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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.
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DISCLOSURE:
1) Zig Lambo of The
Energy Report conducted this interview. He personally and/or his family
own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The
Energy Report: Allana Potash Corp., Karnalyte Resources Inc. and Verde Potash. Streetwise
Reports does not accept stock in exchange for services.
3) Jaret Anderson: I personally and/or my family
own shares of the following companies mentioned in this interview: Verde
Potash Plc and Rio Verde Minerals Development Corp.
I personally and/or my family am paid by the
following companies mentioned in this interview: None. I was not paid by Streetwise for this interview.
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