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July 13, 2013
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August 15, 2013

Potash Will Not Go The Way Of Iron Ore…

The rule with oligopolies is that eventually, someone cheats a bit—then everyone cheats a lot. That’s the reason that oligopolies rarely last very long—particularly when you are dealing with global commodities that are not all that scarce. Or at least, that’s how most economists think of the world. I would like to offer a slightly different axiom—if you are making too much money, you will also destroy the oligopoly due to new supply.

In almost any product, there is almost always a bit of new supply. The oligopolists cannot ever stop all new supply from coming online and lowering prices. However, when the big boys restrict themselves in terms of supply, they can create a world of semi-permanent prosperity—unless of course, they are resticting the market too much and are acting greedy. If you make too much money, someone new will WANT to compete with you.

Take iron ore. Starting in early in 2003 iron prices began a climb that has still not fallen back to earth. In the process, the big 3 iron ore players (Vale, BHP Billiton and Rio Tinto Group) made true fortunes. However, they got greedy. They forced buyers to purchase iron ore using annual contracts rather than the spot market—they effectively colluded to push the price of iron ore upwards and forced the Chinese to overpay. They sold iron ore for a few times what it cost to produce.

By making too much money and making iron ore mining not look risky, these three miners set up their own downfall. Eventually, marginal mines were funded (particularly the massive new mines owned by Fortescue Metals Group)—the returns on capital were just too juicy for investors not to fund them. These mines are now being built and are starting to ramp up. Dozens of other mines are being contemplated. By allowing new mining companies to tout massively profitable business plans, the big players have allowed their competition to blossom. Iron ore prices will eventually head down to the marginal cost of production. Prices may even stay below the cost of production—once the thing is built, you don’t want to cease production—even if you are losing money. It’s usually better to just keep producing and hope for higher prices. Iron ore will have a structural supply overhang for quite some time. As an industry, it’s going to be an ugly decade or two—starting in a few years as these mines come online. The big 3 players got too greedy and destroyed their industry.

I mention the coming oversupply in iron ore as a counterpoint to the recent actions by Uralkali to break up the Belarus Potash Company (BCP), which along with Canada’s Canpotex controls 70% of the global market in potash. Uralkali isn’t stupid; it is looking at the proposed BHP Jansen mine and is rightly scared. At $15 billion in capital cost, Jansen would be the largest potash mine in the world at nearly 8 million tonnes a year of production in a world market of 50 million tonnes—however Jansen is a high cost mine in comparison to Uralkali’s much lower cost mines. How do you scare the top brass at BHP and get them to cancel construction plans and preserve your own massive gross margins?

You start by announcing that Uralkali is going to flood the market by increasing production to 14 million tonnes a year from 10.5 million tonnes currently (there is plenty of excess capacity in the industry). Then you have Uralkali CEO Baumgertner go on television and say;

“My honest answer to the question on how the price is going to change is, I don’t know, but the trend is obvious. If the volumes are up, the prices might reach the production costs of marginal players, around US$250 per ton. So we might soon see figures like this.”

“We expect that everyone will lose out financially; we will see profit reduction, we will also see marginal producers decide what to do next, but nothing will happen in the short term.”

“We then expect a comprehensive review of green field projects. People will need some time to adapt… Most of the green field project owners will review their economics and would be forced to close them, writing off their investments otherwise, the losses will go up.”

Basically, Uralkali is saying;

“BHP—I call you out!! Ball is in your court. If you build this thing, we will use our spare capacity to lower prices to below your cost of production. You cannot stop us from doing this as our mine is already built and you need to first get a return on your investment before you can come after us. The last CEO of BHP got sacked for building massive mines that were over-budget and did not hit their projections. Wanna be next?”

Smart oligopolists know how the game works. They don’t get greedy—they focus on the long term. A few year purge below today’s $400 a ton and into the $200’s will be enough to destroy the financing plans for any junior potash miner (there are dozens of them). It will bankrupt all of the new players with cash costs over $300 that are currently adding supply to the market. Then prices can go back up.

I have never looked much at potash miners. They always seemed expensive based on earnings from current potash prices—and potash has traded for about twice the marginal cost of production for quite some time—clearly that means that lower prices for potash were ultimately in store. Given the recent and sizable drops in potash miners, there could be something interesting to do. Fertilizer usage will be going up over the next few years—it has to if the world intends to feed itself. As prices drop, farmers will use more of it, which should also dampen the price drop.

I see a bunch of anticipated potash mines now being mothballed. Then, the big existing players will simply tighten their grip on worldwide supply and form new oligopolies. In a market with very few secular trends that have cheap assets, potash has my interest suddenly—however, it probably isn’t time to pounce yet. We need to see a bit more potash pain, but keep your eyes on this one. It’s at least time to learn some more.

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