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Michael de Portu Headshot

Bidding War for Potash of Saskatchewan?

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According to the pundits, the Potash saga is about to heat up.

From the day that BHP Billiton, the Australian mining giant, sprung a $40 billion offer for fertilizer producer Potash Corporation of Saskatchewan in mid-August, the reaction of the market has been that a better offer would come along. This was evidenced by the fact that Potash's stock shot well-past the $130-a-share proposed by BHP and has stayed in the $147-$150 range since.

Now rumors are surfacing that Sinochem of China may partner up with Temasek of Singapore to make a rival offer. Rio Tinto, another Australian mining outfit, is also said to be interested.

The Potash story has some truly interesting aspects. First is the fact that BHP is undeterred by an internet-like valuation on a basic material company. Indeed, at $130-a-share, BHP is offering to pay the equivalent of 8 times Potash's revenues and 17 times cash flow. Prior to the offer, Potash was trading in the $112 range, so even before BHP came along its valuation was striking. Speaking of which, BHP's own market value is nothing to sneeze at either: just about $200 billion or almost 4 times revenues.

There was a time when commodity companies had decidedly ho-hum valuations -- a quick glance at their historical stock charts will confirm that. All this changed in 2003-2004, but nowhere was the upswing more dramatic than for fertilizer companies like Potash. When its stock price hit a historic high of $230 in mid-2008, that was up 16-fold from its level in early 2004. If you prefer to think in terms of compound growth, that is better than 220% per year.

Why? Well, in part there is the China demand factor -- they have 1.3 trillion people after all -- in part, no doubt, just plain market hype. But there is something quite a bit more compelling as well.

Specifically, Potash and its North American "competitors," Mosaic and Agrium, are exempt from anti-trust restraints on their activities outside of the U.S. and Canada. All three produce potash, phosphate and nitrogen. Unlike most other industries, however, not only can Potash, Mosaic and Agrium exchange critical information, but they also can and do negotiate overseas sales of potash and phosphate through legally-sanctioned cartels -- Canpotex for Canadian Potash Exporters and PhosChem in the case of phosphate -- only to then divide the production among themselves.

Not to be outdone, overseas rivals, primarily in Russia, Germany and Israel, have set up similar monopoly-pricing organizations -- China also has potash/phosphate activities, but is a net importer.

The net result is that analysts and company executives think nothing of predicting that potash prices will double or triple in the next years, and that phosphate rock and DAP -- diammonimum phosphate -- will return to the heady pre-crisis days when they stood 5-to-8-fold above their historical levels. And why not? For 70% of the stuff, after all, there is only one party you can go to -- unless, that is, you want to go and talk to Boris, who, depending on the day, is said to be quite cantankerous too.

Ah, the wonderful power of deniability! In joining forces and maintaining the iron discipline of focus -- focus on getting the absolutely highest possible price that the market will bear -- erstwhile competitors have turned into allies. That's all thanks to Canpotex and PhosChem, and their success in ascertaining that nothing dampens the crippling effect of population growth and social stability imperatives on the bargaining posture of buyers -- wealthy nations like India and China.

Too bad this isn't allowed for laptops, GPS systems or automobiles. If they could be priced like fertilizer and withdrawn from the market whenever buyers balk, think about how much better those companies would be doing.

This system in fertilizers is well defended. Neither Canpotex nor Webb-Pomerene -- the exemption under which PhosChem was set up in the U.S. -- are under any serious threat. The Province of Saskatchewan itself made clear that it would look askance at any transaction that reduced the power of Canpotex. And while BHP initially indicated that it would withdraw from Canpotex -- it stayed mum on PhosChem -- this is little more than a tactical move, one which BHP soon reconsidered, as it were.

By now, monopoly pricing in fertilizers has become so ingrained and coordination so prevalent and well-established that it would probably take years if not decades to wean producers off it -- assuming there was the will to do so. Even though this monopoly pricing is for exports, it sets the bar for all markets, as U.S. and Canadian farmers know all too well.

Rising prices have been an unimaginable boon for companies like Potash and made them highly attractive -- to wit the rich BHP bid. And high prices do not seem to displease policymakers either. After all, here was a bright spot which partially made up for the losses on toxic and other assets. Besides, who would want a bursting of the commodity bubble? Why risk a deflationary spiral as the economy slows to a crawl?

Now, if the Chinese do jump into the fray, this will surely make an interesting situation truly fascinating. How would it work? Would a Chinese company become a member of Canpotex and PhosChem? Monopoly pricing on exports to... China?

Maybe, just maybe, BHP may have started something here.

The author is short -- through puts -- several commodity stocks in his personal portfolio, including the stocks of Potash and Mosaic.