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Sunday, September 19, 2010

If You Have Gas Pains, Buy Fertlizers

Fertilizer stocks have caught fire recently on the back of the perceived crop shortfalls and takeover activity. In addition to these tail winds, nitrogen exposed fertilizer companies (AGU, CF and POT) have another fundamental driver, namely the decreasing raw material costs as embodied in the already low natural gas prices.

Recently, analyst have been busy downgrading their natural gas price forecasts for the next two years based on persistently high natural gas supply caused by:

1. A record horizontal drilling activity;
2. Steady flow of capital into the E&P sector despite the natural gas glut;
3. Pressure to drill to hold leases that are set to expire and
4. Continued competition from low-cost international LNG.

According to a story at the Wall Street Journal, Jonathan Wolff at Credit Suisse calculates that gas-focused E&P companies will reinvest $1.36 for every $1 of cash flow that they earn this year. What is more, so far this year they have raised $26.8 billion of new equity and debt—more than they raised in the whole of last year—to help finance it.That is despite the E&P sector generating an average return on capital employed since 1991 of just 6.1%, according to Jim Murchie of Energy Income Partners LLC. That is pretty poor when one considers that oil and gas prices have risen by multiples since then and that energy exploration is highly risky.

As the operators drill leases in order to hold them, they have been building a large shadow inventory of natural gas that is expected to hit the market as soon as the producers can see a way to hedge the new production profitably. Therefore, the spikes in the natural gas market are expected to be short lived and the pressure on prices relentless.

With a global price floor for nitrogen products set based on the production costs of the highest cost producers (producers with the highest natural gas costs, currently European producers), North American based producers stand to generate strong operating margins as they have access to significantly cheaper natural gas than the industry’s marginal producers.

Among the North American producers, CF has the largest exposure to nitrogen with approximately 80% of revenues derived from nitrogen sales. It has the second largest nitrogen capacity globally with 13.5 million product tons or 6.3 million nutrient tons.

Disclosure: No positions in the mentioned stocks as of the date of this writing.

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