Why I am negative about nitrogenous fertilizers (Part 6 of 11)
The operating rate in China is below average
Historically, the expense of using coal to produce nitrogen-based fertilizers has kept Chinese firms away from increasing production, because they would have had to sell the fertilizers at a loss. As a result, the operating rate (capacity utilization) in China has been lower than the rest of the world. While the industry’s overall utilization rate holds at 80%, the rate rises to 85% excluding China.
China replacing Eastern European producers
This trend has made Eastern European producers the marginal producers (the most expensive producers that customers are willing to purchase from) during China’s high export tax season. In Europe, natural gas contracts (which are usually long-term) are often pegged to oil price. The history of this practice dates back to the 19th century, when natural gas was first uncovered as an accident when oil producers were drilling for oil.
Back then, there wasn’t a natural gas market, so European importers agreed to peg natural gas and oil together. This naturally made sense because natural gas is often a by-product of oil production, and it was used for heating, power generation, and industrial application. The only difference was that a significant chunk of oil is being used in transportation. While some countries (like Norway) have moved to de-link natural gas prices from oil, the large Russian producer Gazprom hasn’t because it needs to fund expensive exploration and production projects. With several Eastern European countries’ natural gas supplied by Russia, movements in Brent oil (the international benchmark) nonetheless have led wholesale ammonia prices in the past.
The operating rate has increased since last year
But the relative cheapness of coal has made Chinese producers much more competitive in the global market. Historically only fluctuating around a 75% to 80% operating rate, lower than the world’s rate, Chinese manufacturers have been increasing output since the beginning of this year, with their operating rate hitting as high a 90% in April, with an average operating rate of ~77.5%. Although the utilization rate fell recently, the decrease was driven by new capacity additions more than cutbacks in production. This can become problematic if this new capacity starts pumping out urea and further floods the market with new supply. As CF Industries Holdings Inc. (CF) explained it its earnings presentation (see the first chart on this page), the world utilization rate is expected to decline over the next few years—primarily because of new capacity additions in China.
Urea output remains high
As the above chart shows, urea output has risen from 2.5 million metric tonnes 3.0 million metric tonnes a month, representing an increase of 20% in output. Monthly output has since zig-zagged between 2.75 and 3.0 million metric tonnes. According to the National Bureau of Statistics of China, China produced 2.8 million metric tonnes of urea in August. As long as coal prices remain low, urea output will remain elevated—and could even rise higher. Such an increase would mean higher supply and competition, which would drive urea prices down. That’s exactly what we’ve been seeing, starting with China.
Browse this series on Market Realist:
- Part 1 - Crop condition falls, but expect limited downside as summer ends
- Part 2 - Why farmers could demand fewer fertilizers next year
- Part 3 - Retail urea falls sharply, maintaining a negative outlook
- Commodity Markets
- natural gas