Thursday, September 9, 2010

What's the Big Deal with Potash?

Why are the Chinese worried about Potash?

We have read a lot in the press recently about BHP Billiton’s unsolicited bid for Potash Corporation of Saskatchewan. Fertilizers and specifically potash and to a lesser extent phosphate are likely to become the next battleground in terms of access to strategic resources, as they represent one of agriculture’s most important inputs.


Why all the fuss?

Why would BHP be so interested in the space and why might the Chinese enter into the fray? How does potash fit into the fertilizer mix?



The three types of fertilizers

Crops need three major classes of nutrients (apart from some micronutrients and of course water): Nitrogen (N), Phosphate (P2O5) and Potash (K2O). It makes sense to think of fertilizers in two segments: mined and manufactured. Nitrogen is manufactured using mostly natural gas as a raw material whereas both phosphate and potash rely on mined minerals as a key raw material. As a result, supply of phosphate and potash is less elastic and you are more likely to see a price spike for these two in times of elevated demand like in 2008 (see below).

















Because of this price spike, farmers around the world (the example given is for the US, but the phenomenon was even more pronounced in many emerging markets) used less of the more expensive fertilizer and more of the nitrogen group of fertilizers, resulting in a demand collapse for potash and phosphate. It is likely that this is a temporary demand reduction as increased pressure to get more production out of land dictates higher fertilizer applications in all three groups – especially in the emerging markets.


















What’s different about potash

The potash market is special because supply is so tightly controlled by three cartel-like export groups including Canpotex, which sells potash outside North America on behalf of PotashCorp, US-based Mosaic and Agrium of Canada; Belarusian Potash Company, the marketing arm of Moscow-based Uralkali and Belaruskali of Belarus; and PhosChem, which markets phosphate outside the US on behalf of Mosaic and PotashCorp. The nitrogen group of fertilizer, which uses natural gas rather than mined minerals as its main ingredient, is not subject to supply restrictions. These three groups, which are exempt from antitrust law because of special rules, control 70 per cent of global trade in the two key fertilizers which serve both to boost crop growth and protect crops from diseases.

The twist in the takeover saga is that BHP has indicated a desire – if it succeeds in its acquisition – to exit the Canpotex consortium and market the product independently. This would mean true market-based pricing for the first time since about 1971! Not a happy prospect for the other potash producers. What would happen to pricing in a free market environment? Demand would likely grow at its trend rate of about 3% p.a. and supply would likely keep up over the foreseeable future as there are plenty of “brown field” opportunities to expand existing mines rather than develop new ones. As a result, we are unlikely to see a recurrence of the phenomenal price spike of 2008 driven by a combination of strong demand because of high food prices and supply constraints because the industry had underestimated demand growth.


A leveraged way to play the coming agriculture boom

The bottom line is that while we are unlikely to see a repeat of the price spike of 2008, we are also unlike to see a repeat of prevailing prices prior to 2004 as demand growth is on a higher trajectory and capacity expansions are getting more expensive. Fertilizer companies with strong, low-cost assets may continue to attract attention from strategic buyers in China and elsewhere.



- Daniel Grasman

Thursday, August 5, 2010

Wheat wants to make a point

As I mentioned in my last blog, the structural trend of supply tightness across the agricultural complex is still in place. Witness the 50% spike in wheat prices over the past month (yes, month). It only takes bad weather conditions in a few of the former Soviet states to move from an oversupplied to an undersupplied situation.

For those of you believing in "climate change," yet another argument to be bullish on food prices.

Agriculture revisited

Have agricultural commodities run out of steam?

We saw in the last issue that prices of “soft” commodities like coffee and cocoa have held up much better than those of the major crops like wheat and soy. Is this a new trend or is there hope for the major crops as well? The upgrade of diets in the emerging world, coupled with supply constraints in areas such as land and water mean that the secular trend of higher prices of agricultural commodities is very much alive. That being said, the world is not running out of food as new technology and agricultural practices will result in enhanced production. However, the aforementioned constraints will drive up costs and product prices.


Introduction

After the spike of food prices in 2008, prices of many major crops – such as corn, wheat and soy – have collapsed and are still way off record levels set during the peak. This is particularly interesting as in a weak economic environment food might be the last place where consumers seek to cut their spending. However, relative price movements between food-related and other commodities seem to contradict this as the price of many other commodities has recovered sharply. Why the divergence and will this trend of weak food prices persist?



A downward blip in a secular upswing

Food prices, with the exception of products like cocoa and coffee were hit by a perfect storm in 2009, leading to very high inventories still depressing their prices.

In 2009, favorable weather conditions in the major producing nations led to a glut across the board for the major crops. On the other hand, supply was weak for the soft commodities due to poor weather in countries like Brazil, resulting in price spikes for products like sugar and cocoa.


Upgrade of diets in the emerging world

As more of the developing world becomes better off, they start to consumer more calories in general but also greater amounts of protein. A good example of this is meat consumption as a function of household income. As you can see below, countries like China are still early on in their demand growth for meat regardless of whether Japan or Korea proves to be more analogous to their own food demand pattern.
















The Food and Agriculture Organization of the United Nations (FAO) predicts that the average daily caloric intake in the developing world will rise more than 10 percent by 2020, to 2,800 calories a day. In a similar vein, the Organization for Economic Co-operation and Development (OECD) predicts that consumption of beef in the developing world will rise 31 percent by 2015. Higher beef consumption requires a major lift in grain production because it takes about 10 pounds of feed to produce 1 pound of beef.



Land supply constraints

Divergence in the supply of land vs. population growth would seem to result in supply shortages at some stage. Of course, the Malthusians among you have still not been vindicated. [According to Malthusian theory of population, population increases in a geometrical ratio, whereas food supply increases in an arithmetic ratio. This disharmony would lead to widespread poverty and starvation, which would only be checked by natural occurrences such as disease, high infant mortality, famine, war or moral restraint.] Although I don’t see any lasting food crises, a repeat of 2008 can easily take place in the next few years as a number of factors act as a brake on the supply of crops.

The supply of new land through “slash and burn” techniques in places like Brazil and Indonesia is likely to be curtailed as their wealth increases and their governments can afford to better monitor illegal uses of land, aided by concerned Western governments and other entities. Soy is a good example of a crop where supplies might get increasingly constrained.










Source: Censo Nacional Agropecuario, INDEC, 2002;
CIA World Factbook, 2005; Economist Intelligence Unit, 2005; FAO, 2003; Global Insight, 2005; IBGE, 1996; McKinsey analysis



One acid test for any commodity is whether China is or can easily become self sufficient. In the case of soy, that test seems very supportive of future strong pricing (see below) given China’s rapidly increasing imports, currently at 40 million metric tons per annum.














Of course, this positive secular story for crops likes soy can get overwhelmed in any given year by supply or demand shocks.


Water (again)

Apart from the availability of land, the lack of availability of clean water in the places where it is needed most will continue to curtail production. We’ve already seen this play out in the soft commodities recently, but it is likely to become an issue across products as the fastest growing continents, like Africa and Asia are the most water constrained (see graph below).
















Water will be a key constraining factor for crops like rice and cotton which require large amounts of water to grow.



Feeding (and clothing) the world

So, how has the world been able to feed itself in spite of these obstacles? Fertilizers and more efficient farming techniques have been a major enabling factor. We will talk about the role of fertilizers more in an upcoming issue. In spite of all this technology, it is clear that growing production will put increasing strain on natural resources in many countries and that this will put upward pressure on prices.



- Daniel Grasman



1. Includes land rated as having medium to very high potential; land in Brazil does not include Amazon rainforest region


2. Excludes livestock


3. Based on 1996 data from Instituto Brasileiro de Geografia e Estatistica (IBGE)


4. Based on 2003 data from UN Food and Agriculture Organization (FAO)


5. Based on 2002 Censo Nacional Agropecuario, INDEC

Wednesday, July 14, 2010

Is agricultural investing for you?

Is agricultural investing for you?Agriculture is not typically thought of as asset class but increasingly becoming so. Apart from the fairly widely owned Market Vectors Agribusiness (MOO) ETF, which invests in related equities and the Powershares DB Agriculture Fund, which invests in futures, there are also direct investment vehicles buying farmland. I believe that this remains an attractive space for long-term investors. However, a number of changes in the markets for agricultural products and in the financial markets have made agricultural products less of a diversifier in a commodity basket, making futures investing in the space marginally less attractive. The key is to have exposure to a broad basket of agricultural products including crops like coffee and livestock.

Introduction
Much has been written about the radical price swings of oil, copper and gold over the past few years as the financial crisis has unfolded. The impact of the crisis on the agricultural supply chain is less well understood but nonetheless interesting because of the unique dynamics of food production. The long-term economics of investing in food-related assets remain very compelling in spite of a major drop in many food crops in 2009 as the secular trend of more protein-rich diets in emerging markets continues. However, this positive theme has not necessarily resulted in strong price increases for all agricultural products. This piece sets out to explain why different products have had such diverging price paths.

Drivers of agricultural product prices
Let’s start by looking at what has happened to prices recently compared to other commodities (using crude oil as a proxy for the overall commodity complex). Starting with crops, looking at the chart below, comparing corn with crude prices, it is apparent that they have become highly correlated over the past couple of years. The likely reasons are a major increase in general investment demand for commodity futures with an attendant increase in correlations between major traded commodity futures as well as the substitution of corn-based ethanol for crude (primarily as a gasoline additive or even full substitute in the US and Brazil). The correlation in daily price between crude oil and corn increased from 0.05 in 2003 to 0.33 in 2007. Although historically, prices of food went up with energy prices because of its impact on the cost of production, shipping and fertilizer, investment demand and substitution have made boosted the linkage tremendously. The same substitution effect holds for sugar and certain oil seeds (for biodiesel).



Although the correlation has increased, it is interesting to note that crude prices dropped much more from their peak 2008 levels than corn prices. That makes a lot of sense as most corn demand is still for food which tends to be less price sensitive and less discretionary than crude oil demand (think driving, flying, etc.).

The picture is quite different when comparing crude to the smaller crops, where investment flows are less important and prices depend more on weather in key producing nations and other product-specific supply and demand dynamics. For example, comparing crude vs. coffee, it is clear that coffee is much more driven by crop-specific supply and demand issues such as weather conditions in the Brazil and Vietnam. Prices have been high recently as weather conditions in Columbia and Brazil were unfavorable for coffee production in 2009.


















If we next compare live cattle as a proxy for meat prices with crude, we see a similar pattern to coffee where there was a peak in pricing around 2008 but it was of much more modest proportion than the overall commodity complex and generally prices have been fairly stable with a slower trend rate in price increase than crude. For example, while crude oil is still about twice as expensive now as in January 2005, coffee and corn prices are up by about 80% but live cattle (similar to lean hogs) prices have been flat over this period.


















How do we reconcile this with the theme of increased demand for protein from the emerging middle class? Certainly, there is greater supply elasticity in most agricultural products. If product prices are high for a single crop like corn, it is easy to grow more corn the next year by increasing acreage. However, when all major crop prices are up because of an externality like investment demand, this switch from one crop to the other can no longer serve as a lid on prices and correlation between major crops go up.



Unlike other agricultural products, cattle and hog production requires substantial input of other agricultural products – specifically animal feed. In a scenario where all crop prices increase sharply, cattle and hog raising cost spike as farmers can’t simply switch from one kind of feed to another to contain cost. In theory, this would mean that meat prices should have gone up along with cattle prices. However, offsetting higher input cost and healthy demand growth were some unique factors in the cattle and hog space which can explain this anomaly.


Segmentation
What we have thus seen is that there are three major segments of agricultural products when it comes to price behavior: major crops, minor crops, and live cattle / hogs. The table below summarizes why in spite of the fact that the major crops have become more correlated with energy and other commodity prices, the minor products and cattle and hogs maintain unique price drivers which have led to very different recent price behavior.
















Conclusion
Although correlations have increased, diversification through commodities investing is still possible by including exposure to smaller crops and livestock. We’ll talk more about future return potential in upcoming issue because diversification without return – as with livestock – is not what most investors are looking for. With that caveat, how does an ordinary investor gain exposure here? The most obvious way, rather than trading exotic futures, is by owning farmland dedicated to these stocks. Beyond that, fertilizer companies – a favored investment path – provides broad leverage to the agricultural space as does investment in machinery and equipment companies.



- Daniel Grasman

Wednesday, June 2, 2010

The Dirty Oil Business

All the recent press coverage of the BP oil spill at their Deepwater Horizon drill rig points to the ugly truth of our energy supply. As long as we require hydrocarbons, major environmental disasters will occur from time to time. However, we have demonstrated during prior oil spills our ability to cope with the effects of these incidents as well as the pollution associated with the day-to-day operations of producing and processing these oil products. We will continue to have a viable oil and gas business here and investing in oil and gas services and equipment companies will remain an attractive long-term proposition.



Introduction

A lot has been written about the recent oil spill. I thought it would be helpful to have some perspective about the size of the disaster and the lessons from history.

We have seen major oil spills since we started exploring for oil and gas offshore in the 1970’s. If we look at the largest oil spills in recent history, the Deepwater Horizon spill is estimated to be somewhere between the third and the eleventh largest spill.1 In other words, there is still tremendous uncertainty regarding the scope of the disaster but it is certainly not unprecedented in terms of size.

















Another part of the story is that these oil spills are certainly not the only source of oil discharges into our waters. Without accounting for any major disasters, the annual discharge of oil into American waters amounts to about 17 million barrels2 . The largest ever oil spill was 7 million barrels. So, the issue is not necessarily the quantity of oil released into the ocean, which has ways of breaking down the hydrocarbons, but rather the geographic concentration of the release of oil and the concomitant impact on fragile ecosystems such as the Louisiana wetlands. I am no expert in ecology and will make no predictions about the lasting impact of this oil spill, but there is clearly the potential for long lasting damage onshore because of the concentration of this oil spill versus the regularly occurring spills.

From 1970 to 2000, offshore facilities and pipelines were responsible for only 2 percent of the oil in U.S. waters. The bulk of it (63 percent) came from natural seepage, and 22 percent came from municipal and industrial runoff3. Worldwide, natural seepage is the largest source (47 percent) of oil in water, followed by spills from ocean transportation (33 percent). In short, offshore drilling and production activity is only a minor contributor to oil pollution of US waters.


















Clearly, the distribution of oil spills from offshore is skewed with many years of very small leakages and then a big spill every few years. What will and what should be done to improve this?



Is increased regulation the answer?

While increased regulation is the likely outcome, it is unlikely to be the answer. Most of the rest of the world requires a back-up to the blow-out preventer which failed in the case of the Deepwater Horizon. It would seem to be a no-brainer to put similar legislation in place here. Another issue appears to be lax enforcement of existing regulations. We will likely see a combination of both rather than an absolute halt on new offshore drilling. However, it is unlikely that regulations will change the basic equation. Oil and gas exploration and production – like any other industry – will occasionally have incidents. It is just the visibility of these incidents that is higher. That being said, human resolve has dealt with prior spills to ensure that environmental damage is minimized – no matter how painful the images we currently see may be.

As Scott points out in his letter, alternative energy also has a significant cost that may be less visible and explicit but nonetheless it is not a panacea. The bottom line is that a halt of offshore drilling is unlikely to be more than temporary as energy independence carries substantial weight as a political goal and we don’t have any workable alternatives apart from reducing our demand (as discussed in the march issue The Real Energy Solution http://theharddeal.blogspot.com/2010/03/real-energy-solution.html).



Global offshore drilling and production

It is well known by now that most of the easily available onshore oil has been found, so the move to offshore has been gaining ground in recent years. Additionally, we have become more reliant on offshore oil reservoirs. Offshore crude oil production started in the 1940s and has grown consistently from a modest 1 million barrel per day (mbd) in the 1960s to 24mbd today. Offshore has been the main source of growth for world oil production as onshore production has leveled off during the last 2 decades. Offshore crude oil output now accounts for almost one-third of the world’s production.










Because the easy finds in shallow waters have been made and because of NIMBY concerns, we have moved to increasingly deep and complex wells. As technology improves, more complex deep water situations has become viable, including deep water fields and sub-salt very deep wells at offshore locations, such as those recently found by Petrobras. All of this complexity implies risk of operational failure and more oil spills. This is why producing from areas like Brazil and offshore Western Africa where there is much more untapped potential and less political resistance is not the solution it may appear to be. Unfortunately, accidents will continue to happen and shifting production to other regions doesn’t change that fact. If we consider that according to World Oil (Feb 2010 issue) at the end of 2009 there were 2237 oil wells in the Federal waters of the Gulf (down 418 from 2008 and out of 4,000 total offshore platforms in the U.S.) and 242 in the state waters of Louisiana, it seems fair to say that the safety record of offshore operators is not nearly as bad as the press currently makes it out to be. The Gulf of Mexico continues to be an attractive place to drill for oil with a very small incident rate considering the amount of activity.


















You may ask about an alternative way to reach energy independence: oil sands and oil and gas shale formations. US Offshore estimated reserves according to the US Department for Interior are about 115 billion barrels – a sizeable amount to be sure. However, this is only a fraction of the 1.7 trillion barrels of reserves in the Canadian Athabasca oil sands alone. You certainly don’t hear a lot about major spills from those operations. The problem is that processing oil sands into oil requires energy for steam injection and refining. This process generates two to four times the amount of greenhouse gases per barrel of final product as the production of conventional oil.4 If combustion of the final products is included ("Well to Wheels"), oil sands extraction, upgrade and use emits 10 to 45% more greenhouse gases than conventional crude.5

Bottom line is there are no easy answers. Oil and gas drilling and production is a dirty business and no amount of regulation will resolve this. It is clear that US regulators could have done a much better job of supervising activities. However, the risk of major spills will always be there.



Investment implications

There will be a continued need for offshore expertise in the form of equipment and services. Increased regulation will likely mean a need for additional (redundant) equipment to ensure that the failure of one piece of equipment does not result in a disaster. Also, remember that much of the focus of new offshore drilling is now in South America and Africa. Many drilling service and equipment companies derive the vast majority of their revenues and profits from international operations and would seem to offer compelling upside in the medium term.



- Daniel Grasman





1 CreditSights, Thomson Reuters

2 Water Encyclopedia

3 Eric Smith, Bren School of Environmental Science and Management and the environmental studies program (see Washington Post http://www.washingtonpost.com/wp-dyn/content/article/2010/04/01/AR2010040102800.html)

4 Joseph J. Romm (2008), Hell and High Water: The Global Warming Solution, New York: Harper Perrenial, pp. 181–82

5 Bob Weber. "Alberta's oilsands: well-managed necessity or ecological disaster?". Moose Jaw Herald, The Canadian Press.

Thursday, May 6, 2010

Readers' Inflation Expectations

Having completed the polling of inflation expectations of the readers of this blog (recognizing that an interest in hard assets may be a sign of concern about inflation to begin with), this is the result. Fully 72% of readers expect inflation to be in excess of 3% - well above recent levels. Commodities are down in light of recent turmoil but the bull case remains.

The Power of Water

As emerging markets’ share of global economic growth continues to increase, this economic growth will be more intensive in terms of demand for water, energy and basic materials. Coincident with this trend is a shortage of water in those areas where it is needed most: the areas with a concentration of population and industrial activity. As a result, commodities requiring lots of water which are predominantly mined or produced in water deficient areas will likely see more upward pressure than other commodities.

In particular, commodities affected by water availability include copper, predominantly found in arid areas in Chile, Peru, Mexico and Mongolia. Another example would be live cattle which require lots of crops for feed or crops themselves like rice, which are very thirsty.



Introduction

Water is a strange commodity. Unlike crops, the quantity of water is fixed - it cannot be created or destroyed, and thus is not affected by human activity. It is only the availability that changes. To better understand this, let’s take a simplistic example of a world with 7 billion people all clustered on top of one big aquifer which happened to be the only source of fresh water in the world. As our world's inhabitants use the water, it comes up wells and out of the aquifer. Now, some of it will find its way back, but this can be a slow process. Some of it will end up draining out elsewhere, for various reasons. Much of it will evaporate and then blow elsewhere with the prevailing winds. If this process continues, the aquifer slowly depletes, and our seven billion people have a problem.

This is happening right now in places like Mexico City which has mostly depleted the aquifer that has been the main source of water. There is abundant water in the tropical valleys of Mexico, but that’s far away from where it is needed most.

So, there is no absolute water shortage, per se, but rather an issue of availability and cost. There is a significant cost associated with moving water around (think pipelines, pumping stations, etc.). Water is extremely abundant on our planet with a total estimated volume of 326,000,000 mi3. The problem is that only a very small portion of global water is available for human consumption. Of surface water, 97% is in oceans, 2.4% in glaciers and polar ice caps and only 0.6% in other surface water like rivers, ponds and lakes. Moreover, only 1.6% of water is contained in underground aquifers. If we add aquifers and surface waters, we are left with 2.2% of global water supply or about 704,000 mi3 (7.8 1017gallons) theoretically available for human consumption. Population growth per se will remove a small supply from the availability. If we assume that net population growth will be about 400 million over the next five years1 and assuming that each person is about 70% water, this would amount to 4.4 109 gallons of water – an infinitesimal fraction of the above water supply - not available for other uses.



Agricultural use

So, it’s really about the population requiring more products which consume large amounts of water to produce, like coffee, tea, rice or cotton (see table below2).






It gets really interesting, though, when the rapidly growing global middle class starts consuming more proteins3:





For an illustration of how significant water has become, let’s take a look at California.

California’s status as one of the most fertile agricultural regions on earth is at risk because water, the vital ingredient to make the soil productive, is increasingly scarce. For example, Paramount Farms near Bakersfield, is the largest grower of pistachios and almonds in the world, and of pomegranates and citrus fruits in America. Water used to be 20% of Paramount’s costs4, but now accounts for 30%. Looking at the big picture, over 70% of water withdrawals are related to agricultural production5.



Industrial use

Now let’s look at industrial consumption. Grupo Mexico’s Cananea copper mine is a good example of how much water is needed to process minerals. It uses 18 million cubic meters or 4.8 billion gallons of water per year and as a result, the aquifer it is drawing from is reaching critically low levels. Nowadays, getting a water permit is one of the most critical obstacles to getting a new mining project off the ground. This will serve to further drive up the cost for many minerals mined in arid regions. Another example is Chile —one of the world’s most important mining centers and a very arid nation – especially in the North where mining takes place. The government allocates fresh water rights among companies strictly, closely monitors their usage of water, and pressures them to use less of it. Xstrata’s Collahuasi mine was asked to reduce its rate of water extraction to 300 liters a second by 2010, from 750 liters a few years ago. To make up the difference, the company has considered building a desalination plant or shipping in water to the mine.



Another good example is electric power consumption. Power generation is the thirstiest sector of the industrial economy, consuming 195 billion gallons per day, according to the USGS. While about a third

of this is saline (either ocean water or brackish groundwater), the rest is fresh water, competing directly with human consumption. In spite of all of this, we will still be managing domestically with some more prudent management practices.





Overall water balance

Recent McKinsey analysis5 shows a 40% gap between water demand and supply by 2030, bringing to the fore the urgency to reduce water consumption and find alternative sources of water. The shortage is not an absolute shortage but rather a lack of clean, reliably available fresh water in the places where it is needed most.

















Investment implications

As a result of the increasing demands on a shrinking pool of easily accessible fresh, non-contaminated water, not only will the price of water go up, but also farms and industrial companies will need to spend a lot more money on expensive equipment to ensure access to sufficient water. The solutions to water availability issues fall along three axes: improving the productivity of water treatment and distribution, of water-intensive industrial and power processes, or of water usage in agriculture. All of this bodes well for commodities prices but may depress margins for the producers of these commodities if they are unable to pass along the higher costs associated with making these improvements. It is also clearly favorable for companies helping producers use water more efficiently as well as makers of desalination, filtration and other water-related technologies.



- Daniel Grasman







1 Source: United Nations; population in 2008: 6.7B; population in 2015: 7.2B

2 Hoekstra, A.Y. and Chapagain, A.K. (2008) Globalization of water: Sharing the planet's freshwater resources, Blackwell Publishing, Oxford, UK.

3 Cornell University

4 The Economist , Jan 21, 2010

5 McKinsey, The Business Opportunity in Water Conservation, 2010