A must read for graphite investors imo
https://miningwealth.com/buy-graphite-but-do-it-right/
Buy Graphite, But Do It Right
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Ben Kramer-Miller 2 days ago
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Summary
- Graphite has a promising future, but there’s loads of misinformation.
- I point out four common misconceptions that have convinced people that various deposits and business plans are of higher quality than they really are. .
- By understanding these misconceptions and the industry facts that contradict them you will be able to select high quality graphite investments.
Over the past few years we’ve seen a tremendous growth in investor interest in flake graphite. Flake graphite demand growth is typically steady, yet cyclical given that the largest end-user is the steel industry, but new potential sources of demand (e.g. Li-battery anodes) have sown the seeds for a secular bull market.
The first surge in graphite prices came after the financial crisis, and we see that many companies entered the graphite space from 2010-12. While prices have come back down as we’ve seen a cyclical downtrend, it is clear that there is tremendous long-term promise and investor enthusiasm. We see this in the performance of some of the better known graphite stocks, which have provided incredible returns to those who got in early. These companies have since established bullish followings among analysts and investors.
In order to do so many companies have made promises and assumptions that don’t make sense. This shouldn’t be surprising: new, or newly discovered industries that provide investors with promises of tremendous returns often lead to malinvestment.
But the graphite space is misunderstood more readily because it resembles the mining industry even though there are stark differences. Graphite isn’t really a mining business insofar as graphite companies need to emphasize sales and client relations more than, say, a copper company, which only needs to produce copper and sell it on the futures market. But since graphite is mined the new graphite companies are predominantly run by former mining executives. In fact two of the most valuable companies– Syrah (
OTCPK:SYAAF) and Zenyatta Ventures (
OTCQX:ZENYF)–did not start out as graphite companies, but as exploration companies looking for a variety of metals. This caveat is responsible for some very specific yet critical misunderstandings of the market, as we will see presently.
With this in mind I want to address what I perceive to be the most common misconceptions investors have about the graphite market. This list comes from my own experience in trying to understand the space, and my assessment of how others view the space based on articles I’ve read and exchanges I’ve had with readers of past work I’ve published on graphite.
Those investors who understand how most graphite juniors are being mismanaged (i.e. managed like a mining company) will be able to weed through the industry’s fluff to find the true gems. These are not slam-dunk success stories, but they are cheap (we will see why in a bit), and they are being positioned to take advantage of new sources of demand.
1: Flake Graphite Prices are High, and Going Higher
This is simply not true: flake graphite prices are low and moving lower. The flake graphite market is significantly oversupplied as production is ~600 ktpa. while demand is less than 400 ktpa. This has been putting tremendous pressure on prices, especially since the largest source of demand–steel refractories–has seen declines in the face of a weak steel market.
This flies in the face of what graphite juniors are telling us, which is that the world needs more graphite than it can currently produce so that half a dozen new mines will come into production in the next few years. These companies often cite supply/demand and pricing data published by Industrial Minerals, Benchmark Minerals, Roskill, or others, which all provide exceedingly bullish assessments based on rapid growth in small yet growing sources of demand. For instance, Focus Graphite (
OTCQX:FCSMF)
cites Industrial Minerals, which tells us that 2013 demand was 375 kt., while 2020 demand will be over a million tonnes higher, or at least 1,375 kt. That is an annual growth rate of over 20%! I don’t have the exact Industrial Minerals number for 2014 but my sources who are selling graphite have told me that demand is weak. Even if it was flat year over year (Li-battery demand offsetting lost steel demand) the annual growth rate from 2014-2020 is a whopping 24%. But keep in mind that the biggest source of demand–steel refractories–is declining, and the new expected demand is going to come from batteries. Now in 2013 demand for batteries was 82 kt. If it is expected to be at least one million tonnes higher by 2020 that amounts to a CAGR of 45%–a far-fetched assumption. As a result Focus assumes a higher-than-market price for its graphite in its FS.
Focus isn’t the only guilty party here. Companies such as Syrah and Energizer assume that they will be able to realize prices that are much higher than current market prices for their graphite. Syrah, for instance, bases its prices on what Benchmark Minerals says they’ll be, which is 50% higher than what they say today’s prices are. Energizer uses Roskill but arrives at a similar conclusion.
For now, I think such a bullish standpoint doesn’t make much sense: prices now are too low and sentiment is too optimistic. Regarding the first point, people who are actually selling graphite (actually delivering it, not peddling “offtake agreements”) have told me that the price of graphite is substantially lower than what graphite juniors expect to realize (these numbers will be posted presently). Now we should keep in mind that they have a bias in that as sellers of graphite they want to keep competitors out of the market, but I have confirmed, for instance, that 94% Cg is selling for ~$800/tonne from multiple sources.
A quick survey of bulk graphite sales offers at Alibaba reveal more bad news.
- 5,000 tpa. of +80 mesh/94% Cg selling for $900/tonne.
- 15,000 tpa. of 150 micron/90% Cg selling for $500/tonne.
- 5,000 tpa. of 150 micron/96% Cg selling for $900/tonne.
- 30,000 tpa. of -200 mesh (carbon content not given) for $560/tonne.
Now compare this to the price assumptions put forth by the junior graphite companies. Here are a few so you get an idea (note that these aren’t apples to apples comparisons since companies make different pricing assumptions, and some opex assumptions include shipping and or sustaining costs, and these numbers come from data at various stages in development and with various levels of disclosure).
|
Column 1 |
Column 2 |
Column 3 |
Column 4 |
Column 5 |
| 1 |
Company |
Project |
$/T of Cg |
Opex |
Margin |
| 2 |
Energizer (OTCQX:ENZR) |
Molo |
$1,689 |
$690 |
$999 (59%) |
| 3 |
Focus |
Lac Knife |
$1,713 |
$441 |
$1,272 (74%) |
| 4 |
Magnis (OTC:URNXF) |
Nachu |
$2,119 |
$473 |
$1,646 (78%) |
| 5 |
Mason (OTCQX:MGPHF) |
Lac Gueret |
$1,235 |
$316 |
$919 (74%) |
| 6 |
Northern (OTCQX:NGPHF) |
Bissett Creek |
$1,800 |
$725 |
$1,075 (60%) |
| 7 |
Syrah |
Balama |
$1,500 |
$192 |
$1,308 (87%) |
| 8 |
Triton (ASX: TON) |
Nicanda Hill |
$985 |
$315 |
$670 (68%) |
It is incredibly difficult to believe that these price assumptions are realistic given current pricing data, and given that such high operating margins are extremely unusual. Furthermore it seems that everybody–companies and analysts alike–is extremely bullish relative to the prices I’ve been confirming (let’s call it an average of $700/t-$800/t).
Yet the negative sentiment I’m getting from people actually selling graphite suggests to me that this unanimity ought to be viewed as a contrarian indicator–at least for the medium-term. Even if this stance winds up being wrong it makes sense to take it if you are a conservative investor: after all it makes little sense to base a solid, conservative investment thesis on such wild growth and price appreciation assumptions, especially since the market is so weak.
Before moving on it is worth noting a consequence of the market’s pricing misconception, which is that if graphite prices are high and going higher, so are operating margins. I think this has created a false sense of security in the minds of investors, who often believe that these graphite projects are economical even at much lower graphite prices. While confidence begets more confidence there is no actual evidence that this is true.
From the research I present here and elsewhere (e.g.
here, and
here), I would argue that the valuations of many graphite mining projects is substantially lower than formal valuation assessments of these projects would suggest. With this in mind investors looking at graphite companies need to be extremely careful in their assessments of these companies’ operating margins and their ability to generate cash-flow. While you may be confident–as I am–that prices will be higher in a few years, keep in mind that financiers will be making decisions based on current prices and in bearish scenarios.
2: The Graphite Business is a Mining Business
Graphite is something that is mined, and as a result investors conclude that the graphite business is a mining business. So do the past mining executives who make up the bulk of the new graphite companies’ managements. But while graphite is something that is mined graphite is not a mining business. This leads to mismanagement: people with mining backgrounds apply certain principles to these graphite companies simply because they make sense in mining commodities such as iron, gold, or copper.
Here are a couple examples.
First, in mining the size of your mine is in large part a function of your deposit size. While in theory you can produce too much gold, in practice no mine or deposit is large enough to disrupt the gold market. Graphite companies who have let the large sizes of their deposits determine the size of their mines have come up with ludicrous assumptions as to how much graphite they can sell. The largest–Syrah’s Balama Project–is expected to produce 220 ktpa.–or nearly 60% of current demand–in its first year of production. This is an absurd proposition. By comparison, consider that Mason Graphite could mine 200,000 tpa. for several decades given its resource at Lac Gueret, yet its management has chosen to mine a quarter of that amount given current market conditions. Syrah will likely be forced to sell a lot of graphite at incredibly low prices, if it sells any graphite at all. Mason only operates its mine 40 hr/wk so it can easily expand its operation should the market permit. Given the nature of the graphite market,
I suspect Syrah’s actual production will be much closer to 50,000 tpa. than 220,000 tpa. and its valuation will correct accordingly.
Second, in mining you try to maximize your cash-flow by maximizing the amount of metal you produce in the early years. Thus, a typical mine’s cash-flow peaks early in its life and tapers off during subsequent years. But given the difficulty in selling graphite–an issue I discuss presently–the most viable approach is to start out small and gradually grow your customer base and your sales. Cash-flow similarly starts low and grows over time, and it is dictated by sales, not production (the latter doesn’t imply the former as it might in a larger, more standardized market such as copper). This sort of thinking is very counterintuitive to mine engineers, and it also means that any sort of cash-flow optimization strategies they come up with could be stymied by issues negatively impacting graphite sales. Thus, it is crucial to keep in mind that a properly run graphite company’s sales capacity is a determining factor in its mine plan.
3: Graphite companies should aspire to secure offtake agreements for their graphite as a prerequisite to financing or as a way to finance the project through future graphite sales.
Most graphite investors are convinced that securing offtake agreements is a critical part of the business. This is the case because offtake agreements are often critical for other markets where there is no liquid futures market For instance, uranium is often sold in offtake agreements.
But graphite is very different from uranium. Most buyers of uranium are using that uranium for one purpose and buy it in just a couple of forms: uranium hexafluoride and triuranium octoxide. But graphite–while always just layers of hexagonal carbon crystals –comes in different purity levels and flake sizes and shapes. Furthermore, customer needs are generally quantitatively small and qualitatively diverse making sales contracts or offtake agreements that move the needle for companies with very large projects unlikely.
Contacts in the industry who have sold graphite have consistently told me that graphite is sold on a one-year basis at a fixed price. Contracts are renewed annually and prices/quantities/terms change according to market conditions.
Nevertheless we have seen several offtake agreements in graphite–especially in recent months by Australian companies–that have given credibility to the myth of the massive graphite offtake agreement as a viable sales strategy. Triton’s offtake partner–YXGC–has guaranteed $1,000/tonne for 100,000 tonnes per year if the company can get the mine into production in 3 years–an unusual feat in mining. But even if Triton can pull it off (they actually say they can do it in 2) YXGC has little incentive to honor its agreement unless prices rise far higher than today’s prices, especially since Triton has lower quality graphite (it is the only company to value its own graphite at below $1,000/t. In fact the lowest quality graphite that YXGC will accept is 150 micron 90% Cg, or a $500/t. product FOB (meaning it is cheaper in China, where Triton is sending it).
Syrah has an offtake agreement with Chalieco for 80 ktpa. for three years. What it essentially says is that Chalieco likes the Balama graphite, it foresees an opportunity to become a downstream producer, and that it foresees a growing graphite market. Therefore if Syrah gets into production they will negotiate a price on a quarterly basis, and presumably if they can agree on a figure Chalieco will buy 20 kt. Of course there are issues here. The glaring one is the fact that prices are negotiated quarterly, which means that if a price can’t be agreed upon no graphite is sold. Another is that Chalieco is an aluminum engineering company that would be entering the graphite market as a major player with production at 80 ktpa. or 21% of 2013 demand. It is not even involved in processing and selling graphite, yet it plans on becoming a major player in just a few short years. This seems highly unlikely, and Chalieco is under no obligation to buy graphite from Syrah.
Buyers of graphite simply don’t buy that much graphite at a time, and the market changes that we see going forward would have to be dramatic in order to alter the supply chain with the incorporation of large-scale offtake agreements. Not only would the market have to grow, but it would have to grow in the sources requiring the least amount of flake specification or the least amount of processing. But demand sources are growing in high-tech sources requiring a high level of specificity, meaning that a great deal of the value won’t be in graphite mining, but rather in graphite sorting, shaping, and processing. Surely even in the highly promising Li-battery space different competitors will emerge and demand different sized and shaped flakes from one another as batteries are improved. This is great for the graphite producers who recognize this, but it doesn’t bode well for offtake agreements of scale.
4: My graphite investment will benefit substantially from the graphene revolution.
Most graphite companies mention graphene somewhere in their promotional material. Some go much further than that, as we will see in a moment. Graphene is single layers of graphite, or two-dimensional hexagonal crystals comprised of carbon atoms.
(Source:
Chemguide)
Graphene has useful physical qualities such as high strength to weight, flexibility, and conductivity. It could become a ubiquitous material, and as a result a lot of investors are convinced that graphite companies will see direct benefits. Some might such as Focus Graphite and Mason Graphite, which are partners with, and own large stakes in graphene research companies–Grafoid and NanoXplore. But graphene–being a material that is one atom thick–utilizes very little graphite, and commercial quantities in the product’s early years will be measured in kilograms rather than kilotonnes (1 million kilograms). So graphene companies won’t be major customers of graphite producers anytime soon. Furthermore, while graphene startups might be promising they are still at the laboratory stage, and have very little value.
Conclusion
Graphite offers tremendous long-term investment opportunities. You will be best positioned to profit from them if you understand some of the unfamiliar attributes of the sector, especially if you have a mining background. In what I’ve written in this articles I’ve provided investors with an overview of some of these, along with a couple of other potential pitfalls that can easily be avoided. To summarize:
- There is tremendous potential in the graphite market in the next several years but right now it is awful: supply outweighs falling demand, and prices are low and falling. Promises of wide profit margins made by every graphite junior cannot be met in the near, or even in the intermediate future.
- The overemphasis on the mining side of the business has led to mismanagement of most companies in the sector Mining is certainly important–especially since operating margins should be much lower than expectations–but these companies need to place more emphasis on their respective sales strategies.
- The dominant sales strategy–securing offtake agreements for tens of thousands of tonnes of graphite annually–is fundamentally flawed in that the market is far too small and specialized. At the commercial level graphite is typically sold using yearly sales agreements with fixed prices and quantities. They are never larger than a few thousand tonnes.
- Graphene is a promising industry, but don’t confuse it with graphite. Graphene demand won’t materially impact graphite demand any time soon. Graphite companies who’ve partnered with graphene companies could benefit from these positions, but they’re worth very little for now.
It follows that the most rational way to play the graphite market is from the short side. As I’ve argued elsewhere the best opportunity is Syrah Resources, which has the most outrageous project. Since investors believe in the story they have bid up Syrah shares accordingly. Not only does the proposed project size give Syrah the industry’s highest valuation, but in its lunacy the project size makes Balama one of the least likely projects to go into production: who will give these guys money if they don’t understand the industry, and how can they understand the industry if they plan on producing so much graphite?
But while the most rational bets in the graphite space are short bets there are opportunities on the long side. Because investors value these companies like mining companies we find that companies with lower annual output projections have lower valuations. But these companies are run by people who are intentionally keeping their projects small while they develop client bases. This strategy is certainly not market-friendly since markets like bigger projects, but it is rational given my observations of the graphite market.
Thus ironically these smaller companies–often trading with miniscule valuations–are where the lowest risk opportunities are found. Furthermore, since the market has so heavily discounted these companies there are good value propositions, in spite of the weak graphite market. Despite being “small” they can grow as the secular bull market continues. As the graphite market strengthens
they will be the established producers with reputations rather than promotional literature, and they will thereby have a feasible chance of getting the highly prized spherical graphite contracts that investors are expecting to see in the next several years.
