The Graphite Bubble Is About To Take Off

by: Simit Patel

I've written before about why I believe graphite is the next bubble in the resource sector -- the equivalent to what rare earths were back in 2010 and early 2011. In this post I wanted to provide an update to that viewpoint.

First, the macroeconomic conditions remain unchanged. The latest MZM calculation in the US shows money supply at a new all-time high, coming in at 10.852 trillion in the first report for April 2012. Moreover, interest rates are still basically at zero. This environment -- one in which credit is cheap and the money supply is being expanded -- creates ample opportunity for bubbles to be blown. The past 14 years provide us with supporting examples of how monetary inflation and cheap credit fuel bubbles.

In addition to ongoing and aggressive expansion of the money supply is the deteriorating bond market; governments around the world face $7.6 trillion in coupon payments this year. As I've noted previously, I believe this will send capital out of bonds and into equities. The weakness in the bond market, coupled with ongoing inflation of the money supply, is why I agree with folks like Larry Fink who Jeremy Siegel who expect the S&P (SPY) to reach new all-time highs in the near future.

So that is the macro picture, which I believe continues to be supportive of higher equity prices. When we zoom in to the graphite sector, we see situation there is still unchanged. To summarize, technology related to new energy sources is what is driving graphite, specifically its role in batteries. Oil prices remain above $100; I don't believe this will change, as I believe peak oil is here. Moreover, the governments of the world, particularly state governments in the US, are continuing to invest an infrastructure for electric vehicles; as I noted in my update on EVs, both California and Illinois are investing in charging stations and subsidies. I don't regard these as favorable from the perspective of how to efficiently allocate capital to maximize wealth and optimize its distribution, but I do believe it will help fuel a bubble in graphite -- as graphite benefits from the production of batteries used to power electric vehicles.

Finally, let's drill down to see what's going on with my two favorite graphite companies:Northern Graphite (OTCQX:NGPHF) and Focus Metals (OTCQX:FCSMF).

Northern Graphite is a company I'm very fond of and is the only graphite stock I currently own; I believe its Bissett Creek graphite deposit will yield an abundance of economically viable graphite. The firm also boasts Sprott Asset Management as a major shareholder, and of all the research reports on graphite stocks that I've read, Northern Graphite is the one that keeps coming up again and again. This is an unscientific approach I'm using, but the basic conclusion I'm drawing is that those whom I find trustworthy and qualified to comment on this subject and who believe a mania in graphite is coming are overwhelmingly bullish on Northern Graphite. The company recently announced the issuance of options to executives at a strike price of $2.50; I consider this vicinity to be a price worth buying at (personally I'm long at $2.55).

As for Focus Metals, its shares recently shot up over 10% on news that its Lac Knife property held 46.1% large flake graphite (the valuable kind, and the kind that should be of focus to investing in anticipation of a coming mania in graphite) and a recovery rate of 85.9%. This is to be expected, as I believe the Lac Knife deposit is in the Labrador Trough region in Canada -- a region with a rich history of producing minerals at economically viable prices, and with an infrastructure designed to support the mining industry.

With the fundamentals clearly supportive on both the macro picture and the company-specific dimension, let's take a look at how price is behaving.

The chart above of Northern Graphite illustrates why I believe now is the time to invest in graphite. Once the new year started, stocks like Northern broke out; this is the confirmation that a bubble in this sector was on its way. If you missed out on getting in January or late last year, as I did, the best option was to wait for a pullback of at least 38.2%, the commonly utilized metric for Fibonacci traders. There was such a pullback in early March, and upon its completion, price began an even steeper acceleration. We recently had another 38.2% pullback, sending price below $2.40, from which it rallied; Northern is now trading at $2.95.

Based on previous price action, I think price will likely accelerate at an even steeper rate from here -- although I don't know how many more 38.2% retracements we are going to get. If we expect a 9X return from when the bubble began and Northern was at $0.80, that puts share price at $7.20. From this perspective, if investors want a nice return, I think they need to get in as soon as possible before the cat is out of the bag on graphite and the opportunity is covered in mainstream media.

Potential Dealbreakers

I'm confident in the situation in graphite, as I've already invested and do not invest in anything without doing research that gives me confidence. However, with that said, deal breakers that could destroy the opportunity should be noted, so that investors can differentitate between a dip buying opportunity versus a time to sell. So here are some potential dealbreakers:

1. Deflationary spiral -- if we see a repeat of 2008, in which we sell off in everything and capital runs into bonds and cash, that will take the graphite bubble down as well. I find this to be unlikely, though investors may wish to keep an eye on the bond market to see if it is showing any real signs of strength; if it is, the case for a repeat of 2008 grows stronger.

2. China loosens stranglehold -- Graphite is another market in which China is the major participant to watch. China curbed exports of rare earths (REMX) in 2010, which is what what set of the rare earths bubble; now, the Chinese graphite industry is calling for tighter controls, even going so far as to ask for the protection that was afforded to the rare earths industry. If the mentality here changes -- if China reduces obstacles towards a truly free and global graphite market -- price could decline or at least avoid the mania currently anticipated by many experienced observers of the resource market.

3. The return of oil -- I find this to be extraordinarily unlikely, as it would require the thread of carbon emissions legislation to go away, new oil supplies to be found, and geopolitical tensions to unwind. But in the off chance that all of this occurs and oil prices go down and stay down, that could weaken the market for alternative energy -- which is what is really creating true fundamental demand for graphite.

My personal approach towards graphite is to put in some money I feel comfortable losing, and then taking half off on a double. The remainder will be exited based on how the price of other things are faring, and what looks especially undervalued when graphite looks overbought.

Disclosure: I am long OTCQX:NGPHF.

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