By Chris Berry (@cberry1)
With the sentiment around lithium almost universally bullish, the recent hammering of lithium equity share prices can be traced back to one or two reasons: either as a sign that valuations had exceeded reality or a specific catalyst has injected a dose of reality into the markets. It is possible for both to be true and while I think this is the case, anyone with a long-term bullish view of the lithium sector can view the recent carnage as a gift.
Until mid-2015, lithium equities were essentially left for dead despite the hype surrounding Tesla’s plans for multiple Gigafactories. As lithium is an oligopoly, it was thought that the market leaders such as SQM or Albemarle could easily add production capacity to meet any future demand driven by electric vehicle adoption, so broad-based capital injections were not necessary.
The rest, as they say, is history, and it seems that every week a new supply chain participant whether it be an OEM or a cathode manufacturer announces aggressive expansion plans to meet future customer demand. Global automakers such as BMW, VW, Daimler, and Ford committing to spend up to $90B USD on electrifying their auto fleets, and Umicore spending smaller but historically significant sums on cathode capacity expansion are only a few examples and this excludes aggressive Chinese plans to have seven million EVs on the country’s roads by 2025. Depending upon your assumptions around battery size and chemistry, China’s ambitions alone could consume slightly more than today’s entire global supply of lithium.
So if it is a given that security of supply is a major issue for downstream lithium consumers, why have lithium equities valuations suffered recently? In answering that question, I am reminded of a phrase used by Ruchir Sharma, Chief Global Strategist at Morgan Stanley Investment Management:
“The inevitable never happens and the unexpected always does.”
What was inevitable in the lithium world was that as demand continued its strong increase that lithium share prices would follow. What was unexpected was the market reaction to the new agreement between CORFO and SQM. Initially, the terms of the agreement spooked the market into thinking oversupply was imminent and additional supply from a large number of junior mining plays would not be necessary. The permission granted to SQM to ramp lithium production capacity to 216,000 tonnes per year by 2025 was viewed as a negative catalyst for the sector, but this ignored the permitting necessary, enormous capital requirements (perhaps over $1B USD), and onerous new royalty structure which penalizes price maximization.
The sell-off in the lithium sector was broad based and the fall in share price from peak to trough can be seen in the chart below for select companies:
FUNDAMENTALS STILL MATTER
Fundamentally, however, nothing has changed with respect to the lithium demand scenario. The consensus view of lithium demand quadrupling by 2025 is defensible coupled with the fact that enormous investments are being made along the lithium supply chain as shown previously.
In order for the oversupply thesis to come true and sustain itself, one must assume that the hundreds of thousands of tonnes of lithium carbonate equivalent (LCE) supply forecast to come to market between now and 2022 does so successfully, on time and on budget. The history of supply additions in the lithium sector indicates that this is not likely to happen - one needs only to look back to the last lithium boom from 2010 to 2012 to see how easy it can be to raise and misallocate capital in a bull market. Roughly $1B USD was raised during the last cycle and less than 20,000 tonnes of LCE came on stream.
With the cost of renewable energy and lithium ion batteries falling in price aided by regulation and technological advances, this level of capital destruction cannot be allowed to happen again. Should lithium demand quadruple by 2025, by my estimates, the industry will require $9B USD of capital (or slightly over $1B USD per year) to meet the demand scenario. Clearly, it will be more than just strategic lithium buyers who will need to invest and allocate capital in an industry of just $2B in size. This is a major question going forward in the lithium sector: who will the major investors be?
Adding to the financing challenge is the fact that other pieces of the lithium supply chain have never seen this type of stress or requirement for investment. How the downstream aspects of the supply chain such as conversion facilities and cathode manufacturers handle this growth will be key to successfully electrifying the future of mobility and energy.
Though debatable, volatility in markets is a positive force. It punishes poor capital allocation and rewards optimal allocation. Additionally, volatility forces market participants to innovate and create new models or businesses that can prosper in a supply chain that is consolidating and growing as we speak. This consolidation in the lithium industry is set to be the next investment theme as a vertical integration strategy offers the most opportunity and allows a hedge against commodity cycles and macro volatility.
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