*Note that while slightly outdated, this article should be read alongside our article: Investing In Graphite Part 1: Supply/Demand Overview.
2015 was a rough year for the junior graphite industry with many shares losing a substantial amount of value. Some companies--such as Focus Graphite (OTCQB:FCSMF)--have all but fallen out of existence. Companies flaunting "special" graphite such as Zenyatta Ventures (OTCQX:ZENYF) and Northern Graphite (OTCQX:NGPHF) have melted lower as investors have come to realize the difficulties that come with marketing special graphite. Even Mason Graphite (OTCQX:MGPHF), which has some of the most seasoned people in the space on board, failed to differentiate itself through its feasibility study (as we had hoped), and shares sank throughout much of 2015. Flinders (FLNXF)--which got into production--stopped as its raw graphite wasn't worth producing at low market prices. Exceptions to this were, ironically, the one graphite company we think has a reasonable chance of success--Great Lakes Graphite (OTCPK:GLKIF), which roughly doubled for the year--and Syrah Resources (OTCPK:SYAAF), which we picked as our top short in the space.
We think a couple of things are going on here. First and foremost, the largest contributor to graphite demand is the refractory market (graphite can withstand very high temperatures making it ideal for, for example, steel crucibles), and the steel market couldn't be uglier. With steel demand down graphite demand is down, and as we pointed out in our 2015 supply/demand overview graphite is an oversupplied market as it is, with idle mines and plants in China--the world's top graphite producer.
Second, note that the companies we're singling out are all junior companies--producers aren't publicly traded and most are in China. Investors in many of these companies have come to realize that mining is just a small part of the graphite business, whereas they came to the sector thinking that it is like gold in that gold is mined, purified into bars and readily sold. Graphite has to be processed to order, and that means graphite companies need customers to tell them what their orders are--no orders, no sales. An exception to this is that there are graphite "traders," although going back to the gold analogy selling graphite to a trader is probably as bad as selling gold to a pawn broker--you'll get ripped off.
2016 is shaping up to be very similar. Global economic activity is weak, and this is going to restrict graphite demand in the steel industry--expect continued oversupply.
The one strong spot will be the battery space, the lithium ion battery space in particular (graphite is found in other batteries, too). Investors in or spectators of (probably the wiser of the bunch) graphite are well aware that the large number of start-up junior mining companies started in anticipation of rapid demand growth from the battery sector. It is difficult to know whether a given Li-B uses synthetic or natural graphite, or how much graphite is used, but natural graphite demand in the battery sector is on the rise, especially as electric vehicles become more popular. The adoption of EVs has been slower than some had anticipated, but it is still rapid, and it should continue to outpace the economy by a fairly wide margin.
With this being the case every junior graphite company talks about the opportunity in the battery market (which we've covered extensively): this has been the driving promotional force behind the IR literature that most companies have put out, and exaggerated claims on this front has likely soured many investors, probably forever. Li-Bs require graphite to be processed several times since it must be a certain size, shape, and purity. It also must be carbon-coated. This is difficult work for individuals who haven't done it before, especially since many of them come from more conventional mining sectors where the chemistry and processing technology is well-established. Graphite companies have masked this difficulty by announcing to the markets that their graphite has been used to produce coated spherical graphite (aka "CSPG")--the product used in Li-Bs. In every instance, however, this has been done in a lab where the cost of commercial production has yet to become an issue. Only one company--Syrah--has produced spherical graphite using a pilot plant, and its results led to what management is calling an "internal economic assessment," meaning it is of little use for us investors to evaluate. Only one company is close to releasing a spherical graphite feasibility study--Mason--and we are even speculating here--the company has specifically announced a more general downstream feasibility study, and we can only guess that spherical graphite will be included.
What To Expect In 2016
As a whole we don't think 2016 will be an eventful year for the graphite market. There's no reason to suspect a sharp turnaround in the refractory market, although it could bottom and maybe even bounce. The end result will still be an oversupplied market.
We expect more EVs to be built and sold regardless of what happens to the global auto industry since there is a strong secular trend boosted by government incentives in that direction, but recessionary pressures could easily stymie growth, especially in more mature industries in which Li-Bs are used (although they are used in many industries in which. Even if this market is strong no junior graphite company is at the point at which it will be able to produce commercial quantities of spherical graphite any time soon. We suspect that EV producers will continue to get their spherical graphite out of China and southeast Asia for the time being.
With respect to individual companies we suspect that many of the graphite hopefuls will cease to exist. Many are already little more than zombie companies occasionally surfacing to raise a little money or to try one last time to promote themselves to whomever is paying attention. We won't be.
At this point there are just four companies that are on our radar:
- Flinders has reduced its activity to a near stand-still as it preserves capital, but it has retained a Chinese engineering firm to work on its high purity graphite plant. If management can convince the market that its Chinese consultants have something to offer we can see this story perk up again. Flinders also has very strong insider ownership, which we believe to be absolutely critical at this juncture. We did, however, get this one wrong, and we remain skeptical.
- Great Lakes: Great Lakes has taken a different path from the rest of the pack--it has decided not to develop its mine and is instead buying graphite and processing it. Given the oversupply situation this is a sensible move. The company is only performing one of the processing steps--micronization--sometimes utilized in producing spherical graphite, but micronized graphite is a salable product itself that is used in "boring" yet reliable businesses such as paints and lubricants. If they can get to cash-flow they can internally finance the more complex research required to produce spherical graphite. This is long-term, tactical thinking with near-term benefits and relatively low cost, and it's the only story we're betting on right now.
- Mason: these guys have the most experienced management team, but we think their sales ambitions outweigh market demand, especially in this market. But they will have the lowest production costs for raw graphite. They have a strong investor base that's in it for the long haul, and that includes insiders. They are well connected as well, and we think that of the Canadian graphite companies looking to develop mines that Mason has by far the best chance of getting financing. But they still have to demonstrate that they can sell 50,000 tpa. into a global market that is ~400,000 tpa., and that is easier said than done.
- Syrah: This is our short pick for the sector in large part given its very high market capitalization, which exceeds the combined capitalization of the rest of the graphite juniors. Investors are drawn in by the company's enormous project and its offtake agreements. But the offtake agreements are not binding, as we explained in our short article. We also wonder how the company will sell over 300,000 tpa. of graphite when demand is 400,000 tpa. It seems ludicrous to us, and we think investors will begin to jump ship once Syrah's management attempts to sell so much graphite.
The Bottom Line
Graphite is an essential mineral, and its uses are expanding. The growth of high-tech applications such as Li-Bs generated some speculation a few years back. While the original players still exist, and while there are even some new ones that have sprung up over the past couple of years, investors grossly misunderstood the sector and what was required of companies to be successful. In a world where even good resource companies have it rough this is not a recipe for success.
Investors who remain should consider the various failures of the past in order to predict the inevitable ones of the future. Those companies with low pre-production capex, an emphasis on cashflow, and an operationally simple approach have a shot. Everyone else will likely disappear.
Disclosure: I am/we are long GLKIF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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