As growing middle classes in developing nations feed the need for fertilizer, how to increase production has become the real issue in agriculture. Major potash producers are lining up to fill that need. The Energy Report spoke with Adrian Day Asset Management Chairman and CEO Adrian Day and Wellington West Capital Markets Analyst Rob Winslow to get their take on the potash sector, and which companies have the sustainable competitive edge.
The Energy Report: Adrian, in our last interview with you, while discussing the sustained commodity boom that you foresee, you said you were talking about the whole shebang from precious and base metals to uranium, oil and gas to geothermal. You also included agriculture, noting that you expect agricultural assets to be among the best-performing assets over the next decade. Would you expand on that thought for us?
Adrian Day: Absolutely. As you may recall, we also talked about how China has been driving the resource market and will continue to drive it for the next decade. Even if China's economic growth slows from 9.5% 5%, the demand for resources will still be very dramatic much higher than now. As China becomes more industrialized, increasingly more people in its massive population will move up into the middle classes.
Middle class people want houses with electricity, running water and indoor plumbing. They want to have cars, as well as bicycles, which takes copper, aluminum, platinum, rubber, oil, etc. And as more Chinese go from eating the chickens and goats they raise in rural China to an urban environment, they lose their taste for goat meat and want beef instead. Cows consume more wheat than do goats. That's just an example. The point is, the basic factors driving all the resources are also driving agriculture.
TER: As Wellington West Capital Markets' agricultural expert, Rob, what underpins this rush toward potash companies, including the failed BHP Billiton Ltd. (NYSE:BHP; OTCPK:BHPLF) bid for PotashCorp (NYSE:POT; TSX:POT), the upcoming transaction between K+S Aktiengesellschaft (Fkft:SDF) and Potash One Inc. (TSX:KCL)?
Robert Winslow: Whether you're looking at fertilizers or farm equipment, really what underpins all the agricultural (ag) cycle is the grain complex. If you were to pull up a chart of the corn, wheat and soybean prices, for example, you'd see that grain prices bottomed out in early June, down to around the cost of production in the U.S. Corn Belt. They started rallying from there, spurred a little by dollar weakness but also by the supply/demand situation globally. We're in the neighborhood of 50% 55% above those June lows.
TER: Has the hike been more a function of growing demand or supply shortages?
RW: We had some supply shocks, particularly on the wheat side. In western Canada, it was very wet; in Russia, it was very hot and dry. As a result, two of the world's three-largest wheat exporters saw their production cut by about 20%. That showed us how tight the stocks-to-use ratio became globally, which is the metric we use it measures supply/demand for any given commodity.
TER: Could you elaborate on what that stocks-to-use measurement tells us?
RW: It tells us supply/demand levels are down to those last seen in 2007 and early 2008 when the grain complex rallied, as well. The bottom line is we get to a situation where we have insufficient inventory to protect us from supply shocks. That will drive up grain prices. As grain prices go, farm income goes. As farm income goes, so go expenditures on seed, fertilizer, chemicals, tractors, short-line equipment, you name it. The entire complex rides on the back of those grain prices.
TER: That would bode well for a company you told us about the last time we talked, Adrian. You described it as one of your favorites in the general resource area.
AD: Yes, Sprott Resource Corp. (TSX:SCP). If you buy Sprott, which is quite a liquid company, you get it at a discount to NAV. Net asset is about $5.20. The stock's been trading at about $4.65. You also get great management Kevin Bambrough and company and a great balance sheet. As you know, Sprott has direct and indirect investments in different resource areas buying whole companies, sponsoring companies or growing them. When the companies reach a certain level, ideally it'll spin off a certain amount of the shareholding into a public company.
TER: You said it's currently in gold, oil and gas, agriculture and fertilizer. Tell us about the last two on that list.
AD: The agriculture play is very interesting, a joint venture (JV) with First Nations One Earth Farms Corp. First Nations owns more than a million acres of farmland. It'll be a big business, one of the largest commercial farms in North America really quite staggering. It's still a private company, but it's selling some shares in a secondary offering, raising $40M $80M. If it brings in the maximum, it will take Sprott's stake down to 24%. In a year or two, it'll IPO. That's what it's trying to do take a direct investment, build up the company and IPO it.
TER: News has been coming in pretty fast and furious on the potash front; and, Rob, you recently raised your targets on several potash juniors. Without discounting the demand factor, what can you tell us about the rationale behind that decision?
RW: The impetus for that was the bid by K+S for Potash One. On the back of that, we also raised the targets on Allana Potash (TSX.V:AAA), Intercontinental Potash Corp. (TSX.V:ICP) and Western Potash Corp. (TSX.V:WPX), as there's a scarcity factor that needed to be embedded in the valuations of those companies. We're seeing consolidation in the space, with the big players coming and buying up the juniors. When that happens, obviously, the value of those left standing presuming they're still quality assets tend to go up.
TER: How did your targets on these three companies change?
RW: We raised Allana's target $0.15 to $1.15 (and have since raised it again to $1.20) and we rate it as a strong buy. Intercontinental is $1.50/share and Western Potash is $1.05. Among the three, I have a more favorable view on Allana and Intercontinental than on Western Potash because the former two are advantaged juniors.
TER: What do you mean by "advantaged" juniors?
RW: They have some edge, a sustainable competitive advantage that makes them stand out from the crowd. For example, Allana's potash concessions are in Ethiopia's Danakil Depression.
TER: What makes that special?
RW: The potash deposit there may be as shallow as 150 meters or so, which suggests the possibility of an open-pit operation. That would cost less than sinking a shaft in Saskatchewan, where the company would likely have to go down to a depth of 1 km. That's more than $1 billion just to get the shaft down. Parts of the Danakil Depression potash deposit appear to be 600 700 meters, so solution mining would be possible there also.
TER: Some of our readers may know, Saskatchewan supplies one-third of the world's potash demand. But, apparently, Ethiopia has one of the world's largest potash deposits up to 150 million tons (Mt.) concentrated in the Dallol area.
RW: That area, in the Danakil Depression, has enormous potash potential. Water has been running down from the surrounding mountains for millennia, carrying minerals to this low-lying basin. Over time with heat and evaporation, it has produced this giant dish of salt. When you go far enough down into the layers, you reach salt containing a tremendous amount of potassium that's the potash. I've never seen anything quite like it; it's remarkably hot and salty.
The Danakil Depression is among the hottest places on earth. I was there not long ago, and it was 114 F in the shade. The idea with solution mining is to inject a heated solution (or water) down into the salt bed, dissolve the salt, bring it up to surface, and then use wind or solar to evaporate it. At the surface, you can heat up your water quickly with solar panels. Considering all of that, operating costs are potentially materially lower than in a solution mine or any other kind of mine in Saskatchewan.
TER: That would clearly be a competitive advantage. Compared to conventional mining, solution mining means not only lower capex requirements but also operation scalability and a quicker timeline to production not to mention less technical risk and environmental impact.
RW: There's even more to the Allana story. It's quite a bit closer to one of the largest importing nations in the world. Depending on the year, India ranks as the second- or third-largest potash importer in the world. If Allana gets this mine built and the proper infrastructure in Ethiopia to get it over to the coast, transport alone could be $20 or even up to $40 cheaper per ton.
So, once the infrastructure is in place, the cost of those logistics on a run-rate basis would be significantly lower than they would be in western Canada. That's another reason we like Allana. It's also lower on a price-to-NAV valuation on our comp table.
The Energy Report: Adrian, in our last interview with you, while discussing the sustained commodity boom that you foresee, you said you were talking about the whole shebang from precious and base metals to uranium, oil and gas to geothermal. You also included agriculture, noting that you expect agricultural assets to be among the best-performing assets over the next decade. Would you expand on that thought for us?
Adrian Day: Absolutely. As you may recall, we also talked about how China has been driving the resource market and will continue to drive it for the next decade. Even if China's economic growth slows from 9.5% 5%, the demand for resources will still be very dramatic much higher than now. As China becomes more industrialized, increasingly more people in its massive population will move up into the middle classes.
Middle class people want houses with electricity, running water and indoor plumbing. They want to have cars, as well as bicycles, which takes copper, aluminum, platinum, rubber, oil, etc. And as more Chinese go from eating the chickens and goats they raise in rural China to an urban environment, they lose their taste for goat meat and want beef instead. Cows consume more wheat than do goats. That's just an example. The point is, the basic factors driving all the resources are also driving agriculture.
TER: As Wellington West Capital Markets' agricultural expert, Rob, what underpins this rush toward potash companies, including the failed BHP Billiton Ltd. (NYSE:BHP; OTCPK:BHPLF) bid for PotashCorp (NYSE:POT; TSX:POT), the upcoming transaction between K+S Aktiengesellschaft (Fkft:SDF) and Potash One Inc. (TSX:KCL)?
Robert Winslow: Whether you're looking at fertilizers or farm equipment, really what underpins all the agricultural (ag) cycle is the grain complex. If you were to pull up a chart of the corn, wheat and soybean prices, for example, you'd see that grain prices bottomed out in early June, down to around the cost of production in the U.S. Corn Belt. They started rallying from there, spurred a little by dollar weakness but also by the supply/demand situation globally. We're in the neighborhood of 50% 55% above those June lows.
TER: Has the hike been more a function of growing demand or supply shortages?
RW: We had some supply shocks, particularly on the wheat side. In western Canada, it was very wet; in Russia, it was very hot and dry. As a result, two of the world's three-largest wheat exporters saw their production cut by about 20%. That showed us how tight the stocks-to-use ratio became globally, which is the metric we use it measures supply/demand for any given commodity.
TER: Could you elaborate on what that stocks-to-use measurement tells us?
RW: It tells us supply/demand levels are down to those last seen in 2007 and early 2008 when the grain complex rallied, as well. The bottom line is we get to a situation where we have insufficient inventory to protect us from supply shocks. That will drive up grain prices. As grain prices go, farm income goes. As farm income goes, so go expenditures on seed, fertilizer, chemicals, tractors, short-line equipment, you name it. The entire complex rides on the back of those grain prices.
TER: That would bode well for a company you told us about the last time we talked, Adrian. You described it as one of your favorites in the general resource area.
AD: Yes, Sprott Resource Corp. (TSX:SCP). If you buy Sprott, which is quite a liquid company, you get it at a discount to NAV. Net asset is about $5.20. The stock's been trading at about $4.65. You also get great management Kevin Bambrough and company and a great balance sheet. As you know, Sprott has direct and indirect investments in different resource areas buying whole companies, sponsoring companies or growing them. When the companies reach a certain level, ideally it'll spin off a certain amount of the shareholding into a public company.
TER: You said it's currently in gold, oil and gas, agriculture and fertilizer. Tell us about the last two on that list.
AD: The agriculture play is very interesting, a joint venture (JV) with First Nations One Earth Farms Corp. First Nations owns more than a million acres of farmland. It'll be a big business, one of the largest commercial farms in North America really quite staggering. It's still a private company, but it's selling some shares in a secondary offering, raising $40M $80M. If it brings in the maximum, it will take Sprott's stake down to 24%. In a year or two, it'll IPO. That's what it's trying to do take a direct investment, build up the company and IPO it.
TER: News has been coming in pretty fast and furious on the potash front; and, Rob, you recently raised your targets on several potash juniors. Without discounting the demand factor, what can you tell us about the rationale behind that decision?
RW: The impetus for that was the bid by K+S for Potash One. On the back of that, we also raised the targets on Allana Potash (TSX.V:AAA), Intercontinental Potash Corp. (TSX.V:ICP) and Western Potash Corp. (TSX.V:WPX), as there's a scarcity factor that needed to be embedded in the valuations of those companies. We're seeing consolidation in the space, with the big players coming and buying up the juniors. When that happens, obviously, the value of those left standing presuming they're still quality assets tend to go up.
TER: How did your targets on these three companies change?
RW: We raised Allana's target $0.15 to $1.15 (and have since raised it again to $1.20) and we rate it as a strong buy. Intercontinental is $1.50/share and Western Potash is $1.05. Among the three, I have a more favorable view on Allana and Intercontinental than on Western Potash because the former two are advantaged juniors.
TER: What do you mean by "advantaged" juniors?
RW: They have some edge, a sustainable competitive advantage that makes them stand out from the crowd. For example, Allana's potash concessions are in Ethiopia's Danakil Depression.
TER: What makes that special?
RW: The potash deposit there may be as shallow as 150 meters or so, which suggests the possibility of an open-pit operation. That would cost less than sinking a shaft in Saskatchewan, where the company would likely have to go down to a depth of 1 km. That's more than $1 billion just to get the shaft down. Parts of the Danakil Depression potash deposit appear to be 600 700 meters, so solution mining would be possible there also.
TER: Some of our readers may know, Saskatchewan supplies one-third of the world's potash demand. But, apparently, Ethiopia has one of the world's largest potash deposits up to 150 million tons (Mt.) concentrated in the Dallol area.
RW: That area, in the Danakil Depression, has enormous potash potential. Water has been running down from the surrounding mountains for millennia, carrying minerals to this low-lying basin. Over time with heat and evaporation, it has produced this giant dish of salt. When you go far enough down into the layers, you reach salt containing a tremendous amount of potassium that's the potash. I've never seen anything quite like it; it's remarkably hot and salty.
The Danakil Depression is among the hottest places on earth. I was there not long ago, and it was 114 F in the shade. The idea with solution mining is to inject a heated solution (or water) down into the salt bed, dissolve the salt, bring it up to surface, and then use wind or solar to evaporate it. At the surface, you can heat up your water quickly with solar panels. Considering all of that, operating costs are potentially materially lower than in a solution mine or any other kind of mine in Saskatchewan.
TER: That would clearly be a competitive advantage. Compared to conventional mining, solution mining means not only lower capex requirements but also operation scalability and a quicker timeline to production not to mention less technical risk and environmental impact.
RW: There's even more to the Allana story. It's quite a bit closer to one of the largest importing nations in the world. Depending on the year, India ranks as the second- or third-largest potash importer in the world. If Allana gets this mine built and the proper infrastructure in Ethiopia to get it over to the coast, transport alone could be $20 or even up to $40 cheaper per ton.
So, once the infrastructure is in place, the cost of those logistics on a run-rate basis would be significantly lower than they would be in western Canada. That's another reason we like Allana. It's also lower on a price-to-NAV valuation on our comp table.
