I’m attracted to cheap options and this is the main reason why I am long Potash Corporation of Saskatchewan (POT) put options. The LEAP puts are trading with implied volatility in the mid 20s. Potash pricing could collapse due to (A) a wave of excess capacity coming online and/or (B) the potash cartel breaking down. While I have no special insight into whether or not this will happen, the expected return on this trade should be positive as long as the chance of a decline is high enough.
(This is not a high conviction trade for me.)
Potash’s cash flow
On the surface, Potash’s free cash flow looks ugly. Every year, capital expenditures are several times depreciation and amortization. Normally I like to short companies with poor free cash flow because they are probably aggressively capitalizing expenses Worldcom-style. I do not believe that Potash is doing this. There are legitimate reasons why its capex is so high:
- Potash has been expanding its capacity.
- The cost of maintaining its assets has gone up in the past several years due to increases in the cost of labour, mining equipment, steel, construction materials, etc.
I don’t have any major problems with Potash’s management or accounting.
Here’s a slide from Potash’s Dec 4, 2013 presentation:
As you can see, production capacity will increase by roughly a third in the coming years. During the boom in potash prices, all of the industry has generally followed the same strategy in expanding their brownfield capacity. Unfortunately for Potash, they decided to expand capacity in the past and are currently idling excess capacity. In hindsight, Potash should not have expanded capacity. I believe Potash is still trying to maintain cartel pricing. I have no special insight into whether or not the cartel situation will hold.
Many of Potash’s competitors will also see their expansion projects come online in the next few years; Potash’s older presentations show their projections of industry capacity based on announced plans. There is a huge wave of capacity coming online that the market may not be able to absorb. There is a small amount of production that will come online from greenfield projects such as K+S’s solution mine. Unlike Potash, K+S is hiring. There is a divergence here as K+S’s solution mine will have higher costs than conventional mines; I believe their new capacity will have higher costs than the capacity that Potash is idling.
This is not a high conviction trade because I am terrible at predicting commodity prices. However, this is one of my bigger/biggest short positions. Part of this is because:
- Markets are rising (e.g. the S&P 500 is up ~30% this year) and therefore I want to put on more short positions. This may be a little irrational on my part. I think I have ‘permabear’ tendencies; I want to short most stocks and I would feel uncomfortable without some short positions in my portfolio. Hopefully in the next market crash I will cover all of my shorts and go long the market. (In the 08/09 crash, I didn’t have any short positions since I only learned about short selling in mid 2009.)
- I’ve had a hard time finding good shorts that aren’t overly crowded.
This trade is not one of my better ideas.
*Disclosure: Long POT put options. I used to be bullish on Potash and have been long the company before (through common stock and call options).
VIC writeup on shorting Potash – While the author is also bearish on potash as I am, I don’t agree with all of the points. I don’t understand why new “corn & soy hybrids could significantly reduce the need for potash”. Higher-yield crops should drive demand for more potash; the potash becomes part of the plant and is essential for plant growth. For example, we can take a look at nitrogen fertilizer and soybeans. Historically, farmers planted soybeans to replenish the amount of nitrogen in the soil (because soybeans ultimately convert nitrogen in the air into an organic form in the soil). However, some of the newest high-yield soybeans grow so fast that they need a small amount of supplemental nitrogen. USDA data shows nitrogen fertilizer being applied to soybean crops. Similarly, I believe that higher-yielding crops will require more potash and other fertilizers.