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Brazil
offers an ideal environment for potash developers, according to Salman
Partners Analyst Jaret Anderson. A robust agricultural sector, favorable
government policy with excellent transportation and infrastructure are
leading to the development of a number of very attractive potash projects in
Brazil. In this exclusive interview with The Energy Report, Jaret
details his Brazil play and others.
Companies Mentioned: Allana Potash Ethiopian Potash Corp OAO
Uralkali PotashCorp The Mosaic Company Verde
Potash Western Potash Corp.
The Energy Report: We know the general factors
responsible for the growing need for fertilizers, but are there any growth
drivers that aren't quite so obvious?
Jaret Anderson: Absolutely. Everybody knows the earth’s
population needs more food, and there's a greater desire for increased meat
consumption in a number of countries. Hundreds of millions of Chinese and
Indians are making the transition from poverty to having some level of
disposable income, and one of the first things people in that situation tend
to demand is a higher protein content in their diet. One of the things that
tends to get lost in the debate is the fact that in order to produce more
protein we need a lot more arable land, or we need significantly more
production from the arable land currently available.
In order to produce a kilogram (kg.) of beef, it takes about 7 kg. of feed,
whether it's corn or soy or what have you. In order to produce a kilogram of
pork, it takes 4 kg. of feed, and for poultry it takes 2 kg. of feed. So, as
hundreds of millions of people in India and China and around the world
continue to move toward higher protein content in their diets, there is a
need to produce more feed grains on a pretty much finite arable land base in
order to satisfy those demands.
TER: It sounds like making protein is a very inefficient process.
JA: Regardless of whether it is efficient or inefficient, it's what
the world is demanding. I have no desire to give up my meat and I don’t
think anybody else does either. There are ways we can achieve this with
better farming techniques, such as more efficient use of fertilizers,
genetically modified seed and superior irrigation. All of these things can
help us improve crop yields and help us to offer everyone on the planet the
food and protein they desire. So, moving yields up in less developed parts of
the world to the levels that you see in North America and Western Europe,
etc. is something that can be achieved over a longer period of time.
TER: Food producer risks would trickle down to the fertilizer
producers. What are the risks?
JA: At the end of the day, the major risks are the impact of prices,
which incorporate the supply and demand for the various crops, cattle,
poultry, pork, etc. One macro-risk that could have a big impact on the
agricultural system overall—and therefore on fertilizer producers and
those who are trying to bring new fertilizer projects to market over the next
number of years—is the political and economic debate surrounding
ethanol.
A change in the political will to continue to subsidize ethanol in the United
States could potentially have a significant impact on farm economics.
Something like 40% of U.S. corn production is used to produce ethanol. A
$0.45 per gallon subsidy currently goes toward the production of ethanol, and
if that were to go away during this 2012 election season, it could hurt
fertilizer producers.
TER: One Republican presidential candidate went to Iowa recently and
made no bones about the need to reduce subsidies for ethanol.
JA: Yes, Minnesotan Tim Pawlenty made that statement pretty
aggressively. Sarah Palin, whether she's in or out, can have an impact on
this issue. She's saying some of the same sorts of things regarding the need
to end all energy subsidies, including ethanol. So, it's a risk. I don't
think it's something to lose a lot of sleep over, but it is certainly
something that can change the debate and the economics for corn production
and, ultimately, fertilizer products.
TER: In an industry report, you expressed some thoughts about the
significant advantages of producing potash in South America versus Africa.
What thesis are you presenting to your clients regarding these two areas?
JA: Transportation costs represent approximately 40% of the total
delivered North American potash costs. That's another way of saying that
location and infrastructure are critical elements for any prospective
greenfield potash project. It's critical to think about how infrastructure
and transportation costs play into the various projects whether they're
located in Saskatchewan, Canada, Brazil, Ethiopia, Eritrea, the Republic of
Congo or wherever else these projects are being developed.
Brazil, in my view, is a particularly interesting location. It's the
second-largest consumer of potash in the world today, and it has posted some
of the best potash demand growth over the last 10 years. In addition, Brazil
has a number of positive factors going for it. It has a
well-developed infrastructure system, including modern roads, a
well-developed rail network, access to water and power. By comparison, a
number of projects in Africa have very interesting deposits but face
significant challenges with respect to infrastructure, including a lack of
access to rail, water, power and ports.
TER: Potash stocks are taking a well-deserved breather after
phenomenal returns over the past 52 weeks. Is this an opportunity now for
phosphates to catch up?
JA: There has been a big uptick in interest
in phosphate projects over the last six months. I definitely receive more
incoming calls on them than I did a year ago. I believe that phosphate projects
do offer some advantages over potash projects because they are less expensive
to build, and they're generally brought to market faster than the five-plus
years it can take to bring a potash project to market. Overall, though, the
potash industry has offered much better returns over the cycle than
phosphates.
PotashCorp
(TSX:POT; NYSE:POT)—one of the largest fertilizer companies in the
world—has generated an average gross margin over the past five years of
63% in its potash business. Its phosphate business, by comparison, has only
generated an average gross margin of about 22%. I think that is the order of
magnitude you can expect in potash versus phosphate over the cycle. That makes
potash the more attractive business over the long term, but it doesn't mean
there aren't attractive phosphate projects out there that can generate decent
returns for investors.
TER: Companies vary how they report their resources. Investors would
like to understand resource values on an apples-to-apples basis, specifically
when it comes to understanding recoverable potassium chloride versus total
tonnage of ore. This can have significant implications, can it not?
JA: It can. A number of these greenfield potash companies have taken
different approaches with respect to the way they have chosen to report their
resource figures. As you point out, some companies have reported the total
number of tons of potash-bearing rock in the ground while others have been
more conservative and report the amount of potash that they expect to be able
to extract after accounting for the grade of the rock, allowances for losses
during extraction and further losses during processing.
In general, we have found that companies with assets in North America have
been more conservative in the way they have presented their figures than the
companies with assets in Africa. In any event, when comparing two potash
resources, investors have to take into consideration things like the resource
grade, mineralization depth, existing infrastructure and the viability of
moving forward over the long term.
In our opinion, too many of these companies have been painted with the same
brush. Ultimately, not all of these projects are likely to make it to
production. You have to consider carefully which of these projects have the
most desirable characteristics and the lowest risk when making an investment
decision.
TER: Does the Street typically give the recoverable potash resource
reporter a premium?
JA: Not from what I’m seeing when I look at my comps, and that's
where I think there are some opportunities. To me, a company such as Western
Potash Corp. (TSX.V:WPX), which is located in Saskatchewan and has a very
large resource, has been conservative in the way it has presented its
information compared to a lot of its peers in the greenfield potash space.
Yet, it's trading at a discount in terms of absolute EV or market cap to some
of the companies operating in Africa with a fraction of the resource who have
perhaps been less conservative in the way they've presented the figures. So,
I think there are some opportunities there, and I think that a company like
Western Potash does warrant a second look.
TER: Can a prolific producer command a premium price, or is the idea
to get a better margin with lower infrastructure and transportation costs? Or
is it both?
JA: In an ideal world, you want a large potash resource located close
to a large source of end demand with good infrastructure already in place and
a stable geopolitical environment. In our view, the projects in Saskatchewan
and Brazil check most of these boxes. Brazil is particularly interesting in
that it offers well-developed infrastructure, a stable political environment
and very strong growth rates for potash demand going forward. If I had the
ability to create a potash deposit located anywhere in the world, I would
choose to locate it in Brazil. Brazil is likely to overtake China as the
world’s largest consumer of potash sometime in the next decade. In my
view, it offers the best combination of end-user demand, well-developed
infrastructure, and an accommodative and stable government.
Something to keep in mind is the very long-life nature of these projects.
When you're building an operation that is expected to run for several
decades, you need to think strategically about how the world is likely to
unfold. Brazil is currently the world’s number one exporter of beef, chicken,
sugar, coffee and orange juice. Given its very large undeveloped arable land
base, those factors are only likely to go in Brazil's favor. So, in my view,
locating in a country with great agricultural
promise going forward, a stable government, and good infrastructure makes a
lot of sense.
TER: Could you give me a specific example?
JA: Sure, take the example of Verde
Potash (TSX.V:NPK) (formerly Amazon Mining Holding), which has a very interesting
greenfield potash project located in Brazil. Verde plans to produce a new
type of potash in an area called Minas Gerais, a state with a very high level
of agricultural production close to a number of fertilizer blenders that buy
fertilizer today from companies such as PotashCorp, The Mosaic
Company (NYSE:MOS), and OAO
Uralkali (RTS:URKA, MICEX:URKA, LSE:URKA). Verde is likely to face
freight costs of only about $45/ton to truck product from its location a
couple hundred kilometers (km.) to the fertilizer blenders in Minas Gerais
and Mato Grasso states. A supplier today in Saskatchewan such as PotashCorp
or Mosaic is likely to face transportation costs of $35/ton to move its
product from Saskatchewan to the port in Vancouver, another $35/ton via ship
from Vancouver to the port in Brazil, and another $80-$115/ton to move the
product from the port in Brazil to the inland location where the fertilizer
blenders actually need the product. The total cost of end-to-end
transportation is somewhere between $150 and $185/ton. So Verde's $45/ton
transportation cost gives it a very material competitive advantage. It really
can't be frittered away over time unless you believe rail and transportation
costs are going to go down over the years, which is highly unlikely. This is
an enduring competitive advantage.
TER: I am looking at Verde under its old ticker symbol as Amazon
Mining, and its total return for the past 52 weeks is 383%. It's given back
about 14% over the past three months. Is there much left on the upside?
JA: Verde has plenty of upside left. I have a target of $11.50 per
share, and you're talking a return of 64% to my target. I believe there is
certainly another $3–$4 left in the stock over the next 12 months. If
the company's R&D initiatives show positive developments, the stock has
much, much more upside from here.
TER: Is there another company you might discuss?
JA: If you want to play in the Danakhil Basin in Ethiopia, I would
steer someone toward Ethiopian Potash Corp (TSX.V:FED TSX.V:FED.WT), which has
a land package located directly adjacent to Allana
Potash (TSX.V:AAA; OTCQX:ALLRF) and yet has a market cap at roughly
one-third that of Allana's. If you’re bullish on the Ethiopian plays,
they're not all the same. Some are less expensive than others, and I think
that Ethiopian Potash is an attractively valued name.
TER: Isn't the Danakhil project 600 km from a port?
JA: It's roughly 600 km by road to the nearest available port that it
can use, which is Djibouti. Closer ports exist in Eritrea, but political
problems limit access to those ports. Eritrea and Ethiopia have had troubled
relations in the past. So, projects located in Ethiopia may have trouble
gaining access to the ports in Eritrea. That could be resolved over time, but
right now it looks like that's going to be a challenge.
TER: Sticking with that transportation theme for a moment, you're
obviously very positive on Western Potash, but it's 1,730 km to port.
JA: Yes, it's a long ways away from the port in Vancouver. The
difference is that there's well-established rail infrastructure in place,
which has been transporting large quantities of potash from Saskatchewan to
Vancouver for several decades. The risk and the cost in moving potash out of
Saskatchewan is much, much lower than I think you're going to find in other
parts of the world. So, it's a large distance, but the infrastructure is
largely in place to make that feasible.
TER: Thank you for your time. Best wishes.
JA: Thank you.
Jaret Anderson covers the fertilizer, agriculture and
chemical sectors and brings over 10 years of research experience in the basic
materials space to the Salman Partners research team. Jaret spent seven years at
UBS Securities Canada covering paper & forest, fertilizer, chemical, gold
and steel names prior to joining Salman Partners. In 2006 he was ranked #1
for earnings estimates accuracy in the paper and forest sector by Starmine,
and in 2005 he was ranked #2 for quality of written reports (also in the
paper & forest sector) by Brendan Woods International. Jaret holds a B.Com.
(with Honors) from the University of British Columbia and became a CFA
charterholder in 2000.
The
Energy Report
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