Overgrown

Droughts and floods have led to widespread destruction and have ravaged China’s arable land, which accounts for just 15% of the country’s area – but you wouldn’t know it to look at the numbers. China still manages to produce 24% of the world’s grain and has recorded six consecutive years of output growth, with harvests totaling 530.8 million metric tons in 2009. The key is fertilization, which contributes about 50% to grain yields.

Considered a strategic resource, domestic grain yields are boosted by the widespread use of urea and potash fertilizers. These are produced by several state-owned enterprises like China National Petroleum Corp and China Petroleum and Chemical Corp, as well as a growing number of smaller, privately owned companies like China XLX (1866.HK).

With an abundance of coal and secure supplies of natural gas as sources for urea – the key input in domestic fertilizer production – the debate has shifted away from how to ensure there’s enough fertilizer to go around to what to do about all the excess.

"The main issue facing China’s fertilizer industry is overproduction, and with it excessive competition," said Yu Lei, vice general manager of Anhui Zhongzi Ecological Fertilizer. "Right now the fertilizer industry is dispersed and no one can really dominate it."

State support

However, the China National Chemical Information Center (CNCIC), which advises the Ministry of Science and Technology and the Ministry of Commerce, noted in a recent report that the government has clear policies for the fertilizer industry, notably to support agriculture and grain production, and to guarantee domestic supply and national grain safety.

And the government provides substantial support for agriculture. The national budget for the sector increased to US$120 billion this year compared with about US$50 billion in 2006. Subsidies for agricultural supplies – including fertilizers – jumped to US$10 billion from US$1.7 billion four years ago, while supplies of urea and fertilizer were kept high enough to keep price growth under control.

"Too high a price of fertilizer will dampen farmers’ enthusiasm for grain planting," CNCIC said. It said the government did not expect significantly higher export volumes of fertilizers either: A sharp increase in exports would reduce domestic supply, pushing up prices and leaving farmers to foot the bill. 

In 2008, to ensure domestic supplies were maintained and prices remained subdued, the government announced a 100% export duty on phosphoric acid, ammonia, nitrogen, phosphate, potash and compound fertilizers. The National Development and Reform Commission and the Ministry of Finance early last year announced a reversal of these tariff restrictions, but subsidies remain high and so does supply.

Coming consolidation

Chen Shuwei, vice president of Beijing Orient Agribusiness Consultant (BOABC), agrees that overproduction is the main issue today. However, he says the next chapter in the sector’s growth story is consolidation, and with it the tightening of production.

"It is inevitable that smaller fertilizer companies will be taken over by the larger producers. Right now the biggest 20 companies produce about 50% of the country’s fertilizer, but the number of main fertilizer producers has already fallen to about 200 companies from over 1,000 before," Chen said.

This number is likely to shrink further. With the financial crisis now mostly behind it, the central government is returning to its earlier focus of squeezing out inefficient or polluting companies across several industries, including fertilizer. 

CLSA analyst Jonathan Galligan anticipates that smaller domestic players will be forced out of the market allowing for larger state-backed conglomerates to soak up market share. But the consolidation of the sector doesn’t just involve state-owned parents transferring assets top-down to its chemical and fertilizer subsidiaries.

"Will there be more asset injections from parent [companies]? My gut tells me that’s not going to happen," said Galligan.

Using phosphate fertilizer maker China BlueChemical (CMC, 3983.HK), a unit of China National Offshore Oil Corp (CNOOC; CEO.NYSE, 0883.HK), as an example, Galligan said there are indications that state-owned subsidiaries are themselves targeting acquisitions from parents and smaller firms in the region. They are no longer relying on direct asset transfers.

CMC announced in July that it would acquire an 80% stake in a coal-based urea plant in Heilongjiang, while the company’s wholly owned subsidiary CNOOC Fudao recently signed an agreement to buy a 21% equity stake in Guangxi Fudao AMP, bringing its interest in the company to a controlling 51%.

"This restructuring creates better synergies and greater profitability," Galligan said.

Galligan believes that China’s modern fertilizer industry is still in its infancy and that in time, several companies like CMC or Sinofert (0297.HK), a unit of Sinochem, could indeed emerge as market leaders. Galligan has a "buy" recommendation on CMC with a target price of HK$6.14 (US$0.79), and an "underperform" rating on Sinofert with a target price HK$3.26 (US$0.42).

Henan-based China XLX, which produces its urea from coal but still does not control its own mining sources, could face price risks. CMC, on the other hand, derives its urea largely from natural gas. Although gas prices are generally more volatile than coal, it is a commodity that parent CNOOC has in abundance.

While smaller, inefficient fertilizer producers rightly fear that consolidation in the sector will squeeze them out of the market, having two or three dominant players like CMC or Sinofert will allow more leverage for pricing. This should alleviate worries over profitability in the face of the continued strong supply supported by government policy. 

"National policies have both positive and negative influence on the fertilizer industry. But advantages outweigh disadvantages on the whole," the CNCIC said in its report.

Encouraging wastefulness

One disadvantage remains to be addressed, however: Fertilizer oversupply leads to overuse. A recent survey by environmental organization Greenpeace found "abundant" overuse of chemical fertilizer in China, and noted that the country’s consumption of fertilizer continues to be the highest in the world.

Only 30% of chemical fertilizer is actually absorbed by crops, leaving nearly 70% to enter water systems by surface runoff, Greenpeace said. This can lead to phenomena like the algae bloom outburts seen in China’s rivers and lakes. Greenpeace noted that more than 85% of China’s lakes are polluted by excessive richness of nutrients.

Pollution may be a tradeoff that Beijing is willing to make. CLSA’s Galligan believes that at the end of the day, oversupply is what the government wants.

"Oversupply means farmers have wide access to cheap fertilizers and this increases grain output," he said. "And this puts more money into farmers’ pockets."