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Potash Corporation of Saskatchewan Inc. Cuts Production: What it Means for Long-Term Investors

While it likely didn’t come as a surprise for many, Potash Corporation of Saskatchewan Inc. (TSX:POT)(NYSE:POT) announced weak Q3 2015 earnings—earnings were down 10% from last year, and the company reduced its 2015 year-end guidance for both earnings and sales volumes.

What did come as a surprise was that Potash Corp. announced they are fast-forwarding the closure of their Penobsquis mine in New Brunswick. Penobsquis was due for shut down next year as the company transfers to its new lower-cost Picadilly mine facility, but weak demand and pricing contributed to an early closure. On top of this, Potash Corp. will be implementing three-week inventory shutdowns at three operations in December.

While production cuts are always concerning, understanding the reason for the production cuts and how they fit into Potash Corp.’s long-term strategy should provide comfort to long-term investors.

Why Potash Corp. reduced production

Two factors contributed to Potash Corp.’s move to reduce production—a slightly slower outlook on demand and weak pricing. Potash Corp. lowered its overall potash sales volume guidance for the year from 9.3-9.6 million tonnes to 9-9.2 million tonnes. Realized prices for the recent quarter were $250 per tonne compared to $281 per tonne during the same period last year.

There are a few factors influencing demand. Firstly, key crop prices like corn and soybeans have seen price declines in the 30% range. This has been due to several years of record crop production, and low crop prices mean farmers have less money to spend on potash.

Secondly, currency weakness in China, Brazil, and India (key markets for Potash Corp.) has greatly reduced the buying power of farmers in these countries, since potash is priced in U.S. dollars. In Brazil (the source of the majority of Potash Corp.’s offshore shipments), this has been particularly pronounced with the Brazilian real falling 14% over the past three months.

At the same time, weak demand in North America (where 31% of Potash Corp. sales go) combined with heavy competition resulted in both price and volume declines from the region.

As a result of these pressures, Potash Corp. decided to implement production cuts to help manage inventory levels and match supply with demand.

What it means for long-term investors

Looking deeper into Q3 2015 reveals that the demand picture for potash is not as weak as headlines suggest. Despite all the headwinds, potash shipments to offshore markets actually increased by 22% from the same quarter last year. Most of the weakness came from volume declines in North America.

Even with Potash Corp.’s newly reduced sales volume guidance of 9-9.2 million tonnes, the company would come in only slightly below 2014’s 9.3 million tonnes. Over the long term, the demand picture for potash in North America and offshore is compelling as there will be a need for increased crop production to keep pace with grain demand, which has increased by an annualized rate of 2.2% during the past 20 years.

In the mid-term, improving crop prices from crop production coming off record highs and the need to replenish nutrients removed by these record crops should support demand.

Much of the issue for potash comes on the supply front with 15.7 million tonnes of new production currently being planned, and many producers producing near capacity to gain market share. Potash Corp.’s recent shutdowns are a reflection of its overall competitive strategy for dealing with this.

Potash Corp. has long held a strategy of price over volume, which means not producing in excess of market demand in order to maintain prices. This allows Potash Corp. to maintain available capacity for when demand increases and also allows prices to increase quicker with demand than they would if there was excess production.

As the world’s largest producer with 20% market share, this sort of production discipline is important; it also demonstrates their flexibility. Because Potash Corp. has some of the world’s lowest-cost potash operations, it has the flexibility to respond in weak market conditions by increasing utilization at its low-cost operations, while reducing production at its higher-cost operations.

While production cuts are never good, long-term investors should stay focused on the demand picture as well as Potash Corp.’s competitive advantages and ability to respond to all market conditions.

In the meantime, Potash Corp. has a sustainable and growing dividend that typically pays above 4%, making it a top dividend payer.

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Fool contributor Adam Mancini has no position in any stocks mentioned.

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