The effects of the Russia-Ukraine war may reverberate through the global fertilizer industry for years to come. Post-COVID supply-chain disruptions had already pushed fertilizer prices to cyclical highs in 2021. Russia's invasion of Ukraine in February, and the sanctions and trade supply disruptions that followed, then pushed prices even higher. Russia is a major producer of the three main types of fertilizers--nitrogen, phosphate, and potash (NPK), and a major exporter of key raw materials for fertilizer production elsewhere in the world.

High fertilizer prices have boosted earnings and profitability of the 12 global fertilizer companies rated by S&P Global Ratings. We've raised the ratings over the past 18 months on five companies that used the improved earnings to reduce debt, and revised the outlook on another company to positive from stable.

Over the near-term, we anticipate that high fertilizer prices will gradually abate, though will remain at historically elevated levels as long as there is uncertainty about global supplies and trade flows. Additional capacity could ease the market toward normality, but won't completely plug the gap created by missing Russian fertilizer volumes and export restrictions in China --particularly given our expectation of broadly resilient demand, albeit with the risk that high prices will lead to further demand destruction.

We anticipate credit quality in our fertilizer portfolio will generally benefit from these conditions, as prices will remain higher for longer, though so will volatility. Outlook uncertainties beyond the typical supply-demand fundamentals include international sanctions, logistic issues, the rebalancing of global trade flows, and export restrictions, to name a few.

Fertilizer costs, which are at a peak not seen since the 2008-2009 credit crisis, have resulted in demand destruction that is likely to continue into 2023. The lower use of fertilizers may in turn reduce next-harvest crop yields, resulting in reduced food production and ultimately increasing the number of people at risk of hunger worldwide.

Given this backdrop, activity on new projects that will create additional capacity remains remarkably low, with investment decisions hampered by rising interest rates, high inflation that jeopardizes project returns, and expensive raw materials. At the same time, investments in green ammonia production, which could help the industry meet climate change-related emissions targets, are unlikely to significantly ramp up until the 2030s, in part due to an uncertain regulatory and technology outlook.

War And China's Curbed Exports Fuel Fertilizer Prices

World fertilizer prices first reached record highs last year (see chart 1), pushed up by the rising cost of energy and transport as the world emerged from the COVID-19 pandemic. Then prices rose again in 2021, driven higher by sanctions imposed by Europe on Belarus and China's curbs on its fertilizer exports.

Chart 1

Supply considerably tightened again with the outbreak of the Russia-Ukraine war, in February, due to the large role Russia, Ukraine, and Belarus play in fertilizers and the global food supply chain (see chart 2). In 2021, Russia exported about 14% of nitrogen fertilizers, 14% of phosphates, and 21% of potash globally, according to S&P Global Commodity Insights. Russia and Belarus combined contributed around 40% of total potash exports in 2021, while Russia and Ukraine together had about 23% of global wheat exports, and 18% of global maize exports.

The protagonists share of the global food supply chain means the war's repercussions are being felt well beyond commodity and energy prices, with durably reduced exports of fertilizers affecting trade balances. Export restrictions by other key producing countries, such as China, have contributed to a structural shortfall in supply and rising prices for fertilizers and their key feedstocks, such as ammonia for phosphate fertilizers.

Chart 2

Logistics are also affected by the war. State-owned Belaruskali, which in 2019 supplied 20% of the world's potash, lost access to the Lithuanian railway network, which typically handles about 85% of its export volumes to Klaipeda port, while Russian ammonia transit routes via Odessa in Ukraine and Estonia and Latvia in the Baltic Sea are blocked.

Russia's fertilizer trade has not been the subject of official sanctions. The U.S., in March 2022, created a general license for fertilizer imports from Russia, while the EU introduced a quota for potash and complex fertilizers imports from Russia, starting from July 2022. Yet restrictions on payments have made transactions more difficult, and some shipping companies have suspended routes to and from Russia. At the same time, China has restricted phosphate and nitrogen exports to protect its domestic agriculture in response to the tight global market, while Russia has also recommended that all fertilizer exports be halted given logistics bottlenecks.

Availability, Affordability, And Demand Destruction

Shortages have pushed fertilizer to its least affordable level since the 2008-2009 credit crisis, and with prices outstripping the increase in value of agricultural commodities (see chart 3), demand destruction is now a very real concern. This is particularly the case in emerging economies and smallholder farms, which unlike commercial establishments have limited access to funding, low bargaining power, and are more vulnerable to water stress. According to Harvard Business Review, smallholders produce food for more than 50% of the population in low- and middle-income countries. High fertilizer costs may encourage these farmers to reduce use, prioritize application of certain nutrients, or switch production to less nitrogen-intensive crops. The International Fertilizer Association (IFA) estimates global fertilizer use declined 1.6% in 2021-2022 due to affordability issues, changes in crop mixes, and the war in Ukraine. It has also raised the prospect of a further decline next year.

Reducing fertilizer use for a prolonged period will cut crop yields and quality, particularly given the intensive nature of farming to meet increasing demand from humans and for animal feedstock. This in turn will have a knock-on effect on food security. Potash and phosphate under application can be tolerated in the short term: European and North American farmers temporarily reduced phosphate and potash application in 2008, during the last affordability crunch. Yet, nitrogen fertilizers have no demand elasticity because they must be applied annually to avoid negatively affecting harvests.

Over the medium term, demand for fertilizers is still likely to expand by between 1% and 2% per year. This estimate is based on forecast increases in planted areas for cereals and seed oils in Brazil, a globally declining stock-to-use ratio, and continued farm subsidies reflecting the importance of food security for governments. The UN Food and Agriculture Organization reports that farm support in the form of price incentives and subsidies averaged $540 billion per year in 2013-2018 and forecasts it will reach $1.8 trillion in 2030 if current trends continue.

A Closer Look At The NPK Markets

Potash: Tight supply will keep prices high

With 32% of global potash production capacity located in Russia and Belarus, it is unsurprising that sanctions on the pairs' potash has led to shortages in western markets.

In response to potentially prolonged supply tightness, western producers such as Nutrien, Mosaic, and K+S have announced potash capacity additions. But some of these have a long lead time and will not instantly address the current supply shortfall. Nutrien said, in March 2022, that it planned to increase potash production capacity to about 15 million metric tons in 2022--nearly one million metric tons above previous expectations. In May, K+S said that its Bethune mine in Saskatchewan, Canada, would double production to a target four million metric tons per year through incremental increases over the next two decades. AngloAmerican also aims to ramp up its polyhalite project in the U.K. from 2024/2025. Meanwhile, BHP's $5.7 billion Jansen potash mine in Saskatchewan, plans to bring forward its production start by a year to 2026, with initial capacity estimated at 4.3 million-4.5 million metric tons per year.

Against this background we think that short-term potash prices are likely to stay high for longer, supported by lower volumes from Russia and Belarus in western markets as well as relatively limited capacity additions that will keep the market structurally tight.

Phosphate: Improved availability will ease prices, but China remains a wild card

Although the war has reduced global trade with Russian phosphate producers, the product was redirected to key agricultural markets in Latin America and India, somewhat easing supply concerns expressed at the outbreak of the Russia-Ukraine conflict.

Still, the market continues to face significantly curtailed supply from China, which is the world's largest exporter, accounting for about 25% of global trade. The Chinese government's decision to extend limits on exports to international phosphate markets into the second half of 2022 will effectively keep volumes about 60% below normal export levels, according to S&P Global Commodity Insights. The quotas continue government policy, initiated in September 2021, that aims to cap domestic prices of fertilizers amid low domestic production rates due to soaring prices of coal, which is a key feedstock for ammonia production in the country.

Nevertheless, export-oriented phosphate producers have consistently invested in capacity expansion in less politically challenging jurisdictions. The resultant supply means the market is less constrained than in potash. Additional volumes should come primarily from Morocco, through state-controlled OCP's 3 million tonne fertilizer capacity addition at the Jorf Lafsar plant, which is expected to fully commence production in 2022/2023. Added to this, Saudi Arabian state-owned Ma'aden Phosphate Company's Phosphate 3 expansion project will be fully operational in 2024/2025. U.S. producer Mosaic could also provide additional volumes to the international market given its relatively low operating rate in recent quarters. In practice, however, we believe duties on Russian and Moroccan products, announced by the U.S. International Trade Commission in March 2021, along with tariffs on Chinese phosphate, will limit additional volume in the international market.

We anticipate phosphate prices will continue to decline in the near term, reflecting improved international availability, but still remain historically high, owing to the elevated prices of ammonia and sulfur, as well as the potential for further supply disruption.

Nitrogen: High natural gas prices put pressure on European production

Tightness in the global nitrogen market surfaced in early 2021 when weather-related disruptions in North America caused unplanned outages, while planned plant turnarounds, postponed from 2020, also weighed on supply. At the same time a spike in natural gas prices in Europe widened the cost differential with the U.S. and made production uneconomical, leading to curtailments and plant shutdowns in late 2021, early 2022, and more recently in August. Finally, the removal of Russian nitrogen supply from global markets coincided with strong agricultural demand, creating a price spike.

Over the medium term, we anticipate tight supply/demand for ammonia, with only limited capacity additions coming on stream. We expect urea prices will soften over 2022, as several large-scale production projects near completion, but also believe prices will remain historically high in the near term, buoyed by limited volumes from Russia, Chinese restrictions on exports, and the potential for production shutdowns in Europe due to high gas prices. The long-term outlook for urea consumption in Europe is very different to that of ammonium nitrate. S&P Global Commodity Insights foresees urea consumption declining and eventually being phased out in Europe by about 2050. This is because, while it benefits from a lower carbon footprint at the production stage than ammonium nitrate, it releases carbon on application, making it the less environmentally friendly option. Additionally, ammonium nitrate-based fertilizers have proved to be more efficient given European farm's climate and soil conditions.

Climate-regulation and technological uncertainty weighs on nitrogen investment

Since the conflict in Ukraine, investment in green ammonia has gained a new dimension, paving the way not only to fight climate change but also to reduce dependence on Russian production. However, despite strong nitrogen prices, investment activity has proven sluggish, hampered by uncertainty over the regulatory environment, the probable cost of green versus decarbonized ammonia, geopolitical uncertainty, and inflation rates that jeopardize project returns and make financing challenging. In addition, technology to produce green ammonia needs further development, bringing with it risk that committing to one technology now may render a project outdated by the time production starts.

Going forward, investments in nitrogen-based fertilizer capacities will be affected by concerns over emissions and hence will center on green and blue capacity additions (see chart 4).

Notwithstanding this backdrop, projects contributing about 63 million metric tons of green ammonia and 14 million metric tons of blue ammonia could commence production between 2021-2035, according to S&P Global Commodity Insights. Unsurprisingly, the majority of the green ammonia projects are in regions with access to renewable energy, notably in Australia (60%) and the Middle East (20%). S&P Global Commodity Insights' research also found that only 2% of green ammonia projects were announced by entities that produce or consume ammonia, leaving it lagging blue ammonia investments that involve retrofitting grey ammonia facilities with carbon sequestration units.

Investment plans will be reevaluated once there is clearer visibility over medium-term prices, prompting increased commitment to green ammonia projects from 2025, said S&P Global Commodity Insights. We expect the case for investment in the decarbonization of fertilizers will be supported by demand for green ammonia as a hydrogen carrier, tightening regulations, and converging production costs for green and grey ammonia (see "The Hydrogen Economy: Green Hydrogen May Transform The Fertilizer Industry," published April 22, 2021, on RatingsDirect).

Chart 4

Top-Of-The-Cycle Conditions Led Some Companies To Paydown Debt

Our ratings on fertilizer companies factor in the cyclicality of fertilizer prices and their sensitivity to supply-demand patterns, inventory levels of the main crops, export restrictions, subsidies, energy prices, and farm economics. Recent unprecedented top-of-the-cycle conditions led to strongly improved profitability and cash flows in our rated portfolio. This alone does not guarantee a rating upgrade, however, with company-specific factors such as financial policies and the utilization of windfall profits also important considerations.

We have therefore, over the past 18 months, upgraded only five out of 12 fertilizer entities that we rate and revised the outlook on one to positive from stable. The upgrades were supported by gross debt reduction, reflecting financial policy commitment to a higher rating. We maintained unchanged the ratings on four fertilizer companies that have not displayed such a commitment, reflecting our view that their credit metrics will weaken more rapidly in the mid-cycle environment, absent absolute gross debt paydown.

Chart 5

We raised the rating on the U.S. nitrogen-based fertilizer producer CF Industries Inc. to 'BBB-' from 'BB+' in October 2021 on debt reduction, which we believe will sustain its credit metrics during both favorable nitrogen fertilizer market conditions and when these conditions inevitably weaken. The case was similar for another U.S. company, potash and phosphate fertilizers producer Mosaic Co. (The), where a combination of a strong operating performance in 2021, a favorable outlook for 2022, and meaningful debt reduction prompted a rating upgrade to 'BBB' from 'BBB-' in August 2021. We consider Mosaic's debt paydown and its management's commitment to stronger credit metrics as supportive for sustaining its credit quality. The Netherlands incorporated OCI N.V., a global producer and distributor of nitrogen-based fertilizers, has also used strong cash flows to systematically reduce gross debt and has a financial policy commitment to maintaining leverage below 2x across the cycle. This led us to raise the rating to 'BBB-' from 'BB+' in April this year. Over the past 12 months we have twice raised the rating on K+S AG, a German-headquartered producer of potash fertilizers and salt, in response to ongoing high potash prices and debt reduction from asset disposal proceeds. This has pushed up the company's EBITDA and accelerated its deleveraging in 2021. We forecast solidly positive free operating cash flow (FOCF) for K+S from 2022. This assumes no gas supply shortage or other major disruptions in production or the supply chain. We also raised the rating on U.S. nitrogen fertilizer producer LSB Industries Inc. by one notch to 'B' in February this year after tightness in nitrogen fertilizer markets led us to forecast an improvement in its credit metrics and free cash flow generation. That said, while LSB's management has set a long-term leverage target of 4x net debt to EBITDA, we believe the company would be willing to increase leverage incrementally above this level to fund what it deemed to be an attractive acquisition or growth initiative.

Our only rating downgrade on a fertilizer company over the past 18 months was on the 95% state-owned Moroccan phosphate fertilizer producer OCP S.A. We lowered the rating to 'BB+' from 'BBB-' following a change to our rating on the sovereign.

We have also assigned two new ratings in recent months: to Abu Dhabi-headquartered nitrogen fertilizers producer Fertiglobe PLC (BBB-/Stable/--); and Koch Solutions LLC (A+/Stable/--), a newly created subsidiary within the Koch Group.

Except for Hungarian nitrogen fertilizers producer Nitrogenmuvek Zrt. and Nutrien Ltd., all outlooks in the portfolio are stable. Our negative outlook on Nitrogenmuvek reflects our view that its credit metrics are more vulnerable to external changes than most of its larger and better-diversified European peers such as Yara and OCI. This is due to its relatively small size, reliance solely on European gas prices, and limited diversification in production assets, as the company operates a single plant in Hungary. High natural gas prices, and gas availability, pose an additional risk. By contrast, our positive outlook on Nutrien reflects our belief that market fundamentals will remain strong in the near term for potash and nitrogen, and that we could upgrade the rating if the company sustains strong credit metrics while demonstrating a financial policy supportive of a higher rating.

Table 1

A Market In Flux

We have little doubt that the current top-of-the-cycle pricing for fertilizers is not sustainable. That doesn't mean that prices will fall significantly in the near-term, not least while supply remains restricted due to sanctions on Russia and Belarus and Chinese export policies.

The opportunity to strengthen credit quality metrics is clear, and already evident in a handful of recent rating upgrades. Yet, the extent to which high prices will sustain that recent momentum will also depend on credit supportive financial policies.

Such policies will need to be balanced with the opportunity to use the windfall profits from higher prices to invest in new capacities. High inflation, regulatory uncertainty linked to decarbonization, and price volatility has slowed new project launches, but as visibility improves this may change --notably for nitrogen fertilizer projects and the launch of green ammonia initiatives.

Watch this space.