a positive PEA and expects to begin production in 2015, which is still ahead of many other junior developers. Obviously, that should provide Verde with an early-mover advantage in a country that is a major producer of fertilizer-intensive crops and that has very little domestic potash production. Verde seems to have a great opportunity to become one of the major players in the potash space.
TER: Do you expect Verde to have little difficulty financing its project?
CD: I think that would be the case, because the Brazilian government is very interested in becoming fertilizer-independent by 2020. This goal is even more poignant given that, in 2011, Brazil imported 92% of its potash requirements. To this end, the government has lined up lenders or partners who would be willing to help fund the production of these projects.
TER: What kind of market performance do you expect from these stocks as we head into the summer doldrums?
CD: A lot of the junior and small-cap stocks have been negatively affected in the current market environment and the stocks in the junior potash developer sector are no exception. Those are the ones that investors usually abandon first whenever market sentiment turns negative. It might take until the fall for these stocks to start rebounding. However, falling prices present opportunities for accumulation before the summer doldrums really do kick in and volumes completely dry up. I expect to see an uptick, certainly towards the end of the summer and into the early fall.
TER: We appreciate your updates and insights.
CD: You’re very welcome.
Corey Dias has worked in the capital markets industry since 2003 and has spent eight years in institutional equity research and institutional equity sales. In addition, he has worked for a U.S. hedge fund, where he shared responsibility for the running of a $400M portfolio and sought out assets for private equity investment on behalf of the fund. Mr. Dias holds a Master of Business Administration from the Richard Ivey School of Business at the University of Western Ontario.
Major potash stocks are beginning to raise eyebrows with impressive profit margins. But as this developing market expands, industry giants will face competition from greenfield and brownfield projects in the works. In this exclusive interview with The Energy Report, Mackie Research Capital Analyst Jaret Anderson debriefs us on some fascinating development stories that are poised to change where and how the most successful potash producers operate.
The Energy Report: You last spoke with The Energy Report in June 2011. What has transpired in the fertilizer and potash business since then, both in Canada and in Brazil’s emerging market?
Jaret Anderson: The tail end of 2011 saw a period of weak demand for Canadian potash. Fourth-quarter shipments at Potash Corp. (POT:TSX; POT:NYSE) dropped by about one-third year over year (YOY). General concern over the economy gave dealers an incentive to avoid stocking up their warehouses, resulting in soft shipments, higher unit operating costs and quarterly earnings below expectations. However, Potash Corp. posted a 68% gross margin in its potash segment during the quarter, making it one of the most profitable publicly-traded businesses of this scale.
Meanwhile, Brazil overtook India as the top global importer of potash in 2011, with imports of about 7.5 million tons (Mt) KCl. This figure was up 21% YOY, drawing even more attention to the country’s chronic domestic potash deficit.
TER: What should fertilizer producers expect in the next few years?
JA: We’re going to see bullish prospects for fertilizer producers over the next 12–18 months. Demand for fertilizer products is likely to remain soft in Q112, but as the spring planting season in the northern hemisphere kicks into gear in Q212, we expect markets to tighten.
TER: You put out a report last December showing a fairly large global number of both new and expansion projects in the works. How will these projects affect the supply and demand equation over the next five years?
JA: We actively track 19 different brownfield expansion projects and 26 different greenfield projects around the world, totaling ~67 Mt of planned capacity. If all of those projects were built on the timelines put forward by their respective owners, we would see a massive glut of capacity in the back half of this decade. The reality, though, is that only the best of these projects are going to be built, and those are likely to experience significant delays compared to their projected timelines. Potash demand in 2011 was about 55 Mt. If we assume demand growth of 3%/year for the remainder of the decade, that implies we’ll need an incremental 17 Mt of supply by 2020 in order to maintain operating rates at 2011 levels. That is pretty close to the 20 Mt of brownfield projects currently on the drawing board. Any demand growth beyond this 3% level or further delays of brownfield projects would tighten markets further.
TER: You don’t expect an oversupply or downward price pressure?
JA: In any commodity, things don’t go up forever. At some point, the supply-demand balance is going to shift in favor of the buyers. The next several years however, look very positive for potash producers.
TER: Saskatchewan is the potash capital of North America, and although it’s a major supplier to other parts of the world, the North American market is relatively mature. What North American potash companies are still attractive buys at this time?
JA: In my view, the most attractive greenfield potash project in Saskatchewan is Milestone, which is being developed by a company called Western Potash Corp. (WPX:TSX.V). The company has a very large in situ resource of about 3.5 billion tons (Bt) KCl and has the highest grade of any existing solution-potash mine in Saskatchewan. Milestone looks very similar to the former Legacy project of Potash One Inc., which was purchased by K+S Potash Canada (SDFG:FKFT) in November 2010 for $434 million (M). At a market cap of $200M today, we believe Western Potash represents the lowest-risk greenfield potash company in the world, with a very attractive valuation.
TER: Another Saskatchewan company you’ve discussed in the past is Karnalyte Resources Inc. (KRN:TSX). It is developing a relatively low-cost, solution-mining project. What are your thoughts on the company’s risk-reward ratio?
JA: Karnalyte is focused on a different type of project that will seek to extract carnallite mineralization at its Wynyard property. While its carnallite mineralization is only about half the grade of a project like Milestone, Karnalyte’s engineers have designed a plant that can be built in stages, which offers some advantages in terms of capital expenditures. Karnalyte’s shares suffered a significant decline in December after the company pulled a $115M financing. We upgraded the shares from “Hold” to “Buy” during December and believe that below $10/share, the company represents good value. However, it may be difficult to see performance for Karnalyte until it successfully raises capital to begin construction at its Wynyard project in the spring.
TER: Are its prospects reasonable for the company as long as the market holds up?
JA: Its shares now represent good value. That said, I believe Western has a more attractive valuation and project than Karnalyte. But there is a difference between a good project and a good stock. Because Karnalyte has taken a large hit of late, it has some decent upside, especially below $10/share.
TER: You recently visited Brazil to get a little better picture of the country’s fertilizer business. That’s a very large, growing market. Tell us what you learned.
JA: Each time I visit Brazil, I come away with more anecdotes that convince me of the need to find ways to invest in Brazil’s agricultural future. Brazil has over 400 million hectares of arable land, but uses less than 15% of it today for agricultural purposes. It is the largest global exporter of beef, poultry, sugar, coffee and orange juice, and that production should grow for many decades. The problem is that its Cerrado region is generally nutrient-poor and requires significant quantities of fertilizer. Brazil has only one operating potash mine and imports more than 90% of the potash it consumes. In 2011, Brazil was the world’s largest importer of potash, at about 7.5 Mt. The Brazilian government has set a goal of becoming fertilizer independent by the end of this decade and we believe investors should be looking for ways to gain exposure to Brazilian agriculture and fertilizer markets.
To that end, two companies we’ve focused on are Verde Potash (NPK:TSX.V) and Rio Verde Minerals Development Corp. (RVD:TSX). Verde Potash controls the Cerrado Verde project in Minas Gerais state, which contains a large, at-surface deposit of potash-rich verdete slate. The company has developed and patented a process to convert verdete slate into KCl, the same standardized product that’s produced in Saskatchewan and Russia today. This is known as the Cambridge process. It’s very exciting, as it could allow for large-scale potash production in Brazil from an open-pit operation—something that hasn’t been done anywhere in the world.
Verde Potash recently published a Preliminary Economic Analysis that indicated an operating cost of US$274/t during the early years of production, ramping up to $291/t over the 30 year life of mine as the stripping ratio increases. That would give Verde Potash the lowest delivered cash costs to Brazil of any large-scale competitor globally. The potash producers in Canada and Russia have lower operating costs, but face very large transportation costs to deliver product to farmers in Brazil. Capital costs for Verde Potash’s project are estimated at US$800/t, which is about 25% below a typical greenfield solution mining project in Saskatchewan. Based on these attractive economics, we recently increased our 12-month target to $19.00/share. With the stock trading at about $7.00/share today, this is a very interesting story.
Another name we believe offers good exposure to Brazil is Rio Verde Minerals, which controls a land package near Aracaju in Northern Brazil. It is located adjacent to Taquari-Vassouras, the only operating potash mine in Brazil. Rio Verde is still at an early stage of development, having completed drilling on its first drill hole in November. We visited the site a couple of months ago and inspected the core. We await assay results from that hole. Rio Verde plans to drill three holes at its Sergipe potash property and to publish an NI 43-101 resource during Q212. Given the strong outlook for good potash grades on the property and the company’s ideal location in Brazil, with nearby access to a port, roads, power and natural gas, Rio Verde looks to us to offer excellent risk-reward at current levels. Based on our target of $1.30/share, Rio Verde offers more upside to our target than any other company in our coverage universe.
TER: Can you elaborate on the Cambridge process you mentioned?
JA: In December 2010, Verde announced that it had patented a process to convert its verdete slate into KCl. This process was developed by Dr. Derek Fray at Cambridge University in the United Kingdom. This process was tested and optimized by Hazen Research in Denver, CO, and by FLSmidth in Allentown, PA, and SRK Consulting, which resulted in the publication of a Preliminary Economic Assesment in late January. We visited FLSmidth’s facilities in Pennsylvania last week and observed the process in operation. The process is relatively simple and bears many similarities to the cement production process. It employs a rotary kiln, like cement, but uses different inputs, namely Verde Potash’s verdete slate rock, limestone and salt. The Verde Potash KCL production process takes place at lower temperatures than that of cement, about 900C vs. cement at about 1,450C.
TER: Do you expect the Cambridge process to work on a commercial scale?
JA: It’s moved from a bench scale at a university to a pilot plant. To move to a commercial scale is another jump. Staff at FLSmidth and SRK have indicated to us that they typically see fewer problems with commercial scale facilities than they do with pilot plants. Every indication we have points to the commercial scale kiln as being well within the technical ability and experience of the teams at FLSmidth and SRK.
TER: There’s also been some development on the African continent, and a couple of Canadian juniors are working on projects there that are projected to go online in about five years. How are they progressing?
JA: Allana Potash Corp. (AAA:TSX; ALLRF:OTCQX) and Ethiopian Potash Corp (FED:TSX.V; FED.WT:TSX.V) are both working to develop greenfield potash projects in the Danakil depression in Northern Ethiopia. Allana is the much better capitalized of the two companies. It has published a large NI 43-101 resource based on its successful drill program over the last couple of years. The projects in Ethiopia are interesting in that the high year-round temperatures in the Danakil may allow for solar evaporation, thereby materially lowering energy costs in the solution-mining process. Ethiopia is also located relatively close to China and India, two important potash consumers.
Ethiopian projects face a major challenge, however, in that the logistics of moving thousands of tons of potash per day from the project site to the port at Djibouti some 600 kilometers (km) away over roads of varying quality may be a significant hurdle. We believe the transportation costs will end up being materially higher than current estimates.
Both Allana and Ethiopian Potash have seen their share prices languish over recent months and are both near 52-week lows. We believe both stocks have room to move up as the projects are derisked and as Allana moves toward a feasibility study in August of this year. While Ethiopian Potash has more leverage to positive developments given its smaller enterprise value, it is a much riskier investment given its very low cash levels. Allana, on the other hand, has more than $65M in cash on its balance sheet, providing it with a lot of time and resources to derisk its project and make it more attractive to potential suitors.
TER: Will Allana rely on a rail link to be built in order to get its product to market?
JA: There are plans in Ethiopia to build a rail network in the country, and that rail network is planned to approach Allana’s project site. We’ve met with the minister of transportation in Ethiopia on this topic. That project is probably a number of years away from completion, and for at least the first several years of production, Allana is going to need to find a way to transport its product by road via truck. You can’t assume the rail network is going to be ready in the next few years, in our view.
TER: What effect will trucking the material have on the project economics?
JA: Trucking will be much less economic than a rail network. Allana has published its own cost estimates for transporting the product from its project site to the port at Djibouti. We find its estimate of $12/t to be very low. We see a number closer to $50/t, based on the figures we’ve seen at other operations in existence today, such as those in Saskatchewan.
TER: Do you have any other interesting stories that our readers might find useful?
JA: The potash industry today is generating very high cash flow and strong returns on capital for incumbent producers. Potash Corp. generated a gross margin in its potash business last year of 68%. Apple Computer, by comparison, posted a gross margin of 41% in its fiscal 2011. The levels of free cash flow generated by this business and the strong secular trends in agriculture are going to attract capital and will ultimately lead to new greenfield production. With so many companies chasing so few quality projects though, we would caution investors to think carefully about the merits of each individual project. The size and grade of the deposit, the infrastructure in place, the proximity to major potash-consuming countries and the geopolitical risk are all critical drivers of value.
TER: Do you see any further consolidation in this business at this point? Or is it still too early?
JA: We’ve had a lot of consolidation in this business. The successful business strategy that greenfield potash companies have employed in the past has been to identify a good project; then derisk it by defining the resource through engineering and feasibility studies to make it more attractive to well-capitalized companies. A number of greenfield potash companies have had success with that strategy by ultimately selling to large mining companies like BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK), Vale S.A. (VALE:NYSE) and Rio Tinto (RIO:NYSE; RIO:ASX). I think this process makes sense and is going to continue.
TER: What are your top picks at this point?
JA: Our top picks in the sector for 2012 are Verde Potash and Rio Verde Minerals. Both companies offer good leverage to the Brazilian fertilizer market and have the potential to generate meaningful returns to equity investors. By their nature, development-stage resource companies involve much more risk than an operating company. We believe, though, that 2012 is likely to see very strong results for the greenfield companies with the best-quality assets, in the right locations, with attractive valuations. In our view, Verde Potash and Rio Verde check all of those boxes.
TER: Thank you for your time.
JA: Thank you.
Jaret Anderson is a research analyst covering agriculture and fertilizer at Mackie Research Capital. Anderson has 13 years of experience in the investment industry and was rated #1 for earnings estimate accuracy by Starmine in 2006 and #2 for the quality of his reports in 2005. Prior to joining the firm in July 2011 Anderson worked at UBS Securities Canada where he covered Canadian paper and forest companies, as well as chemical and fertilizer industries. Most recently Anderson covered Canadian fertilizer and chemical companies for Salman Partners. He received a Bachelor of Commerce, with honours (Finance) from the University of British Columbia, and was awarded the CFA designation in 2000.
Last year marked the third-largest growth in the potash industry, but hesitancy from India and China may put things on hold in 2012. However, MGI Securities Analyst Corey Dias still expects to see a lot of positive news coming out of the junior potash space. In an exclusive interview with The Energy Report, Dias specifies which companies he’ll be following for progress.
The Energy Report: Total potash demand in 2011 was estimated at 56 million tons (Mt), and the market has traditionally grown at a rate of about 3.5%/year. Do you believe we’ll see a similar increase in 2012?
Corey Dias: I think 3.5% could be at the high end of growth for 2012. I would expect slightly lower growth this year given that India is delaying its potash purchases until the end of Q112. China is also determining its exact needs, and there are rumors that it may reduce its imports this year versus 2011. Everything tends to depend on price. Canpotex (the marketing company for Saskatchewan potash producers) and its Belarusian counterpart are holding out for higher prices than India and the China currently seems willing to pay. With those delays, demand will probably be slightly below the historical 3.5% growth rate.
TER: Potash Corp. (POT:TSX; POT:NYSE) of Canada has shut down two mines in that country, and The Mosaic Company (MOS:NYSE) says potash buying is slow right now as buyers are taking a wait-and-see approach. What do you make of Potash Corp shutting down those two mines?
CD: It is a prudent approach. The company doesn’t want to flood the market with product as it would like to sustain a reasonable potash price that could provide a reasonably profitable return. By shutting down these mines, it’s limiting the output and that should keep the price at a fairly stable level. It’s not a question of shutting down so much capacity that prices are going to spike; it’s simply a way to keep potash prices relatively stable until the moment when a larger buyer comes back into the market, whether it’s India or China.
TER: In 2011, potash had the third-largest price increase among the 32 commodities ranked by the Scotiabank Commodity Index and, over the span of 2011, potash rose about 32%. The leading indicator of potash prices is often the price for corn, which is down significantly after some bumper corn crops in Eastern Europe, Russia, and Australia. What do you believe will be the average price per ton (t) for potash in 2012?
CD: Potash prices seem to be ranging between $450 and $550/t at the moment, depending on the port of delivery. It will probably stabilize around the $500/t level in the short term. I don’t see any reason for a significant spike in the price at this point. Although the corn price has recently seen a dip, it still remains above its historical average. Moreover, given the fact that the U.S. Department of Agriculture said that its stocks-to-use ratio is still well below the historical average, it would take a significant amount of corn production to reach the normal level of 15–20% in terms of that ratio, and reaching that level of production to meet this ratio could be a real challenge, especially when corn demand continues to grow. Therefore, while corn is slightly down, I don’t think there is going to be a downward trend in the corn price, or a complementary downward trend in potash.
TER: You don’t believe that potash will be in the top 10 performing commodities in 2012?
CD: I think it will have a fairly average year. I don’t think it will repeat its price performance in 2012 as it had a relatively low price point from which to start in 2011. It will probably stay somewhere in the middle of the park vis-à-vis other commodities.
TER: In an interview with The Energy Report in May 2011, Dundee Securities’ senior analyst Richard Kelertas predicted that we would see $750/t potash at some point before May 2013. What’s your perspective?
CD: As you said, that was in May 2011. The market looks a little different now than it did then. The fact that India is pushing back on pricing and delaying its purchases and China is reassessing are going to mitigate the potential upside of the potash pricing. Probably $600–650 is a reasonable price going to 2013, but there are a number of different factors that come into play in addition to India and China, whether it is production capacity being added to the market via brownfield or greenfield projects, whether or not there is a recovery in the European market, or whether or not the U.S. recovery continues. The fact that farmers seem to have a lot of money coming out of 2011 could, at worst, bode well for holding a pricing floor on potash at current levels and could potentially even support a higher price. I think that $600–650/t is reasonable.
TER: Tell us about your coverage universe and the types of companies you cover.
CD: I’m now ramping up coverage in the potash space. My first report was about Passport Potash Inc. (PPI:TSX.V; PPRTF:OTCQX), a name that I’ve followed since early 2011 when I was working in an institutional equity sales capacity at MGI. I really like this story and the fact that it’s in a safe, mining-friendly jurisdiction. An opportunity to build a mine in a potash-rich region—the Holbrook Basin—with only two competitors in the Basin could provide an opportunity for consolidation. It is a story with a great deal of appeal.
Generally, I’m looking at small-cap developers and am not restricted to North America. There are developers in Africa and South America that could be appealing in the same way. It will be up to clients to decide whether or not they have the risk tolerance for assets outside North America.
TER: Is that typically the type of company that MGI covers even in the other sectors?
CD: We tend to cover smaller-cap names. Large-cap names would be a bit more difficult for us to champion in a lot of ways because we wouldn’t necessarily get the mind space from clients for large-cap ideas because clients are well covered by banks and bulge bracket firms that are looking at the Potash Corps of the world, companies like Agrium Inc. (AGU:NYSE; AGU:TSX) and Mosaic.
TER: Passport Potash’s share price took a beating in 2011. It’s currently developing the Holbrook Basin potash project in Nevada. Why do you believe that junior is going to rebound this year?
CD: Part of Passport’s problem this past year was based on the market itself being quite volatile, especially toward the end of the year. In general, small-cap names tend to suffer the most in those circumstances. But management made a few promises to the market that it was unable to keep and probably didn’t realize the extent to which it would be punished by the market by having missed deadlines. However, I believe that the company is starting to right itself. It is in the process of putting together an NI 43-101-compliant resource estimate, which we expect to be released by the end of Q112. Following that, we should see a preliminary economic assessment or scoping study and, further, a prefeasibility study from Passport in order to show the economic viability of its project. In addition, there was an announcement on January 18th that Passport has brought on a new chairman who has significant operational experience gained during his time with Rio Tinto (RIO:NYSE; RIO:ASX). It also has added Ali Rahimtula, who has experience in India, which is key in this type of business because there is the potential for an offtake agreement with an Indian partner. Passport has acknowledged the fact that it needs more relevant experience on the board, and has clearly begun to address this shortfall.
Like most of the names in the junior developer space, there tends to be a rerating—in terms of valuation—of these types of businesses once milestones are met along the road to production. As Passport meets its milestones, the market will likely provide the company with a more positive valuation via a re-rating of its stock. The company’s stock price hit bottom at $0.17 toward the end of last year. Since then, it has been able to at least project to the market that it does have some deadlines, which it intends to meet. Passport has engaged the engineering firm ERCOSPLAN to complete its NI 43-101. ERCOSPLAN has a really good reputation in the marketplace and has done a lot of work for developers in the potash space worldwide. The market now understands that the company is working very hard to meet its current deadline and, once met, Passport will have a potash resource estimate to put to the market. The market at that point will respond favorably, in my opinion.
TER: A competitor operating in the same basin that Passport is operating in, the Holbrook Basin, already has an NI 43-101 resource of 125 Mt potassium chloride (KCl). How large do you expect Passport’s resource to be once it’s published?
CD: The competitor has about 94,000 acres of land, while Passport has about 81,000 acres. If we were to use a ratio of acres to contained tons of KCl for the competitor and apply it to what Passport has, Passport would probably come in somewhere about 100–101Mt of contained KCl. Remember, this is in no way a forecast that I am making as to the size of Passport’s resource. Even if Passport has something like 80% of that number, I think it’s still a decent-sized resource. In my report, I am forecasting that Passport will produce about 1Mt/year over 40 years. That implies about 40Mt of in situ KCl. If we’re talking somewhere between 80–100Mt of contained KCl, there is significant opportunity for Passport to increase the size of production on an annual basis, or it gives a bit more leeway in terms of what the potential resource size could be, on a contained-ton basis.
TER: You have a Speculative Buy on that particular equity. What is your 12-month target?
CD: My 12-month target for Passport is $0.75.
TER: Another junior in that space, Allana Potash Corp. (AAA:TSX; ALLRF:OTCQX), jumped out of the gate in 2011 and slipped above $2 in June 2011 before spending the rest of the year retreating from that benchmark. It now sits well below $1. Will that junior rebound this year? If so, what are the catalysts that are going to make that happen?
CD: I think so. Allana probably jumped up based on speculation more than anything else, but as the actual resource-related numbers come in, then it tends to start trading at some kind of multiple based on its enterprise value (EV), whether it’s EV:resource or EV:ton KCl, et cetera. When the market sees that it’s getting closer and closer to production, that’s when the valuation will start to improve. I think that is something that could happen this year. When one has an asset that doesn’t have any economic information tied to it, it’s very easy to speculate as to what you think the value should be. Obviously, the closer one gets to production, then there are hard and fast numbers that one can start applying some kind of multiple to in order to value a company like Allana Potash. That’s probably why it’s now down below $1. It’s probably more reasonably priced here and as more news comes out that’s favorable to the company, then you should start seeing the stock move back up.
TER: What are your thoughts on the Danakil potash project in Ethiopia?
CD: The Danakil project is interesting because it’s a near-surface project, which means the capex should be low. I think that it will have a fast track to production, which is another positive. And the fact that it’s probably selling to India, and perhaps China, is another positive because there is a quicker trade route to those countries when compared to North American or South American potash producers.
That said, there is no domestic demand for the product in Ethiopia. The companies that I believe have an advantage are those that have domestic demand or significant domestic demand, whether it’s a place like the U.S., which imports most of its potash needs, or South America—Brazil in particular—where 90% of its potash needs are imported. Ethiopia is also landlocked, that is, it has to go through another country in order to reach the port. Moreover, there is a greater possibility of political risk in Africa than in the U.S. or in Brazil. However, if everything remains stable, I think there could be a big opportunity for Allana, especially given its low operational cost base.
TER: What are some other small-cap potash plays that you expect will outperform in 2012?
CD: Verde Potash (NPK:TSX.V) is planning to produce a unique product called Thermopotash. Thermopotash, derived from the combination of glauconite and limestone, is a slow-release potash product with no chloride, which is great for crops like tobacco, coffee and oranges. In addition, the company is exploring the use of a new technology—the Cambridge process—which could potentially convert Verde’s potassium-rich rock to regular KCl. This would be a massive opportunity in Brazil. In terms of available infrastructure, Brazil falls behind North America but is certainly ahead of Africa.
Rio Verde Minerals Development Corp. (RVD:TSX) is another small company operating in Brazil that recently confirmed that it has potash on its property. The stock has moved up a little bit on the back of that news. Once an NI 43-101 resource estimate is released for Rio Verde Potash’s potash asset, we should see another re-rating of the stock.
Karnalyte Resources Inc. (KRN:TSX) is another one. Once again, I tend to favor the junior potash developers that have a bit of a unique element or bring something a little bit different to the table. Karnalyte is focusing on extracting potash from the potash-bearing carnallite layer, which is unusual for Saskatchewan because other producers and developers target the sylvinite layer that is usually closest to the surface. Karnalyte’s deposit is based on an anomaly where there is a significant carnallite layer that is relatively near-surface vis-à-vis the sylvinite layer. The technology that it is planning to use also could provide a magnesium byproduct and sodium chloride byproduct, both of which the Company could potentially market and sell in the future. Karnalyte has a number of things going for it; I think management is very strong. The fact that it has four patents pending for its technology could mean that what it ends up with is going to be very unique. It has a massive land holding and has only conducted advanced exploration on 20% of it. Fnially, it plans to expand its plant by using cash flow generated from its initial buildout.
TER: It has done a nice job of managing its share flow, too, with only about 21M shares outstanding vs. something far greater for a company like Allana.
TER: Or do you prefer a larger share count, such as Allana, with its 193M shares verus 20M for Karnalyte?
CD: When you’re in the small-cap space—and especially if your float is small—it becomes a bit riskier for clients to hold when the markets are a bit more volatile. It’s one thing to get into a stock, but when the market is volatile and a client is looking to exit a position, it’s very difficult to do if the trade volumes aren’t there. That’s the risk with Karnalyte. The average trade volume is 34,000 shares a day. So if you have a position that’s 100,000 shares, it’s going to take you roughly three days to get out of that position, and that assumes that you can be 100% of the trading volume over those days. And you could end up driving its price down significantly while you’re trying to exit your position. Having a more liquid position in a stock like Allana that you can get in and out of a lot more easily would likely appeal to portfolio managers.
TER: Could you give our readers an outline of what to look for in the small-cap potash space over the next year or so?
CD: You’ll see a number of companies starting to reach the prefeasibility and feasibility stages. At that point, these companies will start to look for strategic partners, whether it’s to fund the buildout of the products or secure an offtake agreement for the product that’s going to be produced a few years out. At that point, we’ll start to see which projects are going to be viewed as more viable. There probably won’t be enough demand to drive a need for every single junior potash developer that is currently out there to actually move into production. That said, there is also the possibility that some of these companies will be absorbed by larger entities that are looking to enter the potash space given the future, positive fundamentals for potash or those that are currently in the market and are looking to increase potential capacity moving forward. I expect to see a lot of positive news coming out of the junior potash space, especially as a few of these companies meet milestones in order to get a little bit closer to production and production becomes more of a reality.
Corey Dias has worked in the capital markets industry since 2003 and has spent eight years in institutional equity research and institutional equity sales. In addition, he has worked for a U.S. hedge fund, where he shared responsibility for the running of a $400M portfolio and sought out assets for private equity investment on behalf of the fund. Mr. Dias holds a Master of Business Administration from the Richard Ivey School of Business at the University of Western Ontario.
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.
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.
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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.