Description

At the start of 2015 SQM, the world’s largest producer of lithium, traded at a commodity chemical multiple of 8x.  Then the market for lithium went into a deficit, lithium prices went from ~$5,000/t to mid teens, and SQM’s EBITDA revisions started climbing.  Today lithium bulls talk at length about the secular drivers of demand, and SQM trades at ~15x EBITDA.  I think that within the next few years we could see SQM re-rate back to a commodity chemical multiple on EBITDA numbers that reflect a significantly lower lithium price than today.  Sell SQM with the potential for ~50% downside.

As an aside, I also think that ALB and FMC are vulnerable; ALB derives a significant portion of its EBITDA from lithium, and while FMC’s lithium contribution is lower, it is in the process of spinning off the lithium operations into a separate business.  Both companies have seen their multiples re-rate alongside SQM, and I think the current lithium dynamic could negatively impact the SoTP + catalyst framework being applied to FMC.  As a further aside, I think it’s an interesting signal that FMC is looking to monetize / rid themselves of the lithium business at this point in the cycle.

Lithium bulls focus first and foremost on demand, and I believe that commodity cycles are about supply; I believe we’ve seen this time and again with rare earths, iron ore, oil, etc.  I’m actually quite bullish lithium demand because of the exciting prospects for EVs.  I think that Bernstein has done some of the best research on the EV space / opportunity, and EV demand in my lithium S/D model is driven by their bull case EV adoption scenario, which is quite an aggressive S-curve.  Those same lithium bulls downplay supply fears usually by claiming that a lot of future supply is Chinese that will not materialize (Chinese projects represent <10% of incremental supply in my lithium S/D model), and that legitimate supply will take longer and cost more to bring on than people think.  I think these notions are misguided and show a basic misunderstanding of lithium as a commodity.

Lithium is, in fact, one of the most abundant commodities, with over 400 years of reserves life, vs 15-50 for other commodities like zinc, gold, nickel, copper and iron ore.  To get a feel for this dynamic, just look at SQM’s current production vs the massive quota increase they just received from the Chilean resources regulator CORFO.  Additionally, the capital intensity of lithium projects relative to the market price of the commodity is low and extremely favorable.  For frame of reference, expansions in ALB and SQM’s Salar de Atacama brine operations are ~$3,000/t, and greenfield spodumene projects like that of Pilabra Minerals are ~$4,000/t.  Those capital costs per ton are relative to a current market price of ~$16,000/ton, and for another frame of reference, that compares to copper brownfield / greenfield costs of ~$15,000/t / ~$20,000/t vs a copper price of ~$7,000/t.  What this shows is that IRRs for lithium projects are currently off the charts, and that dynamic is why I believe commodity cycles are about supply.  If you look at the last ~30 yrs for nickel, copper, zinc, aluminum, iron ore, met coal, thermal coal, etc. you will see that when project IRRs get above +1StDev from historical averages, the commodity price falls significantly in the following years.  Nickel, for example, had a spike like this in the late 80s, and another in the mid 00s, and both times the price was >40% lower three years later.  If lithium prices fell ~50% to ~$8,000/t, the average project would still have a ~30% IRR.

Recent signposts indicating the cycle is over:

·         FMC deciding to monetize / separate their lithium business

·         Significant news flow re: customer interest in long-term supply deals

·         SQM / CORFO deal to materially increase production quota

·         ALB announcing accelerated investment / production on Q4 call

·         SQM announcing accelerated investment / production on Q4 call

My lithium S/D model shows that while the market went into deficit in 2014 and that deficit accelerated 2015-2017, the market should now go into surplus this year and that surplus should accelerate into 2021, and that is despite what I believe is a bullish demand outlook and only modest (<10% of incremental supply) contribution from Chinese suppliers.

With the stocks ~25% off of their highs, a legitimate question is “how much downside is left”.  Quite a bit, I think.  The price of the commodity has not even fallen yet, and these stocks still trade at specialty chemical multiples of double-digit times EBITDA.  I believe the cycle is over, this is a basic commodity poised for a price fall, and the producer multiples will re-rate back to 2015 levels.

Catalyst

Falling lithium prices

Incremental supply announcements