Spec Value Hunter Comment - January 31, 2012: Verde Potash PEA flashes green light for game changer Cambridge Process
Verde Potash plc was recommended a Good Relative Spec Value Buy at $7.00 on December 30, 2011 based on its ownership of a vast potash resource in southern Brazil and its adoption of a two-pronged approach utilizing process innovation to shift Brazil's potash import dependency to a local source consisting of a lower grade, silicate form of potash called glauconite that was sub-economic at the $100 per tonne market price for potassium chloride (KCl) that prevailed for decades prior to the price explosion in 2008 driven by China and its fellow BRIC emerging economies. Glauconite is a greenish, slate-like meta-sediment which runs 8%-11% K2O compared to the sylvite evaporite beds that lie atop salt beds within sedimentary packages and which run 20%-30% K2O. Potash, confusingly, is the "K" in the standard "NPK" fertilizer blend, the elemental symbol for potassium, with "N" and "P" standing for nitrogen and phosphorus. The nitrogen component of "NPK" fertilizer blends is extracted from air through industrial processes, the phosphorus is produced from bedrock phosphate deposits (P2O5), and the potassium is provided in the form of potassium chloride (KCl) derived from evaporite beds or brine ponds. Phosphate deposits have a broad distribution, and their viability as a fertilizer input depends on impurities, grade, depth, and location relative to destination markets. Although China, the United States, Morocco, Russia, Brazil and northern Africa dominate phosphate production, there is no shortage of near surface phosphate deposits which could be commercially developed to serve local markets if the landed price of imports becomes excessive. Phosphate thus does not lend itself well to "security of supply" considerations in determining the feasibility of production, particularly in Brazil where the partly state owned Vale already supplies half of Brazil's phosphate needs from domestic sources..
Potash is a different matter, because not only are the high grade evaporite beds disproportionately located in regions such as Canada, Russia, and Belarus, they tend to be very deep and require multi-billion dollar underground or in situ mining solutions. The post Cold War explosion of the global economy, driven by very populous regions such as China, India, and Brazil, has fueled fertilizer demand growth, not just because more poor people have the means to consume more carbohydrates such as rice and bread, but because the growth of a nouveau riche class has boosted demand for protein, whose consumption entails tenfold the grains consumed by involuntary vegetarians. Given the double constraints of finite arable land and the interim shrinkage entailed by runaway climate change, short of a catastrophic population collapse or reversal of economic growth in the emerging regions, fertilizer demand has a long term growth trajectory fueled by the need to feed ever bigger appetites using increasingly less naturally fertile land. In other words, the growth of demand for fertilizer will exceed global GDP growth rates. Paralleling this food consumption growth trend is the consumption of transportation fuel, which, for at least another couple decades, will be dominated by crude oil. US oil consumption growth may be flat, but the rest of the world's consumption, led by China, is growing at a pace destined to keep upward pressure on oil prices, and thus the cost of bulk goods such as potash which need to be shipped long distances. This is a problem for regions such as Brazil, which have plenty of marginal land that can be pushed into agricultural productivity through the heavy application of commercial fertilizers.
The cost of shipping potash and phosphate from the dominant suppliers must ultimately be borne by the farmers. With regard to phosphorus Brazil has a natural endowment of phosphate deposits, with Vale supplying half of Brazil's phosphate needs. But in the case of potash, Brazil has only a couple accessible KCl based bedrock deposits in southern Brazil, and lots of KCl evaporite beds deep beneath the Amazon Basin. To exploit its Amazon potash beds Brazil will need to extend transportation infrastructure into this remote region, overcome the technical challenge of the salty waste water generated by mining potash in this water soaked region, and otherwise avoid degradation of this environmentally sensitive area frequently described as the lungs of the world. It is unlikely that any potash culled from the Amazon will ever be called "Green Potash" or "Verde Potash"; it will be reviled throughout the world as "Dirty Potash" or perhaps "Merde Potash". Given the country's vulnerability to higher potash costs arising from potential future supply-demand imbalances such as caught the world by surprise in 2008 before the crash cooled things off, and from higher shipping cost as the world dabbles with dangerous ideas such as "fossil fuels have no causal relationship to rising greenhuse gas levels so don't rain on our gasoline parade", or, "yes fossil fuel combustion is the driver behind climate change, but we are beyond the tipping point so lets enjoy fossil fuel combustion while this energy source remains available", or, "we can neutralize Iran's nuclear ambitions without turning the middle east into a no oil supply zone", it is no surprise the Brazilian government has taken a keen interest in the glauconite resources Verde Potash hopes to turn into a supply of potash fertilizer whose cost is a function of domestic energy costs.
Although Brazil is developing a newfound abundance of offshore oil, its production will be of a high cost nature and do nothing to mitigate already high diesel fuel related shipping costs. As things now stand Brazil's potash consumption relies 90% on imported potash, and with the supply growth potential for conventional KCl limited, this dependency can only worsen. When I adopted Verde Potash plc at the end of 2008 as a bottom-fish buy in the $0.10-$0.19 range it was because the company had a pile of cash, an intriguing conglomerate gold play in the headlands of the Amazon Basin, and a large package of recently staked claims in Minas Gerais state covering a huge known resource of low grade potash that had been investigated during the eighties but abandoned as hopelessly uneconomic compared to cheap potash from Saskatchewan. Verde Potash still has about $5 million working capital, the conglomerate gold play has been put on indefinite hold, and the "verde potash" claims in the heart of the "cerrado verde" farming region have become this junior's flagship story.
My enthusiasm for Verde Potash plc, then called Amazon Mining Company plc, jumped in 2009 after Cris Veloso staved off a gang of raiders seeking more cash to support a loan sharking operation whose clients included a jailed Canadian media magnate, and unveiled a plan to resurrect the ThermoPotash process developed during the seventies. Glauconite is a potassium bearing silicate that is worthless as a natural fertilizer because it is insoluble. Although the material has a greenish color, hence the "verdete slate" name, the areas where it outcrops is hardly lush with green vegetation. I know, for I visited the region in 2011. But Brazilian scientists discovered that if the glauconite was finely ground and heated in a rotary kiln, it would undergo a chemical reaction that would make the potassium somewhat soluble, which character could be preserved by cooling the material rapidly through a method such as quenching the hot powder in water. The resulting "ThermoPotash" material was billed as having a "slow release" character due to its lower solubility than conventional KCl fertilizer, which in Brazil was deemed to be a virtue because the acidic soil frequently inundated with heavy rains tended to dissolve and wash away the KCl in NPK blends faster than crops could absorb the potassium.
The slower release rate did not overcome the fact that ThermoPotash was only 8%-11% K2O - less when diluted with limestone as an acid neutralizer as Verde Potash proposed to do when it revived the process in 2009 - compared to the 63% K20 in potassium chloride, the standard material blended into fertilizer. This meant that farmers had to apply 6-10 times as much volume representing the "K" portion of the NPK blends in order to get the same K bang from their fertilizer if ThermoPotash was to be a total KCl replacement. Brazilian farmers never had to deal with this extra burden, for during the eighties the energy costs of producing ThermoPotash hopelessly exceeded the K2O equivalent cost implied by the $100 per tonne cost of imported potassium chloride. ThermoPotash was shelved and Vale eventually let all the claims covering the glauconite deposits drop.
When Verde Potash decided to resurrect ThermoPotash in 2009, the price of KCL had hit $1,000 per tonne in 2008, but had retreated to a range of $300-$400 per tonne that remained well above the historical average, a pattern that has become familiar and understandable in the raw material sector for anybody not swayed by the "China is a Mirage" story pushed by libertarians horribly choked up by the prospect that the winner of the globalization free-for-all of the past couple decades might be a rather un-libertarian creature called China Inc. Verde Potash decided the best approach was to market ThermoPotash as a fertilizer blend supplement, made possible in part by government wishes to reduce KCl import dependency, and partly by the argument that the slow-release ThermoPotash would still be feeding potassium to crops long after the KCl component had dissolved and washed away. How difficult this was as a marketing sell became apparent to me last year during a visit to a fertilizer blender when I realized the blenders were not overly keen about a concept that delayed a farmer's need to place the next fertilizer order. And it also became apparent that Brazilian farmers were disinclined to expend much grey matter on topics like the relative efficiency of different fertilizer blends, preferring instead to trust the wisdom of pronouncements by Brazil's agricultural academics. Not surprisingly, Verde Potash management has focused most of its ThermoPotash efforts on convincing scientists and government bureaucrats that including ThermoPotash as a fertilizer blend supplement makes sense from the standpoints of efficiency and security.
Verde Potash published a preliminary economic assessment (PEA) for a ThermoPotash based development scenario on October 28, 2010 which envisioned producing 2.2 million tonnes of ThermoPotash annually over a 40 year mine life. The after-tax net present value of this scenario at a 10% discount rate and assumed FOB Vancouver KCl price of $400 per tonne was $858 million, which worked out to a rather impressive $30 price target based on 28.4 million shares issued at the time. The next step was to complete a feasibility study during 2011 involving a scaled up pilot plant study, which did result in Verde Potash replacing the water quenching step with an air cooling step that created less process water supply and recycling issues. When I visited the test facility in June 2011 the company had already shifted the ThermoPotash tests to a larger facility. Although little has been published about the ThermoPotash process during the past six months, management assures me that the process met all expectations.
But, as some Verde Potash shareholders seemed to realize for the first time, on January 31, 2012 the junior announced that it had decided to "temporarily suspend its continuing feasibility study work on ThermoPotash". This announcement was buried inside a news release announcing the completion of a PEA for the production of conventional potassium chloride from the Cerrado Verde resource, which on January 10, 2012 was updated to a 43-101 indicated and inferred resource of 2,682,180,000 tonnes of 8.88% K2O. Management had guided us last year that it planned to postpone the ThermoPotash strategy if pilot plant studies on the so-called Cambridge Process resulted in a positive PEA, but the market seemed to be taken aback on Tuesday when the junior confirmed that the Cambridge game was on. Admittedly there had been anticipatory buying in the stock which drove it to a recent high of $8.99 last week, but the sharp $1.66 pullback to $6.90 on 530,100 shares volume on January 31, 2012 after the junior declared the Cambridge Process does work, and that the proposed mining scenario has a $2,258,700,000 after-tax net present value using a 10% discount rate, which translates into a stock price of $64 based on 35,321,222 shares fully diluted, caught quite a few shareholders and management by surprise.
The price retreat did not surprise me at all, because the PEA news release was a case study in how not to present the results of a preliminary economic assessment, even though its content was advised by SRK Consulting which prepared the PEA. On Monday after reviewing the PEA news release published by Matamec Explorations Inc for its Kipawa rare earth project I congratulated Matemec's Caroline Wilson for what I viewed as an exemplary professionally written and detailed PEA announcement. My only regret was that my analysis of the Kipawa PEA scenario and the strategic context led me to the conclusion that the only way Matamec shareholders, which include me, would experience any significant upside in the near term would be in the unlikely case that Toyota walked away without signing a binding agreement, or a hostile bidder materialized to snatch the junior away before the Japanese giant signed on the dotted line. On Tuesday, after reading the Verde Potash PEA and realizing that key elements required to understand the physical dimensions of the mining scenario were absent, I communicated to management my disappointment over the disclosure level of the PEA. That earned me an hour long conversation with CEO Chris Veloso, who sketched out for me many of the missing pieces, more of which will be available when the technical report gets filed on SEDAR in what management predicts will be 2-3 weeks as opposed to the 45 days taken by companies who rush out a PEA summary before the details have been hammered out and vetted.
What aggravated me about the Verde Potash PEA news release was the following set of omissions:
First of all, there was little explanation regarding what the PEA was all about. In late 2010 after Verde Potash started to get traction in the wake of the ThermoPotash based PEA, which included raising $10 million at $4.17 from investors that included deep interests in the Brazilian fertilizer industry. But in December 2010 management introduced a new wrinkle to the story by stating that it had filed for patents regarding a process developed on Verde Potash's behalf by Cambridge scientist Derek Fray which purported to represent a potentially commercial way of converting the silicate based potassium in the "verdete slate" (glauconite) into the conventional fertilizer materials potassium chloride (KCl) and potassium sulphate (SOP). Nobody bought the private placement on the basis of this story, and for me to appreciate its significance Cris Veloso had to draw my attention to it and explain it, at which point I realized Verde Potash had morphed from an interesting "security of supply" story into a potential game changer for the potash industry. If the Cambridge Process worked, as it became known, Verde Potash would no longer be restricted to nibbling away at its vast 8%-11% K2O glauconite resource to produce a whole rock based product called ThermoPotash which the government force fed as a supplement into fertilizer blends farmers had little choice but to adopt. Because of its large volume relative to KCl, ThermoPotash could never replace KCl, and would at best replace 15% of Brazil's KCl requirement. In contrast, if the Cambridge Process could convert the glauconite into KCl at a price competitive with the lowest foreseeable delivered cost of imported KCl potash, and there were strategic reasons for blenders and farmers to purchase locally sourced KCl if given an option, Verde Potash could eventually supply all of Brazil's future potash requirements. This had huge implications in a style similar to that of the process Orbite Aluminae Inc is working to commercialize for the conversion of its vast alumina clay deposit on the Gaspe Peninsula into the dominant source of smelter grade alumina for the Quebec aluminum industry. The Grande Vallee alumina clay resource is so large the mining plan proposed by Orbite's PEA can be duplicated 10 times to replace 50% of the Quebec industry's bauxite derived alumina import dependency. A similar scaling up is possible for the verdete slate whose PEA proposed KCl output would be 600,000 tonnes annually from 2015-2018, expanding to 1.6 million tonnes from 2019 to 2024, and 3 million tonnes from 2025 to 2045 reflecting the arbitrarily set 30 year mine life.
Verde Potash has published scant details about the nature of the Cambridge Process, and the PEA news release not only fails to mention the "Cambridge Process" on which anybody who owns the stock has pinned their hopes, but offers little beyond declaring the PEA to be about the "production of conventional potassium chloride" and that it involves a "proprietary production process". There is nothing to signal that a year of pilot plant studies and optimization efforts have turned Dr Derek Fray's conceptual process into a flowsheet ready to be engineered into a large scale production plan. In fact, one is left either with the impression that this is just another boring potash play that will never get funded into production, or some black box story best avoided. Verde Potash did organize a field trip on February 2 to Allentown in Pennsylvania where a couple dozen analysts had a chance to see a demonstration plant in action and secure a pretty good understanding of how the Cambridge Process works. I suspect that this first hand knowledge will start to manifest itself in the market within a couple weeks as these analysts share with their clients the comfort they gained from the demonstration.
The second omission is that Verde Potash fails to make any reference to the physical resource that will feed the mining plan, which I've already mentioned is an indicated and inferred resource of 2,682,180,000 tonnes of 8.88% K20, which is equivalent to 375 million tonnes of KCl or roughly seven years of current global production. Instead, Verde Potash talks about 600,000 tonnes of KCl output ramping up to 3 million tonnes by 2024. It talks about costs per tonne of KCl, but does not provide the grades needed to convert costs into costs per tonne of ore, the basis by which discounted cash flow models generally get constructed. In fact, the reader is left wondering on what basis Verde Potash thinks it has a 30 year mine life on its hands. Veloso explained to me that phase 1 involved mining the verdete slate at 15,000 tpd, phase 2 at 45,000 tpd, and phase 3 at 87,000 tpd, which for a year round operation would deplete about 771 million tonnes over the proposed 30 year mine life, which is about 25% of the inferred resource, which in turn is about 25% of the global resource in the region. In other words, there is more than enough potash ore for the mining plan proposed by the PEA.
The third omission involves treating this industrial mineral play as if it were just another gold mine whose audience is only interested in misleading figures like cash cost per ounce and how many ounces will be produced. The market is full of dummies inclined to like gold, but finding a dummy who likes potash is not so easy. The sort of audience willing to entertain an industrial mineral play with a process innovation twist will want to know details about input costs in order to determine the vulnerability of cost assumptions. Cris Veloso did explain to me that the flowsheet involves grinding the glauconite in conjunction with limestone, which Verde Potash already controls (Calcario - 43-101 estimate 269 million tonnes Sept 26, 2011), and sodium chloride (salt) which is readily available in Minas Gerais, and putting it into a rotary kiln where it is heated with petroleum coke, a refinery waste product that works well as a fuel for rotary kilns. This process creates a chemical reaction that results in salt based products which get dissolved in water from which the KCl can be selectively precipitated. This tells me that the supply and cost of reagents are not a major concern, and, assuming petroleum coke supply becomes even less of an issue when Brazil's offshore oil reserves come on stream, a supply of electricity for grinding is the main energy variable.
A fourth omission is Verde Potash's failure to make clear its revenue side assumptions. The company declares that the PEA assumes "an average granular KCl price of $539.97 per tonne FOB Vancouver based on market research by CRU International", and that "the net sales price per tonne realized by Verde has been adjusted for the final costs of delivered product in the Brazilian Cerrado, approximately $120 to $180 per tonne". What this means is that Verde assumes it will be able to sell its KCl to blenders in Minas Gerais for $660 to $720 per tonne. Is this a reasonable price assumption? Hard to tell unless you are a potash expert, which most readers of the PEA news release are not. Veloso explained to me that the PEA is based on annual FOB Vancouver price forecasts by CRU as well as its shipping cost projections for Brazilian port delivery - in effect a speculation on future oil prices - , on top of which are added a variety of costs that would not apply to KCl produced in Minas Gerais from the verdete slate. These include various port charges, a 25% Brazilian tax on the cost of transporting a good from source to Brazilian port, demurrage fees (how much time a ship waits in a harbor to load or unload), transit loss (material that "blows" away during shipment), freight insurance, the financing cost for the 150 day shipping cycle, currency hedge costs, and finally the overland transport cost from port to blender, all of which make up the $120 to $180 price adjustment to the original FOB Vancouver cost. These CRU forecasts envision the KCl FOB Vancouver port price to be in the $434-$455 per tonne range during the early years of production (2015-2018), climbing to $651/t during 2019-2024, before settling back to $549-$551/t in 2025 when the output scales up to 3 million tonnes of KCl annually, with a $50 per tonne shipping cost from Vancouver to Brazil assumed.
Conclusion: With the help of management I was able to boost my comfort level about the monetary disclosures made by the PEA news release, and I am no longer concerned that the stock's price retreat reflects a negative reaction by knowledgeable market players to the glaring absences in the PEA news release. I think the stock went down because the market expected the sort of fleshed out news release that in a sense I have just provided, and once the suspicion disappears that this sloppily written news release is not a reflection of deeper problems (annoyingly this is not the first time a badly written Verde Potash news release has hurt the stock price - remember the carrot study last April which suggested that ThermoPotash was as effective as no ThermoPotash, which was also the case for the KCl control?), I think the stock will move up sharply. Possibly weighing on the market is the fact that Verde Potash will have to raise some money later this year. It has about $5 million working capital left, and Cris Veloso indicates that a bankable feasibility study, which will largely involve engineering work and a resource upgrade to measured and indicated (2011 pilot plant work involving the Cambridge Process was sufficient to rule out additional scaled up studies), will cost $15 million. So our friends on Bay Street and Wall Street will be doing their best to work the stock price down to ensure a lucrative financing price. I have watched the stock closely over the past year, hoping it will suffer a sharp price drop as it did during the carrot fiasco so that I can get a position at a really good price, but despite a generally illiquid market and a fair amount of volatility, buyers always seem to be in the wings ready to pick up stock above $5. If we assume the current 35.3 million fully diluted gets boosted to 40 million through a major financing over the next six months, the $2.3 billion after tax net present value provided by the PEA translates into a $57.50 price target. The mining expansion plan has been designed to start with an initial capital cost of $654 million, requiring an additional $1,715,200,000 to expand capacity to 3 million tonnes KCl output per year by 2024, with the later capital raised through internal cash flow. Obviously if a deep pocked major such as BHP or Vale decided a year from now that the feasibility study was sound but too conservative, it could initiate a buyout on that basis which might value Verde Potash in the $40-$50 range, and then use internal cash resources to scale up to 3 million tonnes of annual KCl output much more rapidly. The willingness of Verde Potash to publish a PEA with the endorsement of SRK Consulting for the production of conventional potassium chloride from a low grade silicate based form of potash hitherto regarded as a geological curiosity using a recently developed process should be viewed as a green light that the technical challenges have been solved, and that the greatest risks preventing a substantially higher price for Verde Potash are a population collapse, cheap crude oil, and a magical decline in the high capital costs of all those underground KCl potash projects in the development pipeline. With the publication of this PEA Verde Potash goes from a Good Relative Spec Value Buy to a Good Absolute Spec Value Buy at current prices. In terms of an end game, an obvious takeover bidder is Potash Corp itself, which stands to lose a major market for its potash output if the verdete slate comes on stream as a domestic source of conventional potash in Brazil, and which would garner considerable strategic benefit by having a foothold in one of the world's most important future agricultural districts.