Our Response to Morgan Stanley’s Lithium Research

March 7, 2018

Summary: On February 26th, Morgan Stanley analysts came out with a very bearish report on Lithium entitled “The Long Term Pain of New Supply.”  Their belief is that Lithium prices will fall by 45% by 2021. They downgraded Albemarle (ALB) and Sociedad Quimica y Minera (SQM) as well as really the entire Lithium market.  Here, we present their main arguments and our responses to them. But before we get into it, we want to be clear that we have no issue with Morgan Stanley’s call, and take no offense to their view of the lithium markets.  We strive to maintain a clear head and objectivity in everything we analyze and publish on.  

Morgan Stanley Point: Chile’s market share has rapidly declined over the past few decades, but their new agreement with SQM indicates that they are looking to gain that back.

Our Response: We completely agree- Chile doesn’t want to be left behind, and is probably upset about their market share declining.  However, this argument completely ignores the fact that the market as a whole has grown and is growing exponentially. Furthermore, MS just briefly glosses over the fact that the new royalty rates agreed to by SQM are very prohibitive, and the the contract length to 2030 makes it tough to make long term investments in the country given the need for SQM to start unwinding and restoring the land before returning it to the country at the end of the lease.  So while we do agree that Chile probably would love to be the dominant lithium producing country in the world, we couldn’t disagree more that their actions are supporting those motives.

Morgan Stanley Point: We forecast expansions to add 200ktpa to Chile’s lithium output by 2025….the new production arising from brine resources in Chile and Argentina sits toward the bottom of the global cost curve, with cash costs sub US $5,000/t.  It’s therefore set to flatten the cost curve and drive higher cost-tonnes (notably smaller-scale hardrock producers) out of the market.

Our Response: If you take a look at a lot of the upcoming producers – many are to be below the US $5,000/t mark.  This is nothing new and will not have an effect on pricing until supply increases beyond demand. Pricing is based on supply and demand.  Currently, supply is coming online but demand is still very tight. According to the latest USGS lithium overview, released in January 2018, supply in 2017 came out to 236k tonnes whereas demand was at 228.5k Tonnes.  This, along with recent comments about a balanced market from ALB and SQM, show a very tight market. Moreover, over the longer term horizon to 2025, demand forecasts continue to increase (see recent earnings from ALB, SQM, and FMC) while new companies will have to prove that they can bring supply online quick enough to keep up (more on this below).  So in conclusion, while MS may be right that new supply (whether it’s in Chile or elsewhere) will lower flatten the cost curve, this dynamic will not matter until the market is in a state of oversupply.

Morgan Stanley Point: We now only carry one OW {overweight} rating in the global lithium space, namely, Mineral Resources which bodes well both on fundamental and quantitative metrics.  

Our Response:  The jury is still out on DSO (direct shipping ore) and its merits in the Lithium space.  Mineral Resources is currently mainly a DSO story which makes its really interesting that of all the names out there, Morgan Stanley would choose this one over any others.  Moreover, are they familiar with the DSO story and do they feel it’s profitable moving forward? The feeling on the street is that DSO will go by the wayside if there is in fact an oversupply in the market.  Even without an oversupply, there are challenges with the long term sustainability of this model- higher shipping costs, the added step of concentrating the ore by customers before refining it, and the need to handle much larger amounts of waste/by-products by customers.  Given this fascinating debate, we’re excited to have Chris Ellison, CEO from Mineral Resources to present his take on the story shortly.

Morgan Stanley Point: A bottleneck in conversion capability will keep a lid on realised carbonate production from hardrock mines in the near term – but this is expanding too.  

Our Response: This is why we have said repeatedly to focus on the nearest term producers who will be producing over the next 12-18 months.  

Morgan Stanley Point: Our revised price outlooks includes near term upside price risk as new supply due on stream in 2018-2019 may be delayed, keeping the market closer to balance through 2019.  

Our Response:  While this isn’t something we are rebutting, we do think it needs to be touched upon.  There are two very recent examples to keep in mind regarding this. Lithium Americas, originally scheduled for production in 2019, recently shifted to 2020.  Nemaska, the other producer set for 2019, still hasn’t received financing. This is problematic. Originally, the company said financing would be done by end of Q1 2018 – the company has less than 1 month to stick with its proposed timeline.  Finally, it should be noted that these are just two examples on a long list of delayed projects attempting to enter the market. We discuss it here because while MS seemingly acknowledges this point for the short run, they basically forget about it for the rest of their argument without providing much evidence to why this won’t be the case in the long run.

Morgan Stanley Point: As seen in the past with other commodities (e.g. iodine recently) SQM has kept prices not far from production costs, in order to prevent new entrants from gaining share.  

Our Response:  This point was mentioned several times throughout their analysis.  There’s a few points to consider here as we end off our analysis:

  • New market entrants have already entered the market and gained share.  Neometals/Mineral Resources (~15%), Orocobre (4%), Galaxy Resources (5%) have all gained shared over the last year.  Moreover, Pilbara Minerals, Altura Mining and Tawana Resources will gain share in 2018.
  • One would imagine the iodine market and the Lithium market are day and night between the two.  Using iodine as an example might make sense if the lithium industry were in a more mature phase of the market. Given the long term story only now beginning to play out, game theory like arguments are a bit premature to make. Furthermore, as we have seen, the lithium production game is much more complex that other mining industries, which makes any comparison like this a bit simplistic. To flood the market, SQM can’t just turn on a spigot, they will have to fly under the radar over a multi year period while they ramp up capex and production (disclaimer: we do not claim to be experts at all on the Iodine market).
  • It seems less than likely that SQM would in the near term lower its price to production by a significant margin – this would decrease their cash inflow thereby decreasing value for the company and hurt shareholders in the process.  The more realistic scenario would be increasing supply to remove market entrants over the long term. It is possible that at some point in time in the future SQM decides to flood the market to maintain their market share. However, currently, incumbent producers are barely able to keep up with the growing market.  As such, everyone is currently focusing on growth and capturing the new customers in the expanding pie.
  • On maintaining market share- the big assumption that Morgan Stanley is making here is that SQM decides to dominate the market by increasing Chilean production.  There is absolutely no guarantee that they do this. In fact, they just spent the last week talking about geographic diversity outside of Chile- on SQM’s call, CEO Patricio de Solminihac noted that they have to pay much higher rent.  At PDAC 2018, Irina Axenova, head of IR said “all in, Chile’s not really the cheapest place to produce.” Furthermore, in our discussions with management, they reiterated their ability to maintain market share by investing in greenfield opportunities as well as partnerships with junior miners.  Which brings us to our next point: MS’s assumption that SQM will put the Lithium Americas and Kidman Resources JVs on the backburner and not care about them as much is just misplaced. Both projects have the potential to be long-life, low cost projects in lower rent jurisdictions. As such, even MS would agree that any rational market participant would prefer to maintain market share via those types of investments versus further expansions in the high-rent Chilean operations.

Morgan Stanley Point: Infrastructure investments and subsidies will be needed to increase EV penetration rates by 2025.

Our Response: While it is certainly true that over the long term, EV charging stations will need to develop across the country to make it possible for drivers to take long-distance road trips.  However, a recent Goldman Sachs report pointed out that 75% of driving trips are less than 80 km. Thus, for the vast majority of trips, charging at home overnight would more than suffice. Furthermore the private sector is already getting ahead of the infrastructure issue by beginning to invest in charging networks and new fast-charge technologies.  Even oil and gas companies like Shell see the future and have begun investing in charging stations across Europe.

On the subsidy point, many different products in the tech industry have shown that if they deliver clear value-add in our lives, promote sustainable practices, and are sprinkled with some aesthetic appeal of course (think Apple and Tesla), consumers are willing to pay more to consume those products.  By no means are we saying that subsidies have had a clear and major impact in EV uptake. We are simply stating that consumer behaviors are changing, especially with millennials beginning to dominate the market. So, sticking with the old assumption that price rules all is a one-dimensional argument doesn’t consider all of the facts.

Morgan Stanley Point: Improvements are being made to the extraction process that are likely to enable improved recoveries, faster project ramp-ups and better reliability in future.

Our Response: MS is willing to stake their claim on companies that have given them reassurances that new technology is increasing lithium output at faster rates and lower costs, while mostly ignoring major, incumbent companies that are telling them and the whole world that new supply will take a long time to develop.

Final Points:  

  • In our opinion, we believe that some of what might be at play here is Morgan Stanley was never really that bullish on the lithium sector to begin with, and is using the recent volatility and uncertainty to get ahead of the market with a bold call.  Their price target on ALB was never higher than $100/share, and SQM never higher than $50/share, and even those were lagging the market prices for the most part.
  • They could be right but the main points around pricing seem brought forth notable gaps in their theories
  • While we have no issue with MS’s views of the lithium market, we are a little disappointed by their report. It was filled with bold calls here and there but little supporting evidence to go along with it.  They made claims like “new technology is coming to disrupt the slow mining process” and “Chile will flood the market to maintain market share” without backing it up with tangible evidence of such technology, or reasons why the actions Chile has taken will incentivize producers to maintain production within the country.