Natural gas: A major cost input
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 the 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).
On the rise
Since hitting a low of ~$2.00 per MMbtu (million British thermal units) in 2012 due to warmer winter, natural gas prices have recovered, driven by increased use of the natural resource for electricity. On November 27, natural gas prices averaged $3.91 per MMbtu, based on information from the New York Mercantile Exchange.
Prices for natural gas have risen lately on the back of colder weather, which drives up heater use, and lower-than-estimated inventory levels. Lower inventory reflects less-than-anticipated supply or more-than-estimated demand.
Impact on profits and earnings
Lower natural gas prices are positive for nitrogenous fertilizer producers that have operations in the United States. While the cost of North American producers have fallen since 2008, fertilizer prices depend more on the more expensive producers in China and Eastern Europe. Falling natural gas prices in the United States have contributed to the significant outperformance of companies like CF, TNH, and AGU over the past few years.
Low natural gas price expected
As long as natural gas price stays low, fertilizer stocks and ETFs like CF, TNH, AGU, POT, and the VanEck Vectors Agribusiness ETF (MOO) are at an advantage. Since these companies do hedge, it’s preferable to look at medium-to-long-term price movements in natural gas rather than short-term movements. Given the continuation of the U.S. natural gas boom, most industry experts expect natural gas prices to stay low over the medium to long term, which is positive.