May 8, 2018
The potential of an impending supply glut has sent shock waves through lithium stocks. Initially, we thought the story would blow over, but with shares not bouncing back from the lows, it’s becoming clear that the sell-side may have really spooked investors into staying on the sidelines. So we wanted to take a second to share a few of our thoughts on the potential of an near term supply glut.
With so many companies now entering the lithium space (over 200 at last count), we can certainly understand why analysts are maintaining higher supply estimates compared to demand. The below graphic from Lithium Americas’ (LAC) presentation shows the more well known projects expected to come online in the next 4-5 years, some of which are already online. If successful and on time, these projects could potentially add 300+kt of LCE capacity to current supply of around 230kt per year.
This potential has caused analysts to expect a supply glut by 2020, leading to a dip in pricing. In two years, BMO Capital Markets is expecting supply of 505kt vs demand of 313kt; Morgan Stanley 437kt vs 309kt; and UBS is expecting total capacity of 597kt vs demand of 317kt. While we believe that the selloff caused by these expectations will ultimately prove to be an overreaction when considering the long term investing picture, investors should always be cautious when dealing with such long and unpredictable resource cycles, especially like in lithium where new capacity needs to be planned over multi year periods. And if realized, these surpluses in supply have many potential ramifications for the industry as a whole.
New supply is tough: Anyone who has been following the lithium story knows that it is very tough to bring new supply online. Just ask Orocobre, the most prominent recent example of a greenfield brine operation- they’re still trying to optimize their operations! The graphic below from their presentation is a dramatic example of how tough it really is to bring new supply online.
Comparing this graphic with the previous one from LAC, it’s tough to imagine that all of the new capacity will come online on time, particularly the projects at the feasibility stage or earlier. Furthermore, even if all of these projects do come online on time, that would only mark the beginning of the growing pains for many of the companies. In our opinion, it takes 7-10 years for a brine operation to go from scratch to operational efficiency, or a couple of years less for hard rock production. And even that is assuming adequate access to funding for all of the projects.
At the same time, we get it- readers may be looking at this saying we’re just being cheerleaders for our cause. So here we consider the reality of a supply glut at the turn of the decade, and what that would mean for investors.
Can a Glut Be Positive? While oversupply would lead to a drop in prices, one thing we believe is not being considered out there is that it could actually be a net positive for the industry. Automakers and governments have embarked on a push for an electrified future. Volvo plans to have 50% of sales coming from electric cars and trucks by 2025; Porsche is targeting to be 50% EV by 2023; Ford just announced $11B in investments and 40 electrified vehicles by 2022; and finally, countries like China and India where large populations are just beginning to afford cars on a larger scale are being introduced to EVs without having gotten used to traditional internal combustion engine (ICE) vehicles.
These are just a few examples, but they demonstrate the concerted effort to phase out ICE for electric vehicles. Some may say that the countries are forcing autos to make this transition. But in our opinion, such a broad trend is reflective of a larger movement led by changing consumer preferences.
With that backdrop in mind, if consumer preferences are truly leaning toward EVs, one of the limiting factors for mass adoption will be battery production and the availability of raw materials. There’s already an incredible amount of investments taking place into conversion capacity and battery production, which will continue over the coming years. So if we do get an oversupply a couple of years before these autos expect to be transitioning heavily into EVs, we believe demand could likely pick up in response to lower (but not crashing) lithium prices. Stated another way- we acknowledge that pricing would be impacted in an oversupply environment, but not to the point where everything falls apart, as battery producers would absorb the higher quantities of lithium available to ramp up production and increase inventories in preparation for the expected EV demand in subsequent years.
Analysts can’t have it both ways: If analysts are correct, and an oversupply causes pricing to come down meaningfully, we believe it is tough to simultaneously forecast new project development to continue at a rapid pace, leading to a continued oversupply environment. 2018 has already showed us that investors are on the fence with the lithium story. If their worries materialize in the next few years, how can we really expect them to continue providing capital to even more lithium projects? Hence, an oversupply in what would still be the early stages of the lithium cycle, would be unlikely to continue for an extended period unless demand fails to materialize as quickly as expected. It is more likely that investment in new projects would slow temporarily pending a demand side push, at which point it would pick back up again.
Offtakes provide cushions: Even with an oversupply in the market, companies will be shielded from it initially. Offtake agreements in place for most of the junior miners are often for at least 5 years of production. Additionally, ALB locks in their customers through multi year agreements as well. These agreements tend to have price floors and ceilings in place, so while the companies can’t participate in the maximum upside of market prices, they are protected during short term dips in pricing like the one expected to come in 2020/2021.
Top tier assets, strong balance sheets: In our opinion a short term oversupply will benefit those companies with top tier assets, low cost operations, and strong balance sheets. While their stock prices will inevitably come down along with the rest of the sector in such a scenario, they’ll be in the best position to snatch up, take stakes in, or partner with earlier stage projects that will lose some access to funding. In addition to the traditional larger players like Albemarle, SQM, Tianqi, and Ganfeng, Pilbara will potentially be in full swing, Lithium Americas will be entering the fray, and Mineral Resources, and Galaxy Resources will still be there as well. This isn’t an exhaustive list, but our point is that these types of companies will have an easier time defending or gaining market share by putting their cash and expertise to work.
The real concern: Finally, the bottom line we’re trying to get at is what investors should really focus on- their longer term view of the lithium story. If you expect that by the mid-to-late 2020s EV demand will accelerate and reach higher penetration levels, like the 12% number expected by ALB in their most recent earnings call, then an oversupply prior to then shouldn’t be as big of a concern because demand will catch up. In that case, investments in new projects should be viewed as building the groundwork to meet demand that will start to ramp up faster but with a shorter term lag to supply. But if you’re not as optimistic on that timeline, and think EV adoption will be much slower, or other applications like energy storage won’t be as big of a driver, then you should be concerned about a near term oversupply, and take a more cautious approach to lithium stocks.