Observations On The Graphite Market - Where Do We Go From Here?
"Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning."
- Sir Winston Churchill - November 1942
Having watched the evolution of the graphite market over the past 18 months, it's fair to say that Sir Winston's words are as true today in 2012 as they were in 1942. We have just returned from a literal world tour of speaking engagements in Germany, Canada, and the US. Graphite was the topic du jour. There is a great deal of curiosity about graphite and how to take advantage of the exploding interest in the space across many parts of the world. This unquenchable desire for education has no doubt been responsible for the near-parabolic rise in the share prices of junior mining companies exploring for graphite.
We have constructed a proprietary market capitalization-weighted index of junior mining companies involved in graphite exploration and the chart really speaks for itself:
We are strongly of the opinion that while Discovery Investors can still profit from the interest in graphite, the initial move, or "Phase I", is over and caution and selectivity is now the order of the day. The chart above would seem to confirm our belief having topped out in early April 2012.
By Phase I, we hearken back to the idea of the lifecycle of a junior mining company where the interest in or mystery surrounding a mineral or metal serves to bid up share prices until these mysteries are uncovered. As a project moves from exploration to development-phase, the share price can sometimes "go sideways" as investors take profits and watch as a company evolves towards a production decision.
What Got Us Here?
The lifecycle of a junior mining company exploring for graphite is no different and it has been interesting to watch this area of the market develop. It seems to have developed incredibly quickly relative to some of graphite's cousins like rare earths. We still believe there are profits to be had here as the macro themes which brought graphite to the fore initially are still intact. They are:
1. The Rising Quality of Life in the Emerging World - Any growing society (Middle Class) will demand affordable and reliable electricity as a base for a better existence. Graphite's role in conducting electricity is key here.
2. Resource Nationalism - With a single country (China) controlling upwards of 80% of global graphite production and clear intentions to build her own industrial base and next-generation manufacturing capability, it is safe to assume that graphite exports from the Middle Kingdom will decrease in coming years. This, more than anything, argues strongly for a reliable and steady supply of all types of graphite (flake, amorphous) in various jurisdictions throughout the world.
3. Security of Supply - This factor dovetails nicely with the Resource Nationalism theme and revolves around the idea that end users (Toyota, A123, LG Chem, for example) must maintain a reliable supply of raw materials which measure up to their demanding specifications for purity. Any disruption here can wreak havoc on a company's supply chain and curtail production of finished goods materially affecting profitability.
So as these forces listed above play themselves out over the course of months and years, the increasing interest by junior mining companies in graphite is entirely justified. We are long-term believers in the graphite story, but are somewhat more sanguine in the near term. Here's why:
Some Threats To Junior Graphite Explorers
1. China - China is, of course, the largest producer and consumer, of a long list of minerals and metals and graphite is no exception. Roughly 1.2 million tonnes of natural graphite (ed note: flake production was between 450,000 and 600,000 tonnes) was produced globally last year and we understand - from our sources both inside and outside China - that there is ample excess capacity in the marketplace; perhaps upwards of 200,000 tonnes. Should China feel threatened, investors must be aware that the possibility exists that She could effectively flood the market to snuff out any threats. Admittedly, this is a bit of a stretch as the graphite market in China is sometimes hard to read. However, we have seen China institute mercantilist policies surrounding rare earths, so why would graphite be any different? In many ways, your belief in the future of graphite rests on your evaluation of China and her future economic prospects.
2. Synthetic Graphite - Unbeknownst to many, it is synthetic graphite that is predominantly used in lithium-ion battery technology today. This graphite is manufactured from calcined petroleum coke and can be done so to a high degree of specificity - exactly what end-users of graphite require. The synthetic graphite market is at least as large as the natural graphite market today. The ray of hope here is that synthetic graphite is quite energy-intensive to produce and, as such, is a great deal more expensive than natural flake graphite which must also be used in lithium-ion batteries as well as other applications. It is the higher cost of synthetic graphite (some estimates are $10,000 per tonne versus $3,000 per tonne for large flake natural graphite) that has many junior mining companies focused on the flake markets in their exploration efforts. A higher margin means more cash flow.
3. Pricing - As the graphite market is one where pricing is negotiated between buyers and sellers, the pricing can sometimes fluctuate. In other words, just because you see a quote for a given flake size and carbon content of graphite does not necessarily mean that this is the price that the graphite producer will realize. The graphite world is a highly specialized relationship business where end users cannot afford mistakes in the purity level of graphite they buy from producers (this is not unlike the lithium world). The possibility exists of a lengthy process in involved in a new graphite producer convincing an end user that it can produce graphite to a specific purity level. In mining, as in other businesses, time is money and investors should be looking for graphite exploration and development companies that are actively searching out end users throughout their march towards commercial production.
Graphite Demand Appears Healthy Going Forward
It isn't all bad news for juniors, however. One of the things we have always liked about the graphite world is its myriad avenues of demand including steelmaking, refractories, crucibles, brake linings, lubricants, anodes in lithium-ion batteries, pebble bed nukes, and fuel cells to name but a few. This diversity in demand between "today's uses" and "tomorrow's uses" colors us optimistic that there is a healthy appetite for graphite both today and in the future. If you assume a 5% CAGR (compound annual growth rate) out to 2020 for today's uses and ignore the potential higher growth rates in tomorrow's uses, natural graphite will be a 1.86 million tonne market. Though batteries are a relatively small part of overall graphite demand, this segment is growing the fastest which is why so many are excited.
That said, we invest with a longer-term view and though we believe in an "electrified future" this may not occur as soon as we or graphite junior mining companies may like. Investors should keep this in mind when hearing stories of breakneck compound growth rates in electric vehicles, for instance. We're believers in this future, but it won't be a linear progression.
The Most Important Factor When Evaluating Graphite Junior Exploration Companies
So as the maturation of the graphite sector continues and junior companies of all stripes rush headlong into graphite to capitalize on opportunities, we argue for caution on the part of investors. I have had the pleasure of speaking with many of you in recent weeks throughout the world on how to interpret the graphite space and one thing is for certain - it's more confusing than ever.
That said, as Phase I of the graphite mania is over there exists a methodology, we believe, to evaluate the potential of a graphite junior mining company as interest in graphite continues.
We call this the company's "footprint" or more specifically, "knowing the footprint". It's no secret that all graphite deposits are not created equal and contain various flake sizes and carbon contents throughout. Each of the mesh sizes can command a different price on world markets as well. Mining companies will discuss operating cost on a per tonne basis, so having an idea of what percentage of a deposit is a given mesh size along with the cost to produce a tonne of ore can give you a very rough estimate of potential economics.
An example of a graphite deposit footprint:
25% +48 mesh jumbo flake 97% C $4,500 to $6,000 per tonne
20% +80 mesh large flake 94% C $2,500 to $3,000 per tonne
40% +100 mesh medium flake 95% C
15% +200 mesh small flake 94% C
Amorphous Powder 80 to 85% C $600 to $800 per tonne
Synthetic Graphite 99.95% C $7,000 to $20,000 per tonne
There is danger here in that your costs can change as well as the price you can command for various flake sizes of graphite. It's wonderful if a graphite company is telling you they want to produce large flake graphite to supply it to the lithium-ion battery industry, but what percentage of their deposit is suitable for this industry? If it's only 20% of a deposit for instance, what does the company intend to do with the remaining 80%? To be fair, many junior mining companies do not yet know the answer to the question I pose here. However, we view it as information critical to establishing an economically viable graphite deposit.
As an aside, we are not willing to overlook the importance of Management in any company, graphite or otherwise. A management team with ample graphite experience is obviously a necessity for success. We view this as blindingly obvious, however, and choose to focus on other less obvious ways to gauge a junior mining company's potential for success, hence the "footprint" theory.
On To Phase II of Value Creation in the Graphite Market
In writing this Note, we're trying to inject a sense of balance surrounding the potential looming supply and demand mismatch in graphite. The quote we chose at the start of this Note from Sir Winston Churchill is a perfect encapsulation of where we are in the burgeoning interest in this mineral. Like most of the industrial metals/minerals, graphite is an opaque marketplace which can be hard to navigate under the best of circumstances. Though graphite is a larger market than rare earths, lithium, or vanadium (in terms of tonnes produced), it is quite a fragmented industry with the largest global producer responsible for 90,000 tonnes per year (in a 1.2 million tonne per year market). Despite the risks, we wish to make one thing clear: we are absolute believers in an "electrified future" and the crucial role that graphite will play in making that future a reality. Investing in junior mining shares is an inherently risky proposition, regardless of the asset. We remain convinced that graphite will continue to be a profitable place to invest for savvy and risk-tolerant investors. Educating yourself on the potential for a company's asset is crucial.
The material herein is for informational purposes only and is not intended to and does not constitute the rendering of investment advice or the solicitation of an offer to buy securities. The foregoing discussion contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (The Act). In particular when used in the preceding discussion the words "plan," confident that, believe, scheduled, expect, or intend to, and similar conditional expressions are intended to identify forward-looking statements subject to the safe harbor created by the ACT. Such statements are subject to certain risks and uncertainties and actual results could differ materially from those expressed in any of the forward looking statements. Such risks and uncertainties include, but are not limited to future events and financial performance of the company which are inherently uncertain and actual events and / or results may differ materially. In addition we may review investments that are not registered in the U.S. We cannot attest to nor certify the correctness of any information in this note. Please consult your financial advisor and perform your own due diligence before considering any companies mentioned in this informational bulletin.