The Long Cycle


By Monish Chhabra ǀ 24th August 2013

On 18th July, the city of Detroit filed for chapter 9 bankruptcy, which is the largest municipal bankruptcy filing in the US history.

The following picture encapsulate the dramatic fall of this once thriving center of business.

Michigan Central Station, 2012
Source: Jennifer Garza-Cuen

Cyclical & creative destruction is an essential part of both evolution and capitalism. The length of the cycles vary and sometimes get so long that we start believing a cyclical phase to be a permanent state of affair.

Another cycle that seems to have turned is that of bond yields. In July, 10-year US treasury yield hit a high of 2.75%. This yield bottomed at 1.38% last year, also in July. The rate has exactly doubled in last one year.

As the era of super-cheap and super-easy money comes to an end, expected ROC (return on capital) would have to rise to justify new or existing investments.

A higher expected ROC can be the result of; either a serious de-valuation and/or higher growth prospects. If the growth is lacking, de-valuation and de-rating would put many entities under pressure.

One such institution—Belarusian Potash Co—cracked and fell apart this month.

This JV (actually a Potash Cartel) was formed in 2005, between Russia’s Uralkali and Belarusian state-owned company Belaruskali, to control about 1/3rd of the global supply of Potash and fix it prices.

Along with another such north-American cartel (comprising of PotashCorp, Mosaic and Agrium), they together controlled and fixed 2/3rd of the global supply.

Potash—an important ingredient of fertilizers—reached its peak price of $840 a ton in 2009. China is the largest consumer of potash, taking up almost a fifth of the global supply. The spot price in China fell below $400 per ton in July.

More than halving of prices since 2009 has put potash producers under stress and particularly those with higher cost of production. On 30th July, Uralkali announced its exit from the JV, effectively ending the cartel’s policy of putting ‘price before volume’.

It’s rationale is simple to see. They do not expect potash prices to rise anytime soon. In fact, Uralkali also announced that they expect potash prices to fall to $300 per ton by the end of this year.

In the face of rapidly falling revenue, the company chose to exit the JV that limits its output. It now intends to produce at full capacity and sell at whatever price it can, to protect its revenues.

Its an open price war now and each company has to fend for itself. Marginal producers would be wiped out. Excess capacity would be wiped out. Excess leverage would be wiped out. Until a new low is reached where a new equilibrium is established between the ‘much-subdued growth expectations’ and the ‘production capacity at a higher cost of capital’.

This is the cyclical destruction in action. Potash is just the beginning.

This write-up is for informational purpose only. It may contain inputs from other sources, but represents only the author’s views and opinions. It is not an offer or solicitation for any service or product. It should not be relied upon, used or construed as recommendation or advice. This report has been prepared in good faith. No representation is made as to the accuracy of the information it contains, nor any commitment to update it.