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Why Agrium Inc. suspending capacity addition will affect other producers (Part 1)

The importance of capacity utilization

Capacity utilization measures how much of an industry’s or company’s available production output is being used. It’s based on dividing actual output by potential output. Because an industry or firm will often try to match production to demand, a rising capacity utilization rate means faster growth in demand relative to available output. This will often push the selling price of the produced goods (such as nitrogenous fertilizers) higher because good times often lead to less competition among firms in the industry.

Agrium, Inc. (AGU) suspending capacity addition

On June 3, Agrium Inc. (AGU), the third largest manufacturer of nitrogenous fertilizers, suspended its engineering work on a proposed $3 million plant in the U.S. Midwest because several competitors or peers were also planning to add capacity. If added capacity surpasses expected demand growth, it can pressure prices. Instead, AGU will focus on finding a partner to share the capital cost and securing long-term natural gas contract for the project, which is positive for nitrogenous fertilizer price in the future.

Henry Hub Natural Gas Spot Price 2013-07-12Enlarge Graph

Natural gas boom in the United States encouraging capacity addition

Several competitors are planning to add capacity in the United States, as an increased amount of natural gas supply (driven by a boom in horizontal drilling and hydraulic fracturing) has made prices for natural gas cheaper. The Henry Hub natural gas spot price, the benchmark of natural gas prices in the United States, for example, has historically averaged $6 per MMBtu (million British thermal units). It has since fallen to an average of $4 per MMBtu. This is significant because natural gas cost makes up the largest component of nitrogenous fertilizer’s costs.

North America Natural Gas Price and Fertilizer Margins 2013-07-12Enlarge Graph

Fertilizer producers are chasing profits

As a result, nitrogenous fertilizer companies’ margins and profitability ballooned. While fertilizer manufacturers were only generating below $150 in profit for each metric tonne of nitrogenous fertilizers produced in the United States prior to 2008, profits have since increased up to $300, which has benefited nitrogenous fertilizer producers such as Agrium, Inc. (AGU), CF Industries Holdings, Inc. (CF), Terra Nitrogen Company, LP (TNH), and Potash Corp. (POT), as well the Market Vectors Agribusiness ETF (MOO).

Learn more about the nitrogenous fertilizer industry

As profits grow, several companies are looking to add capacity. Continue to Why Agrium Inc. suspending capacity addition will affect other producers (Part 2).