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The Agriculture Boom Goes Bust

by: Andrew Mickey July 22, 2008 | about stocks: AGU / CF / MON / MOS / POT / TRA    

Andrew Mickey

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The agriculture boom is in full swing. Ag commodity prices remain high. A worldwide race to buy up farms in far off lands is in full swing. And fertilizer stocks have been the top performers during the whole downturn.

Fertilizer stocks like Potash Corp (POT), Mosaic (MOS), and Agrium (AGU) have had stellar runs. But over the last few months, fertilizer stocks have been very volatilite.

I’ve got good news though. For anyone that missed out on the first run-up in fertilizer stocks and has been waiting for a dip, a chance to buy could be days away. A few top fertilizer stocks have the potential to get crushed in the next few days. The combination of lofty valuations, high expectations, and soaring costs could spark it all.

Input Costs Soar

On page 29, Mosaic said it all:

A significant increase in the price of natural gas, ammonia, sulfur, or energy costs, that is not recovered through an increase in price or our related crop nutrients products could have a material impact on our business.

Over the past few months, natural gas, ammonia, and sulfur prices have risen sharply. Ammonia prices are up 140% in 2008. Sulfur prices have skyrocketed too.A ton of sulfur cost $30 a ton in 2000. It climbed to $450 a ton at the start of the year. The last sale I saw was at $800 a ton.

Sulfur and ammonia are traded between privately and prices are set by private contract, much like uranium. So it’s tough to get exact pricing data from day to day. However, prices are going up. And the rise in the first half of the year has been very strong.

Sulfur and ammonia price increases aren’t good for fertilizer producers. That’s not the biggest factor here though. The largest impact on fertilizer producers’ profits will be natural gas.

Natural Gas and Fertilizer

According to Mosaic’s most recent annual report, the company has a lot of exposure to natural gas prices. Mosaic states, ‘Natural Gas is the primary raw material used in nitrogen production and may represent as much as 90% of a ton of nitrogen-based fertilizer.”

That’s huge exposure. 90% of costs!

Of course, that’s just for nitrogen-based fertilizer. It takes a lot of natural gas to make other types of fertilizer.

Natural gas costs account for as much as 85% of ammonia-based fertilizer. And solution mining of potash, which Mosaic owns the largest potash solution mine in the world, uses a lot of natural gas. Mosaic estimates 14% of its potash production costs go to pay the gas bill. 

When it comes to fertilizer, natural gas is very, very important. During the 2nd quarter of 2008, natural gas prices climbed about 40%. Mosaic admits only “a portion” of its natural gas consumption is hedged. As a result, I expect high natural gas prices to have a big impact on profits.

Not all Fertilizer Companies Created Equal

Not all fertilizer companies are the same though. Only a few produce highly sought after and monopoly protected potash. They are the only ones that really benefit from soaring potash prices. Other fertilizer companies, which have to buy potash, ammonia, etc. don’t enjoy being able to pass on higher costs forever.

Sure, they can pass on the higher costs to customers for a while, but that will only work for so long. Reuters published the headline, “New threat to food system: pricey fertilizer.” High prices will reduce total fertilizer used.

It’s simple economics. Fertilizer prices are not inelastic. High prices are reducing total fertilizer use around the world. We could see a big impact on reduced consumption when the Q2 numbers come out in the next few days.

It’s Happened Before

This wouldn’t be the first time high costs wrecked fertilizer stocks though. Back in 2005, when hurricanes sent natural gas prices soaring, fertilizer stocks were hit hard. In the two months that followed Hurricane Katrina, fertilizer industry stocks fell 25% on average.

Among the hardest hit were Mosaic, Terra Industries (TRA), and CF Industries (CF). They are all diversified fertilizer producers.

This time, it’s not going to be a sudden price shock. It’s been building for a long time. And when you consider the run fertilizer stocks have had, a sharp sell-off could be on the way.

Fertilizer Takes Center Stage

The catalyst for the sell-off is probably going to be earnings reports. Although it’s tough to ever predict earnings down to the penny, there’s a lot going against the fertilizer sector.

After huge run-ups, they are at some of the highest valuations they’ve been at in years. And Wall Street is expecting a lot from this sector to justify those high prices. In just the past two months, consensus estimates for Mosaic’s profits have risen 40%. Even missing by a penny or two could send these high-flyers down another 10% or more.

Monsanto (MON) is the perfect example of what can happen when news isn’t good enough in the agriculture sector. Monsanto reported earnings in June. The results were good. Wall Street was expecting earnings per share of $1.34. Monsanto booked profits of $1.45 per share.

Everything should be good, right?

Wrong. Earnings were strong, but they weren’t strong enough. Monsanto’s shares fell 8% right away. Sine then, the downtrend has continued. Monsanto is a diversified agricultural company and is not a pure fertilizer play. It does, however, show what can happen when expectations aren’t met…regardless of the long-term outlook. 

Now, with earnings reports coming in just a few days, I expect more downswings to come. The three stocks I expect to get hit the hardest are the most diverse fertilizer producers. They all report earnings within the next 10 days.

Terra Industries reports on July 24, Mosaic on July 28, and CF Industries on July 29.

Buy on Weakness

There are a lot of considerations to make when it comes fertilizer stocks. As we’ve seen many times in the past, the combination of extremely lofty valuations, high expectations, and missing the quarterly numbers or cutting the outlook for the future can send share prices plummeting.

In this case, it still doesn’t look like too many traders have accounted for the impact of natural gas prices on fertilizer company profits.

Over the long-term agriculture is set to be a secular bull market. For now though, it comes down to a risk/reward proposition. If a fertilizer company beats estimates…it might get a small spike. But if they miss…they sell-off will surely come.

There’s not much upside and a lot of downside. So many things are going well for the agriculture sector for the long term. For now though, I’m afraid that could be what spells a big correction in agriculture stocks.

At Q1 Publishing we always focus on risk/reward. And when it comes to agriculture stocks and the upcoming earnings, the risk certainly appears to outweigh any potential reward.

Disclosure: Currently, I am not short or long any of the stocks listed in this article. But if Mosaic shares climb back to the $145 level this week or we see a 10% rally in Terra Industries or CF Industries, I will be.

 

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This article has 27 comments:

  •  
    Jul 22 10:43 AM
    If natural gas is such a drag on this sector, why has a dip in Natural Gas prices not resulted in an increase in Ag stock value?
    Reply
  •  
    Jul 22 10:54 AM
    MOS recently sold it's stake in Saskferco, the joint venture with the Sask government.
    Reply
  •  
    Jul 22 11:09 AM
    Dear Andrew, I think you are full of BS. You had POT as in your own words "The Best value in the Fertilizer industry" in December, in your article you were recommending it as a buy at $140, and the last part of your article in BOLD said clearly that the boom is not over and should double again in the next 2 years. No why the change of mind? Firstly I think seeking alpha is where the pretenders try and make a name for themselves, there are some good opions expressed, but this article is a load.

    PS - To all those who read this article please go to author bio and then to previous articles and see for yourself what he has said.
    Reply
  •  
    Jul 22 11:13 AM
    Natural gas prices are falling from highs in the thirteen dollar range to a current ten dollars. When was this article written?
    Reply
  •  
    Jul 22 12:09 PM
    Andrew, read again what you quoted on page 29 of Mosaic's annual report where they said IF they could not recover increases in energy costs through higher prices, THEN there could be a material effect on their business. Well, there have been huge price increases in their nutrients sold that should more than offset the higher energy prices. So you are right. Page 29 said it all. You just have to know what you are reading.
    Reply
  •  
    Jul 22 02:08 PM
    User 230527: you're kidding, right? The author is suggesting a great time to buy on a dip. Sounds bullish on the stock to me. It's okay to be short-term bearish but long term bullish, it all depends on how actively you want to manage your holdings.
    Reply
  •  
    Jul 22 03:00 PM
    Fertilizer companies, especially POT, have been able to cover higher input cost through higher end prices. In my opinion, the focus needs to be on the DEMAND side of the equation.

    There seams to be a strong case for growing demand due to the wealth affect of developing nations with large populations. However, the author says:

    "High prices are reducing total fertilizer use around the world. We could see a big impact on reduced consumption when the Q2 numbers come out..."

    Does this really make sense? Did farmers cut back on fertilizer use in April, May & June? If there were signifcant cutbacks then how POT negotiate very large price increases for current and future deliveries? Something does not add up here. Where is the analysis of the net affect?

    Disclosure: long RJA (thinking about buying POT below $200)
    Reply
  •  
    Jul 22 04:41 PM
    High prices won't reduce fertilizer use very long.
    If farmers want good yields per acre then they have to fertilze.
    They might get away with using less one season but thats about it.
    With the population of the planet exploding food will be in demand.
    Come to think about it, it already is :)
    Reply
  •  
    Jul 22 06:13 PM
    Don't trash the author-- a lot of other economists are supporting this notion that MON and the like will rebound.
    Check out this:
    www.greenfaucet.com/tr...

    MON and others reach their bounce point.
    Reply
  •  
    Jul 22 09:13 PM
    Why the sudden change of opinion on POT and even the sector just before earnings announcements? Hedging your bets and comments I think? You aound like Citibank......Potash prices have jumped to more than cover input cost increases, and Phosphate prices have held and moved up slightly from record highs now over 1200/ton. Earnings drive stock price, and the fertilizer run still has legs.
    Reply
  •  
    Jul 22 10:02 PM
    Look at what you wrote here, Andrew:

    "It’s simple economics. Fertilizer prices are not inelastic. High prices are reducing total fertilizer use around the world. We could see a big impact on reduced consumption when the Q2 numbers come out in the next few days."

    Wrong. Fertilizer prices ARE relatively inelastic. As long as there's a strong demand for food, farmers are gonna try and grow it. In fact, the precise reason for the recent spike in fertilizer prices is BECAUSE of the ever-increasing world food demand. There's a pretty direct correlation between fertilizer prices and food prices, because as DeltaXray7 wisely said, "If farmers want good yields per acre then they have to fertilze [sic]."
    Reply
  •  
    Jul 22 10:48 PM
    Has anybody quantified the cost of fertilizer as a % of some unit of a crop's price (Wheat, Corn... any major agriculture commodity)? How about the cost of Potash as a % of fertilizer prices?

    I would assume there are a lot of fixed cost that a farmer incurrs regardless of output/yield (land, equipment, facilities/storage plus some fixed number of employees). If I'm right (I have no data to support this) that crop farmers have lots of fixed cost to cover, then the incremental cost to produce incremental crops is insignificant. Any extra crops he can get out of using more/better fertilizers is almost all profit that drops to his bottom line.

    Am I wrong?


    Reply
  •  
    Jul 23 12:29 AM
    50% of TRA's gas purchases are hedged. Presumably, given that gas is now falling in price, the next comment will be that this company has taken a big loss on its hedges. There is a 30% short position in the outstanding shares, that would subscribe to your view however. A short position looking for the facts to justify it.
    Reply
  •  
    Jul 23 01:48 AM
    I think we almost have it. The key will be demand. And demand has been strong due to high food COST, not high food demand. As soft commodities have come down, the demand for fertilizers will drop off. Also I agree that the risk reward right here is very bad in the short term. Disclosure I am short MOS.
    Reply
  •  
    Jul 23 08:40 AM
    Even with all these stock increases, forward P/E for AGU remains around 11... and remember they have already pre-announced an increase in earnings and the Indian/Chinese contracts are up for re-negotiation. This stock might explode to the upside if they guide further higher. Already the stock has retraced back from 110 to 95. Buy now and hang on atleast until end of the year.
    Reply
  •  
    Jul 23 09:30 AM
    In your disclosure, you say, "I will be". You will be what, long or short?
    Reply
  •  
    Jul 23 09:32 AM
    I disagree with the fertilizer thesis as stated above. First of all, higher rates on fertilizer stockas are expected to go into effect on Sept. 1st, additionally, if you look at global pricing -- such as that being planned in Pakistan, for DAP, etc. the prices are going up. Throw in uncertainty of Russian potash production not being disupted again and there is additional catalyst in the stock pricing. The stocks have declined perhaps on the rotation into financials, but the fundamentals fo fertilizer demand have not changed...There is not enough food in the world and fertilizer helps meet that demand.

    Disclosure -- Long POT, MOS, AGU, CF, CAGC.OB, SQM.
    Reply
  •  
    Jul 23 10:31 AM
    I bought AGU I think it is a steal with its excellent earnings and prospects. The market has not fully valued this stock


    On Jul 23 08:40 AM andyn wrote:

    > Even with all these stock increases, forward P/E for AGU remains
    > around 11... and remember they have already pre-announced an increase
    > in earnings and the Indian/Chinese contracts are up for re-negotiation.
    > This stock might explode to the upside if they guide further higher.
    > Already the stock has retraced back from 110 to 95. Buy now and hang
    > on atleast until end of the year.
    Reply
  •  
    Jul 23 10:34 AM
    100% percent right, I think stocks with inelastic demand in what we need in these kind of markets



    On Jul 22 10:02 PM Rocknrollleg end193 wrote:

    > Look at what you wrote here, Andrew:
    >
    > "It’s simple economics. Fertilizer prices are not inelastic. High
    > prices are reducing total fertilizer use around the world. We could
    > see a big impact on reduced consumption when the Q2 numbers come
    > out in the next few days."
    >
    > Wrong. Fertilizer prices ARE relatively inelastic. As long as there's
    > a strong demand for food, farmers are gonna try and grow it. In fact,
    > the precise reason for the recent spike in fertilizer prices is BECAUSE
    > of the ever-increasing world food demand. There's a pretty direct
    > correlation between fertilizer prices and food prices, because as
    > DeltaXray7 wisely said, "If farmers want good yields per acre then
    > they have to fertilze [sic]."
    Reply
  •  
    Jul 23 04:06 PM
    I have just looked at the natural gas futures prices. They did peak near the end of June. Hence those prices may have effected this quarter's earnings. However, analysts have been raising estimates on earnings for companies such as Potash consistently. The old saying, "a hundred frenchmen can't be wrong", comes to mind. You have to think that POT will beat earnings. Add that natural gas prices are now back to their March levels. Add that Canpotex has recently raised pricing on potash (the commodity) by 21%. Further this raise is substantiated by worlwide price increases. You have to think that POT will guide higher -- considerably higher. What more could you want???
    Reply
  •  
    Jul 23 09:14 PM
    WOW!

    Too many experts, I don't dare sell anything right at the moment. POT, Monsanto, MOS, Mechtel, almost anything having to do with earl (petroleum). No choice but to hang in and wait...hopefully not for a vortex spiraling further downward.
    Reply
  •  
    Jul 24 12:15 AM
    natural gas plunges below $10.00 bucks on heavy selling. lets see thursday the natural gas inventories. weather has been hot suggesting usage, however it is turning milder. any build in nat gas will plunge to the 8's.....big boys will be crushed and fertilizer and industrials, consumers will be euphoric.....nat gas will build and plunge...
    Reply
  •  
    Jul 24 12:38 AM
    It is high time to think rationally for radical changes. The way energy sectors searching for renewable sources, the Fertiliser Society is to emulate them in searching for traditional/natural manures etc. This is the ultimate answer to the problem. Moreover, judicious utility of the limited non-renewable energy resources is to be practised by one and all honestly to the benefit of future generations.
    Reply
  •  
    Jul 25 02:12 AM
    my friend i have to correct you on your theory. Food demand doesn't go down like oil consumption has due to higher cost. Luxury foods might fall down a bit, but the basic necessities that most societies eat (fruits and veggies) need fertilizer to keep the crops producing and giving a strong harvest. Fertilizer demand won't fall off. The BRAC nations have an up and coming middle class who all want to lead better lives, just like the Americans have enjoyed. They'll be able to consume more of the items that in the past were not there for them. Hence bigger food demand equates into a bigger seed and fertilizer demand. We have reached a bump in the road, but even Wallstreet can't stop mankind from growing and evolving. Demand will go up as will AG stocks.


    On Jul 23 01:48 AM Jim Punkrockford wrote:

    > I think we almost have it. The key will be demand. And demand has
    > been strong due to high food COST, not high food demand. As soft
    > commodities have come down, the demand for fertilizers will drop
    > off. Also I agree that the risk reward right here is very bad in
    > the short term. Disclosure I am short MOS.
    Reply
  •  
    Jul 25 02:13 AM
    Ag may have lost it's glamour, but it's demand remains in tact.
    Reply
  •  
    Jul 25 12:47 PM
    Andrew, your article has a lot of merit, and I agree with many of your assertions. The facts related to production cost play into the AGs, and to a degree, I think part of your reason for modifying some of your opinions for Ag stocks is based on the sudden and recent decline in oil. It was unpredictable as far as the timing.

    Still, I believe, for all of the right reasons, that stocks like Mosaic, and the AG sector in general continue to offer traders and investors what may be arguably, the safest and potentially the most profitable opportunities in the current market.

    Analysts should not be the catalyst for pulling the trigger on any stock, but good analysts are like trackers--they know what we are hunting for, and they know how to track the prey.

    Many of the best of breed like Goldman Sachs, Credit Suisse, and even S & P continue to reiterate and/or upgrade their ratings for the AG sector and specific stocks with fantastic outlooks, buy and overweight ratings, and high great target prices on stocks such as MOS POT and others. Analysts can be a fickle group so the saving grace about most of these ratings is that they have based their analysis on solid research, fundamentals, and the fact that the dynamics of the AG sector are more straightforward than other sectors.

    With most of the key statistics looking solid, and the products they produce being "Need Based" rather than discretionary, one only needs to use common sense and a Economics 101/102 analysis to arrive at a consensus that AG related goods and services will continue to be in high demand for a predictable period of time.

    The supply and demand side will settle into trend cycle, but we are not at that point yet. Emerging markets are and will continue to grow and demand a greater diversification in diet, as well as more of their traditional foods. Factors like the price of oil, weather conditions, and government policies will play into the Ag sector, but once again, given the absolute need for these products, we should all take some comfort that the Agricultural “Bust” will be short lived.

    On the other hand, I must emphasize that institutional investors (hedge and mutual funds, banks, etc.), may represent the most unpredictable element to for traders and analysts of AG stocks because their market power constitutes an ever present challenge to the savviest of traders.

    Too often, these entities are the primary reason for unwarranted volatility as they manipulate the prices of solid stocks for their institution’s benefit alone.

    The extraordinary power they have to move and/or manipulate the markets by trading stratospheric amounts of shares and their history of turning on a dime during the course of even one day is well documented.

    These firms trade at levels that some governments can’t match, so I don’t consider it a stretch to compare their market moving power to those of weather events like a small hurricanes or winter storms. Needless to say, investors should always be looking over their shoulders and be aware that a hedge fund or other institution can come out of the shadows and we have to board out windows up for a stock or sector storm. The only traders that have the front on their radar are the very people that are doing these massive trades for the institutions.

    It appears that the primary motivation is to control the stock as much as possible and move it in a somewhat predicable fashion that will allow them to safely double and triple dip their profits. They move into a sector or stock because of the great fundamentals, but then move the prices without regard to the fundamentals, good news, or great outlooks of the company or sector.

    My bottom-line on the Ag play is that need based stocks like Mosaic that have great financials and supply and demand fundamentals other sectors would sell their in-laws for, so there is no doubt that the AGs will be able to weather the storms brought on by oil and the institutional investors and once again, move up at a rather sustained pace.

    Mosaic will move back up to around $145 to $165 before September, and we could see a high (spike or otherwise) of around $180 by the end of the year. At this point, 2009 is too hard to call but there will be a new growing and thus a demand cycle for crops for both the Northern and Southern hemispheres, so I am looking for another positive year for AG stocks.

    In the current markets, the Ag sector and well managed companies like Mosaic will continue to represent one of the few areas that offer us all an opportunity to sleep well knowing that the sector will be relatively stable for some time to come.

    Finally, the hedge funds, other institutional investors and short-sellers know their clients want to be where the profits are. These institutions also know that their job is to do it in a manner that provides their clients with a safety edge, and there are few, if any areas that can provide both of those factors like Ag stocks.

    Finally, the institutional investors know the fates of their careers are based on keeping their clients where positioned in sectors that consistently produce the highest profits and have high comfort levels in a volatile or for that matter, non-volatile markets. At this point, there is really no other place for them to go except for a quick dip, so we should all sleep better knowing that the Agriculturals will be relatively stable and wildly profitable for some time to come.
    Reply
  •  
    Jul 26 12:47 PM
    Hello,

    While, I think you're discussion of the fundamentals of these companies is impeccable, I worry you may be ignoring the fact that the trading dynamics of these stocks are not only influenced by fundamentals. While these companies are in fact still booming, their stock prices can only sustain 100% growth rates for so long. These stocks(just look at Monsanto) have gone up around one thousand percent since 2002. Their major market drivers - the devaluation of the dollar lead to the heavy buying of their products abroad and increase of oil price which caused farmers to want to use chemical treatments instead of tractors - are now likely to lose steam because of the reinvigoration of the dollar and the decrease in the price of oil. The ag sector is not going to go insolvent, but its growth rate into the future is not simply attractive enough for the use of capital meant for value investing.

    Personally, I would consider shorting far out of the money calls for the Jan2010 expiration on price spikes.

    As a side note, I am a frequent reader of seeking alpha and think highly of the analysis at this website.
    Reply
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