CVR Partners: Likely A Yield Trap (NYSE:UAN)

Eloi_Omella

Over the last two years, I've seen a lot of companies that look cheap due to higher commodity prices and higher prices on correlated services such as shipping, but end up being value traps as the supply chain issues present in 2022 are corrected. An example of a company I wrote about two months back was ZIM (ZIM). My view is that investors bought into the stock due to the low P/E ratio and high yield without understanding the risks involved. Soon after the company's earnings went down as it's a cyclical business, the dividend was completely cut, and the stock price crashed. I potentially see something similar with CVR Partners, LP (NYSE:UAN), in that many are buying simply due to the high yield without understanding the risks involved with it and the possibility that the distribution is completely cut.

I think the opportunity with CVR Partners is that the yield is substantially reduced when fertilizer prices go down, which causes purely distribution-focused investors to sell out. This could longer term lead to a deep-value investing opportunity for investors who aren't just buying as a pure yield play.

The biggest impact on CVR Partners is the macro environment and more specifically nitrogen fertilizer prices.

Nitrogen fertilizer prices went up in 2021 due to high inflation, higher energy prices, higher demand, and years of underinvestment in the commodity complex. Then in 2022 prices skyrocketed even further due to the Ukraine War. In the process, the unit price for CVR Partners went up 22x from its 2020 lows.

Over the last year, fertilizer prices have retreated and this showed up in the most recent quarterly earnings when operating income was down 40% over the prior quarter. While this is very bearish and the price is down due to this weak earnings report, I don't think the market has priced in how low fertilizer prices could truly get and how much that would impact CVR Partners.

Below are fertilizer prices:

World Bank

Source

Urea is what primarily impacts the revenues of CVR Partners, so that is where most of the emphasis should be put when doing analysis in my view. It's down from its high but is still nowhere close to where it was in 2021.

When it comes to forecasting future fertilizer prices the trouble is that the fertilizer market doesn't have many liquid futures markets and unlike well-followed commodities like agricultural commodities there are few institutional analysts covering this space. So directly looking at inventories and demand for fertilizers is tough. Instead, I like to look at the main input into producing fertilizers which are natural gas and the energy complex; as energy prices go up it cost more to produce fertilizers so supply goes down and vice versa.

Below is a chart of fertilizer prices and their correlation to both corn and natural gas prices:

Farm Doc Daily

Source

As can be seen, ammonia fertilizer prices are highly correlated to both natural gas and corn prices. This is because natural gas is a cost input and the agricultural industry creates demand for fertilizers.

I want to start by looking at natural gas prices and where they are headed. The biggest trade in the natural gas markets since the Ukraine War was the arbitrage trade between European natural gas and American natural gas. American natural gas stayed cheap as the U.S. producers are producing all the natural gas that the U.S. economy needs, while natural gas in Europe went up due to the sanctioning of Russian imports.

Below is the price of natural gas on Dutch front-month Natgas Futures:

WolfStreet

Source

Below is the spot price for natural gas with the Henry Hub settlement:

Tradingview

Source

While both American-settled natural gas and European-settled natural gas contracts went up in 2021 and 2022, American natural gas didn't go up anywhere close to the amount that European natural gas did. This created an arbitrage opportunity where natural gas in the U.S. could be sent to Europe and the spread could be pocketed. Unlike oil, natural gas is very hard to transport; the only way to get natural gas from the U.S. to Europe is by turning it into LNG and then transporting it from an LNG terminal. In this process, there were also many hiccups such as the Freeport LNG terminal, one of the largest in the world, being shut down for two months due to a fire.

Because this process is difficult the spread between American and European natural gas has taken a long time to get closer to converging. But now European natural gas prices have started to get to the point where it won't be as economical to import natural gas there from the U.S. Once this happens then the demand for American natural gas will go down.

At the same time, production of natural gas in the U.S. is at all-time highs:

EIA

Source

With the production levels of natural gas continually going higher in the U.S. and with demand likely to slow significantly with the closing of the arbitrage between European and American settled natural gas contracts, it's likely that natural gas prices are headed lower.

With a high probability of lower natural gas prices, fertilizer supply should go up.

On the flip side, we want to look at corn prices and where they're headed to find out the demand situation for fertilizers.

Below are the biggest corn-producing countries:

Statista

Source

CORN ETF:

Tradingview

Source

Initially, the war in Ukraine caused corn prices to spike as can be seen on the above chart. Since then prices of corn have retraced down, but it's still not down to 2019 levels yet.

Similar to the situation with natural gas the corn market has reacted to the 2022 spike in corn prices by introducing more supply:

Kansas State University

Source

With high inventories of corn in the U.S., there is unlikely to be a price spike over the next year.

On top of this, even if the U.S. has a serve drought or other climate impacts over the next year it seems unlikely that corn inventories will go down a lot. This is because other parts of the world are having record production which will provide more supply over the next couple of months. Brazil for example has record corn production as seen in the chart below:

Farm Doc Daily

Source

Both 2021 and 2022 had a record 41.3 million acres of farmland, which in 2023 made a record 4.030 billion bushels. With more farmland than ever and record production for two straight years, Brazil is expected to outpace the U.S. in corn exports:

Farm Doc Daily

Source

Brazil is also increasing acreage at high double-digit rates:

Farm Doc Daily

Source

With corn production in Brazil going up, exports in the U.S. are dropping. This means there's an expected surplus supply of corn in the U.S. over the next few years. I think this will likely cause lower U.S. corn prices, making for lower demand for fertilizers.

Overall the macro looks bearish on fertilizers with higher supply and lower demand.

This does beg the question of why this bearish forecast on fertilizer prices isn't getting priced in by market participants. While UAN has come down from its highs its nowhere near where it was in mid-2021; the reason I use mid-2021 as a base level is because that is likely where fertilizer prices are once again headed as that is where it was prior to the supply chain and inflationary pressures in 2022. Keep in mind that the mid-2021 level is still generous as that is above where fertilizer prices were from 2014-2020.

The reason I think that the bearish forecast hasn't been priced in is that UAN has attracted investors who invest purely for the yield. This can be seen by comparing the performance of UAN to peers in the same industry:

Seeking Alpha

Source

As can be seen, the total returns for UAN far surpass peers in the same sector for the last three years.

The yield for UAN is also the highest compared to peers:

TipRanks

Source

UAN has the highest yield by more than 11 fold. UAN is also structured in a partnership structure rather than peers which are structured as a corporation. This means that UAN is forced to make distributions to LPs which a corporation doesn't; there are pros and cons to both approaches, but often retail investors may see a high yield and buy without taking into account the risks involved with the yield and whether paying out a large distribution is actually the best capital allocation strategy for the company.

I think this can be seen with the number of bullish articles on this partnership in mid-2022 at the unit price's peak:

Seeking Alpha

Source

As can be seen, titles mentioned the high yield and how the units looked cheap.

Since these articles were published the price per unit is down 35-40% and total returns are around negative 20%. My view is that many contributors similar to retail investors become bullish due to the low P/E ratio, growing earnings, and high yield, without understanding that the high earnings and high yield were a one-off event. There are also other minute issues such as many referring to the distributions as a dividend, which it is not.

Now that last quarter's earnings were put out and we've already seen a 40% cut in the operating income and with likely even lower earnings ahead, I see the distribution getting cut by more than half over the next year, which would bring the distribution yield to around 17% or so, which is still high but nowhere close to where it used to be.

The even bigger risk here is the left-tail risk from reflexivity. Most investors are familiar with the concept of reflexivity as it was popularised by George Soros but for those not familiar here's the meaning: "Reflexivity is a theory that positive feedback loops between expectations and economic fundamentals can cause price trends that substantially and persistently deviate from equilibrium prices"(Investopedia).

A simple way to think about this is that the mean or average of something (could be anything not just in financial markets) is 10. Over the last two years, it's been at 15, so to get back to the mean of 10, it needs to spend the next two years at 5. Many traders make the mistake of thinking that it just needs to go back to 10 when it actually needs to overcorrect down to 5. This is the biggest risk here; commodity markets naturally mean revert. This means that when the price goes really high, market participants may overreact and introduce far too much supply causing the price to not just go back to its mean, but to overcorrect to the downside, and vice versa. I find this to be the biggest risk since so much supply is being introduced, as I discussed earlier, and in my opinion, most investors are ignoring fundamentals and just buying for the yield; if this corrects to the downside then UAN could get significantly undervalued as the retail yield trade unwinds and there is an oversupply of fertilizers.

Fertilizer prices are down to mid-2021 levels and are likely to go lower, but the price per unit is around $25 above where it was in mid-2021. My view is that investors have been buying for the high yield without taking into account that these distributions will go down as fertilizer prices go lower. As the distribution goes down over the next few quarters the price is likely to go lower as investors buying for the high-yield sell out.

This will likely overcorrect to the downside providing a deep value investing opportunity on the other side of a cyclical downturn.

This article was written by

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