Gas curtailment can certainly be in the running for the most hated word of the year, if there ever was one. Amongst those who have a particular disliking for the phrase, fertiliser manufacturers must be at the top, facing a cumulative 55 per cent curtailment YTD in 2011. Like some other facets of Pakistani life, news flows of gas being restored is met with ironic joy and relief – albeit short lived. Everyone seems to complain; from industrialists to CNG stations to household consumers. With all pun intended, give them gas man!
But I often ask myself why should fertiliser manufacturers complain so much? Fine, gas is the primary feed for urea production, but compared to others, they seem to be at a vantage point in so far mitigation from supply shortages is concerned. This is because fertiliser manufacturers have the real business luxury of increasing product prices as soon as their off-take drops owing to production constrains. This emanates from considerable demand inelasticity and a decent gap between local and international urea prices – the result being that the bottom line effect is a protection of margins. We have seen this over the past year where the industry has been subject to this phenomenon. What would be very interesting is to value this ‘real option’; just a side consideration for the more financially inclined of you. But anyway, this advantage exists and is expected to be a feature for the imminent future unless our gas supplies are replenished somehow or the authorities decide to eliminate the CNG fad that keeps gripping the country. The latter is not a bad idea but that’s talking on a different tangent altogether.
Back talking about urea price increases, another, perhaps somewhat less talked about question springs to mind. Fertiliser prices for all companies move in tandem; possibly defying the stereotype dynamics of a competitive structure. The fertiliser sector can be categorised in two: (i) those who are supplied gas from the SNGPL network and (ii) those plants which are on the SSGC network. The two gas providers have different curtailment schedules and so their user companies have been subject to different levels of supply shortages. But whenever one company increases prices owing to additional curtailment, other companies replicate the move in the pursuit of higher prices. What happened to the economic principle of lower price would result in higher demand? Or does this not apply in this case?
First of all, the fertiliser sector is hardly a competitive industry. The industry constitutes seven producers with the top three (FFC, ENGRO, FFBL) holding 80 per cent market share of urea capacity. The HHI for the industry comes out to be around 2,500 and if we factor in cross-holdings amongst certain manufacturers, concentration may in reality be higher. Urea may seem to be a homogenous product but this does not provide reason for prices to move together in the wake of shortage instigated price hikes. That’s because an important aspect of product differentiation is easy access to substitutes. This is a feature that farmers cannot enjoy as it remains costly to purchase from other manufacturers owing to transport costs rather than purchase from close proximity distributors even if a price differential exists. But let’s suppose for argument sake that these transport costs are eliminated. Does it seem that cartelisation in present in the fertiliser sector or is there still a case for similar price movement across the board?
The answer may lie in competition behaviour for which a little bit of game theory needs to be examined. Assuming that one company increases its price and the other does not, then theoretically the latter should capture the former’s client base. However, factoring in the current setup of distribution implying limited access to substitutes, the benefit from keeping prices low diminishes. Therefore, the more profitable thing to do is to increase your price as well. When this is applied across the board, theory suggests that all manufacturers should be following suit whenever one company increases its price as the benefit of improving margins outweighs the prospect of captured demand in a supply shortage environment. But this does not imply that the opposite should be true nor should all urea prices be at the same level. This is what we have observed over the past year; upward price movements have been in tandem while manufacturers maintain different urea price levels, bound by the maximum difference that can be kept till it is feasible for the customer to shift to other suppliers. Rivalry between fertiliser manufacturers does exist but it does not manifest itself due to the dynamics of the industry itself; what is the point of engaging in competitive activity where there is no economic reason to do so? Other factors, such as barriers to entry and bargaining power of buyers, also play roles which are indeed real influencers. Often the action of increasing prices is confused with collusion but surely the maxim of guilty till proven innocent does not apply here.
The writer is a financial analyst with Pakistan Credit Rating Agency (PACRA)
