April 25, 2018
We had a recent conversation with a sell side analyst at a major bank about what makes a good business or industry, covering examples from tech to oil. When talking about commodities, we agreed that it’s a tough business to be in, because in the long run, the only competitive advantage available to companies is being the lowest cost producer. This leads to firms competing to spend large amounts of cash acquiring and developing new projects or innovating to maintain their cost advantage. Bringing the attention to lithium, the analyst felt that it was just another commodity. Maybe there was potential for higher margins given the specialty aspect of products, but eventually it will probably get commoditized like other resources/metals. We thought this was a thought pattern that was likely reflected by many investors, hence explaining the 2018 dip in lithium stocks. So we decided to explore if lithium really just another commodity, and whether investors should be worried about that?
Features of a Commodity Industry
There are a few characteristics of a commodity industry. Commodities are basically indistinguishable when comparing the product of one company to another. This leads to a lack of pricing power on the part of suppliers. Consequently, the only thing that producers can compete on is costs, leading to the lowest cost producer winning in the long run. Due to this feature of commodity industries, firms are forced to spend large amounts trying to develop scale, and chase rock bottom production costs. This coupled with cyclicality often seen in these industries leads to massive amounts of value destruction over the long run masked by short periods of value creation during commodity upswings.
How Does Lithium Fit in?
The biggest misconception investors have when taking a topical look at the lithium industry is that it is not a typical mining industry. You can’t just dig a hole and start chipping out lithium. For starters, whether you’re working with brine or hard rock, you have to run a few processes just to extract the lithium into a form you can work with. From there, you have to formulate products meeting specific requirements of end users, be it battery grade hydroxide, carbonate, formulations for technical markets, etc. Given this specification required by customers, the lithium production game could arguably be classified in the specialty chemicals industry as opposed to mining.
Combining this with the fact that it takes 4-7 years for hard rock producers to start from scratch, and even longer for the brine producers, we see that lithium producers, at least currently, enjoy some barriers to entry and competitive advantages. New entrants attempting to come in and compete have to possess extensive knowledge of developing a lithium project, and be well funded for a long period of time.
However, while Lithium production does require a degree of specification, there’s no denying there are features of a commoditized business in there. First, the name of the game is becoming the lowest cost producer. Second, while it is a more chemical intensive process to extract the lithium, and companies use different process and ore body types to get there, for the most part, a wide range of companies can get to the end products desired by customers. Finally, once projects get up and going, especially the hard rock operations, planning supply in conjunction with expected demand will not be as big of a problem as it is today.
The Bottom Line
At the risk of providing a cop-out argument, in the end we believe that investors shouldn’t necessarily care about this issue just yet. In the long run, it’s almost inevitable that lithium becomes a commoditized business. Unless battery chemistries or other customer needs keep evolving, allowing producers to maintain competitive advantages, knowledge will spread and the products will become commoditized. But when will we get there is the key question? We already know the lithium supply demand picture has been tight for a few years. Major producers, analysts, and experts all believe this phenomenon is likely to continue for another couple of years at least. If electric vehicle demand hits an inflection point by then, and energy storage continues to take off, you can extend that timeline into the mid 2020s.
This ensures two things- elevated pricing and margins for producers; and producers are focusing all of their energy and efforts on just bringing projects online let alone being the lowest cost producers. Combine that with the fact that lithium stocks are sitting at bargain levels (like Pilbara at a single digit forward EBITDA multiple, or majors like ALB and SQM at low double-digit EBITDA multiples), and you will see that there is a lot of upside to be had by lithium investors. We can hear long-term oriented investors crying foul here, but it’s not like we’re talking about day trading these companies. We’re simply arguing that the early stages of a major secular trend in natural resources can be very lucrative for investors over a multi-year period. And discussions like marginal cost of production, commoditization, and long run pricing are still too early to be had.