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Morning Notes May 8, 2012
Observations On The Graphite Market - Where to From Here?

Chris Berry
Posted May 9, 2012

Today’s Note:

“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”- Sir Winston Churchill - November 1942

I have studied the evolution of the graphite market for the past 15 months. It is fair to say that Sir Winston Churchill’s words are as true in 2012 as they were 70 years ago. We have just returned from a world tour of speaking engagements in Germany, Canada, and the US. Graphite was the topic du jour. There is a great deal of “graphite curiosity” around the world, about how to take advantage of its exploding interest. This desire for education has been responsible for the near-parabolic rise in the share prices of junior mining companies now exploring for graphite.

We have constructed a proprietary market capitalization-weighted index of junior mining companies involved in graphite exploration. The chart speaks for itself:

(Click on image to enlarge)

Source: Bloomberg

We are strongly of the opinion that while Discovery Investors can still profit from the interest in graphite, the initial move, “Phase I,” is over. We caution selectivity as the order of the day in the graphite space. The chart above seems to confirm our belief. Graphite topped out in early April 2012.

By Phase I, we refer to the initial phase of the lifecycle of most junior mining companies where the interest, a function of the “mystery” surrounding a new mineral or metal, serves as a powerful force to bid share prices higher. This occurs till these “mysteries” are understood. As a project moves from the exploration to the development phase, the share price often “goes sideways” as early investors take profits and sit on the sideline as a company evolves towards a production decision.

What Got Us Here?

The lifecycle of a junior miner exploring for graphite is no different. It has been interesting to watch this market develop. It seems to have developed incredibly quickly relative to some of graphite’s young cousins like rare earth elements. We believe there are still profits to be had here as the macro themes which brought graphite to the fore initially are very much intact.

They are:

The Rising Quality of Life in the Emerging World – For example, any society growing its Middle Class will demand affordable and reliable electricity as a base for a better lifestyle. Graphite’s role in conducting electricity will be key here.

Resource Nationalism – With a single country such as China controls approximately 80% of global graphite production and fosters clear intentions to build her industrial base and next-generation manufacturing capability, it is safe to assume that graphite exports from the Middle Kingdom will decrease in coming years. This fact, more than most, argues strongly for a reliable and steady supply of all types of graphite in various jurisdictions throughout the world.

Security of Supply – This factor dovetails with the Resource Nationalism factor and revolves around the idea that end users (Toyota, A123, LG Chem, for example) must maintain a reliable supply of raw materials which measure up to their demanding specifications for purity. Any disruption of supply can wreak havoc on a company’s supply chain and curtail production of finished goods, materially affecting profitability.

Innovation Of New End Uses – Much has been made of graphene, the one atom thick wonder material derived from flake graphite. Development here will impact the importance of graphite mining and the supply chains that will be developed over the next few decades.

So as these forces play themselves out over the course of the next months and years, the increasing interest by junior mining companies in graphite is entirely justified. We are long- term believers in the graphite story, but are somewhat more sanguine in the near term.

Here are some threats to junior graphite explorers.

  1. China – China is, of course, the largest producer and consumer, of a long list of minerals and metals. Graphite is no exception. Roughly 1.2 million tonnes of natural graphite (ed note: flake production was between 450,000 and 600,000 tonnes) was produced globally last year and we understand – from our sources both inside and outside China - that there is excess capacity in the marketplace; perhaps upwards of 200,000 tonnes. Should China feel threatened, investors must be aware that the possibility exists that she could flood the market to reduce threats to her dominance in the space.

    Admittedly, this is a bit of a stretch as the graphite market in China is hard to read. However, the world is well aware of China’s mercantilist policies in rare earths, so why would her policy in the graphite market be any different? In many ways, your belief in the future of graphite rests on your evaluation of China and her future economic prospects.

  2. Synthetic Graphite – Unbeknownst to many, it is synthetic graphite that is predominantly used in lithium-ion battery technology today. This graphite is manufactured from calcined petroleum coke to a high degree of specificity – exactly what end-users of graphite require.

    The synthetic graphite market is at least as large as the natural graphite market today. The advantage of natural graphite here is that synthetic graphite is very energy-intensive to produce and, as such, is a great deal more expensive than natural flake graphite which may also be used in lithium-ion batteries as well as other applications. It is the higher cost of synthetic graphite (some estimates are $10,000 per tonne versus $3,000 per tonne for large flake natural graphite) that has many junior mining companies focused on the flake markets in their exploration efforts. A higher margin means more cash flow.

  3. Pricing – The graphite market is one where pricing is negotiated between buyers and sellers. Therefore pricing can sometimes fluctuate. In other words, just because you see a quote for a given flake size and carbon content of graphite does not necessarily mean that this is the price that the graphite producer will realize. The graphite world is a highly specialized relationship business where end users cannot afford mistakes in the purity level of graphite they buy from producers, not unlike the lithium world. It is possible that a lengthy process is involved in a new graphite producer convincing an end-user that it can produce graphite to a specific purity level. In mining, as in other businesses, time is money and investors should be looking for graphite exploration and development companies that are actively searching out end-users throughout their development progress towards commercial production.

Graphite Demand Appears Healthy Going Forward

It isn’t all bad news for juniors, however. One of the things we have always liked about the graphite world is its myriad avenues of demand including steelmaking, refractories, crucibles, brake linings, lubricants, anodes in lithium-ion batteries, pebble bed nukes, and fuel cells to name but a few. This diversity in demand between “today’s uses” and “tomorrow’s uses” makes us optimistic that there is a healthy appetite for graphite today and in the future.

If you assume a 5% compound annual growth rate (CAGR) to 2020 for today’s uses and ignore the potentially higher growth rates in future applications, natural graphite will be a 1.86 million tonne market. Though batteries are a relatively small part of overall graphite demand, this is the fastest growing segment which is why so many investors and junior mining companies are excited.

That said, we invest with a longer-term view and though we believe in an “electrified future” this may not occur as soon as we or graphite junior mining companies may like. Investors should keep this in mind when hearing stories of breakneck compound growth rates in electric vehicles, for instance. We’re believers in this future, but it won’t be a linear progression nor will it occur in the near future.

The Most Important Factor When Evaluating Graphite Junior Exploration Companies

So as the maturation of the graphite sector continues and junior companies of all stripes rush headlong into graphite to capitalize on opportunities, we argue for caution on the part of investors. I have had the pleasure of speaking with many of you in recent weeks throughout the world on how to interpret the graphite space and one thing is for certain – it’s more confusing than ever.

That said, as Phase I of the graphite mania is over there exists a methodology, we believe, to evaluate the potential of a graphite junior mining company as interest in graphite continues.

We call this the company’s “the footprint” or more specifically, “knowing the footprint”. It’s no secret that all graphite deposits are not created equal and contain various flake sizes and carbon contents. Each of the mesh sizes commands a different price on world markets. Mining companies will discuss operating cost on a per tonne basis, so having an idea of what percentage of a deposit is a given mesh size along with the cost to produce a tonne of ore can give you an estimate of potential economics.

Here are a few examples of graphite footprints. The initial percentage represents what might be sold at the indicated price range.

25% +48 mesh jumbo flake 97% C $4500 to $6000 per tonne
20% +80 mesh large flake 94% C $2500 to 3000 per tonne
40% +100 mesh medium flake 90% C  
15% +200 mesh small flake 94% C  
Amorphous Powder 80% / 85% C $600 to $800 per tonne
Synthetic Graphite 99.95% C $7000 to $20000 per tonne

There is danger here in that costs can change as well as the price for various flake sizes and allocations of graphite. It’s wonderful if a graphite company is telling you they want to produce large flake graphite to supply it to the lithium-ion battery industry, but what percentage of their deposit is suitable for this industry? If it’s only 20% of a deposit for instance, what does the company intend to do with the remaining 80%? To be fair, many junior mining companies do not yet know the answer to the question. However, we view it as information critical to establishing an economically viable graphite deposit.

As an aside, we are not willing to overlook the importance of Management in any company, graphite or otherwise. A management team with ample graphite experience and a track record of successful mining development is obviously a necessity for success. We view this discovery investing factor as central, however, and focus on other less obvious graphite specific issues to gauge a junior mining company’s potential for success, hence the “footprint” theory.

On To Phase II of the Value Creation in the Graphite Market

In writing this Note, we’re trying to inject a sense of balance surrounding the potential looming supply and demand mismatch in graphite. The quote we chose from Sir Winston Churchill is a perfect encapsulation of where we are in the burgeoning interest in this mineral.

Like most of the industrial metals/minerals, graphite is an opaque marketplace which is difficult to navigate under the best of circumstances. Though graphite is a larger market than rare earths, lithium, or vanadium (in terms of tonnes produced), it is quite a fragmented industry with the largest global producer responsible for 90,000 tonnes per year (in a 1.2 million tonne per year market). Despite the risks, we wish to make one thing clear: we are absolute believers in an “electrified future” and the crucial role that graphite will play in making that future a reality. Investing in junior mining shares is an inherently risky proposition, regardless of the asset.

We remain convinced that graphite will continue to be a profitable place to invest for savvy and risk-tolerant investors. Educating yourself on the potential for a company’s asset is crucial.

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May 8, 2012
Chris Berry
email: info@discoveryinvesting.com

The material herein is for informational purposes only and is not intended to and does not constitute the rendering of investment advice or the solicitation of an offer to buy securities. The foregoing discussion contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (The Act). In particular when used in the preceding discussion the words “plan,” confident that, believe, scheduled, expect, or intend to, and similar conditional expressions are intended to identify forward-looking statements subject to the safe harbor created by the ACT. Such statements are subject to certain risks and uncertainties and actual results could differ materially from those expressed in any of the forward looking statements. Such risks and uncertainties include, but are not limited to future events and financial performance of the company which are inherently uncertain and actual events and / or results may differ materially. In addition we may review investments that are not registered in the U.S. We cannot attest to nor certify the correctness of any information in this note. Please consult your financial advisor and perform your own due diligence before considering any companies mentioned in this informational bulletin.

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