How BHP is breaking new ground

Amid the discussion about whether BHP Billiton's $43 billion bid for PotashCorp will succeed and how much it ought to pay, little has been said about why it wants to buy the company in the first place.

One reason is that BHP has an embarrassment of riches and must either buy something big or start returning money to shareholders. And a major acquisition would put BHP way ahead in the management-bragging stakes.

A benefit of this particular acquisition is that it reduces risk. It involves mining, which BHP clearly knows about, but not iron ore, oil or gas. Nor is it located in a dodgy part of the world. BHP describes it as a "large, long-life, low-cost, expandable and export-oriented” project with minimal political risk. And if there is an international trend towards increased minerals taxes in response to the Australian resources rent tax, fertilisers may escape.

But against that is the obvious question, why fertilisers? And why potassium (i.e. potash) fertiliser in particular? Why not phosphate or nitrogen?

BHP answers the first question by pointing to the outlook for world agriculture – increasing demand for food, particularly protein, decreasing arable land per capita, and the obvious and growing need for fertilisers to increase yields. It also points to relatively low potash use per head in countries like China, Russia and India. What the company doesn't mention, but could say, is that there growing demand generated by biofuels.

This same outlook is influencing BHP's rivals in the iron ore market, Vale and Rio Tinto. Brazil's Vale is about to go on a fertiliser buying spree and intends to capture a sizeable share of Brazil's huge and growing market for fertiliser, with potash also top of its agenda. Rio Tinto is contemplating investing in potash production in Russia.

If you wanted to get into the fertiliser market in a big way, buying PotashCorp would certainly achieve that. It is the world's largest supplier of potash and also one of the lowest-cost producers, according to BHP. In addition, it has significant investments in phosphate and nitrogen fertilisers.

BHP began investing in Canadian potash four years ago and now has exploration leases over 14,000 square kilometres. Preparations are underway to bring three areas into production over the next decade. Buying PotashCorp will get BHP into the main game immediately and allow the new mines to come on stream as demand determines, with less competition.

But that still leaves the question of why potash rather than phosphate or nitrogen fertiliser? Some have suggested the phosphate and nitrogen assets may even be spun off in the event that it succeeds in taking over the company.

Of the three fertilisers, phosphate probably represents the greatest speculative opportunity as demand inexorably rises and major US reserves are exhausted. Some believe the world may be heading towards a shortage, in part because China's growing domestic demand is leaving it less to export, although others dispute that. There are actually plenty of phosphate reserves still to develop, but their quality is generally lower than existing sources.

BHP briefly owned a world class phosphate mine and production facility in Australia, which it picked up when it acquired WMC Resources in 2005. The operation was sold to Incitec Pivot.

Nitrogen fertiliser is produced from natural gas, which accounts for 70 per cent of its cost. BHP has gas resources, but converting it into fertiliser is not as appealing as selling it as fuel. Fertiliser production growth is concentrated in countries with abundant supplies, low wages and benign environmental regulations, such as China, other parts of Asia and northern Africa. Given some of the political factors, the price does not always reflect the cost of production either.

Potash is abundant, with sufficient reserves to last 1000 years. That makes it less susceptible to speculative price fluctuations. However, mining potash is a complex process requiring the ground to be frozen a kilometre down to reach the deposit. Because of the cost, no new mines have been developed in the last 40 years although that will change soon due to price increases over the last few years.

The price of potash is also heavily influenced by export cartels. PotashCorp is a member of the North American cartel, Canpotex, which is legally allowed to coordinate prices among North American producers. That tends to dampen price fluctuations compared to phosphate and nitrogen fertilisers.

BHP has indicated it would withdraw PotashCorp from the cartel and operate its mines at full capacity, to minimise production costs and gain share. That may set off a price war, from which it should emerge stronger.

As part of a long term plan to diversify the company's activities without departing from its core expertise in mining, buying Potash Corp makes sense. Demand for fertilisers will undoubtedly increase, and there is no obvious reason why BHP could not extract and sell potash as profitability as any of the other commodities it produces.

Whether it makes sense to pay more than $43 billion for it is another question.

David Leyonhjelm works in the agribusiness and veterinary markets as principal of Baron Strategic Services, which provides consulting and market information services, and Baron Senior Placements, which provides executive recruitment services.