Natural gas and nitrogenous fertilizers
Natural gas is a major raw material input in the production of nitrogenous fertilizers, such as urea and ammonia, ranging from 40% to 70% of cost of goods sold. A higher natural gas price increases the cost of goods sold and compresses margins. This in turn lowers earnings and free cash flows for firms such as Agrium Inc. (AGU), Terra Nitrogen Company LP (TNH), CF Industries Holdings Inc. (CF), and Potash Corp. (POT).
Natural gas price declines due to seasonality
On August 28, the Henry Hub Natural Gas Spot Price, a benchmark for natural gas traded in the United States, stood at $3.54 per MMBtu (millions of British thermal units). Despite warmer temperatures lately, natural gas price has fallen from a recent peak of ~$4.30 per MMBtu in April, as the longer-than-usual cold weather came to an end and a cooler-than-normal summer kept electricity and natural gas demand low.
Inverse relationship between natural gas price and producer margin
Lower natural gas prices are positive for nitrogenous fertilizer producers that have operations in the United States. While the cost of North American producers is falling, wholesale ammonia and urea prices are more dictated by more expensive fertilizer producers in China and Eastern Europe. So falling natural gas prices in the United States have driven margins higher over the past three years, making investors wealthy.
Forward-looking effect of natural gas prices
Because of an energy boom in the United States, natural gas price has a good probability of staying low. Low coal prices, which is an alternative source of energy in the United States also support such a case. Unfortunately, current natural gas prices have already been priced into shares of nitrogenous fertilizer producers such as CF Industries Inc. (CF), Terra Nitrogen Company LP (TNH), Agrium Inc. (AGU), and Potash Corp. (POT), as well as the Market Vectors Agribusiness ETF (MOO), as margins had expanded. So it’s we’re unlikely to see earnings growth through lower natural gas prices.
In fact, profitability could be at the corner of shrinking. See Why Chinese producers affect world nitrogenous fertilizer supply. On a positive note, companies continue to take advantage of low natural gas prices in the United States. That could support earnings growth—and so share prices as well. See Why Agrium Inc. suspending capacity addition will affect other producers (Part 1) for information on which producer is increasing capacity the most.
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