Lithium's Chinese Connection

Summary

• SQM shares fell 7% last week as the company missed consensus projections of EPS and total revenues.
• Meanwhile, the company's lithium revenues have cumulatively increased 189% through the end of 2017 since 2015 as the price of a metric ton of lithium reached all-time highs.
• In the first quarter, lithium poked through the $16,000/metric ton threshold for the first time, an unprecedented 23% increase for the period.
• SQM's production limits have been lifted as supply is now projected to reach 180,000 metric tons by 2021 as China assumes a commanding role in the EV space.

Sociedad Quimica y Minera's (NYSE:SQM) lithium production through the end of 2017 came to 49,700 metric tons, translating into $644.6 million at then current world prices, a 25% YOY increase in revenues from 2016 revenues of $514.6 million. Interestingly, the company's production needle through the end of 2016 didn't budge, coming in at 49,700 metric tons. More on that later. Going back another year, SQM's lithium production came to 38,700 metric tons through the end of 2015, making the company's 2016 production total larger by some 28%. The company's lithium revenue soared from $223.0 million to $514.6 million for a crisp 131% increase YOY. On the production side, the cumulative increase came to just over 28% for the period. On the revenue side, SQM cumulative gain topped 189%. In 2017, the average price for a metric ton of lithium came to roughly $13,000, about $10,350 in 2016 and just under $6,000 through the end of 2015. Through the end of the first quarter, lithium scratched out a new scorching high of $16,000 per metric ton, a 23% increase over the course of three months rather than over the course of a year. Through the end of 2016, the price of lithium came to $12,970 per metric ton. In 2015, that price was $5,760 per metric ton, almost 80% lower than the settling price of $10,360 through the end of 2016.

Lithium sales provided the company with 71% of its gross margin through the end of 2017. In 2016, lithium sales were responsible for 66% of gross margins and 51% in 2015. Cumulatively, lithium margins were up 125% for the period. Further price increases are expected up until the time when supply and demand come closer to some semblance of equilibrium in the next year and beyond. Until that time, demand is well out in front of supply, creating a classic seller's market for lithium worldwide by any measure.

In its recent first quarter earnings report, SQM outlined a very ambitious $525 million capital spending program in the lithium space. In a three-phased program, the company will increase production from its current 49,700 metric tons to 70,000 metric tons by the end of the year - a 41% uptick. That production will balloon yet again to 120,000 metric tons by mid-2019 in phase two, a 71% increase over current levels. By 2021, lithium production is slated to peak at 180,000 metric tons in phase three - a 50% increase - with an expected completion date of early 2021. Assuming a 23% increase in lithium over the rest of the year, rather than what was witnessed in the first three months of the first quarter, the per price metric ton price projects into the neighborhood of $19,680. If the company supplies the market with 70,000 metric tons of production by the end of the year, SQM's lithium revenue tops out at $1.38 billion, a cool 114% YOY gain in its lithium segment-alone. Through the end of 2017, lithium contributed 30% of SQM's total revenue, second only to the company's specialty plant nutrition segment which produced 32% of total revenue through the end of 2017. Lithium revenues are up 189% since 2015, growing exponentially from 13% to 30% of total revenues over the period. Specialty plant nutrients are up 6.9%, falling from 38% to 32% of total revenues over the three-year period.

SQM missed consensus EPS estimates by a penny, coming in at $0.43/share. Overall revenue came in at $518.7 million through the end of the first quarter YOY, wide of estimates by some $20 million. The stock fell 7% on the news (green line, upper detail frame). SQM (green line, upper frame) has outpaced the S&P 500 (green area, upper frame) since the beginning of 2016. A ratio of the S&P 500 (middle frame) saw the stock falling prey to the market's correction in February, recovering much of the territory it lost in the market's slide before falling off on its first quarter earnings report. Market momentum (bottom frame) turned largely negative thereafter (see Figure 1, below).

Figure 1: Sociedad Quimica y Minera against the S&P 500

SQM got its initial start in the mid-19th century producing sodium nitrate for use in explosives. By the end of the century, the company became a world leader in the production of nitrates for fertilizers and other agricultural applications. It wasn't until 2005 until the company began production of lithium hydroxide at a facility in the Salar del Carmen near the town of Antofagasta in Northern Chile, about 230 kilometers (140 miles) from the company's Salar de Atacama holdings. SQM now claims 23% of the global market for lithium - the largest lithium producer in the world (see Figure 2, below).

Figure 2: Percent of World Lithium Market, 2017

Like all other mining companies with operations in the Salar de Atacama region of Chile, SQM holds temporary mineral rights on 140,000 hectares with arguably the richest and most cost-effective deposits of brine lithium on the planet. Forty-seven percent of the company's consolidated revenue comes from the Atacama. The company has the exclusive right to mine about 81,000 of those hectares in a lease arrangement with the Corporación de Formento de la Producción (CORFO), a governmental regulatory authority. The Comisión Chilena de Energía Nuclear (CCHEN) further stipulated a production limit of 180,000 tons of lithium, considered a strategic mineral by the Chilean state.

A contract dispute between SQM and CORFO over royalty rights, back taxes, environmental compliance and corporate governance dating back to 2014 placed SQM's lease rights in legal jeopardy. The original lease for the Salar de Atacama parcel dates from 1993 and runs through the end of 2030. While about 13 years remained in the contract, a full 64% of the lithium production allowed under the contract had already been extracted to date, placing severe constraints on the company's ability not only to supply a growing lithium market. Without leasing rights from CORFO and CCHEN, SQM would quickly fall into receivership.

A new contract was finally forged between SQM and its various regulatory overseers this past January. Without the standard admission of guilt, SQM paid out a $17.5 million fine to CORFO and changed both the board composition and ownership of the company which excluded the Ponce family who had ties by marriage to ex-dictator Augusto Pinochet and was long a political irritant of subsequent Chilean governments across the public spectrum. Lithium production was allowed to increase in accord with the parameters outlined in the company's first quarter earnings release. The capital outlay will increase the lithium processing facility at Salar del Carmen by adding a second production facility which will be operational in the latter part of the year.

SQM was not the only lithium producer in the Atacama that saw their lithium quota increased. US-based Albemarle (ALB) also received permission from CORFO during the quarter to increase their lithium production by as much as 145,000 metric tons annually through 2043, based on a new extraction methodology that could result in as much as 125,000 metric tons of lithium carbonate equivalent of annual production without further brine pumping from the company's Atacama holdings. Lithium sales for the company were up 38% YOY through the end of the first quarter. Lithium sales as a percentage of total sales for the period were up 36% to $298 million, an increase of just over six percentage points YOY. On an EBITDA basis, ALB's lithium sales as a percentage of total sales soared 53% YOY. Through the end of 2017, ALB's lithium sales grossed $1.31 billion or 43% of total sales, up 35% YOY.

Of course, junior companies with outsized Atacama holdings that have yet to compile proven lithium reserve data become all the more appealing as the consolidation of the lithium space gathers steam. Wealth Minerals (OTCQB:WMLLF), with 45,000 hectares in the Atacama comes readily to mind.

SQM's cost of goods sold will be important moving forward as a new lease payment rate comes into effect. In regard to lithium carbonate, the existing rate is 6.8% on FOB sales. That rate will increase on a progressive scale based on the total sale and prevailing market price of lithium. Through the end of 2017, the market price came to $12,600/metric ton which computes to an average lease payment of 19.14%, about 2½ times the rate of lease payments made to date. COGS for lithium already increased 7.8% to $199.2 million through the end of 2017 YOY due to higher lease payments made to CORFO. Those lease payments will invariably keep close pace with the company's increased production and capacity for processing lithium for delivery to industrial users in 2018 and beyond.

For ALB, the difference between total lithium sales and EBITDA lithium sales largely represents the lease payments to CORFO for its Atacama production where 36% of the company's $3 billion in global assets are located, an increase of 16% YOY.

Of course, the May announcement of China-based Tianqi Lithium's purchase of Nutrien's (NTR) 24% voting stake in SQM for an estimated $4.1 billion promises to change the stakes in the global lithium space for the foreseeable future. Tianqi is purchasing 2.65 million A-shares from NTR, giving the Chinese company three of SQM's eight board seats, already raising anti-trust fears among both current SQM shareholders and the Chilean government. Tianqi would be in line to eventually take control of SQM if the other two major shareholders of SQM, the Chilean Pampa Group and the Kowa Groups which own a 32% stake in the company ever sold off their block of A-shares in part or in total. Anti-trust investigations continue. NTR will retain an estimated 20 million non-voting B-shares in SQM that it is obliged to sell by April 2019 in a regulatory divestiture in the wake of last year's merger between Saskatchewan Potash and Agrium. If the deal goes through, Chinese companies will control an estimated 70% of the world's known lithium reserves. In terms of SQM sales of lithium to China, that percentage already tops out at 79% through the end of 2017. By way of contrast, SQM's percentage of lithium production that went to North American industrial users fell over the period by a percentage point to 7%, down from 15% in 2015. For Europe, SQM sales came to 14% of the company's lithium output, down from 19% in 2016 and down even further from 21% in 2015. Tianqi's SQM purchase would increase its global share of the global lithium market to about 15% (see Figure 2, above).

Meanwhile, Tesla (TSLA) just last week signed a three-year lithium supply contract with the Australian miner Kidman Resources, which is developing hard rock deposits in the Mount Holland region of Western Australia. The contract came after Tesla's very public sniffing around NTR's SQM stake in early February.

For its part, SQM has also branched out of its ensconced Chilean brine enclave with a 50/50 joint venture with Kidman Resources. Together, the JV is projected to produce about 40,000 metric tons of lithium with the building of a hard rock lithium processing facility in Kwinana, Western Australia, starting in 2021.

Figure 3: World EV Battery Production Countries

China remains the white elephant in the global lithium space. Perhaps a better characterization would be this: China strives tenaciously to lead the world in the EV space. As part of President Xi Jinping's industrial policy couched in his signature Made in China 2025 program, the government is spending furiously on clean energy technology, particularly in the EV space. Fujian-based Contemporary Amperex Technology (CATL), China's biggest battery manufacturer is now poised, with the investment help of Goldman Sachs, to raise an estimated $8 billion from its offering on the Shenzhen Stock Exchange. CATL now lays claim to being the largest battery manufacturer in the world after recently surpassing Japan's Panasonic in sales due largely to a government mandate that requires all EV battery packs being sourced through Chinese companies to qualify for the generous $9,000 government-sponsored buyer incentive program (see Figure 3, above). The mandate, in and of itself, keeps China at the fore of the EV breakout in the world's largest automotive market. The company has ambitions of selling battery packs across Europe and the US from a proposed manufacturing Gigafactory that will rival Tesla's offering in the Nevada desert.

Chinese regulators have set in place an ambitious EV timetable for auto manufacturers that sell into the Chinese market. Manufacturers will be required to field 3% to 4% of their respective offerings in the EV space, defined as plug-in hybrids, battery electric and fuel cell vehicles, by the 2019 model year. The requirement increases to 4% to 5% of their line-up in 2020. These EV offerings will generate credits of 10% in 2019 and 12% in 2020 that can be bought and sold in public markets by other manufacturers to meet government guidelines.

By way of contrast, the US EV purchasing incentive at the federal level is $7,500 for a new or leased vehicle. The incentive squeaked back into the Tax Cut and Jobs Act package passed by a Republican-controlled Congress in December at the last possible moment after being initially axed from the program as an offset to the rising cost of reducing the corporate statutory tax rate to 21%. While Chinese authorities have clearly added increasing regulatory pressure on automobile manufacturers to meet its ambitious clean air requirements, US regulators are just as clearly moving in the opposite direction. The Corporate Average Fuel Economy (CAFÉ) requirements put forth by the Obama administration in 2012 would have required automakers to roughly double the fleet fuel economy of cars and trucks sold in the US market to 54.5 miles per gallon by 2025. The rules would have cut the country's oil consumption by an estimated 12 billion barrels and reduced greenhouse emissions by about 6-billion tons over the duration of the agreement. The rules would have required a significant shift by both domestic and foreign manufacturers who sell into the US market toward zero emission cars and away from the SUV, light truck and crossover vehicular format that currently dominates the US auto market today. Under the Trump administration, the policy has shifted away from fuel efficiency and zero emissions toward affordability. The end result for the US market is bigger, less fuel efficient-and a significant increase in CO₂ emissions over the medium term and beyond. Foreign manufacturers supplying the US market will largely follow suit, pushing the recent gains toward greater fuel efficiency and the threshold of achieving zero emissions further into the future in the world's second largest automobile market.

California, which has a special exemption from federal emission requirements under the Clean Air Act (1970), has brought legal action against the Trump administration over the rollback of the 2012 CAFÉ rules. Twelve other states that follow California's lead on the issue have joined the suit. By 2012, Canada and the US were the only G7 countries to mandate emission standards through 2025. The EU has only recently initiated such mandates.

While also a newcomer to crafting forward standards for automobile emissions, the scourge of China's environmental degradation over the past decade in the face of the country's rapid, largely unbridled industrialization wave is infamous in both breadth and scope. The government's push into clean air technologies come as much from environmental necessity as it does from Xi Jinping's economic chivalry. And in stark contradistinction to the US automobile market, foreign suppliers to the Chinese market will continuously feel the strong regulatory push from government regulators to release a progressively growing array of EV offerings to their future sales lineups.

There is little question that SQM will remain an outsized player on the world lithium stage by the sheer heft of its cost-effective Chilean lithium holdings, but even here, the influence of China looms large. With Tianqi's 24% lock on SQM's voting shares and control over three of eight board seats, China's influence over the company's operations will be singular for the foreseeable future. The possibility of Tianqi increasing its hold, even gaining majority hold over SQM operations at some future date, cannot be ruled out. That said, the political pendulum could easily swing in the opposite direction under a government of more protectionist persuasion.

In the meantime, the lithium breakout continues to gain momentum. Sadly, that breakout will not come to fruition in the US, or Europe or any other G-7 country - as China cements its lead in the space.

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

Analyst’s Disclosure: I am/we are long SQM, WMLLF, ALB. 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.