Following the release of first-quarter results, we continue to think
Potash Corp of Saskatchewan Inc (POT) has a wide economic moat thanks to its low-cost potash assets and the high barriers to entry in its industry. PotashCorp is on the low end of the potash cost curve, allowing it to pump out profits even if potash prices should approach marginal costs of production in the future. Lower costs stem from the geology of the company's Canadian deposits and the scale of its mines.
Barriers to entry in the potash market are high, in our opinion. Economically viable deposits are found in only a handful of locations around the globe, with Canada, Russia, and Belarus as the main producing regions. PotashCorp's brownfield expansions come at lower capital costs per ton than proposed greenfield projects, most notably BHP Billiton's Jansen project. Additionally, greenfield projects can take more than seven years to complete and fully ramp, creating a barrier to entry for new participants.
PotashCorp will be able to produce potash for many years to come with reserve lives for its mines ranging from 65 to 85 years at current production levels. We expect returns on invested capital of roughly 20% in year five of our forecast, despite pressure on potash prices from growing supply and a potential end to the higher prices previously supported by a rational oligopoly. If we become more confident that the cartel-like nature of the potash oligopoly is truly dead and all competitors in the industry begin to produce at capacity without regard to price, we may reduce our wide moat rating for PotashCorp, as this could mean high-cost producers could be kicked off the cost curve, leading to lower marginal producers setting market-clearing prices. However, we view this scenario as unlikely.
The company's potash production in the first quarter showed a small increase of 1.6% from the first quarter of 2014. This was an encouraging result, given weakness in PotashCorp's important North American market caused by a late start to the spring planting season and above-normal offshore imports to the continent.
Over the long run, we expect PotashCorp's production volume to increase significantly as the company fills capacity that it has built over the past few years. In the meantime, this extra capacity serves as deterrent to expansion projects from other potential players, most notably BHP Billiton (BHP).
Average realized potash prices were up 13.5% from a year ago. We expect potash supply and demand to grow at similar rates over the next several years and we anticipate that potash prices will increase at an average annual rate of 2.25% from 2016 to 2019.
We think the market is underappreciating PotashCorp's long-term production potential and its ability to increase free cash flow. The market seems more concerned about the long-term supply/demand outlook for potash, competitive dynamics and disappointing contract prices with China in 2015.
Our long-term view of the potash market gives us confidence that near-term headwinds will fade and strong fundamentals will eventually take hold. Following a temporary step back in demand in 2014, we expect normal growth to return in years to come. Capacity is expected to grow at a faster clip, but we're not expecting much pressure on prices, as current producers add supply judiciously.
Potash is the crown jewel
While PotashCorp has its hands in the production of all three primary crop nutrients--potash, nitrogen and phosphate--potash remains the jewel of the firm's operations, accounting for nearly 60% of gross profit in 2014. With a 20% global market share, PotashCorp is the world's largest producer of potash fertilizer by production capacity. The firm's Canadian mines sit at the low end of the cost curve and should generate profits even if prices drop to marginal costs of production. PotashCorp is wrapping up an $8 billion potash expansion, with operational capacity expected to reach roughly 17 million metric tons by 2018. With a handful of players controlling a large portion of global potash assets, the industry has recently functioned as an oligopoly, with big producers shuttering production temporarily in periods of low demand. The sustainability of pricing power in this oligopoly is somewhat in doubt after Uralkali's plans to produce near capacity and accept lower potash prices. That said, lower near-term prices are likely to lead to indefinite delays for large potash projects, which should eventually produce a tighter market.
The nitrogen and phosphate fertilizer industries have lower barriers to entry than potash. From a competitive standpoint, we rate the firm's phosphate operations as more attractive than its nitrogen business. PotashCorp owns phosphate rock mines in the United States and benefits from not having to purchase expensive rock from third parties. Non-integrated producers, which typically buy rock from Morocco, are commonly the marginal producers, and PotashCorp's access to cheaper rock currently places it below the marginal producer on the phosphate cost curve. Nitrogen fertilizer production is essentially natural gas upgrading, so the ability to produce is dictated by access to natural gas. PotashCorp uses long-term contracts to purchase the majority of its gas from Trinidad. With gas prices in North America subdued from the explosion in unconventional extraction techniques, the company's gas currently sits at a cost disadvantage to North American competitors.
Fertilizer prices depend on crop prices
Crop prices, which take their cues from demand and weather, can drive fluctuations in fertilizer pricing. Fertilizer prices have varied wildly in the past, and uncertainty of future supply makes it difficult to predict long-term prices. For example, BHP could theoretically break up the potash oligopoly by successfully developing the Jansen project. PotashCorp is exposed to underground mining risks associated with its potash assets in Canada. In addition to mining safety, underground water issues could drive up potash costs. The firm may be subject to lawsuits and regulations related to its phosphate mines. Further, the company has run into antitrust issues in the past, given its strong position in the potash industry, and these concerns could resurface.
