Weathering a fertilizer storm

The global nitrogen market faced a great deal of uncertainty in 2015. Over-capacity put pressure on pricing and the supply-driven phase kick-started by the ramp up of new capacity since 2012 continued. Urea prices were under severe stress and, while ammonia and nitrates markets fared somewhat better, they were still caught up in the cyclical weakness of the nitrogen market.

A large part of the decline in nitrogen prices was attributable to energy markets. The price of gas in Europe and coal in China – key metrics influencing the production economics of swing nitrogen production clusters – fell to their lowest levels in almost 10 years in 2015, flattening the global nitrogen cost curve and shifting the nitrogen industry floor price down.

During periods of market weakness, much like cyclical downturns in other commodity markets, nitrogen producers have to find ways of improving their financial standing, often through internal improvements. However, the weakness also tends to stimulate industry mergers and acquisitions. Following plenty of speculation and mutterings of consolidation by various nitrogen producers in a number of locations, the standout M&A development in 2015 was the announcement of a proposed merger between CF Industries and OCI; however, the deal was abandoned in May 2016. Nevertheless, Integer expects to see continued interest in industry consolidation as nitrogen producers seek out the increased market share and efficiency gains that come with mergers and acquisitions.

Weaker energy prices mean a much flatter industry cost curve and one should be careful not to read too much into the prevailing nitrogen market price weakness. It also needs to be recognised that what is being looked at today is a cyclical price downturn in energy and nitrogen commodity markets, which naturally follows the cyclical upturn of the mid-2000s. Commodity clichés such as ‘the cure for high prices is high prices’ are as relevant now as they were in many previous cycles.

The cause of the recent drop in nitrogen prices is obviously abundant supply, but the ability of Chinese producers to offer volumes at lower prices is a logical consequence of what has happened to exchange rates. The Chinese government’s decision to devalue the Renminbi against the US dollar was intended to boost the competitiveness of Chinese exporters against a backdrop of static domestic demand and a weakened economy. So it is no surprise to see increased nitrogen export competitiveness and increased volume offered at lower prices.

A flatter industry cost curve has other implications for producer profitability, which will be important to keep an eye on looking forward. When energy prices were at recent cyclical peaks and the industry had little spare capacity, everyone made money – including the high cost producers – but profits for producers with low and fixed energy costs reached record levels. Those producers tend to be export-orientated located close to pockets of stranded energy and in that climate investment in additional capacity looked attractive.

With a lot of spare capacity today, and continuing downward pressure on nitrogen prices, overall profits decrease. What is also interesting though is that with weaker energy prices, the profitability gap between high-cost and low-cost producers is much smaller. This tends to provide a significant disincentive to build new capacity. So in the next few years, Integer would expect to see interest in building greenfield plants diminishing. By the end of 2016, the picture is one that is likely to reveal capacity growing more slowly than demand, implying that utilisation rates will creep up. This, in turn, promises higher prices and profits and perhaps signs of movement toward the next cyclical upturn.

The safe bet in a fertilizer storm: nitrogen demand remains recession-proof, but not enough to offset oversupply burden

The global nitrogen market hosts a wide range of under and overindulgent practices, that is, countries that do not apply enough nitrogen fertilizer to produce optimum yields and those that apply too much, leading to nutrient losses and environmental impacts. China is the most striking example of the issues that can arise when nitrogen is subsidised as a means of enabling food self-sufficiency. Chinese nitrogen fertilizer application has now grown to such an extent that the government recently announced a policy to limit growth to 1%/yr between 2015 and 2020 in a bid to prevent further environmental damage from nitrogen pollution.

Generally speaking, nitrogen is the most ‘recession-proof’ of the fertilizer products; it forms the building blocks of plant growth and is an essential requirement to produce crop yield. Even in periods of low crop prices and economic uncertainty, nitrogen application remains a crucial investment for farmers to secure yields. This is in contrast with the other macronutrients, such as phosphates and potash, where there is often decreased application in years when agricultural budgets may be tighter, as farmers choose to skip a year in favour of securing a margin on their crop production. There is often a misconception that low crop prices lead to low nitrogen prices but it is important to stress that this is correlation and not causation – largely driven by nitrogen being an energy-derived business and by the correlation observed among various commodity products, including crops, fertilizers and energy.

In the meantime, the nitrogen market remains overwhelmingly supply driven and, in the short term, capacity additions show little signs of slowing. In the last month alone, several nitrogen capacity investment projects reached milestones in their construction process, such as the Mendeleevsk plant, which was commissioned in Russia in February; KBR’s confirmation that work was restarting on the Kima plant in Egypt; and Petronas’ SAMUR project in Malaysia which reached 90% completion, to name but a few. Furthermore, there is the addition of significant new North American nitrogen capacity in 2016 and 2017, which will have consequences far beyond reducing the region’s import dependency.

Spotlight on China

The Chinese coal price decline was the primary contributor to the downward shift in the international floor price for urea over the past year. In 2015, new Chinese urea capacity continued to come on stream, even though urea had been in oversupply in China for some time. The emergence of many new plants relying on competitively priced feedstock and showing high energy efficiency, and the Chinese government liberalising its urea export policy, has led to additional urea capacity becoming competitive in international markets. In China, coal-based urea capacity represents more than 70% of the total and the remainder is gas-based. Anthracite is the most widely used feedstock for urea production and, although prices have seen a downward spiral in the last three years, between 2008 and 2012, anthracite coal prices increased rapidly. By comparison, the price of other types of coal, such as lignite and bituminous coal, have been much lower – sometimes 30% below anthracite prices. As a result, additional bituminous coal-based urea plants were built, and some large-scale anthracite-based urea producers also started to upgrade their technology so that they could use alternative types of coal. In 1Q16, bituminous coal prices for some Chinese urea producers were assessed as low as US$1.5 million/Btu. Integer’s analysis of the Chinese urea market has revealed that about 75% of total urea capacity can operate at production costs below US$200/t, benefiting from falling prices of all coal types driven by the Chinese coal market’s own oversupply issues. China has become increasingly influential in international markets along with the improvement in its competitiveness on the export stage, but the question now remains as to whether coal prices in China have hit a floor and whether there is room for Chinese coal-based urea producers to lower costs further.

Falling production costs have provided shelter from widespread financial turmoil

Abundant supply and weak prices have created some of the most difficult fertilizer market conditions seen in a decade. The nitrogen market, however, is not feeling the brunt of financial losses seen in previous market downturns. Nitrogen producers at the high-cost end of the industry cost curve in particular have found themselves better equipped to withstand the tumbling nitrogen prices experienced in 2015 and 2016 so far, as a result of the fundamental shift in energy pricing that has occurred in the last 18 months.

Decreasing feedstock costs to nitrogen producers have mitigated the extent to which producers are feeling the strain of current cyclical weakness in the market and, contrary to other fertilizer nutrients, investment in nitrogen capacity continues, although there are signs of slowing as the gap between international nitrogen prices and the incentive price to build new capacity widens.

In light of the overhaul in global energy costs, the competitive makeup of the nitrogen industry has now fundamentally changed. A key development is that the range in production costs is now far smaller than it was in previous years and this makes it more difficult to determine the location of the industry margin.

Another key development is the decreasing profitability of urea relative to other nitrogen products, such as ammonia, nitrates and UAN. The effect of global nitrogen oversupply has been most critical in the urea market, which has driven tumbling prices, much more so than in other product markets where supply growth is less rapid and consumption is more regional. Therefore the focus for producers that are involved in more than one product market is to maximise returns from niche nitrogen markets where margins are somewhat shielded from the commodity cycle and where higher unit returns can be achieved. Similarly, there has been growing interest from urea-focused producers looking to diversify their product mix by entering downstream or value-add markets in order to reap the rewards that can be achieved over urea in today’s market.

As a result, there must be increased importance placed on analysing the relationship between nitrogen products, from comparative investment rationale and production economics through to substitution effects and the long-term balancing dynamics between the nitrogen products in the short and long term. According to Integer’s analysis of over 120 nitrogen producers in its Nitrogen Cost and Profit Margin Service, UAN and nitrate price premiums in Europe and North America led to better performance in unit profit margins on a comparative nutrient per tonne basis in 2014. The average global urea profit margin decreased by over 10% year-on-year in 2014 due to downward pressure on urea prices caused by oversupply. Tight merchant ammonia supply conditions saw the average global gross margin increase by over 20% in 2014 compared to the previous year, driven by higher prices to export-orientated ammonia producers. However, the most profound change was seen in the nitrates market, where global ammonium nitrates (AN) and UAN gross margins increased by over 30% and 60% year-on-year respectively in 2014, driven by lucrative price premiums in key regions and tighter supply. In recent months, the nitrates and UAN premiums in Europe and North America respectively have held firm and producers continue to receive a higher return on these products over urea.

This trend is most obvious when the unit margins of producers with a broad nitrogen product mix are considered, such as CF Industries and Yara. CF Industries’ AN gross profit margin increased by 26% year-on-year in 2014 to US$571/t despite the AN NOLA price remaining relatively stable over this period. By comparison, CF Industries’ urea margin fell by 26% year-on-year to US$344/t in 2014. Yara’s AN gross profit margin from its Sluiskil, Netherlands, plant also increased by 13% year-on-year to US$472/t in 2014.

The global gross margin curve, which measures competitiveness of producers per tonne of nitrogen product, allows Integer to identify standout regional clusters across all nitrogen products. It shows that UAN producers in North America remain highly competitive as a result of low costs due to falling natural gas prices, benefiting from a significant local price premium driven by import parity pricing in the US. The NOLA UAN price premium increased from historical averages of around US$35/t before 2013 to around US$45/t on an FOB basis in recent years compared with Black Sea FOB prices. Another significant development is the improvement in Russian AN producer margins, which increased by 27% year-on-year in 2014 as a result of depreciation in the Russian rouble – which significantly reduced US dollar denominated costs.

Spotlight on US investment activity

The US dominates the UAN market, both in terms of production and consumption and, despite weak global prices, there is still investment rationale in key pockets of regional consumption. The main drivers behind continued capacity additions in the US are low gas costs, as a result of the recent shale gas revolution, coupled with a domestic price premium over international levels as a result of continued import dependence. US imports of urea increased by 68% (3.2 million t) between 2004 and 2014 to meet consumption in the face of capacity closures at a time when North America was operating as the industry swing producer. Similarly, UAN imports increased by 52% over the same period.

There are several advanced nitrogen projects in the US, whose feasibility Integer analyse in its Nitrogen 10-Year Outlook Service to show how the current US domestic supply deficit is most likely to evolve. Based only on those projects that have already received finance and have progressed to their construction phase, the US supply-demand balances for ammonia, urea, AN and UAN all remain in deficit until 2030. This suggests that there is still room in the US market for additional capacity investment, which will most likely come from a handful of the current projects under discussion. This begs the question of which projects are most likely to succeed from the many that have been announced.

Of the current planned greenfield projects in the US, the IFCo/OCI project in Lee County, Iowa, is the most advanced and due for completion in 4Q16. The urea integrated facility has a urea capacity of 765 000 tpy, most of which will be used for UAN at a capacity of 1.5 million tpy. CF Industries’ new plant in Port Neal, Iowa, will also add 770 000 tpy of UAN capacity when the plant begins commercial production in 2017. There is also a significant stream of new ammonia capacity additions, which are due to come online in the next 18 months. The projects by Dyno Nobel at Waggaman, Louisiana, Yara/BASF in Freeport, Texas, and JR Simplot in Rock Springs, Wyoming, will add a combined ammonia capacity of 1.7 million t by the end of 2018. This additional capacity will displace some US imports in the near future and require producers to reallocate US import volumes. These developments will have profound implications for the US nitrogen market and beyond, from substitution trends between nitrogen products and the balance between growth rates for fertilizer and industrial markets, to quantifying opportunistic exports from the US Gulf and where one can expect traditional exporters to the US to redirect their export volumes to as the country’s import dependency shrinks in the coming years.

Author

Laura Cross, Integer Research, UK.