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Potash training - Investors should consider more than the recent history of a company or sector

18/10/2013

Ian Kelly

Ian Kelly

Fund Manager, Equity Value

Would it surprise you to learn there can be such a thing as too much profit? To illustrate how this might be so – and in the process provide a neat example of the behavioural finance mistake of ‘anchoring’ – let’s take a look at the world’s potash industry. Along with phosphate and nitrogen, potash is one of the three main nutrients for plants and, as such, is extremely important to global agriculture.

It is also extremely abundant. According to the latest available figures, Canada, the world’s biggest source of potash, produced 9.5 million tonnes of the stuff in 2010 but can point to reserves of some 4.4 billion tonnes. In the same year, global potash production totalled 33 million tonnes, which compares to 9.5 billion tonnes of reserves.

Given that, you might conclude there is little money to be made from potash but, over the last six years you would have been wrong. The period 2007/08 saw fertilizer prices jump on the back of a rise in agriculture prices, which appeared particularly good news for the two cartels that control most of the world’s potash production – and pricing – Canpotex in North America and BPC in Eastern Europe.

From a price of $113 (£71) per tonne in 2002, the price of potash rapidly spiked up to a high of $773 per tonne in 2008 before falling closer to $400 per tonne over the last few months. That, as it happens, has been a period of some upheaval in the potash sector, most significantly because Uralkali, the world’s largest potash-producing company, broke away from the BPC cartel.

Why would it do that? Well, as a percentage of sales, the Russian company was making exceptionally high margins of 25% free cashflow and 45% operating cashflow. Uralkali – in common with all the other potash producers – was simply making too much money and, when that happens, other people begin to sit up and take notice.

A raft of new potash producers started popping up – many of them in Canada but there have even been plans to build a new potash mine in the UK – and the bigger players twigged that the only way to preserve their market share would be to use their scale to reduce the price of potash and so discourage new players from entering the sector.

This is actually how cartels of any sort tend to break up – the ‘scale’ player sees potential new entrants, worries about losing its advantage and quits the cartel – and indeed how capitalism works. Potash is not a scarce resource but it has seen its price artificially inflated by cartel behaviour. If you make too much money in any market, however, it attracts new competitors and prices eventually end up falling.

What does that mean for potash? In the wake of Uralkali’s departure from the BPC cartel – and indeed the recent break-up of smaller North American cartel, Phoschem – market watchers have started talking about a fall in the price of potash to around $300 a tonne. This, some of them go on to argue, represents a great buying opportunity but, before anyone gets too excited, let’s take a look at the following chart.

Why People Form Cartels

Date: 2nd August 2013

This plots the price of potash going back almost a century and illustrates that, for more than 80 years, it was never higher than its 1920 price of $200 per tonne. Anyone who therefore believes $300 per tonne represents a great buying opportunity looks to be guilty of ‘anchoring’ their perceptions on only the last few years and ignoring the decades of history when the price was much, much cheaper.  If the potash price continues reverting to the mean, that would prove an expensive mistake.

Author

Ian Kelly

Ian Kelly

Fund Manager, Equity Value

I joined Schroders European equity research team in 2007 as an analyst specialising in automobiles. After two years I added the insurance sector to my coverage. In early 2010 I moved into a fund management role, and then took over management of two offshore funds investing in European and Global companies seeking to offer income and capital growth. 

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