CF Industries Holdings (CF) – Speculating on commodity prices

CF produces nitrogen fertilizer.  It is a bet on:

  1. Natural gas prices in the US staying low, allowing CF to have lower costs than its foreign competitors.
  2. Corn prices staying high, driving demand for nitrogen fertilizer.

The current P/E is roughly 6.25.  CF is buying back shares and building new capacity.

Industry basics

There are some economies of scale in producing nitrogen fertilizer.  Larger operations will have lower depreciation costs and lower labour costs.  This has driven the industry trend towards bigger and bigger manufacturing plants.  As well, newer plants tend to be slightly more energy-efficient than older plants.  However, none of this really matters as the biggest cost in producing nitrogen fertilizer is the cost of natural gas.  Energy costs account for roughly 80% of expenses.  The plants located near cheap natural gas will have a cost advantage.

CF’s profits depend mostly on the spread between its input costs and fertilizer prices.  The majority of nitrogen fertilizer is used on corn, so corn prices are the main factor in fertilizer prices.  Using more fertilizer can increase yields of corn.  When corn prices are high, it makes economic sense for farmers to use a little more fertilizer.  High corn prices also encourage farmers to devote more acreage to planting corn over other crops.  This also increases fertilizer use.

The highest margin producers will need to have access to cheap natural gas and have low transportation costs to its customers.  CF happens to have the combination of both those things.  The US has abundant shale reserves and a government subsidized agriculture industry.

Sometimes you’d rather be lucky than skilled

CF has been incredibly lucky over the past decade.  It has enjoyed the benefit of two sustained trends:

  1. Increasing corn prices.  In the US, corn is the main feedstock used to produce biofuels.  Government legislation has artificially created an American biofuel industry and created unusually high demand for corn.  Roughly four tenths of all corn produced in the US is used to make ethanol.  Current legislation is supposed to force even more production of ethanol.  However, the fuel industry may hit a “blend wall” as there are limits to American ethanol consumption.  Very few cars can use fuel with more than 10% ethanol without problems.  On top of that, gasoline consumption has been falling.
  2. Shale gas technology.  Historically, natural gas has been more expensive in the US than abroad.  The US also imports roughly half of its nitrogen fertilizer as other countries used to have lower natural gas prices.  Shale gas technology has changed everything as the US has abundant sources of cheap natural gas.  Improvements in shale technology could even keep prices low for a very long period of time.  Natural gas producers such as Southwestern Energy (SWN) and Ultra Petroleum (UPL) have indicated in their shareholder presentations that their costs have come down in the past several years.  Despite record low natural gas prices, the lowest-cost producers still have big drilling budgets and are projecting increases in production.

I am absolutely terrible at predicting commodity prices.  With that being said… I am (masochistic and) still willing to bet on advances in shale technology keeping natural gas prices down.  Increases in ethanol usage would be icing on the cake.  Both biofuels and shale technology are trends that may last for several years or more.

In terms of capacity, the US nitrogen fertilizer industry is underbuilt.  With abundant natural gas, the US should be an exporter of nitrogen fertilizer.  Yet the US imports somewhere around 40-50% of the nitrogen fertilizer that it consumes.

Management is mediocre

Management has bought back shares both at high prices and at low prices.  When CF announces a share repurchase program, there doesn’t seem to be any price considerations.  They announced a $500M buyback, bought back exactly $500M, and simply stopped buying back shares.  Their capital allocation seems arbitrary and lacking confidence.  The steady dividend doesn’t make sense from a tax perspective.

The company took on a lot of debt to finance its takeover of Terra.  (Some people argue that CF overpaid.)  CF has been reasonably prudent with its debt levels and issued stock to keep its leverage down.  I’m sure they paid a lot of money to underwriters to issue stock.  Now that CF is making record profits, it is buying back shares at prices higher than what it sold them at.

Returns on capital

CF appears to have very high returns on capital.  However, this is mostly because its plants were built in the past when the cost of new capacity was significantly lower.  The replacement value of CF’s assets is well above book value.  Other fertilizer companies haven’t built too much new nitrogen capacity as the returns on new capacity are great but not phenomenal.  Big fertilizer companies such as Potash Corporation of Saskatchewan have also been focusing on building new potash capacity over nitrogen capacity (at the time, it seemed like new potash capacity would deliver better returns).

If you make the simplifying assumption that buying CF shares costs about the same as building a new plant, then the expected return on new capacity would be around 16%/year.  Of course, actual returns will depend on fluctuating commodity prices.  The record spread between natural gas and fertilizer prices should stimulate new capacity and ultimately drive down returns in the future.  The low P/E provides some margin of safety against the spread getting smaller.  At the same time, I don’t like to buy things at record highs because most things revert to the mean.


Yara fertilizer industry handbook – this PDF explains the fundamentals of the fertilizer industry

*Disclosure:  Long CF.  This is not a high conviction idea for me.

3 thoughts on “CF Industries Holdings (CF) – Speculating on commodity prices

  1. I whiffed on this opportunity. Well kind of…

    I came to the exact same conclusions as you but with CF industries spinoff -TNH. I was looking at it mid September 2014 and I thought I had missed some salient risk factor (it was selling at a P/E of 4-6).

    Oh well can’t make all the $.

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