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Why Agrium Inc. and Potash Corporation of Saskatchewan Inc. Are Buys: Merger or Not

Most often, some of the biggest returns in investing are generated with contrarian plays—buying sectors and names that are generally out of favour in the investing community. Like anyone who bought oil names in February this year (when bearishness was at its peak), this strategy can be handsomely rewarded when it is supported by sound fundamental analysis.

While it would be very likely incorrect to say the agriculture and fertilizer sector will see the type of rapid and recovery oil saw earlier in the year, the sector as a whole is showing attractive value, especially given both the medium and long-term favourable backdrop.

Weakness in the sector has been driven by an abundance of factors. Four straight years of historic bumper crops have weighed down crop prices and farmer incomes. Corn prices, for example, averaged $5.71 per bushel from 2010 to 2014, $3.51 in August 2015, and August 2016 averaged only $3.11. The end result is that U.S. farm net cash income has fallen to an eight-year low.

This has pressured demand for fertilizers (especially potash) at the same time that weak emerging-market currencies have affected demand, and the potash industry has suffered from a significant state of oversupply due to increased competition, currency tailwinds for Eastern European producers, and too much capacity expansion.

The result? Potash Corporation of Saskatchewan Corp. (TSX:POT)(NYSE:POT) is only 14% off its 52 week low, and most of that increase off the lows was due to mergers news.

Things are turning around

Looking first at crop prices, the long-term fundamentals are positive. Firstly, low crop prices are due to abnormally high supply levels, not insufficient demand. Demand for all the major grains (corn, wheat, and soybeans) are currently at record highs, and global population (currently at 7.4 billion) is rising rapidly; the population in 2050 is estimated to be between 9.6 and 10 billion.

This means there will be a staggering 2.6 billion more people. According to a recent Financial Post article, these extra 2.6 billion people will also require more calories—3,050 calories per day, per capita, which is up 3.6% from today—by 2030. This increase in both population and calories per person will occur with less arable land. Arable land in hectares per person has declined by 46% over the past 55 years, and with global warming and urbanization, this trend should continue.

These trends will both increase the demand for crops while putting pressure on supply. While the past four years have seen booming crop stocks thanks to ideal growing conditions, less perfect conditions (like too dry or too wet weather) will put pressure on supply and could lead to huge price spikes (like in 2012 when dry weather caused a big spike in prices).

Improving crop prices are good for fertilizer prices

Over the long term, the only way to meet the food requirements of a growing population with less arable land is to increase the yield per hectare by using fertilizer. While 2030 and 2050 may seem far away for investors, fundamentals for potash and nitrogen fertilizer are slowly improving already.

On the potash front, there have been major supply curtailments. In North America, all of the producers that were on the expensive end of the cost curve have closed, which equals six mines and 2.25 million tonnes of capacity. Globally, about 5.7 million tonnes have come offline since 2014. This is significant for a market with an estimated 2016 operational capacity of 65 million tonnes. At the same time, fertilizer is now more affordable than it has been in years.

On the nitrogen side, Agrium Inc. (TSX:AGU)(NYSE:AGU) estimates that 60% of global nitrogen capacity is currently uneconomic. The result is that in China (the highest-cost producer, about 24 million tonnes per year have been coming offline.

Currently, both Agrium and Potash Corp. are trading at P/E ratios significantly under the S&P 500, and with the long-term outlook in mind, they are good buys today.

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Fool contributor Adam Mancini has no position in any stocks mentioned. Agrium Inc. is a recommendation of Stock Advisor Canada.

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