What’s next for potash?

In the wake of BHP Billiton’s (BHP-N, BLT-L) US$39-billion failed bid for Potash Corp. of Saskatchewan (POT-T, POT-N) and K+S Aktiengesellschaft’s $434-million friendly offer for Potash One (KCL-T), investors have pushed up share prices of potash juniors, betting that the M&A activity in the sector is far from over.

The short-term fundamentals of the space are indisputably positive, with demand in the developing world growing steadily (at an average of about 3% a year for the past 15 years), mirroring rising living standards and populations.

But with huge players like Potash Corp. dominating the market — and planning to ramp up production over the next five years — where do juniors fit into the picture?

“Where they fit in is there hasn’t been a greenfield potash mine built on planet Earth in over thirty years,” says Jaret Anderson, an analyst at Salman Partners. “Because potash prices have risen dramatically over the last number of years as food prices have moved higher, you’ve got a financial incentive for people to consider greenfield projects now that didn’t exist five or ten years ago.”

Potash prices fell off a cliff last year as the credit crunch and global recession took their toll and farmers around the world cut way back on fertilizer applications. However, prices have since rebounded, says Patricia Mohr, vice-president, economics, at Scotiabank.

“What’s happened this year is demand for potash has moved back up to normal levels and demand has actually surged in recent months for potash around the world — not only in the U.S. but in some of the emerging markets,” she says. “I think next year will be a year of very strong fertilizer application generally and very strong potash application.”

Russia’s ban on wheat and barley exports, which followed a terrible drought this spring and summer, has helped feed demand, Mohr says. The export ban won’t likely end until late 2011, putting pressure on farmers in the rest of the world to increase grain production. Add to that demand from the U.S., which grows a lot of fertilizer-hungry corn, and it’s no wonder the sector has been the subject of renewed attention.

While there is still some under-utilized capacity at existing potash mines, Mohr does see some room in the market for production coming online from greenfield developments in the second half of the decade.

Even then, however, the odds are stacked against most potash juniors. The steep price of developing a greenfield potash mine — currently around $2.5-$3 billion capex even for a solution-mining project (a cheaper option than a conventional potash mine) — is well beyond the means of any junior.

That’s why the exit strategy thus far has been for juniors to sell out to larger, more experienced companies with the financial wherewithal to cope with steep capex costs. But that isn’t the only option, says Salman Partners’ Anderson.

“I think a lot of these other companies are considering whether that’s the way to go or whether they want to try to advance the project and build it completely on their own,” Anderson says. “It hasn’t been done yet, and it does require a great deal of capital. . . But there may be more upside by going that route, especially if you’re bullish on potash prices, although it does involve more risk.”

The dominance of the market by a few large players, and the fact that potash projects are generally large and long-lived, further tilts the balance away from your average junior.

With the big producers bringing more production online, BHP possibly opening its Jansen potash mine in Saskatchewan as early as 2015 and K+S now likely to bring Potash One’s Legacy (also in Saskatchewan) online as well, oversupply could become an issue in the industry in the longer term.

“These projects take a significant amount of time to develop, so I think for the next two, three years, there’s very little risk of oversupply in the potash market,” Anderson says. “It you start looking out five and ten years, it becomes a lot less clear.

“If prices are high, the industry will attract capital, which is what you’re seeing right now. Historically, in all industries, that’s led to oversupply. This is a unique industry in that you’ve got a large player in Potash Corp. that’s done a very good job of balancing supply and demand for the industry, but over five or ten years, things can change a great deal.”

Joel Jackson, an analyst with BMO Capital Markets, points out that when the Saskatchewan potash mines were built in the late 1960s and early 1970s, there was initially a lot of oversupply in the market.

“It took a long time for the industry to recover from that oversupply — partly they were able to use some supply management techniques in order to create the types of returns we’ve seen recently from the global potash producers,” Jackson says, referring to Canpotex, the marketing agency that represents Potash Corp., Mosaic Co. (MOS-N) and Agrium (AGU-T, AGU-N) overseas.

If demand grows at 3.5-4% globally for potash, the market will be able to absorb some new greenfield mines, he says. However, there’s a fine line between meeting burgeoning demand and tipping the market into oversupply.

“The operating rates are quite sensitive to demand, so with demand (growing at) 4%, the industry can absorb some greenfield for sure, but demand of 2.5% or 3% per year, you could have a significant oversupply situation,” Jackson says. “And if you’ve got several greenfields coming on, you could have more issues.”

It all leaves Jackson skeptical of investors’ expectations of more consolidation in the sector.

“I wouldn’t hold my breath,” Jackson says. “A lot of investors think there’s only a handful of potash developments out there because there’s only a handful of developers listed on Canadian stock exchanges, but in reality there’s over fifty potash projects in the world.”