Does Potash Have A Future At BHP?

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

– Global potash oligopoly smashed
– BHP's Jansen project now in question
– Brokers see a reduced commitment
– Subsequent cashflow lift a positive

By Greg Peel

For many years BHP Billiton ((BHP)) sold iron ore to China based on a one-year contract price, and for many years BHP tried to shift away from contract pricing towards spot pricing, but this was never going to happen unless Rio Tinto ((RIO)) joined in the push. A change in CEO at Rio finally brought the company on-side, and today while a quarterly contract price system still exists, more and more Australian iron ore is being sold to China at spot.

A few years ago BHP took an unusual detour as part of its then mega-project expansion spree by moving into Canadian potash. How does one reconcile fertiliser alongside iron ore, coal, copper and oil? The connection is that potash is mined, just like any mineral, and in potash, then CEO Marius Kloppers saw a diversification opportunity.

The global economic downturn and subsequent fall in commodity prices has since seen BHP, Rio and international peers rapidly backpedalling on significant capex and offloading non-core assets. BHP decided to stick to a collection of tier one assets, one of which is Canadian potash. The company failed in an attempt to takeover Canada’s Potash Corp, settling instead on spending big on its Jansen project, adjacent to Potash’s major operations.

Shareholders have never really been convinced.

The global potash industry has been dominated to date by two cartels representing 70% of trade. They are the Belarussian Potash Company (BPC), made up of Russia’s Uralkali and Belarus’ Belaruskali, and Canpotex, made up of Canadian companies Potash Corp, Mosaic and Agrium. Despite being two separate organisations, the two have operated as a form of uneasy oligopoly in the style of OPEC. But as always been the case with OPEC, cartel members have sometimes broken from their production and price agreements.

Having tasted success in breaking down the longstanding iron ore contract system, it was always BHP’s intention to elbow its way into the global potash market and break the cartels, forcing the industry into a spot pricing framework. It was a given that such a strategy would lead to a lower potash price, but it would also allow BHP the chance to sell more product and thus increase cashflow from its Jansen operation.

Be careful what you wish for.

In December last year the Belarussian president stepped into the fray and cancelled the exclusive rights of BPC to sell Belarussian potash. China has recently invested US$12bn in Laos potash production. China is a major customer of the cartel, but this latest investment means China could be 60% potash self-sufficient by 2017, UBS notes. UBS also notes Potash Corp recently decided to renege on a promise to its Canpotex partners that it would manage volumes to provide price support for all.

All of this leads us to Uralkali's decision on Tuesday to leave the BPC and go it alone. Uralkali has apparently agreed, notes JP Morgan, to sell potash to China at US$350-360/t. The previous cartel price to China was US$400/t but China’s domestic production traded at US$350-360/t. Clearly as China shifts towards greater self-sufficiency a 400 price is unsustainable.

So now it’s game on. Uralkali has shattered the BPC cartel and if the Canpotex cartel wasn’t already shattered by Potash Corp, it probably is post Uralkali’s move. The global potash industry has played right into BHP’s hands, as pricing will now move to spot without any “elbowing” required. Uralkali has signalled it is prepared sell product as low as US$300/t.

So it’s good news, isn’t it? Maybe not.

In 2011, BHP committed a further US$488m investment in Jansen, taking its commitment to US$1.2bn. Add in further neighbouring Saskatchewan acquisitions and the company is now into potash for US$2bn, UBS notes. All committed funds have now been spent, and BHP was due to make a decision this month about committing further funds. The problem would be convincing sceptical shareholders, who have watched Marius Kloppers’ mega-plans subsequently written down in value (including a big blunder in US shale) and the same happening over at Rio. In a low commodity price world, shareholders want to see cashflow out of BHP’s remaining tier one assets, and subsequent distributions, not more quixotic capex investments and lack of share price appreciation.

No doubt BHP envisaged a slightly slower transition to global spot pricing for potash, not a sudden 25% price slash, as appears to now be the case. Uralkali has effectively started a potash price war, and intends to pump its production into overdrive. Citi believes the war could last 12 to 18 months, and such disruption tends not to be very beneficial to fellow producers in the interim.

Citi suggests Uralkali’s move is a “game-changer” for Jansen. The broker’s valuation for Jansen within the BHP portfolio assumed US$16bn capex in total to reach full expansion at 8mtpa, a long term potash price of US$500/t and a subsequent net present value of US$7.2bn. At US$300/t, this NPV becomes minus US$2.2bn. Citi is now assuming BHP will not move forward with Jansen.

Citi also believes this would be positive for the stock.

UBS believes BHP may reduce its Jansen capex, rather than shelve it altogether. A lower commitment, combined with reduced capex on US onshore oil & gas, could reduce the company’s net FY14 capex guidance by US$18bn thus, as the broker suggests, “increasing the perception of increased returns”.

Macquarie notes that if Jansen were to run at capacity it would represent around 15% of global production, and the same pricing outcome now triggered by Uralkali would have been reached anyway. On that basis, Macquarie suspects management was already assuming a sub-400 price in assessing Jansen’s economics. It will be hard to convince shareholders, but Macquarie thinks BHP will continue to drip-feed capex into Jansen to keep the option open. In light of this immediate potash price adjustment, the broker has removed expectation of full-scale capex and subsequent forecast cashflows. The reduction in net asset value equates to 97c, but the flipside is that the reduction in capex thus lifts the company’s net fee cashflow by US$3.7bn, implying a 5.3% free cashflow yield in FY14 and 6.8% in FY15.

The bottom line is that no FNArena database broker has yet changed its BHP rating or target as a result of the potash bombshell.

With respect to Incitec Pivot ((IPL)), which was yesterday sold down by association as a fertiliser producer, Deutsche Bank suggests there are few direct implications. Incitec produces diammonium phosphate (DAP), not potash, and that market is more fragmented and less cartel-controlled. Margins are also much lower, and the broker was already forecasting lower DAP prices as it was. The only risk, says Deutsche, is that much lower potash prices encourage fertiliser consumers to switch their preferences.
 

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