Originally Published at the Metal Augmentor.
In the Conference Board of Canada’s (CBOC) recent report, entitled Saskatchewan in the Spotlight: Acquisition of Potash Corporation of Saskatchewan Inc.—Risks and Opportunities,we are told that “with the exception of significant government revenueimpacts… few negative takeover effects” would come as the result of atakeover of Potash Corp (POT) by BHP Billiton (BHP).
Essentially,if BHP proceeds with the development of its greenfield Jansen Lakepotash deposit and acquires Potash Corp, BHP will be able to deferroyalty payments from the Potash Corp mines using the capitalexpenditures undertaken to develop the Jansen Lake mine. This would havethe effect of reducing royalty revenues by about $200 million per yearthrough 2020.
On the corporate tax side of things, it is alsoanticipated that BHP would be able to deduct its debt servicing costsfor the acquisition against taxable income of Potash Corp operations,meaning lower federal and provincial taxes. However, the extent of thisloss is not estimated within the report due to its dependence upon “amyriad of factors”.
So we’re basically looking at a negativeimpact of $200+ million per year for the province as a result of theproposed acquisition.
Alright. Fair enough. So what did the goodfolks over at the CBOC have to say about the most likely alternativebidder, Sinochem Group? First, they explain how China is the world’slargest consumer of fertilizer and how it would therefore make sensefor Sinochem to pay a significant premium for Potash Corp as a sort ofcounter-strategy to BHP exercising similar power in the potash marketas they already have in the iron ore market.
Then they go on to —perhaps rightly — assume that control by a state-owned enterprise ofan importer country may create significant risk that Sinochem will“ignore market disciplines” and overproduce rather than carefullycontrol supply in order to produce an economic return on theirinvestment.
The effect of overproduction would be tosignificantly lower the price of potash and along with it reduce theProvince’s royalty revenues. At one point the report goes so far as tocharacterize this risk as “severe”, but considering the impact of thisworst-case scenario would be an incremental loss of $350 million peryear compared with the BHP estimate (equivalent to approximately 3.5%of the Province’s annual revenues), this sounds a bit like fearmongering.
The “severity” conclusion is also potentially inconsistent considering that according to Potash Corp“the report chose to assume that BHP would not operate full out indirect contradiction of previous BHP public statements” — a scenariothat would result in the same incremental $350 million per year loss inroyalty revenues if not worse given the tax situation surrounding thedevelopment of Jansen Lake.
In the end, the CBOC is probablyright to express concern over Sinochem’s potential lack of a profitmotive, at least compared to BHP, but other than the impact toSaskatchewan and other potash producers, it would be a good thing forthe rest of the world if Sinochem decides to “lead the worldmarketplace toward price competition” rather than let BHP use its“market discipline” to support prices.
CheaperFertilizer = Better Crop Yields = Cheaper Food = Fewer StarvingChildren (all other things being equal, which they rarely are)
Worldhunger aside, the most revealing information in this report is theapparent vulnerability of the potash market to oversupply, and we mustcarefully weigh this information when contemplating investments inpotash explorers and developers such as one of our favorites familiar to subscribers of the Metal Augmentor.
Therisk of future price weakness is probably greater in a world whereSinochem takes up residence in Saskatchewan, but the risk still existswith mining giant BHP, reminding all analysts out there to be carefulabout assuming ever-higher potash prices in long-term valuation models.That said, there are also trends that suggest potash demand will growsubstantially in the years ahead so our argument isn’t that potash haslittle potential for investment or speculative profits but rather thatwe should balance the supply-demand equation in a realistic manner.