By Chris Berry (@cberry1)
There is a famous phrase in resource investing:
“When the ducks are quacking, you feed them.”
The “ducks”, of course are the investment community and the “feeders” here are the companies with shares for sale.
In 2016, the ducks quacked loud and continually for lithium, and rightfully so. The price of lithium chemicals rose dramatically and almost all publicly traded lithium juniors rose as well with some well into the triple digits. Other than zinc or iron ore, lithium was a star performer in 2016.
As I said in June, managing risk and profit taking in the face of lithium’s impressive strength and secular bull market seemed to be the prudent strategy. My warning turned out to be accurate as many of the high flyers in the lithium space ran out of steam.
Source: Bloomberg as of 12/29/2016; Returns and market caps in currency of primary exchange.
While I’ve always considered forecasting a fool’s errand, this note offer some thoughts on how those of us involved in the lithium supply chain should approach the sector as tight lithium markets appear to be a foregone conclusion for the next couple of years.
2017 will be the year when execution outranks exploration in lithium value creation. With dozens of lithium juniors claiming promising discoveries, finding lithium is no longer the optimal path to wealth creation. Instead, producing battery grade material at scale for a voracious downstream appetite is. This is the segment of the market that has the most to prove – those companies with de-risked projects and well-defined economics –with most long-term upside.
Based on my analysis, to bring a new lithium mine on-stream ( a 25,000 tpa lithium carbonate brine plant) will cost approximately $400M USD (about $16,000 per tonne of production). In 2016, approximately $400M USD was raised globally in the sector to advance projects. Given my projections of needing one new lithium mine to come on-stream every year between now and 2025 to meet anticipated demand, the supply response is already lagging, requiring accelerated investment in the lithium sector. The lithium market will remain tighter for much longer with every month without a major financing deal.
This means companies such as Lithium Americas (LAC:TSX), Nemaska Lithium (NMX:TSX), and Galaxy Lithium (GXY:ASX) must become creative to avoid excessive dilution to equity holders and take advantage of the current robust pricing environment in the lithium space. I think you’ll see at least one major lithium financing deal announced in the first six months of 2016. Therefore, capital deployment and capital efficiency are the true keys to wealth creation in lithium going forward.
This execution risk extends to major producers as well who could certainly just maintain their operations and continue to generate cash flow from their lithium businesses. However, Albemarle’s (ALB:NYSE) expansion at La Negra, FMC’s (FMC:NYSE) expansion of hydroxide capacity and SQM’s (SQM:NYSE) doubling of capacity allow them to capture both market share and additional margin subject to successful execution of their strategies – a wise investment given this bull market and the oligopolistic market structure.
Given some of the stretched valuations of development-stage companies, I expect the voracious appetite of Chinese companies to extend to the project level rather than M&A surrounding entire companies. The thesis of wise capital allocation doesn’t stop at Chinese shores, though Chinese companies have overpaid for assets in the past.
Regarding lithium pricing, it’s important to think in terms of probabilities. The opaque nature of the lithium business requires this as multiple products are priced and sold to multiple customers. Guessing whether or not lithium prices will rise or fall in a binary manner in 2017 isn’t enough for your analysis. Understanding the probability of a given trajectory is what is important. I find it highly unlikely that lithium pricing will repeat its 2016 performance in 2017. I would agree with Joe Lowry that mid-teens pricing for both battery grade lithium carbonate and hydroxide are a reality in 2017 with a longer term average LCE price of $10,000 to $12,000 per tonne as this becomes the new break even.
As pricing remains robust, this will continue to re-define overall lithium mine economics. While hard rock operational expenses will not be able to match those of brine op exes, the potential for margin expansion across both types of projects means a détente of sorts between the two types of projects.
Part of the reason hard rock development stories in Australia had so much success in 2016 had to do not only with their proximity to China, but more importantly Chinese converters’ urgent need for feedstock. Recent spodumene pricing as high as $900 per tonne is an obvious sign that product will be had, no matter what the cost. The faster feedstock gets to market, the better (especially for investors). GXY and NMT have proven this.
The higher prices for lithium feedstock and chemicals have also reduced the need for extraction technology to lower costs. While I still believe that the lowest cost producer in a given industry will always ultimately win, the obvious need for additional lithium supply dictates that there is room for additional producers along with the expanded capacity coming from existing producers. It appears that “conventional” lithium production will be a resurgent theme in 2017.
While the lithium market overall will expand, this will also cloud the investment picture as marginal projects will be able to secure financing to live to fight another day. This is an unfortunate reality in the small cap resource sector. Your own due diligence here is crucial as most of these “lottery tickets” will end up in tears. Remember the $1 billion that was raised during the last lithium bull market in 2009?
There are, as always, threats to this thesis and they include: battery costs at the cell and pack level slowing their decline; currency fluctuations playing havoc with economic studies; capital sitting on the sidelines due to stretched valuations; another commodity becoming the “story of 2017” and so the ducks stop quacking.
Thinking in terms of probabilities, these are low probability events, but ignored at your own peril. 2017 promises to be more transactional in nature than in years past, but the lithium bull market will remain intact until ample supply can come on stream. This doesn’t appear likely until 2019 at the earliest.
Whether the ducks continue to quack in 2017 is immaterial to the long term shift in how we generate, use, and store energy - a theme I've discussed many times in the past. What is important is altering your strategic and tactical plan as the lithium market continues to grow and evolve in 2017 and beyond.
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