The economic argument for investing in a new ammonia plant today is that ammonia prices, being cyclical, will recover from their present short-term low, but that natural gas prices, being fundamentally altered by the shale gas revolution, will stay low in the long-term.

Timing investment decisions in a cyclical industry
There is an conflict inherent in the traditional process for making project financing decisions. In a sensible attempt to reduce risk, investors and debt providers use current and historical prices to predict whether future income will be enough to earn profits. Unfortunately, in a cyclical industry like fertilizer, when recent prices are used to estimate future profits, the strongest justification for an investment always comes when prices are at their most inflated – which happens just before the market collapses.

This is like advising someone to buy high and sell low: the least profitable strategy. It can take years to build a plant, and the favorable market conditions that prevailed at the time of the investment decision may have evaporated by the time the plant is built. Hence US Nitrogen’s pain.

Illustration: CF Industries
In 2012, CF Industries’ nitrogen segment was hugely profitable, with a gross margin of 57.2% on 13 million tons of product. In late 2012, CF announced it would spend $3.8 billion (finally $5.2 billion) to build out another 4 million tons of product capacity. Given those fat margins, this may have looked like a wonderfully profitable idea.

But by the end of 2016, when all that new product finally became available for sale, CF’s gross margin had shrunk to 22.8% on 17 million tons. In yesterday’s Q1 2017 results, it is down to 10.2%. (CF’s definition of “gross margin” includes many factors that affect whether we interpret these numbers as good or bad, like accelerated depreciation on its new assets, which is included, causing major tax benefits, which are excluded.)

But fertilizer prices have been low before, and they’ll be low again. CF may have had a poor quarter, like every other nitrogen producer, but these new ammonia plants will probably be wonderfully profitable in the future. They are not short-term investments.

The driver of CF’s investment decision wasn’t only, or even primarily, the temporary high price of ammonia but the long-term low price of natural gas. To illustrate the impact of the shale gas revolution on the profitability of ammonia production, compare today’s business with that of 10 years ago.

Ammonia prices have run their cycle, from the $300s up to the $600s (when CF made its investment decision) and back down to the $300s. Natural gas costs, however, moved in a different pattern: down.

CF INDUSTRIES	2007	2012	2016
Ammonia, average sale price, per ton	$388	$602	$341
Gross Margin *	21.9% $85/ton	57.2% $344/ton	27.3% $93/ton
Ammonia, cost of sales, per ton	$303	$258	$248
Natural Gas, cost, per mmBTU	$7.81	$3.39	$3.07
Natural Gas, consumption per ton ammonia	33 mmBTU	33 mmBTU	32 mmBTU
Feedstock share of Ammonia cost of sales	85% →	43% →	40%
* Gross Margin is for “Nitrogen” segment in 2007 and 2012, but for “Ammonia” segment in 2016. Data from source material is given in regular font; computed data is given in italics. Units: US dollars, short tons of ammonia, mmBTUs of natural gas. Sources: CF Industries Annual Reports, 2007, 2012, 2016.

In the US, natural gas traditionally represented 75% to 90% of an ammonia plant’s operating costs (85% for CF Industries in 2007). Today, natural gas represents less than 40% of the operating costs.

Not just CF Industries, but across the US
For some companies, those operating costs have simply shrunk and the profit margins grown. For CF in 2016, the costs haven’t shrunk that far: I assume some of the natural gas savings have been replaced by significant additional capital costs and depreciation associated with the capacity expansion projects.

For reference, at Dyno Nobel’s plant in Waggaman, LA, we have precise estimates for operating cost per (metric) ton: 32 mmBTU feedstock consumption, plus $47 cash costs, plus $12.5 maintenance costs ($10 million annual sustaining capex amortized across 800,000 tons). These operating costs come to less than $160 per ton ammonia, assuming CF’s 2016 natural gas price, but probably omit investment costs and depreciation so aren’t directly comparable to CF’s numbers.

But the same trend holds true even for a project that saw terrible cost escalations. I was glad to note from its Q1 2017 earnings that LSB Industries doesn’t appear to regret its investment decision – unlike US Nitrogen. The benefits at El Dorado, AR may be small, in this pricing environment, but they should grow with time.

A significant benefit of the new ammonia plant at our El Dorado facility is producing our own ammonia versus previously purchasing it. During the quarter, we picked up approximately $6.5 million in EBITDA versus the first quarter of 2016 by producing our own ammonia.
Seeking Alpha, LSB Industries Q1 2017 earnings call transcript, 04/23/2017

(Note, given the debt load caused by the El Dorado project, I suspect that this $6.5 million before interest drops to a more significant negative number after interest.)

Now, because natural gas is only 40% of ammonia opex …
This new reality, that feedstock costs could represent less than 40% of the operating costs at a new ammonia plant, or around $100 per ton ammonia, underpins the efforts of project developers like Northern Plains Nitrogen to launch a second round of industry expansions.

Financiers look to reduce risk, which means using proven data like historical prices to demonstrate profitability. So, although today’s ammonia prices don’t make an obvious investment argument, the performance data we’re seeing from these new plants do.

It is now a demonstrable fact that the generation of new plants launched in 2012, like CF’s Donaldsonville and Port Neal or Dyno Nobel’s Waggaman, run at such low costs that they can be successful even in low pricing environments. If this is enough to overcome the other proven fact – that most 2012 projects went horribly over-budget – we may have another spate of investments in North American ammonia.

The pipeline of projects is already well established, but nothing will happen unless investors and lenders buy into this revised business case. For more on US Nitrogen’s regrets and Northern Plains Nitrogen’s ambitions, see my article: Ammonia prices are low (so start building your ammonia plant now).

The last question to ask would be: how long will natural gas stay so cheap?