Continued from Part 1
Natural gas price will have support
But as natural gas prices are near historically low levels, guided by the energy boom over the past five years, energy companies have switched away from natural gas to the more profitable oil drilling. The number of rotatory rigs (which are used to explore resources and build wells for extracting natural gas, and which often foreshadow future supply) has fallen from the highs of ~900 to 362 as of July 12. This means production increase is unlikely to account for why natural gas prices fall in the short to medium term, which will support natural gas price.
Natural gas price has moved inversely to profitability
For nitrogenous fertilizer producers, this development would be negative. Since natural gas prices inversely affect margins (higher natural gas prices will lead to lower margins for producer in the United States and vice versa), higher natural gas prices will result in lower margins and earnings. But as low coal prices and the possibility of higher future production (due to higher natural gas prices) will keep natural gas prices low over the next few years, nitrogenous fertilizer producers should continue to enjoy favorable cost inputs going forward.
Growth to come from capacity expansion, not natural gas
Unfortunately, the market has likely priced in margin expansions due to lower natural gas prices. Several companies—such as CF Industries Holdings Inc. (CF), Potash Corp. (POT), Terra Nitrogen Company LP (TNH), and Agrium Inc. (AGU)—have all benefited greatly from the trend over the past five years, with margins hitting a record in 2012 and share price returns exceeding those of the overall U.S. market. But because natural gas price will likely remain near $4 per MMBtu (millions of British thermal units) in the long run, much of future share price appreciation will have to come from production volume growth. In the short to medium term, natural gas prices may fluctuate slightly higher due to increased electricity use, which is negative for the fertilizer companies, but much uncertainty remains because of coal prices and China. This will also affect the Market Vectors Agribusiness ETF (MOO).
Learn more about other drivers that affect nitrogenous fertilizer producers
But many firms in the United States are rushing to expand production. Will this hurt future profitability? Continue to Why Agrium Inc. suspending capacity addition will affect other producers (Part 1) to find out.
Other investors have also read a more current driver. Learn more in Why Chinese producers are driving nitrogenous fertilizer prices down (Part 1).
© 2013 Market Realist, Inc.