The Lithium Big Short

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Includes: ALB, FMC, GALXF, OROCF, PILBF, RDRUY, SQM
by: Laurentian Research
Summary

There are plenty of lithium reserves to satisfy the demand for many years.

The current production capacity ramp-up scramble is driven by fear of missing the price spike and greed for sharing a bigger slice of the incredible growth of demand.

There may be a huge excess of production capacity in 2018-2019, which may cause a recession in the lithium mining space following the pricking of the lithium bubble.

Prudent investors should, on the one hand, apply caution as to the junior lithium explorers and, on the other hand, be prepared to take advantage of opportunities offered by such a recession.

"I don't see the logic of rejecting data just because they seem incredible." - Fred Hoyle

"Mining is like a search-and-destroy mission." - Stewart Udall

1. Introduction

Lithium is the new oil in the age of automobile electrification. It is generally thought that lithium will ride on the coattails of the secular trend of the electric vehicle (aka, EV) revolution to reach higher and higher price levels, thus benefiting investors who have the acumen to invest early in the lithium miners. In addition, this metallic element is also an essential ingredient in energy storage applications for renewable energy - another budding trend over the next decades. These seem to be foregone conclusions. However, when it comes to investing, can one desire too much of a good thing?

On the other hand, lithium mining, after all, is part of the natural resources extractive industry, which is notorious for its ingrained business cycles. Is lithium mining exempt from the alternating boom and bust? Is it possible that it is different this time? If a recession is unavoidable going forward, how do we investors prepare for it and, hopefully, take advantage of it? Will the burst of the lithium bubble be able to pave the road for a widespread adoption of EVs, just like the pricking of the tech bubble ushered in an age of the internet?

In this article, we attempt to answer these questions on the basis of an examination of the supply and demand of lithium.

2. Lithium reserves aplenty

While lithium is found in minerals, clays, and brines in many parts of the world, high-grade lithium ores and brines are the main sources for all commercial lithium production (see here). Seawater also contains a huge amount of lithium but the lithium extraction therefrom is still not commercially viable (see here). Lithium recycling, now commercially operative, provides another source.

The lithium reserves came in at 14,469,000 tons or 77.02 million tons of lithium carbonate equivalent (LCE) and the resources stood at an additional 39,780,000 tons as of 2016 or 575.58 million tons of LCE. The vast majority of the lithium resources is concentrated in the so-called lithium triangle, namely, Bolivia, Chile, and Argentina, followed by the U.S., China, and Australia.

The global reserves increased by 7.0% from 2015 to 2016. Over the past few years, it seems that a new junior lithium company popped up every month; some of these explorers may succeed in booking new lithium reserves. So we can expect lithium reserves to continue its healthy expansion in the next few years.

As of end 2016, the reserves of lithium can last 410 years at the 2016 production (Table 1). Table 1. World lithium mine production and reserves, author's compilation of data sourced from USGS statistics.

3. Lithium demand

Global lithium end-use markets are estimated as follows as of 2016: batteries, 39%; ceramics and glass, 30%; lubricating greases, 8%; continuous casting mold flux powders, 5%; polymer production, 5%; air treatment, 3%; other uses, 10%. Except for 2009 when the Great Recession occurred, lithium demand used for all of these purposes has expanded, but that for batteries has claimed the lion's share.

Driven particularly by rechargeable batteries, the worldwide lithium demand grew at a 10% CAGR from 2000 to 2008, and, after a hiatus in 2009, it resumed growth at an 11% CAGR until recently (Fig. 1).

Going forward, Li-ion battery mega-factories are thought to continue to drive lithium demand growth. Tesla's Gigafactory 1 may be the center of attention, but battery production facilities are planned in many other parts of the world, particularly in China (Fig. 2). By 2020, Li-ion battery production capacity is projected to reach 174 GWh, more than 6 times of the 27.9 GWh production capacity as of 2016. Using kg/kWh as detailed in note 1, lithium demand in 2020 is expected to be as high as 522,000 tons of LCE, which is more than 10 times of the lithium production capacity of 2015.

Fig. 1. Historical lithium demand, after here.
Fig. 2. Li-ion battery production facilities under various phases of construction in the world, modified after here.

3. Lithium supply: expanding production capacity

There are two ways to produce lithium in industrial quantity. One method is mining ores of mineral spodumene (LiAl(SiO3)2), with some of the largest spodumene mines in Australia; lithium mining tends to be expensive and capital intensive.

The other method, far cheaper than mining, is to extract lithium by evaporating lithium-rich brines, with some of the largest brine extractive operations located in the so-called Lithium Triangle - Chile, Argentina, and Bolivia - which is not only endowed with the world's largest lithium salars but also ideal weather for evaporation (Fig. 3). Lithium production comes in the form of lithium carbonate (Li2CO3), lithium hydroxide (LiOH), lithium chloride (LiCl), butyl lithium (C4H9Li), and metallic lithium (Li), which are usually reported in lithium carbonate equivalent.

Fig. 3. A lithium salar (left) and spodumene (right), modified after Wikipedia.

Worldwide lithium production capacity was reported to be 49,400 tons (or 263,000 kton of LCE) in 2015, of which only 64% was utilized in 2015 and 71% in 2016. Global lithium production increased by 12% to 35,300 tons (or 188,000 kton of LCE) in 2016 (Table 1). Two brine operations in Chile (Salar de Atacama and La Negra), two brine operations in Argentina (Olaroz and Salar del Hombre Muerto) and a spodumene mining operation in Australia (Greenbushes) accounted for the majority of that output.

Fueled by the optimistic expectation of lithium demand growth, a total of 16 mining firms have had some 17 lithium projects in various phases of planning, developing, construction and commissioning, targeting the first production from 2017 to 2020 beyond (Table 2). Such a scramble to ramp up production capacity was spurred both by fear of missing out high-flying prices and greed for expansion on the back of the EV revolution.

In 2016, worldwide lithium spot price increased 40-60% year over year and large, fixed contract prices of lithium carbonate rose 14%, although in China spot lithium carbonate prices at one point of time shot up 300%, briefly exceeding $20,000/ton, due to a temporary shortage of imported spodumene from Australia (see here).

Mining companies began to come up with demand growth forecast based on announced EV plans by automobile OEMs; e.g., lithium demand is projected to increase at a 15% CAGR from today's consumption of 188 kton LCE until 2021-2025 (see kton LCE until 2021-2025 (see here and here).

On top of the scheduled expansion of production capacity, companies are also working on recycling projects; for example, one lithium recycling facility in Lancaster, OH, already began operation in 2015. By 2021, an increasing amount of used EV batteries should start to arrive at recycling facilities, given their useful life averaging 7-8 years.

Is lithium production capacity getting ahead of the demand growth?

Table 2. New lithium projects, after Lithium Americas presentation of August 2017.

4. When supply meets demand

In order to construct a lithium supply-demand profile for the foreseeable future, we calculated the future production capacity by adding incremental production from new projects as they are scheduled to come onstream. We then compare it with the demand profile at various rates of growth. The result as shown in Fig. 4 reveals:

  1. In the base case of 15% CAGR of demand growth, there will occur a major episode from 2018-2019 of 75-105% overcapacity above demand.
  2. Even if demand grows at a much higher rate of 45%, production capacity will still exceed demand by 29-39%.
  3. Such a supply surplus will not be absorbed until 2020 when the completion of a slew of Li-ion battery mega factories pushes the lithium demand to 522 kton of LCE (see above).

Unless the vast majority of the new development projects is suspended or delayed until much later, that overcapacity will occur and consequently, decimate the lithium price if they actually come onstream upon completion. If such a dismal scenario of oversupply plays out, the lithium price may not stop dropping until it lands on the level of production costs, i.e., $4,600-4,700/kton of LCE (see note 2).

In the aftermath of this 75% lithium price fall, a large swath of high-cost producers will be forced to halt production, from Pilgangoora of Pilbara Minerals (OTCPK:PILBF) via Mount Cattlin of Galaxy Resources (OTCPK:GALXF) to the Chinese producers. Some of these producers may have to file for bankruptcy, while others may be acquired by the stronger competitors; as a result, the industry will consolidate to eliminate the excess supply.

Only some of the lowest-cost lithium operations will be able to produce below costs, whose production will be more than enough to meet the market demand, these including, from the lowest to medium costs, La Negra, Chile of Albemarle (ALB); Olaroz Lithium Phase I and II, Argentina of Orocobre (OTCPK:OROCF); Salar de Atacama, Chile of SQM (SQM) and of Albemarle; Asset 3 of Albemarle; Salar del Hombre Muerto, Argentina of FMC (FMC), Greenbushes, Australia of Talison, a 50:50 joint venture between Albemarle and Tianqi Lithium Corporation; and Mount Marion Lithium Project, Australia of Neometals Ltd. (OTCPK:RDRUY) (Fig. 5).

Fig. 4. A comparison of production capacity profile with demand growing at 15% (the base case), 25%, 35% and 45%, author's calculation using parameters as in here and here.

Fig. 5. 2020 LCE production costs, modified after Lithium Americas' presentation of August 2017.

To those familiar with the natural resources extraction industry, such a recession should not come as a surprise; booms and busts are part of life for both the mining and oil industries. What is unique about the lithium cycles is that it is mostly a supply-side self-inflicted alternation of prosperity and recession with little demand-side pressure to reduce the prices of lithium.

The seed of this anticipated episode of lithium surplus was sowed a long while ago when the miners' greed was first whetted by the sign of rising price of lithium (Fig. 6). Alliance Bernstein analyst Paul Gait et al. said late last year in a report called “Lithium: the Big Short” that, though demand for lithium could double, “the lithium frenzy should all end in tears” (see here).

Fig. 6. The mineral resources development cycle and life cycle of a mining project, modified after Harazz.

Ironically, in a presentation dated May 2017, lithium giant Albemarle even went to length to model "a prolonged recessionary period" between 2018 and 2020 (see here), which makes us wonder what its archrival Sociedad Química y Minera de Chile S.A., or SQM for short, has in plan. Historically, SQM has played the role of an industry leader, using pricing actions to discipline fellow market participants and fending off aspirant entrants into the industry.

In the late-1990s, just when the lithium prices approached the point to make lithium ore mining economically viable, SQM flooded the market, dropped prices from $4,000/ton down to $1,400/ton, effectively slaughtering the aspirant new producers. In October 2009, when Bolivia started to think about developing its vast lithium resources, SQM again reduced prices by 20% while raising production capacity by 40,000 tons per year (see here). It is thus a bit uncharacteristic for the lithium giant to have sat on hands for long and watched numerous new entrants encroach on what it considers to be home turf this time around.

5. How do we play the lithium big short?

Although we are confident that a correction looms on the horizon, we cannot pinpoint the exact time that it will happen. As a matter of fact, we doubt that anyone can predict it. However, when it indeed happens, those who invest heavily in the higher-cost lithium producers, especially the junior explorers that are currently being promoted, may lose their shirt.

Therefore, a prudent investor knows that he should avoid the vast majority of the junior lithium producers. He would limit his lithium positions to less than full and mostly stay with the majors, i.e., Albemarle, SQM, and FMC, and well-funded small players that have low-cost projects to come onstream imminently. He may even consider shorting a selected few of junior lithium names that mostly hype and lack verifiable substance.

In addition, he makes sure that he will have the wherewithal to back up the truck on the stocks of the lithium majors along with the high-quality small players, which have survived the trials and tribulations of an industry recession, on the cheap at some point of the recession. After the bubble bursts, the lithium majors may acquire some assets of quality for a song and will end up to be stronger with the elimination of excess production capacity; the surviving small producers, if not being acquired, will be able to experience a tremendous growth from then on.

We at Laurentian Research will present our bottom-up, in-depth research on some of the lithium producers mentioned in this article to the subscribing members of TUOH, our Seeking Alpha Marketplace exclusive service. We invite you to sign up here to access our actionable investment thesis.

Note:

1. In reality, Li-ion batteries use four times as much lithium per kWh as the theoretical quantity. After making allowance for cycle-related capacity fade, losses in purifying raw technical grade Li2CO3 into low-sodium battery grade material, some 3 kg of lithium carbonate will be required per kWh of final usable battery capacity (see here).

2. Lithium only represents an insignificant (from below 2% to 4-5% according to various estimates, see here and here) part of the costs of battery production. Therefore, the battery manufacturers may not exert their bargaining power over the lithium miners. Consequently, they are insensitive to lithium price fluctuations.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.