Description

Idea: Long OCI NV (Ticker: OCI NA)

Thesis:

OCI is the world’s 4th largest producer of nitrogen products after Yara, CF Industries and Potash Corp. The nitrogen market (urea is the most common nitrogen product) is currently facing a cyclical low. Prices crashed over the last 4 years and are set to recover going forward as the market tightens. OCI invested heavily and added substantial capacity over the last few years and its capacity has increased by 50% from 2015 to 2018E, but it has not seen the benefit of this as its share price has collapsed by 50% since 2014 as nitrogen/urea prices have collapsed. Global urea prices fell from $450 to around $210 year to date and I forecast them to recover to $300 by 2020. Because of the increased operating and financial leverage, OCI’s EBITDA will expand from $750m in 2017E to $2,058 by 2019E. OCI will already have a 10% FCF Yield in 2017, rising to 37% in 2019. On a 7.0x multiple in 2019, this will result in a 2 year target price for OCI for 2019 of €49.1, from €20.1 currently, a return of 144%.

Nitrogen market:

Nitrogen (N) is a fundamental building block of plant proteins that improve crop yield and quality. It is also essential for proper animal nutrition and maturation. Synthesized from natural gas or coal, ammonia (NH3) is a concentrated source of nitrogen and the basic feedstock for all upgraded nitrogen products. It is also used to make industrial products and as a direct-application fertilizer.

The most commonly used nitrogen fertilizer is urea, which is also the feedstock for industrial products such as plastics, resins, adhesives and increasingly for emissions control. Liquid forms of urea and ammonium nitrate are combined into UAN solution, which is used in agriculture. Urea is also the only form that’s traded globally and hence sets the price for other nitrogen fertilizers as well.

Most of the urea globally is produced and consumed locally, with the largest production and consumption in China. China has rapidly expanded capacity over the last decade and has been a net exporter over the last few years. Meanwhile US, Europe and India are all net importers of urea with the Middle East being the biggest exporting region.

While the rest of the world uses natural gas to produce urea, China has been producing urea from coal. The price of the fuel can represent more than half the cash costs of urea production, and the global cost curve is effectively based on fuel costs in the respective regions, with Middle East and US shale based natural gas being the lowest cost, while Russian urea has to incur significant freight costs despite also having a low fuel cost advantage. Chinese coal based urea represents the high end of the cost curve. Hence the marginal cost of urea in the market was being set by the Chinese coal price. The coal used for urea production in China is a mix of anthracite coal and thermal coal. Since the US market is a net importer of urea, and local production is much cheaper than the global marginal producer (coal based Chinese players), the local US price is set by the import price and hence global prices, and the local producers can benefit from the higher profits.

With the advent of shale gas in the US, most of the incremental gas production in US is to come via cheap shale based sources, and the urea industry decided to take advantage of this low cost fuel phenomenon and lots of new urea capacity was sanctioned by a number of firms in the US to take advantage of the lower fuel costs. Gas prices have remained low since the advent of the US shale gas production.

This followed increased supply to take advantage of cheaper gas in Middle East as well. Please note below the new supply entering the market.

During 2013-2016 coal prices in China declined precipitously and this led to the marginal cost of urea production (which is Chinese coal based production) to also fall rapidly as China ramped up exports to take market share.

In 2016 coal prices in China have stabilized as the Govt. has implemented supply reform. Its main state planner, (NDRC), implemented strict controls on domestic mines, limiting their operations to 276 days a year at end of 2015. Domestic coal production plummeted 7.8% year-on-year during 2016, which reduced global production by more than 5% and hence thermal coal prices bottomed at the start of 2016 and rallied throughout the year. Urea consumes a combination of thermal coal and a higher quality coal called anthracite coal, but anthracite coal didn’t start recovering till nearer the end of 2016 as it had become too cheap relative to thermal coal, leading to substitution. Anthracite coal prices have continued to recover, which has increased the marginal cost of urea production in China, leading to a collapse of Chinese coal exports at current urea prices.

Coal prices are expected to stabilise going forward as China both produces and consumes about 2/3 of the global coal production. Hence Chinese regulatory policies are a major driver to global coal prices. As you can see above, coal prices were falling throughout 2011-2016 as China was adding a lot of capacity even as its own demand growth for coal started to slow down due to lower energy demand growth in Chinas as well as a massive increase in renewables capacity. China decided to stabilize prices at start of 2015 by implementing a framework of limiting mining days at the mine, which buoyed thermal coal prices. NDRC has since then managed the supply to give support to thermal prices at around 550 RMB and also produced a framework of managing mining days if prices are to fall below 500 RMB. This has stabilized and supported global coal prices as China has been tweaking the mining days allowed back and forth several times over the past year and half.

In addition China has implemented environment protection legislation which has led to curtailment of significant amount of old and polluting urea capacity in China. This has also caused a reduction in exports from China. These factors have led to urea prices bottoming and starting to recover with anthracite coal prices at the start of 2017.

But this relief from lower exports from China in 2016 and in 2017 did not help urea prices for long as 2016-2017 are the peak year of new supply additions, and this has continued to depress urea prices throughout 2017 and they remain at a low level. The new additions are in low energy cost areas, and are replacing the higher cost Chinese coal based production, which has dampened prices.

Nitrogen prices currently are nominally lower than at any other time except briefly during the financial crisis over the last 2 decades, and remain unsustainably low given the increase in marginal cost of production and inflation.

Until recently urea price remained near lows in 2017 as new capacity additions peak, but going forward prices are set to recover as demand growth outstrips supply additions in the coming years. It takes 3 years or more to build out new capacity and we have good visibility till the end of the decade on supply additions. For 2020, supply additions are almost 0.5m tonnes. There has been a recent seasonal uptick in prices but the market doesn’t expect these to be sustainable.

Once demand growth outstrips supply growth over 2018 and onwards, China will again be called on to increase utlilization levels and increase exports, and that will require higher urea prices as China’s cash cost of production has been rising with the rebound in coal prices, as well as curtailment of cheaper and more polluting capacity.

China will be called on to increase exports to 5m tons by 2018 and 7m tons by 2019. This will lead to a rebound in urea prices from the current levels around $180-200 to closer to $275-$300 by 2020, based on break-even levels for China’s urea capacity as anthracite coal continues to rebound. The reason China will have to increase exports is that demand growth appears robust even as supply additions ease off.

Demand for nitrogen and urea is expected to stay healthy going forward, and continues to increase. This is being led by higher per capital consumption of fruits and vegetables, grains and oilseeds, and other crops. Some of the factors being improved diet in emerging markets, as well as higher per capita consumption of proteins (which are more grain intensive).

The ability of farmers to afford better and higher amounts of fertilizer is somewhat dependent on crop prices but urea is the most immune of the three main fertilizers as the ability to thrift urea use is minimal. Crop prices have fallen over the last few years as some portion of crops were being used in biofuels, and the crash in oil prices dented that incremental area of growth as oil became cheaper and substitution with biofuels was reduced.

This hit to demand has now abated as oil prices have stopped falling, and the increase in demand via food consumption and feed consumption for livestock can continue. This has allowed food prices to bottom and start a slow recovery. If oil prices rally, from $40s to $60-70, this will provide additional demand but I have not taken this to account in this thesis. Oil prices dropping further won’t hurt either as remaining biofuel demand is protected with regulation. If US rolls back E10 standards, this could be an area of concern but there’s no indication this will happen.

This decline in agricultural demand from 2014-2016 was partly offset by stronger demand growth in industrial uses. And the stabilization in food prices has led to a strong recovery in agricultural demand of nitrogen consumption in 2017, leading to overall record consumption again. This strong demand growth for nitrogen is expected to continue.

And after initially levelling off from 2014-2016, consumption has bounced up significantly in 2017 on the back of the oil-crash effects rolling off, and the bounce back in demand from emerging markets. Demand for grains had a strong bounce in 2017.

More recently, in China, the market has been quiet following the recent run-up in export prices. Producers are quoting up to USD 230/tonne fob for coming shipments of granular urea with little product available, which is an early indication that urea prices are likely to move up. Operating rates are around 60%, in line with recent weeks, and producers are facing high costs due to firm coal prices – implying negative netbacks for coal-based producers. Urea prices will have to move up if demand growth remains firm and China has to increase exports next years.

India had delayed a tender earlier in the year but just announced a tender for September shipments which has buoyed urea prices in the near term. The delay is partly attributed to the recent run-up in urea fob prices. Latest official data puts July urea sales at 2.92m tonnes, which brings the cumulative sales from April - July at 9.25m tonnes, up 6% y/y. For comparison, production is marginal down in the same period and urea imports year-to-date are also down - thus stock levels are down nearly 0.8m tonnes from same period last year. Hence India had to call a tender and it was received positively by the market.

I expect urea prices to rebound from $185ish currently to rise to atleast $275-300 by end of 2020. Considering spot just rallied to $270, this average urea price forecast for 2020 may prove to be conservative but the stock is cheap already as shown in the valuation section. The market expects the recent rally from $200 to $270 on spot to fade but the long-term firming trend will hold going forward. The marginal cost of production will increase as China’s exports have to increase to fill the supply/demand gap in the coming years, and the marginal cost of urea required to breakeven at current anthracite coal levels is higher than average urea price for the year. If oil prices also stabilize in the $55-60, leading to some recovery in biofuel demand then urea prices can strengthen more, also this is not required for this thesis to work. Any further recovery in coal prices will also support urea prices, although I am only factoring in continuing price stability based on China’s NDRC’s current policies.

Methanol and related

Mathanol is a chemical produced from natural gas and that can then be used to produce olefins from plastics and can even be blended into fuel. It effectively arbitrages cheaper gas price for hydrocarbon molecules in place of crude based alternatives. Note methanol demand growth below.

The oil price crash has effected the methanol sector as well and very little new capacity was sanctioned. The sector has already tightened a bit and will stay firm going forward.

Methanol is primarily used in a range of products in China as a cheaper alternative to oil.

Methanol demand quickly bounced from the lows after the oil price crash but haven’t fully recovered. But demand from China remains very firm and prices are expected to continue to firm up.

OCI company information and valuation

OCI produces nitrogen fertilizers, methanol and other natural gas based chemical products. It is one of the world's largest nitrogen fertilizer producers, and can produce nearly 8.4 million metric tons of nitrogen fertilizers and industrial chemicals at production facilities in the Netherlands, the United States, Egypt and Algeria. With its new facilities coming online, total production capacity will exceed 13.8 million metric tons in 2018.

OCI will be increase its production capacity by more than 50% between now and 2018 which will drive volume growth.

As all these new facilities come online, OCI’s capex will fall back to maintenance capex levels and it is set to receive significant free cash flows just as the urea market is strengthening.

Currently 80% of production is from nitrogen and after the new additions in ammonia and methanol and UAN, that amount will still be closer to 73%.

OCI has two major facilities coming online, one for UAN and one for Methanol (50% owned)

Based on my urea price forecast I have annualized urea prices rebound from $216 this year to $260 and then $300. Note spot has already rallied to $270 currently. Other nitrogen prices increase proportionately. Melamine is unrelated and Methanol is already $549 on spot and will likely strengthen further.

The following table shows sales given the volumes and commodity prices. Raw material costs per tonne have been falling as incremental capacity is being added in the US which has cheaper feedstock.

Given the 50% increase in volume as well as 50% increase in commodity prices from the bottom, OCI’s EBITDA explodes beyond EUR 2b. FCF yield is already 10% and strengthens rapidly to 40%. OCI will be trading at close to 2.8x EV/EBITDA by end of 2019.

Calculating a target price with a 7.0x target EV/EBITDA gives almost 160% return and a target price of EUR 52 for a stock currently trading at EUR 20.1.

Compared to other  agricultural  and fertilizer stocks, none of them trade below 8.0x for next year’s EBITDA. Hence using 7.0x for target price is quite reasonable.

In addition to being cheap on an absolute basis, OCI will likely become a takeover target again. CF tried to buy OCI’s European and North American assets in 2015 and at the same time do a tax inversion by moving the HQ to UK and the tax authorities scuttled the deal. But I believe OCI’s assets remain very attractive to both Yara and CF and will likely come under takeover speculation again. There has been a huge amount of takeover activity in the ag/fertilizer sector (Bayer/Monsanto, Potash Corp/Agrium, Potash Corp/K+S, CF/Yara, CF/OCI, Sinofert/Synngenta etc) and OCI’s main shareholder Naseef Sawiris is a willing seller. He was happy to agree to the sale in 2015 to CF and he’s probably waiting for another bid from one of the players.

Risks

The main risk to the thesis is that urea prices fail to rally. The reasons could be weaker demand than expected. Weak crop prices could result in some thrifting by farmers although Nitrogen has historically experienced the least thrifting relative to potash and phosphates. With weaker demand growth the recovery could take longer than the time period forecasted, and be slower, so the thesis could get delayed.

Another risk is a significant spike in natural gas prices (from a severe winter or supply constraint) leading to higher costs for OCI, although these are somewhat mitigated by forward hedging. This is also why OCI has modest gains from a gas price collapse as well. Another risk is a further collapse in oil price leading to weaker demand from biofuels although oil prices are only strengthening now and remaining biofuel demand is mostly protected by regulation. A risk could be a rollback of E10 in US leading to erosion of the biofuel demand protected by regulation, although there’s no indication of such an event.

Other risks include the company possibly undertaking M&A that’s not accretive. CF already tried to purchase OCI in 2015 and,  when that deal fell apart, had to pay significant fines and penalties. Another potential risk could be OCI gets taken out at a modest premium closer to current price levels, and the long term gains fail to be captured. There is considerable M&A activity in this sector, Agrium and Potash Corp merged, and CF and Yara (the largest nitrogen producer) contemplated a merger in 2014 before calling it off.

Catalyst

Nitrogen prices continue to firm up. CF comes back for another takeover bid for OCI. Someone else snaps up OCI.