The credit risk profiles of India's fertiliser companies may come under increasing pressure over the medium term, on account of rising input costs coupled with the likelihood of delays in subsidy settlements by the the centre.

The delays are likely because of the increasing strains that fertiliser subsidies impose: 'farm gate' prices of fertilisers - the prices that end-users pay - remain largely constant, while imported fertilisers and raw materials for fertiliser manufacture grow ever more expensive, leaving a gap that the government has to fund. CRISIL believes that players with healthy operating efficiencies and conservative capital structures are better equipped than others to withstand these mounting pressures.

Capacity utilisation levels of domestic urea manufacturers were more than 95 per cent in 2007-08 (refers to financial year, 1 April  to 31 March). However, unfavourable government policies continue to thwart fresh investments in urea capacity. India's import dependence on urea is, therefore, set to increase over the medium term, unless the centre releases a long-term policy attracting fresh investments in the sector. The country's dependence on imports for di-ammonium phosphate (DAP) has also increased over the last couple of years on account of limited domestic availability.

Increasing imports, international prices, and input costs India's overall dependence on imported DAP and urea has increased steadily in recent years. In 2007-08, India imported around 6.9 million tonnes of urea, an increase of 47 per cent over import levels in the previous year. The country's increasing dependence on imported urea has been on account of stagnant domestic production - consumption has continued to grow steadily, but no new urea plants have been commissioned since 1999.

Likewise, DAP imports meet a significant 37 per cent of India's total demand, despite a marginal reduction in import levels to 2.7 million tonnes in 2007-08 from 2.9 million tonnes in 2006-07.

The problems relating to increasing imports have been aggravated by substantial increases in international prices. International urea prices increased to $500 per tonne in April 2008 from $330 per tonne in March 20071. Similarly, global DAP prices increased to $1220 per tonne in April 2008 from $435 per tonne in March 2007.

Additionally, the costs of raw materials such as naphtha, which are linked to the prices of crude, have increased over the last 12 months. The price of ammonia increased substantially to $618 per tonne in April 2008 from $382 per tonne in March 2007.

Similarly, the international price of phosphoric acid has more than trebled to $1985 per tonne in April 2008 from the contracted price of $566 per tonne in 2007-08.

The centre's mounting subsidy burden and its repercussions
The centre's subsidy bill continues to increase steadily on the back of rising international prices and input costs. This is aggravated by the increasing dependence on imported fertilisers; the centre not only has to subsidise more tonnes of imported fertiliser, it also has to pay more subsidy per tonne as global prices increase while farm gate prices do not.

According to the ministry of chemicals and fertilisers, the fertiliser subsidy burden is expected to more than double to nearly Rs.950 billion in 2008-09 from Rs.450 billion, the previous year; against this, the centre has budgeted Rs.310 billion as fertiliser subsidy for 2008-09.

For manufacturers, high input prices in 2008-09 will result in increased subsidy receivables. How fast these receivables actually translate into receipts will depend almost entirely on centre's fiscal position; CRISIL believes that fertiliser manufacturers will face increasing delays in subsidy settlement, especially during the second half of 2008-09, once the government's subsidy budget has been exhausted. Manufacturers will have to make up the difference through increasing levels of working capital borrowing in a high interest rate regime, a combination that will exert considerable downward pressure on coverage ratios.

Given its large subsidy burden compared to the budgeted amount, the centre could also issue more bonds. Since November 2007, the centre has begun funding part of its subsidies through fertiliser bonds in lieu of cash, with fertiliser companies then selling these bonds in the secondary market. However, the buyers, mostly banks, provide only a discounted value on the bonds: the currently high interest rates will result in larger discounts on the bonds in 2008-09, further eroding players' profitability.

In 2007-08 urea has been imported from Oman India Fertiliser Company (OMIFCO), at substantially lower prices, but the amount was only around 1.6 million tonnes out of a total domestic consumption of 25 million tonnes.

Despite the many difficulties that the centre faces, CRISIL believes that subsidy settlements will not be delayed indefinitely. Beyond a point, delays in subsidy reimbursement would stretch manufacturers' working capital position, resulting in a slowdown in domestic fertiliser production and the possibility of some plants shutting down. This in turn would trigger fertiliser shortages with ensuing farmer unrest, which the centre will be keen to avoid, given its objectives of continuous and easy availability of fertilisers to farmers. Increasing the level of imports would not be a preferred route for meeting any shortages because of high global urea prices, which are significantly higher than the retention prices being paid to domestic producers.

An eventual increase in farm gate prices of urea is also becoming a more and more likely outcome, at least in the long term. The current level of subsidies is likely to prove fiscally unsustainable at some point, forcing GoI's hand despite the deep political sensitivity of the issue. The recent reduction in the farm gate price of complex fertiliser, though adding to the subsidy bill, was done to give farmers an incentive to switch away from urea and DAP, and thereby help restore the nutrient balance in the soil. CRISIL does not believe that this action implies a tolerance on GoI's part for higher fertiliser subsidies across the board.

With all these trends playing out, CRISIL expects fertiliser manufacturers' credit risk profiles to show some degree of strain in 2008-09. The extent to which individual manufacturers can take this strain is closely linked to their operating efficiency and capital structure.

Natural gas is the most efficient feedstock for fertiliser manufactures, and entails lower working capital requirements than naphtha because of the lower cost of production.

Players that use natural gas as feedstock will be more efficient than those that do not; gas-based plants that can switch to alternate feedstock such as naphtha will cope better with periods of gas shortage. Operating efficiencies in terms of high capacity utilisation and low energy consumption also assume criticality for players in view of the mounting subsidy receivables. The more efficient a manufacturer's operations are, the lower its working capital requirements will be, and the better placed it will be to weather the current phase in the industry.

CRISIL also believes that fertiliser manufacturers with conservative capital structures will be better placed than their more leveraged peers. Access to working capital funding will come easier to such players and be less burdensome for them, and they are also better equipped than others to cope with the likelihood of decontrol over the long term.