Saturday, May 3, 2008

An Entry From My Dromediary About POT and MOS

Commodities are clearly in the midst of a bull market. On a daily basis, we're being deluged with stories of rising gasoline prices, rice shortages, soaring demand for steel, etc. These high prices will certainly encourage the development of new supply in time. A nearer-term impact will be product substitution when feasible. If steak costs too much, buy chicken instead. If the price of rice is too high, substitute potato. If the cost of cocoa soars.....bad example. I'm still buying cocoa.

The following example of the substitution effect is from a recent article in the Financial Times. It has me seriously thinking of swapping my Accord for some sled dogs.

Farmers in the Indian state of Rajasthan are rediscovering the humble camel.

As the cost of running gas-guzzling tractors soars, even-toed ungulates are making a comeback, raising hopes that a fall in the population of the desert state’s signature animal can be reversed.

“It’s excellent for the camel population if the price of oil continues to go up because demand for camels will also go up,” says Ilse K√∂hler-Rollefson of the League for Pastoral Peoples and Endogenous Livestock Development. “Two years ago, a camel cost little more than a goat, which is nothing. The price has since trebled.”

The shift comes not a moment too soon for a national camel population that has fallen more than 50 per cent over the past decade, to about 450,000, according to government figures.

Market prices for these “ships of the desert”, which crashed with the growing affordability of motorised transport, are rising again as oil prices soar.

A sturdy male with a life expectancy of 60-80 years now fetches up to Rs40,000 ($973), compared to Rs5,000-Rs10,000 three years ago, according to Hanuwant Singh of the Lokhit Pashu-Palak Sansthan, a non-profit welfare organisation for livestock keepers. Entry-level tractors cost around $4,000.

As far as I know, there are no camel futures or ETFs, and I'm not suggesting you mail order a caravan of camels in the hope of reselling them for a tidy profit . Remember, you have to pay for shipping, feed them, and pick up after them. And then there's the spitting. Oh, the spitting!

The point, as usual with commodities, is that the end of the bull for any particular commodity will eventually come from falling demand, rising supply, or both (2 years spent getting an MBA for that insight). Product substitution is just one factor to keep an eye on. In the short-term, we're more likely to see it in the agriculture space than metals or energy, given their relative fungibility.

If you really know what you're doing and have a great handle on the fundamentals of different agricultural commodities then you can do very well in the futures market. This can also be a bit dangerous since not all crops move together and significant retracements should be expected.

My preferred way to gain exposure to the agriculture space has been through the fertilizer space, which has been enjoying and is likely to sustain favorable supply/demand fundamentals. With these firms, we don't have to worry too much about product substitution. Yes. Different crops have different fertilizer needs, but there's nothing in the immediate future likely to totally replace potash and nitrogen use.

This past week, I added to positions in Potash (POT) and Mosaic (MOS). Both of these stocks have pulled back roughly 15% in the past 10 days as investors began rotating out of the the commodity space in general. I believe these names (and AGU which I also own) are in a secular (rather than cyclical) bull market. Their earnings growth is terrific, their valuation looking into 2009 is attractive (low double-digit P/E for both), and they're generating a ton of free cash.

Key fertilizer supply is constrained and demand continues to grow given the rising populations and dietary demands of the developing world. The rising prices of agricultural commodities is increasing the demand for fertilizers in order to maximize crop yield and also increasing the ability of farmers to pay higher fertilizer costs. These are the types of names that institutions will want to own given their fundamentals, valuation, and stock performance. This share demand support is likely to limit downside barring a significant adverse change in fertilizer supply or demand.

My strategy with these names has been to lighten as they've gone parabolic or become too large a portion of the portfolio and to add when we get these 10-20% pullbacks. A core position has been maintained regardless of price action. Should the stocks continue to fall in the coming weeks, I fully expect to keep adding.

The author currently has no camel position.