Excess Capacity, Commodity Deflation
Wednesday, 4/08/2015 10:00
But energy metals set to keep fueling disruptive technologies...
CHRIS BERRY is a writer, speaker and analyst focused on the dynamism of energy metals – those metals or minerals used in the generation or storage of energy.
A student of the theory of Convergence, and editor of
Discovery Investing, Berry believes it will have profound effects across the globe in the coming years as urbanization, innovation, and technology create multiple opportunities.
Here
The Gold Report's sister title
The Mining Report asks Chris Berry bout these technologies and paradigm shifts, and how investors can participate in the growing electric car and energy storage battery markets...
The Mining Report: You have talked in the past about the epic macroeconomic battle being waged between inflation and deflation. What are the indicators you are watching and where are we headed?
Chris Berry: Right now, the scales still appear to be tipped toward deflation, but that's not uniform across the globe. It still appears that disinflation is the predominant force.
There is evidence of economic growth, but productivity is stagnating and living standards are moderating as we haven't seen the 'escape velocity' growth necessary to start a new economic cycle. The excess supply in many commodities like iron ore is referred to as 'good' deflation. However, savings rates are up and consumer demand is lagging. This is 'bad' deflation. According to economist Gary Shilling, both of these are happening today. It appears that economic lift-off has been postponed. The secular stagnation thesis put forth by Larry Summers looks increasingly valid.
Disinflation is one of the reasons commodities, metals in particular, have been under pressure for the last couple of years. Globally, central banks have embarked on unprecedented measures, including quantitative easing, to kick start their economies. The QE program in the US has ended, but the results are mixed. Unemployment has fallen precipitously, but concerns over wage gains and the 'types' of jobs created linger. The Federal Reserve, in particular chairwoman Janet Yellen, seems intent on a Fed Funds rate increase, but precisely when is a moving target. Given the recent softness in economic data in the US, a rate hike could be pushed to the end of the year as opposed to June, which is when many were thinking it would happen.
The Eurozone has embarked on its own version of QE to the tune of about €60 billion a month, and Japan has been involved in its own QE program of unprecedented size. In short, no intervention of this type has generated the 2% inflation target that central banks are targeting. It appears that they are running out of tools to ignite escape velocity growth. If you think of debt as future consumption denied, then deleveraging obviously still has a long way to go before a new credit cycle can begin.
Around the world, inflation appears dormant for the moment. Rates in many parts of the world are actually negative, specifically in Europe. What this means is that you, as an investor, pay the government to lend it money, a phenomenon known as financial repression. This policy is intended to discourage saving and encourage consumption and spending. When we observe the beginning of the formation of a normal yield curve, we will have the first sign that the commodity cycle is indeed turning. It just doesn't appear to be imminent right now. The problem is secular and not cyclical.
Additionally, US Dollar strength has put a lid on commodity prices. As you can see below, the US Dollar (shown in white) has gone parabolic since last year against other currencies. There really is no need for the Fed to tighten as the stronger Dollar is in itself a tightening measure for the US economy.
The US Dollar has taken a little bit of a breather, and that's why we've seen a floor in some of the commodity prices, in particular gold. Copper seems to have bottomed nicely, which is a positive. But because many commodities are priced in US Dollars, they become more expensive in other currencies as the US Dollar strengthens.
TMR: Will some commodities prices turn faster than others?
Chris Berry: The global economy is dealing with the excess capacity built up during the commodity supercycle in the last decade. This excess capacity will eventually be consumed, but it's going to take time, and it's going to vary from metal to metal.
Some of the energy metals – any metal or mineral used in the generation or storage of electricity – are growing well above global gross domestic product and aren't flooding their respective markets in the way that iron ore is. Examples include lithium, cobalt, vanadium, scandium, rare earth elements, uranium, and copper. I think this value chain is going to be an enormously profitable sector in the coming years. There is overcapacity in some energy metals today, but pricing, while soft, has seemed to stabilize.
In these smaller markets where many prices are negotiated from sale to sale, there is less elasticity than with other more liquid markets. Both lithium and cobalt are well supplied, just as base metals are. But lithium demand is growing at 8% and cobalt is growing at 6–7%. This has been fueled by a number of different catalysts including advances in technology and lifestyle changes that are pushing energy metals to the forefront. That said, it will likely be two or three more years before these markets equilibrate and we see stronger upward pricing pressure in these markets.
For any junior looking to be acquired, its financial metrics MUST match that of a major producer. For example, if a lithium junior is hoping to be taken out, it would need to show economics as strong as or stronger than anyone in the existing oligopoly. So if a lithium major's earnings before interest and tax (EBIT) on its lithium business is a 10% margin, any lithium junior must show a margin of at least 10% to even be considered. With many of the juniors producing preliminary economic studies, it's too early to tell which will be acquired and which will be forced to go it alone, as the economics in these studies can vary widely.
TMR: A lot of the energy metals growth is connected to electric vehicle batteries. You have been skeptical of some of the top manufacturers, but the cars are so sleek and cool looking. What makes you think the demand for electric cars may not be as phenomenal as the headlines make them out to be?
Chris Berry: You're correct when you say that much of the growth in energy metals demand comes from batteries. Outside of batteries, much of the energy metals growth is slower – tracking GDP. It's very encouraging that battery costs are falling by 7% to 8% per year. Should this continue, it's not that hard to see how vehicle electrification will become more ubiquitous in the coming years.
With respect to the big EV companies, I'm really questioning the valuation. What troubles me most is that they appear to be priced for perfection. Dozens of major automakers like Mercedes-Benz, BMW, General Motors and Ford are entering the market with their own electric or hybrid vehicles and prices are bound to fall. That's good for consumers, but a real challenge for automaker margins. Additionally, with mileage standards for internal combustion engine autos also increasing, EVs of all types are really going to have to enhance their overall economics to go mainstream.
Much of the value created so far in the battery supply chain hasn't been in the automotive space. It's been in the actual battery manufacturing niche. We've also seen some interesting deals at a smaller scale with a British vacuum cleaner firm that invested money in a small US-based tech firm pioneering solid state lithium-ion batteries.
That also speaks to something that makes me somewhat nervous with the lithium-ion battery business as it exists today. As technology pushes forward and demand for smaller, more powerful devices increases, today's technology may not be the optimal technology in five year's time. Given this reality, the large battery factories currently under construction will need to be able to shift their production processes should technology shift. Ultimately, the question of raw material access will come front and center, but right now, major corporations haven't publicly considered it to be a significant issue.
The real driver for battery growth won't be vehicles – it will be energy storage. When we look at the rate of growth in solar power adoption, the costs are crashing through the floor – an example of good deflation. Over one third of new electricity capacity in the United States in 2014 came from solar and, since 2010, the average price of a photovoltaic module in the US has dropped by 63%, according to the Solar Energy Industries Association. As costs per watt continue to fall, photovoltaic installations are forecast to double in the US in the next two years, to approximately 40 Gigawatts. The growth in other parts of the world is equally impressive. The natural step to get around the intermittency of renewable power is storage through batteries. I'm excited about the pace of innovation in the battery sector and think that this may ultimately be where Tesla has a substantial impact.
TMR: What are you looking for in the mining companies that could supply the battery manufacturers?
Chris Berry: I pay particular attention to what a company like is saying and doing. Is it working to increase supply and capacity or does it not view cobalt supply as something it needs to worry about? You don't want to take your eye off of the juniors by any stretch of the imagination because in a few years they are going to be the next suppliers.
Another area to consider is recycling. I have long thought that cobalt could emerge as a pinch point for battery supply chains due to availability stemming from geopolitical issues and the fact that cobalt is mainly a byproduct. Should we see sustained higher cobalt prices, recycling could become more prevalent. It's a remote possibility, but one worth considering.
A final note on cobalt: One of the real challenges with the energy metals space is that the pricing is opaque. A lot of it is determined based on handshake agreements and much of the publicly available pricing data is only indicative. Cobalt futures contracts are listed on the London Metals Exchange, so you can monitor what speculators and hedgers are thinking by studying the futures markets 12 to 18 months out. The cobalt futures curve is in backwardation right now, meaning that futures market participants are expecting higher cobalt prices in the future. There are a number of reasons for that, but the battery market growth really underpins it.
TMR: What are the sources outside of China that could supply lithium for battery manufacturing?
Chris Berry: The question is who can supply battery grade lithium – either carbonate or hydroxide – at a price competitive with the oligopoly? The majors and the Chinese are able to supply the market and it appears that there is evidence of excess supply. Should lithium demand continue at its current pace, this excess will get mopped up over the next couple of years and therein is the window for new entrants. Lithium is another one that I think has a positive future. It is oversupplied right now. It's probably going to be a couple more years before that balance tips. The companies that I'm looking at right now are actively employing some sort of technology or strategy to lower costs and become more attractive, either as acquisition candidates or in order to raise financing.
TMR: What are the other energy metal raw materials that we should be watching?
Chris Berry: I'm particularly interested in scandium. While lithium and cobalt are the 800-pound gorillas in the space, scandium is much smaller and is misunderstood, I think. Though estimates vary, scandium is widely believed to be a 10 to 15 tonne per year market – that equates to about $40M. Once the potential for scandium is discovered, things will get very interesting and the market size could be multiples higher.
TMR: Scandium is used in advanced aircraft and metal halide lamps. What is the shape of the resource market and who are the promising players?
Chris Berry: In addition to my previous comments, there is no primary scandium mining anywhere on the globe right now. It's produced as a byproduct in China and sourced from stockpiles in other parts of the world. Much has been written and published around the use of scandium in solid oxide fuel cells and also as an alloy with aluminum. A Google search for "Scandium patents" or something similar will validate this claim. So the issue isn't potential demand; it's security of supply. It's a real chicken-and-egg quandary. Financing scandium projects will remain a challenge until people are convinced of a growing end market, but those end markets can't grow until reliable supplies are on stream.
TMR: The other metal needed for batteries is graphite. What are the prospects for that market?
Chris Berry: I'm following graphite, but I'm not as bullish on it as I am on some of these other resources that we've talked about. My sense is that too many juniors are focused on the EV market and would be better served by attending to some of the "less sexy" uses for graphite. The market is fragmented from a production perspective, which I think is a good thing if you're a junior or an aspiring producer. Graphite isn't all that different from lithium in that I think the lowest-cost producers are best positioned to ride out the current malaise in the markets. In graphite, you need to be able to produce a product to the exact specifications of a given customer and do so profitably. A unique strategy may also be creating a company's own high-tech supply chain, which Focus is aiming to do through a private subsidiary. This way, a company is not just subject to the cyclicality of the mining business and can enter higher margin businesses.
TMR: Rare earth elements (REEs) are used in a lot of new technologies, including batteries. Will non-Chinese REE companies start to come into their own as China begins to focus on its environmental challenges?
Chris Berry: That's the thinking in the investing community. I'm inclined to agree with that with one major caveat. One of the things we've learned in the last five years as REEs have come to the forefront is that all deposits aren't created equally. It seems that every time I turn around, there's a new acronym to describe a deposit and what differentiates it. First, it was light versus heavy REEs, then it was critical REEs. Soon, it will be something else.
We have learned over the last five years that the technology used to extract, separate and purify the oxides is critical. As rare earth prices crashed, this became and remains painfully evident. In the same way that the right lithium production process can lower lithium extraction and production costs, a number of emerging technologies in the REE space can perhaps do the same thing. At the end of the day, we will still need to compete with China on price.
TMR: We have covered a lot in the energy metals space. Some of our investor readers have been very stressed watching some of the prices lately. What words of hope and wisdom do you have for them?
Chris Berry: I have been stressed, too, so know that you are not alone. During the first decade of this century, we all benefitted from the commodity supercycle, the likes of which many of us had never seen before. Now that growth has slowed, it's forcing us all to adapt and re-examine our expectations and approach. But even while some of the macro headwinds I talked about at the beginning of the interview are still visible, there is cause for optimism. The global economy is still growing overall and technology is advancing at an ever faster pace. I don't think investors should throw the baby out with the bath water and disregard commodities out of hand because this cycle will turn eventually. What we're experiencing now calls for a more innovative or creative approach to investing in metals.
It is more important than ever to find the low-cost, sustainable opportunities. Right now, a lot of them are leveraging technology to lower costs and enhance returns. I would temper your expectations for short-term exponential gains. You have to have patience to be in the junior space right now, but ultimately it will be vindicated.
TMR: Thank you for your time, Chris.
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