What's Driving Lithium? Merrill McHenry on the "Technology" Metal
Source: The Energy Report (9/10/09)
Demand for lithium is on the rise, as hybrid car batteries and portable electronic devices often require rechargeable lithium batteries. Analyst Merrill McHenry, MBA, CFA, in this email interview, gives The Energy Report readers the lowdown on automakers racing to see how many cars they can get into the market, and the importance of project economics in looking at investment opportunities.
The Energy Report: Merrill, can you comment on how the recession is impacting the price of lithium?
Merrill McHenry: In 2008, lithium's (Li) growth was only slightly affected by the recession. Lithium has had compounded annual growth of 5% to 7% over the past five years, according to Patricio de Solminihac, EVP of the world's largest lithium carbonate producer, SQM (Sociedad Química y Minera de Chile S.A) (NYSE:SQM). At a conference on lithium last January, Solminihac also said 2008 demand for lithium carbonate equivalent is estimated to have been in the range of 115,000 to 118,000 tons (about 2% above 2007 levels). This is in sharp contrast to Li's 31% 2007 sales growth.
It's interesting to note that lithium actually got a big start in the Great Depression. While some may know that Coca-Cola originally contained a tiny amount of cocaine (9mg/glass until 1903), very few know that the "Up" in 7-Up, launched two weeks before the Wall Street Crash of 1929), contained lithium citrate, a mood-stabilizing drug. 7-Up was specifically marketed as a hangover cure. Long before today's "Energy Drinks," the soft drink industry had a medicinal heritage.
So, back to our present-day situation. . .keep in mind most all of the metal is traded under longer-term market contracts, typically adjusting in various degrees over time to the spot. 2009 contract Li prices were down to $2.80 to $3.00/lb (or $6,613/ton); down approximately 5% to 10% from the prior year's peaks.
Future growth estimates vary wildly—anywhere from 20- to 40-fold by 2020—driven largely by car battery demand. The USGS expects demand for lithium-ion batteries to increase 15-fold from 2006 to 2012.
Obviously, a major factor driving demand is the race among the major automakers to see who can get how many cars into the U.S. and European markets in 2010. Demand is expected to accelerate as Li-ion battery-powered Hybrid Electric Vehicles (HEV) come on-stream beginning in 2010. Production in 2011 is where we will begin to see notable market share growth vs. carbon-based vehicles. Price Link (US Geological Survey)
TER: There are concerns that China is cornering the "technology" metals sector and the implication is that China could dominate mining of these metals. Is this also a concern with lithium?
MM: Over 80% of lithium-ion batteries are manufactured in Asia. So, to me, yes, the issue of China cornering the "technology" metals sector is a significant concern. China, and for that matter, many strongly capitalist countries, are subsidizing and supporting 21st century growth industries.
In 2008 Warren Buffet invested $230m for a 10% stake in BYD, which makes hybrid cars in China. He has now made roughly $1 billion on that investment. BVD recently announced they intend to start shipping their cars to the U.S. beginning in 2010. At the beginning of the year BYD had over 10,000 Chinese engineers "from the best schools" (Forbes interview April 2009); they have another 7,000 in training for positions. They provide them shelter and dinning (helps to keep them at work), and the average wage is $190 a month ($150 in Taiwan). The company's founder Chairman Wang Chuanfu readily admits "there is no way we could do this in the U.S."
Clearly the Asians are exploiting a cost structure differential, which is a tremendous disadvantage for North American industry.
TER: What should lithium mining investors be aware of when investing in this sector?
MM: Project economics drive the "car" and the industry. While size matters, this industry has, and will continue to be, driven by project economics. Investors should realize Li is not nearly as much an exploration and discovery-oriented mineral as they may be used to. Li is considered an original "big-bang" element, thus the deposits are largely known and not obscured by geological forces. Therefore Li is a very bulk, relatively lower cost, mineral.
Because of that, the deposit economics and strategic incentives for a potential acquirer become more important parameters. Strategic incentives would include favorable sovereign risks, location, etc. In any scenario the deposit economics are essential and that requires that proper valuations need reasonable extraction costs (net of any by-product mineral credits) factored in.
Therefore, in contrast to higher unit cost minerals (i.e. gold @$950/oz), investment Net Asset Value ("NAV") calculations based on all project costs are more important. Any potential JV partner for any of the Li juniors coming out of the woodwork are going to look at the total cost of getting Li out of the ground. In essence, that means only the lowest cost, and larger scale projects are likely at first. Deposit grade may make a small deposit interesting (e.g. Canada Lithium Corp. (TSX.V:CLQ)), but you run higher risks that no one asks the partner to dance on small projects.
Also, near term, the stocks may be ahead of themselves. While a JV partner may be interested in a large deposit, I do not believe they will justify a price as rich as many of the companies currently imply. I have to run 20-year discounted cash flow models out to 30 years to try and justify some current share prices. For me I want to see some consolidation in the share prices and continuing progress in economic recovery before I would become a buyer of North American Li stocks. I do not win friends saying that, but I believe the North American Li group is just too much risk vs. reward in the short term. Maybe they can continue to be "pumped" upwards—for now. Or maybe it is because I became spoiled over how much lower share prices were over the last year when I had perhaps the first Li stock coverage out on Western Lithium Corp. (TSX.V:WLC). In any event, for many companies my models and intuition say to stand back for now.
Keep in mind, industry leaders such as SQM have very low cash costs (US$1,600-1,800/t; <$1/lb). At the margin, many of the current leading projects can bring on additional capacity for small incremental costs. Most of the attractive Chile and Argentinean projects have very attractive potash mineral by-product credits that offset significant amounts (approximately one-half) of production costs. Many of the projects currently being touted do not have such advantageous mineral by-product credits.
I am working with Max Capital Markets Ltd. in Toronto, and we expect to have some new projects and relative valuation comparables that capture the great diversities among the Li juniors out in the near future.
TER: You've stated that you are concerned that "headline risks" could adversely affect the sector. Could you explain what you mean by "headline risks"?
MM: Sure. Li batteries have had significant safety concerns for years. Just this week the U.S. Airline Pilots Association called for banning the shipment of lithium from air cargo. It seems several lithium products have recently caused (fortunately) limited cargo fires. Recently the BBC reported French authorities are investigating alleged explosions in iPhones.
Quality control in battery construction has traditionally been a concern. The batteries used in hybrid and electric vehicles typically consist of 200 to 400 small cells, strung together into one powerful whole. Individual cells sometimes overcharge, emitting heat when they reach too high a voltage and pushing neighboring cells past the breaking point to set off a runaway thermal reaction. As the batteries are constantly discharging and recharging, the capability of the battery's overcharge regulation components is essential to avoid overheating. The ability of most types of lithium batteries to fully discharge very rapidly when short-circuited, leading to overheating and possible explosion, is a process called "thermal runaway." Most lithium batteries have thermal overload protection built in to prevent this, and/or their design inherently limits short-circuit currents. Internal shorts can occur due to manufacturing defects or damage to batteries that can lead to spontaneous thermal runaway.
In the last year there have been, and will continue to be, significant advances in Li battery molecular structuring, as well as new electrolyte battery additives to control thermal runaway. However, changing electrolyte additives may pose environmental and health issues and adapting improved molecular changes in Li battery substrates will take time to become mainstream. Some manufacturers may not want to pay patent royalties or the costs of manufacturing changes.
TER: There's been talk about lithium shortages, and with increasing demand, that could drive the price up. What's your thinking on that?
MM: I believe any predictions of Li shortages in the near term are hyperbole. Many of the current larger projects have incremental capacity expansion possibilities. I believe the sector is, short term, ahead of itself. My price performance theory (for the Li) group is that for any mineral without a spot market to track the sector can and will get ahead of itself as retail, cheered on by newsletter pumping, etc., causing runups in price that will have swift and sharp corrections on market weakness and investor second thoughts.
You take a mineral with no spot market and very obtuse pricing and combine that with a significant distance from here to high future volumes, significant market penetration of hybrids and higher pricing estimates and you have a scenario ripe for volatility. While rosy predictions ("new era," retail over enthusiasm, pumping, etc.) can always drive a sector further and faster than anyone thought, people would do well to remember risk is a function of time—and there is a great deal of time and uncertainty, made worse by a lack of pricing visibility, before these companies will see any potential profits.
Strong future Li pricing and aggressive demand growth assumptions are already factored in the group. The problem with predicting future demand of lithium in transportation, as a preferred method of energy storage, is that no one actually knows just how enthusiastic and sustainable the trend will be. There is already one new producer (Rincon Lithium Ltd.—Argentina Project) estimating production in 2011-2012.
While demand growth is happening and gearing up, I do not believe the market will be tight for some time. Earlier this year, a top Li industry consulting firm, TRU Group, forecast that, due to the current recession, the market would be in oversupply through 2013. TRU does not see a tight supply/demand until 2017 to 2018. And how do we know those will not be mines in Australia—close to massive Chinese consumption? In fact, China is already signing JV deals over in Australia (e.g. Galaxy Resources Ltd. (ASX:GXY)). If you are serious about wanting a likely Li producer, I would look to Australia Li companies. The capex (>$150 often) and lead times to production are onerous burdens for junior prospects to overcome. I believe very few North American juniors will make it to production in the next five years.
Keep in mind that not all bull claims are as strong as they appear. No doubt Li's outstanding rapid recycle time and power-to-weight ratio make it the choice for portable power ("electromobility") in the future—but making money with Li juniors is a lot more difficult than it seems. Much of the industry information is private and prices are under long-term contracts, so industry claims can vary all over the place. It remains to be seen whether annual hybrid electric vehicle growth will meet the consensus forecast growth of four-fold in the next four years, but given currently planned Li capacity additions, how much can the Li price rise? I am not of the sustainably strong rapid worldwide economic camp and believe that the Li bulls will inevitably have the burden of proof of tangible Li gains—beyond what is already assumed (e.g. $3.00 to $3.50).
Many bulls argue the Li price is very inelastic to total production cost (similar to uranium and a final electrical cost) and can easily have room to run. They assert the actual raw cost of the lithium in vehicle batteries is currently less than 3% as a proportion of cost. I would point out a producer is getting little money on the "raw cost" (e.g. currently $3.00/lb or less) for Li—it is as the producer steps up the purity of Li through significant refining processes where the true "cost" of Li becomes much greater. With the refinement costs of raw Li largely fixed, the actually inelasticity of the Li price is not as great as the strongest bulls may assert. Moreover, the market is well supplied in the near term and buyers can substitute suppliers as needed. In fact, buyers typically keep several supply channels open in case they need to switch. (Li typically has less bargaining power by producers than uranium does, owing to more substitute suppliers.)
TER: What are the implications for some of the juniors out there?
MM: Major projects could easily come on-stream, wiping out the near-term chances of many juniors. While the niche industry may seem "new" to many investors, it is far from "undiscovered" by the current major players. In addition to the existing major Li suppliers (SQM, FMC Technologies (NYSE:FTI), Rockwood Holdings Inc. (NYSE:ROC) /Chemetall (part of Rockwood), etc.) having significant current expansion plans there are major known resources—specifically in Bolivia—on the shelf that could wipe out many JV hopes. With its 5.5 million metric tons of reserves, Bolivia's Salar de Uyuni is recognized as the world's largest reserve, and could be used to supply the worldwide automotive industry for over 100 years. Though they will not be the easiest to extract, the Salar de Uyuni resources make Bolivia the Saudi Arabia of lithium.
So far Bolivia's government has resisted Toyota, Nissan, Sumitomo, Mitsubishi, China's BYD, France's Bollore Group, South Korea's LG Group, and all foreigners who've tried to strike a deal. While the race for carbon/petrol-based cars is well advanced, the race for dominance in electric and hybrid-based autos is just beginning. The industry has a blank slate in these early days and Japan and China are fiercely competing for the prized Salar de Uyuni resources. The right relationship with the government in La Paz will hold the key to everything. Beijing's courting of the authorities in La Paz has already included a cash donation to build a school in the town where President Morales was born and a gift of about 50 military vehicles, including two ships.
The current government wants not only to supply the batteries—they want it all—the complete industry of car-making as well. My bet is that as they see continued development elsewhere that some rationality eventually comes along to their thinking and something less than all-or-nothing results in some battery JVs. Rio Tinto is also considering bringing its Jadarite lithium-boron mine in Serbia into production in a few years.
In the interim, sizable attractive deposits may attract financing, but I expect for North American Li junior stock investors this will be much slower than the market expects. Keep in mind the alternative energy sector is littered with hopes exceeding realized growth.
Chile and Bolivia dominate current and likely future supplies. This is a major risk to the development of North American deposits. Moreover, North America does not have nearly the demand growth that China does, which China can supply from Australia.
In summary, the distance from here to the future high growth ramp up is too far to become very aggressive as to who those suppliers will be. As mentioned, current and already signed Aussie/Chinese agreements could well satisfy the next few years—so why chase the shares? Many niche sectors have gotten ahead of themselves in recent years—coal-seam gas, uranium, moly, alternative energy. While these sectors may well have secular (long-term) merits, in my opinion the risk/rewards of chasing something right after a rapid advance are too risky.
I have stated that I believed this is a short-term cycle ready to correct, and the recent correction supports that. I would look to add select long-term positions; avoiding many early-stage late entrants to the sector. In many cases, the late entrants are unlikely to have projects with sufficient scale.
TER: Can you share some companies that our readers should look at?
Sure. There are a few that I like. Galaxy Resources Limited, currently a favorite of mine, recently completed a definitive feasibility study (DFS) that suggests the Mt Cattlin Lithium / Tantalum project (Ravensthorpe, Western Australia) is commercially viable, based on a processing rate of 1 million tons per annum over a 15-year mine life. The company is planning to begin developing the mine in Q3 with first concentrate production scheduled for Q3, 2010.
GXY recently signed agreements for financing of its lithium project with China's Creat Group, raising at least A$26 million for the company. In addition, Creat will provide Galaxy with 100% debt finance of approximately A$130 million for the purpose of developing both the Mt Cattlin spodumene (lithium/tantalum) and Jiangsu lithium carbonate projects.
One advantage GXY's JV has is that Creat requires no off take product and GXY is free to market its own product and thereby take advantage of any upward pressure on Lithium Carbonate prices.
Another is TNR Gold Corp. (TSX.V:TNR), a project generation company that has been around for a long time. Fortuitously they have 15 projects in Argentina, some with senior and mid-cap JV partners including Barrick Gold and Xstrata, and the Argentine experience gave them an early stage leg-up on acquiring one of the low cost brine-based salares (salt lake) in the Salta region close to a Orocobre (ORE:ASX) Li project currently undergoing a Bankable Feasibility Study as it advances towards production expected in 2012. TNR intends to spin out its Li and Rare Earths division in Q1 2010 and also has attractive copper and gold projects. As the pieces of TNR are developed and/or carved out, I expect investors to be well rewarded and as the projects are explored, and ideally, developed.
Finally, early in the year at half the current share price we recommended Canada's Western Lithium, which has a NI 43-101 resource estimate for the initial stage of development at its flagship Kings Valley, NV, property. The project total hosts a historically estimated (by Chevron Resources) 11 million tons of lithium carbonate equivalent (LCE). While I still like the project because it is one of the largest Li resources in the world (#6), after the recent share dilutions and share price rise I currently have the stock rated as a "Hold." While one could add a small position to have some Li exposure, without aggressive assumptions still far from certain I would not buy the stock unless it corrects—ideally under C$1.00.
WLC's Stage 1 project is huge, boasting an indicated resource of 48.1 million tons grading 0.27% lithium with a lithium carbonate equivalent (LCE)—688,000 tons and 42.3 million tons grading 0.27% lithium (LCE - 606,000 tons) inferred. A scoping study is planned for completion during the current quarter, which could show attractive mineral by-product credits, and the company hopes for first production in 2013. I expect it would be no sooner than late 2013 owing to the novel metallurgy of this hectorite clay-based deposit.
In the report, I believe the flow-chart processing will appear attractive for first of a kind metallurgical processes. My estimates are for production costs of $2.00 to $2.50/Lb. I believe Chevron's cost estimates were approximately $1.05 in the 1970s. The upside is that I believe there are significant by-product mineral credits not factored in either estimate that could significantly reduce. It also remains to be seen what JV and/or off take agreement terms could eventually be signed.
I personally and/or my family own the following companies mentioned in this interview: N/A
I personally and/or my family am paid by the following companies mentioned in this interview: None
Merrill W. McHenry, MBA, CFA, has been in the investment business for 25 years. As a portfolio manager he managed over US$1.5 billion in two U.S. mutual funds, and set up an international mining merchant bank. As an analyst he has worked both the buy and the sell sides; and currently provides research for Max Capital Markets Ltd, as well as prominent global investors. Mr. McHenry is a member of the CFA Institute, and the Toronto Society of Financial Analysts. He is owner of the domain name, and previously ran the site Uraniumanalyst.com. He can be reached at [email protected].
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