Hydrocarbon energy sources, even though they’ve been sidelined by investors during the ESG craze, still power the world, and are still essential for industry’s functioning and consumers’ wellbeing. Overhasty calls for a total decarbonization are coming up against the hard limits of reality, as ideology usually does. Besides the potential fallout from war between Russia and Ukraine, which is putting Europe’s dependence on Russian energy in stark outline, investment in U.S. hydrocarbon production capacity has been falling off a cliff for almost a decade.
Source: Bloomberg, LLP and Crescat Capital, LLC
Hydrocarbons and fossil fuel energy should not be considered down for the count.In spite of lower levels of investment in growing production, legacy energy producers can continue to generate ample cash flow, even if their valuations remain challenged. We’ll write about this topic in future letters.
Decarbonization and Lithium
But still, it is apparent that decarbonization is going to proceed inexorably, even if not at the pace desired and anticipated by its more extreme advocates. This transformation will involve several new forms of industrial “life blood,” of which perhaps the foremost is lithium — the most critical ingredient in the currently dominant lithium-ion battery technology. (The Department of Defense agrees that these minerals are critical — so it is boosting its strategic stockpile of lithium, cobalt, and rare earths.)
Other battery technologies are in development, and we follow them; but so far, there is nothing apparent in the near- or mid-term that will displace the lithium-ion batteries being churned out (mostly by Chinese factories).
Lithium is abundant in the United States, although the world’s largest reserves are in Australia, Chile, and China. (The situation is thus not dissimilar from that of the “rare earths,” critical technological materials which are not really rare, but whose production is centered in China and Africa.) It’s abundant, but production in the U.S. is undeveloped. Globally, it is still a young supply chain, and the chemistry underlying different kinds of battery production (for example, lithium iron phosphate versus nickel cobalt manganese) is in flux and can cause short term disruption in the market for different processed forms of lithium.
The big picture is simply exponentially ramping demand for batteries to power everything from homes to cars to smart devices. That demand curve is headed “up and to the right,” and battery manufacturers are making use of whatever form of lithium they can secure. Even though lithium itself may be plentiful, producing battery-grade lithium at the quality levels required for large-scale battery production is proving not to be trivial.
Companies capable of doing so, such as Albemarle [ALB] have in recent years commanded a valuation premium to other more prosaic commodity producers both for this reason (the technical demands of processing) and because of the significance of the global move towards decarbonization.
Still, ALB disappointed some traders and investors at its recent earnings conference call. Some people were hoping ALB was raking in the dough based on spiking spot lithium prices.
Battery grade lithium carbonate price in China
Source: Bloomberg, LLP
Some traders might take the stocks of lithium producers as proxies for the mineral itself, and expects them to trade in line with these recently spiking spot lithium prices, but this is a long term trend that will require and understanding of the nuance and complexity.
Only 10% of ALB’s production is sold at spot, the rest being tied to various longer-term contracts. (Also, high spot prices mostly reflect the mainland Chinese market.) That caveat applies to lithium producers as a whole: they should be bought out of conviction for their valuation in the context of the long-term process of decarbonization and projections for multi-year growth in battery demand — as well as their runway for capacity expansion, which will allow them to gradually realize rising spot prices in their future contracts.
Discussing pricing of battery-grade lithium during the call, the management of ALB said that China “is the lead, sort of the tip of the spear; where that goes, the indices follow globally. Those global indices are about half in some cases of current China prices. So there’s probably room to go in those indices, but… with prices where they are in China, one could only speculate where they would go and could they go down, we don’t know.”
The company’s full-year guidance was for 20–30% growth in lithium volumes — and a 65–85% growth in lithium EBITDA. And we’re still early in the lithium demand cycle.
Investment implications: Like rare earths, lithium is a long-term theme. As usual, we would prefer to enter a position in this theme after a correction and not at the peak of speculative fervor, and some lithium producers have already obliged with a significant correction from the pandemic liquidity highs of 2021. One available catch-all is the Global X Lithium & Battery Tech ETF [LIT]. Investors with access to Canadian securities could look at the Horizons Global Lithium Producers ETF [Canada: HLIT]. However, investors should note that there is likely to be a wide dispersion in the performance of the securities underlying these ETFs — and that like cybersecurity ETFs, this may be an area where due diligence on individual companies can produce superior results.
