BHP on the brink of a hot potash war

The breaking up of the Russian end of the potash cartel is being interpreted as the nail in the coffin for BHP Billiton’s "fifth pillar", the massive Jansen project in Canada. That’s not necessarily the case.

Earlier this week OAO Uralkali, the world’s biggest potash producer, withdrew from the marketing joint venture with Belaruskali after accusing the Belarus producer of selling potash outside of the agreement.

It also announced a deal with a Chinese fertiliser importer to supply China with up to 10 per cent of its annual potash requirements, which may have had something to do with the break-up as China has been taking a tough stance with the producers in contract negotiations.

As the world’s low-cost producer, with productions costs of about $US60 a tonne and earnings before interest, tax, depreciation and amortisation margins of around 60 per cent, Uralkali is better placed to absorb the $US100 a tonne fall in potash prices it is anticipating, as a consequence of its decision to go it alone and accept market prices, than its competitors. It also has the most unused capacity and plans to lift production by about a third over the next two years.

The Russian producers have, for nearly a decade, coordinated their 'marketing' with Canada’s Canpotex, a similar 'marketing' joint venture exists between Potash Corp, Mosaic and Agrium. Between them the two vehicles have created what has often been described as a cartel, strictly limiting production to maintain higher prices. The Russians account for about 43 per cent of global supply and the Canadians about a third.

The Russian divorce may or may not be permanent – there have been tensions in the relationship before – but assuming it is the potash price is likely to be forced down from around $US400 a tonne to below $US300 a tonne – a far cry from the heady days of prices around $US900 a tonne when BHP was bidding, unsuccessfully, for Potash Corp.

There is a lot of spare capacity in the industry after the cartel cut production – Potash Corp alone took out 3.5 million tonnes, or nearly 30 per cent of its capacity – in the face of falling demand in a weak global economy. Demand for potash fell nearly 10 per cent last year.

If the cartel breaks up completely and the industry shifts to market-based pricing, Belaruskali and the Canadians would probably still be solidly profitable but higher-cost producers and prospective new entrants – and BHP’s Jansen project would be the biggest of the new entrants – would come under significant pressure.

BHP’s board was scheduled to consider whether to press ahead, or not, with Jansen – at a cost estimated at around $US13-$US14 billion – this financial year.

Both Andrew McKenzie and his predecessor, Marius Kloppers, however, have described Jansen as an "option" that doesn’t necessarily have to be exercised in the near term. McKenzie has made it clear that BHP will be very conservative in committing to new projects in the next couple of years as it focuses on improving returns but Jansen is seen as a "great option" and the one 'mega project' that BHP might proceed with.

The knowledge that a review of Jansen by the BHP board was looming might also have influenced Uralkali – a big drop in the price generated by a major increase in supply and the breakdown of the cartel might deter the major new entrant, capable of producing about 15 per cent of global demand once fully operational.

It is worth considering, however, both the timelines for Jansen and BHP’s thinking about potash.

If Jansen were to get a go ahead soon, it probably wouldn’t start producing for four or five years and would take up to a decade to reach capacity.

BHP is attracted to the sector because its long-term fundamentals are attractive, with demand rising steadily as the bigger developing economies, particularly in Asia, rise up the wealth and protein curves and the pressure on the availability, and productivity, of arable land intensifies. The trajectory of that demand is also attractive – it follows, but lags, the demand curves for commodities like iron ore and coal.

BHP always intended, whether by acquiring Potash Corp or developing Jansen and the other major potash resources it has in Canada’s Saskatchewan province into the world’s biggest potash producer, to market its output outside the cartel in keeping with its preference for market-clearing prices. It would have recognised the implications that would have for prices.

In effect Uralkali has done that job for it and in the process will, if its stance is maintained, force some rationalisation of the sector that improves the near-term supply demand balance and establishes the price at which the market is in balance.

BHP has several different Jansen options it could exercise.

It doesn’t have to commit to the project fully (it has already spent up to $US2 billion on preliminary works) or abandon it but could delay that decision until the market settles and it has better information base to work with. It could continue on cautiously with the sinking of the main shafts. Or it could freeze the project indefinitely, awaiting a better and more settled environment. There has also been some speculation that it would bring in a joint venture partner to share the risk.

Regardless of what Uralkali has done and what the remaining cartel members might do in response, BHP would only have committed to Jansen if it was confident of the long-term fundamentals for demand (which has been growing at about 3 per cent a year for the past decade but which is expected to accelerate) and was also certain that it could develop Jansen into a low-cost producer.

BHP’s commitment to market-clearing prices, regardless of where prices might be, means Jansen has to be at the lower end of the industry cost curve for it to ever proceed.

Uralkali’s move might give it pause for thought – and perhaps quite a lengthy delay in making a decision as it re-evaluates its assumptions – but, given the long-term nature of the project and BHP’s own convictions, an earlier-than-anticipated move to market-based prices doesn’t ultimately change the fundamental questions the project analysis always had to answer.