Growth Commodities: Don't Get Taken Out Before It Takes Off

by: Nemo Incognito

I was struck by a recent post on Paul Kerosky’s blog which showed wireless broadband utilization ramping up.

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For those who were not around at the time of the “broadband bubble” capacity build out of cables based upon blue sky projections of demand for data led to an enormous amount of value being “destroyed” via over-investment in fiber optic undersea cables. It was a fiendishly tricky problem at the time: you have demand which is going to explode somewhere between fast and inconceivably fast – try throwing these questions and variables into a demand model:

- How quickly will people get Internet access?

- What will uptake be like?

- Will everyone use email in the future?

- What else can you send over cables? Music? Videos?

- Is everyone going to stop travelling for business and use video conferencing?

Etc., etc.

and supply which was, like most commodity products, something you took a few years to get in place making the risk of over/undershooting very very likely. It was a lot like one of those old chestnuts from industrial organization, the beer distributor game.

At work I’ve been looking at electric cars and particularly what it is going to do to the lithium market. By way of background, lithium is used in lithium ion batteries and some industrial applications – ceramics and industrial greases mostly. The industrial stuff is mature and is the sort of thing you model as demand = a +b*GDP growth – dull, simple, and something that lends itself to econometrics 101 very well. The lithium for consumer electronics and particularly autos thing is a whole different ball game:

- How quickly will people adopt electric cars? What drives that? Is it just the lease equivalent to owning a gas powered car? How do people heuristically estimate that – a moving average of gas prices, some “guesstimated” curve or just whatever pump prices were on their way to the dealer? How do you model demand on that basis – some kind of diffusion equation?

- Could it just be easier to use an S curve?

- How are costs of electric cars and battery packs going to change over time? What are the technologies? Do they differ much? Will battery packs increase in size or shrink?

- How much lithium goes into a battery pack today? Is that going to change? What drives that?

The two outcomes for markets like this are the chronic oversupply situation – like broadband in 2001 – or the chronic undersupply situation of rare earth metals. For investors the implications are pretty clear cut: you’re either going to zero or close to it or you’re going to get something in the order of 10x – just ask those who invested in Molycorp (MCP) in 2008.

With odds like that, its pretty much venture capital right? Well, not necessarily. There’s an important consideration when evaluating these businesses and those are cash cost curves – for broadband variable costs are ~0 for all providers so in a glut there is no real limit as to how low prices can go. For metals the game is quite different because not all producers have the same costs and leverage. If everyone had the same costs you would see prices move towards the market marginal cost and no one makes money. For an industry with a non-flat cash cost curve the guys at the top end get wasted and go on the MCI Worldcom heap and those at the bottom survive to see the light at the end of the tunnel and ultimately the bull market.

You can still lose out on leverage if you borrow a lot even if you are making money – funny how 50% EBITDA margins can go to 20% EBITDA margins and a manageable debt load of 2x goes to 5-6x pretty quickly. To that end, the lesson in these “growth” commodities is simple: if you are not at the bottom or close to it on the cash cost curve and if you borrow too much you are are long an option on a market rather than long the equity of the market. The difference is subtle – for option holders if things don’t work out within your time horizon the company will go insolvent or dilute before the revolution comes, for equity holders you have to wait longer and reduce your IRR but you generally don’t have to take a haircut. Some of the best trades in the 2001-2003 credit cycle were in telecoms and some of the best ones this time around were in rare earths [Molycorp, Lynas (OTCPK:LYSCF), etc.] largely from picking the bones of companies who took a bet on demand and missed only to find they did not have any ability to protect themselves and had to dilute or liquidate at the bottom.

To that end I can still see why its easy to like SQM (NYSE:SQM), Orocobre (OTCPK:OROCF) and others with near production and decent cash reserves whereas all things hard rock and spodumene like Talison (OTC:TLTHF) and Galaxy (OTC:GAXIQ) seem as likely to end up as martyrs to a transport revolution as anything else because when the chips are down they cannot compete on costs.