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Why fertilizer companies’ exposure to natural gas prices varies

Xun Yao Chen

An investor's guide to nitrogen fertilizer companies in 2014 (Part 8 of 8)

(Continued from Part 7)

Input: Natural gas

As natural gas makes up 40% to 80% of fertilizer companies’ cost of goods sold (and much higher on a cash cost basis), for nitrogen fertilizer producers such as CF Industries Holdings Inc. (CF), Potash Corp. (POT), Terra Nitrogen Company LP (TNH), and Agrium Inc. (AGU), natural gas prices have important implications for earnings.

CVR Partners (UAN), which uses pet coke primarily supplied from an affiliated entity to produce fertilizers, is unaffected. So when natural gas prices rise, CVR Partners outperforms, perhaps driving CVR Partners’ recent outperformance compared to Terra Nitrogen Company LP (TNH). But when natural gas prices fall, CVR Partners will perform well.

Hedging activities

It’s important to note that these companies engage in hedging activities. For example, CF Industries recently said it has hedged ~75% of its first-quarter NYMEX (a commodity future exchange) natural gas exposure and 50% of the second quarter’s exposure at prices well below $4 per MMBtu.

Companies forfeit the opportunity to benefit from lower natural gas prices when they hedge. For example, realized natural gas costs were higher than Henry Hub’s average daily natural gas price during the first two quarters of 2012. (Henry Hub is a widely used benchmark price for natural gas prices in the United States.)

But hedging activity protects companies’ earnings when natural gas prices rise. While short-term volatility doesn’t affect these companies’ earnings as much, long-term changes would.

Potash Corp.’s Trinidad assets

Note that Potash Corp.’s (POT) natural gas costs have historically been much higher than CF or TNH’s, because POT’s primary plant is located in Trinidad, and it pays a fee indexed to ammonia prices. So although Potash Corp’s margin isn’t as high as its peers that enjoy lower-cost natural gas prices in North America, Potash Corp.’s nitrogen fertilizer profits are somewhat protected when fertilizer prices fall. But when ammonia prices rise, Potash Corp. benefits to a lesser extent. Potash Corp.’s realized natural gas prices should fall in the future as it completes its expansion plant at Lima, Ohio, by the end of 2015.

Note: We’ve excluded Agrium Inc. (AGU) from the chart above since some data didn’t match, but as a producer that primarily uses natural gas in North America, it follows a similar trend as CF and TNH.

To learn more about investing in the fertilizer industry, see the Market Realist series Why did Intrepid Potash stock sink 9% after its earnings release?

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