Should This Miner Move Forward With Its Potash Project?

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In August, mining giant BHP Billiton (ADR) (NYSE: BHP) is expected to make a decision on whether to move forward with its potash project in Saskatchewan, Canada. While the company has already pumped in billions of dollars into the project, the breakup of one of the two cartels in the potash market on July 30 has raised the possibility of a drop in potash prices. Given this scenario, the big question is whether BHP should continue with the project.

BHP Billiton’s “fifth pillar”

A slowdown in China, a major consumer of raw materials, has put pressure on prices of commodities over the past year, forcing major mining companies to sell non-core assets and avoid investments in big mining projects. BHP Billiton has been no different. Last year, the company announced that it will delay its planned $20 billion Olympic Dam project. BHP had also said last year that it will not approve any major projects in the year to June 2013. But with the end of the moratorium period, investors have been speculating whether the company will move forward with its Jansen potash project in Canada.

Apart from these steps, BHP has been also looking to enter the potash market in order to diversify its operations. With potash, the company is looking to capitalize on rising food demand. In 2010, BHP announced a hostile $40 billion bid for PotashCorp (NYSE: POT). BHP, however, eventually backed out after Canada’s national and provincial governments blocked the takeover attempts, citing national interests.

But BHP did not shelve its plans to enter the potash market. The company had a strong reason to pursue the potash business. Rising income levels in countries such as China and India boosted global food demand by the mid-2000s. This in turn led to an increased demand for fertilizers as farmers looked to improve crop yields. As a result, prices for potash, an essential commodity in the production of agricultural fertilizer, surged to $825 a ton by 2009. Although prices have since then fallen by more than half to around $400 a ton, the fundamentals for the potash market remain strong.

Potash has been described as a “fifth pillar” for BHP Billiton, with the other four being petroleum, copper, iron ore and steel-making. However, the company may have to rethink whether it is feasible to move forward with building the “fifth pillar” following a major development in the potash market on Tuesday.

Breakup of the Belarusian potash cartel

On Tuesday, Russia-based Uralkali pulled out of the Belarus Potash Company (BPC) export cartel, citing violation of an agreement from its Belarusian partner. BPC was one of the two cartels operating in the potash market, with the other one being North America’s Canpotex. The North American cartel includes Potash Corp., Mosaic (NYSE: MOS), and Agrium.

Between them, BPC and Canpotex control 70% of the global potash market and hence had been able to maintain potash prices at profitable levels. However, with the breakup of the Russian cartel, the virtual duopoly in the potash market has ended.

The dismantling of the world’s largest potash cartel is likely to have a significant impact on potash prices. Uralkali’s CEO Vladislav Baumgertner expects global competition become stronger in the near future, which will push prices down. The company expects global potash prices to fall below $300 per ton in the second half of this year.

Not surprisingly, shares of North American potash producers have tumbled. At last check on Tuesday, Mosaic shares were down nearly 18%, while Potash shares were down nearly 20%. The development comes just a few days after Potash had reported that its average realized potash price fell from $433 per ton in the second quarter of 2012 to $356 per ton in the second quarter of 2013. The company had cited competitive pressures, which moved contract and spot market pricing lower, as the reason for lower realized prices.

Mosaic recently reported fourth-quarter fiscal 2013 results the company’s average potash selling price fell from $455 per ton to $368 per ton. With the latest development in the potash market, the outlook for North American potash producers has turned gloomy, even though demand for potash is expected to remain robust.

Should BHP Billiton move forward with its Jansen project?

BHP Billiton has already spent over $2 billion on preliminary development work at Jansen. Goldman Sachs said last month that it expects the company to invest another $500 million of pre-approval development capital into Jansen ahead of a final decision on the project in 2015 and 2016. But the potash market has just turned upside down.

With potash prices expected to fall sharply following the breakup of the BPC cartel, it might not be feasible for BHP Billiton to pursue the project. If as Uralkali’s CEO predicted, potash prices do fall to below $300 a ton, that would significantly reduce margins for potash producers. According to Goldman Sachs, the average expenses for potash producers are about $240 a ton currently.

Given that BHP’s Jansen is a greenfield project, one can expect the company’s cost when the initial production begins to be on the higher side. If prices remain below $300 a ton then the project would not be feasible for BHP Billiton in my opinion even though potash demand is expected to remain strong.

I expect BHP Billiton to put the Jansen project on hold until there is a clear indication that potash prices will remain at around $400 per ton. However, without the “fifth pillar” BHP is not an attractive investment, given the weak demand for industrial metals and minerals. I would therefore remain on the sidelines with BHP Billiton for now.

Varun Chandan Arora has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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