2018 will be the year of lithium M&A. Oversupply fears are grossly overstated.
Whilst I don't consider myself a contrarian I seem to be taking that stance quite often lately - especially when compared to "market analysts". Last year I wrote about the oil price and why the "lower for longer" narrative was misplaced. Here we sit with WTI trading at $66 / bbl, 6 months after major wall street banks predicted it would be range bound between $40 - $55/ bbl until 2022.....Today some of those banks are now calling oil to $80/bbl this year. All of the reasons why oil wouldn't stay in that lower price range were in plain sight. To my mind there are obvious facts as to why lithium chemicals aren't close to being in oversupply and why their prices won't come under pressure.
So I'm going to risk making another prediction that goes against a number of analysts - the oversupply fears for lithium are grossly overstated. A friend who works in investment banking in London recently told me their large asset management clients in Canada felt - "there's lithium everywhere" - "largely a retail story" - "once Rio's Jadar mine comes on-stream the juniors are dead". Essentially a barrage of negative comments.
Here are some facts you'd do well to consider when we assess supply / demand later on:
To bring a brine or hard rock mine into full production from initial discovery takes at least 6-8 years minimum (part of the reason I'm an M&A believer)
Lithium is everywhere, however, economically viable lithium, with limited impurities, isn't everywhere
Whilst lithium has been mined for decades very few greenfield projects have been developed in the last 20 years. As such technical skills for either brines or hard rock are not in abundance. 3 companies produced over 80% of the worlds lithium in 2016
Numbers vary but based on the companies I cover the capex cost to bring a new mine online to produce 20,000 /tpa of lithium carbonate is approximately US$500m
The entire lithium chemicals market was 197,000/t in 2016 worth less than $2bn
The adoption of electric vehicles (EV's), like other disruptive technologies, is projected to follow an s curve. Namely, after a period of slowly rising penetration, mainstream conversion to EV's will be exponential (think colour TV's, mobiles, i phone)
2017 was the year when all the upside revisions were for future lithium demand and all the downside corrections were in lithium supply. However, in January 2018 a bomb dropped. Sociedad Quimica y Minera ("SQM") and CORFO, a Chilean development corporation, struck a deal to allow SQM to produce an increased amount of lithium until 2030. This announcement has wiped billions off the valuations of lithium companies globally. Analysts everywhere have speculated that the lithium price is destined to fall substantially. Really....I don't think so.
If one drills down into the terms of the deal, which effectively makes SQM a contract miner, there aren't a lot of incentives for SQM to invest heavily in increased production. To be clear, the Salar de Atacama in Chile is the gold standard of brine deposits. Exceptional grades and a vast resource, but, it's largely owned by the "people". It's the people's lithium, not SQM's. SQM leases the land and mines it on behalf of the people. So whilst you can potentially overlook all the local community payment requirements, progressive royalty schemes, forced sales at low prices to downstream Chilean chemical processors etc etc etc the real rub comes in the clause that says the assets revert back to CORFO in 2030. At this point CORFO will pay SQM the depreciated value of the assets and a fair price for water rights etc and put the assets on auction. It's quite possible that SQM could win the auction but there's also a chance it doesn't. Given the past tensions between SQM and CORFO, SQM has entered into 2 joint ventures, one with LAC in Argentina and the other, Kidman Resources in Australia. Therefore SQM has already committed to capital expenses and managerial input elsewhere. In a word, they have diversified. Further, SQM's current expansion of 15ktpa in the Atacama, to 63ktpa, is already in progress and factored into the markets calculations. Realistically an expansion beyond this, given water / environmental permits, evaporation pond installation etc, couldn't be achieved before 2022. For the next four years there are no potential supply surprises on the upside. In theory SQM could increase its production in the Atacama (unlikely they'd initiate a greenfields development elsewhere in Chile) substantially by 2025 and beyond. But I ask you this, from a corporate strategy standpoint, why would you invest heavily in capital and management expertise if your payback period is 5 years or less? Why would you risk your production profile plummeting in 2030 when there are other junior miners you can JV with or buy outright and have secure production for 30 years? What will the cost to SQM be if the company has to go out and buy or develop new assets in 2030 to replace lost production? Notwithstanding the environmental hurdles etc from a production profile and profitability perspective it makes no sense for SQM to invest heavily in the Atacama much beyond 2022 assuming an arms length auction process of the assets by CORFO around 2030. If I were to hazard a guess I would say at a peak SQM will produce 100 ktpa in the Atacama, substantially below the 216 ktpa limit that they theoretically can produce under the new agreement.
I won't dwell on the demand side other than to highlight the following:
Demand growth forecasts are largely clustered around 15% CAGR from here to eternity
Roskill's forecast is for 1,000,000/tpa LCE by 2026 (5x 2016 level)
EV sales in China, where pro EV legislation is in place, hit 3.3% of total car sales in December 2017. Global EV sales growth in 2017 of 58% y-o-y over 2016, Dec 17 over Dec 16 growth of 67% (above forecasts)
Benchmark Mineral Intelligence megafactory tracker includes 26 battery cell plants either in production and expanding or new operations due in production by 2021. The combined capacity of these plants is 344.5 GWh versus 2017 estimate of 100 GWh
In order to ensure battery metals are available for new megafactories battery companies are increasingly looking upstream and signing offtake agreements with junior / developing miners. Offtake agreements typically include an equity stake in the miner and assistance with debt, potentially through a prepayment agreement for future metal deliveries. This commitment is key for a junior miner to succeed. Pre production capex funding is everything. A project, even a good one, is worthless in the hands of a junior that cannot secure funding. Given some of the hurdles that new lithium producers (and old) have faced (Orocobre, Galaxy, Albermarle) in ramping up new production the ratio of debt to equity re project capex may be skewed more towards equity than originally hoped, even with solid offtake partners. This highlights why a fall in share prices can have severe implications for junior miners. The greater the number of shares that need to be issued to fund the equity piece of project capex spending the greater the dilution to shareholders. By comparison, a mid sized or major company, with ready access to reasonably priced debt funding (and therefore a reduced reliance on equity financing), can improve a projects financial returns materially. Add to this in house technical expertise and experience and the merits of a partnership with a mid sized or major company, from a junior companies perspective, are very evident.
The recent sell off in junior / developing lithium mining companies has opened the door for the larger, more price stable players, to look at either JV agreements or outright purchases. Currently junior / developing companies, some potentially within 2-3 years of production, offer a reasonably priced alternative for bigger operators to increase production in the mid term. We may even see battery cell manufacturers look to vertically integrate and go beyond offtake agreements. In my opinion, these juniors offer SQM well priced diversification, future production stability and long term rates of return in excess of the CORFO deal. For diversified mining majors the quality juniors offer a good entry point into the growing lithium market. Right now I would say the quality junior / developing miners, the mid sized / major players and the battery cell manufacturers need each other equally. Fertile ground for M&A activity. To be clear I'm not suggesting that every lithium miner with a spade, wheel barrow and a power point is worth buying. Far from it. But equally I'm not in agreement with certain analysts that all lithium juniors / developing companies are dead and buried. What I am saying is that there are quality junior / developing lithium companies that are very undervalued at present and when the market realizes lithium prices will remain stable (or will rise) for some years to come I expect them to perform extremely well.
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