Under the Radar: Grey gold

PORTFOLIO POINT: Lithium miners will be relatively immune if a collapse in Chinese fixed-capital investment hits the resources sector. In light of this, Australia's only major pure-play lithium stock is very interesting.

As each week passes, the signs of a looming crisis in China look more troubling. While until recently those bearish on Australia’s major trading partner were in the distinct minority, misgivings around the sustainability of China’s economic growth trajectory have not proved entirely wrong (see Looking beyond China).

As the Communist Party edges towards its change in leadership, and as GDP growth targets are revised down to 7.5% – issues I’ll discuss in greater detail on Monday – many investors are now exiting mining stocks on the anticipation of a great rebalancing. Still, it would have been much better to exit mining stocks a year ago, based on their relative underperformance of the benchmark ASX200 index.

So much for the mining boom'¦
Source: Stock Doctor

It’s not all bad news, however. The outlook for other commodities, notably in energy and agriculture, has entirely different drivers and as both Tom Elliott and Tim Treadgold wrote on Monday, companies like Graincorp, UCL Resources and Minemakers are once again attracting interest (for my thoughts on each of these stocks this time last year, see Food for thought and Phosphate's promise).

Yet food and fuel are not the only commodity themes that have little to do with China’s twin housing and infrastructure bubbles – bubbles that, unfortunately for Australia and many of its largest companies, I believe are in danger of popping in the short to medium term. Precious metals, despite their own price inefficiencies, may be attractive to some investors, as may the inputs for energy alternatives such as uranium, molybdenum, graphite and rare earth metals, though these of course also have their own risks and caution is urged.

My preferred exposure is in something that was seen as quite exciting about a year ago, but has since fallen off many investors’ watch lists due to a price slump: lithium, the silver-white substance often obtained from brines and clays that many in the industry refer to as "grey gold".

Traditionally used in ceramics, glazing and lubrication, lithium is now increasingly important in both disposable lithium batteries (the type in your watch or remote control) and rechargeable lithium-ion (Li-ion) batteries (now the most common type in your laptop or iPhone).

Lithium estimated global end-use markets
Source: US Geological Survey

The attraction of lithium to me, however, is not so much in existing consumer electronics demand – which I believe will continue to rise globally in spite of economic deleveraging in the rich world or the risk of economic deceleration in the developing world – but in future electric vehicle demand.

Already, Toyota's Prius and other hybrid and electric vehicles use a range of lithium-ion batteries, and while their environmental credentials are still debatable, revenues for the transport segment of the Li-ion market are expected to grow 700% to 2017, according to a new report from Pike Research. According to the same report, installed costs for Li-ion are expected to drop 33% over the same period.

Even the Formula 1 is getting into the action, with next year's Grand Prix in Melbourne expected to host a demonstration "Formula E" race, with petrol engines replaced by electric drivetrains.

Part of the reason why analysts are predicting a surge in lithium-ion battery revenues is that prices for lithium itself are expected to remain suppressed, as a number of low-cost projects in South America, using cheaper brine-based extraction methods, come online. Yet although this poses bad news for higher-cost hard rock miners – especially in China, another major source of supply – in the long-term I believe this will form a virtuous cycle for those who already enjoy a competitive place along the cost curve, especially as cheaper Li-ion batteries attract more consumers to the brave new technologies of electric and hybrid vehicles, and demand for that emerging transport segment increases.

At the heart of this dynamic, as I see it, is Australia’s only major pure-play lithium stock, Orocobre Limited (ASX:ORE), with a market cap of $181 million. The company’s four main projects – Salar de Olaroz, Cauchari, Salinas Grandes and Guayatoyoc – are all located in the Argentine corner of South America's "Lithium Triangle", which also reaches into northern Chile and southern Bolivia and the company's flagship, Olaroz, which Toyota is providing commercialisation funding for, also hosts an estimated 19.3 million tonne potash resource, in addition to 6.4 million tonnes of Lithium Carbonate Equivalent, with first commercial production targeted for mid-2013. Total operating costs at Olaroz – with or without the potash included – are estimated to be materially lower than hard rock projects and competitive with the existing brine producers that have led to a slump in the lithium price.

South America's 'Lithium Triangle'
Source: Company presentation

With zero debt, a cash balance of $27.7 million as of December 31 and a consensus broker price target of $3.02, versus Thursday's close at $1.75, the company also looks fairly cheap, despite having no current earnings. And compared to its trading price in January last year, when it touched $4 per share, entry at current levels is somewhat de-risked.

Orocobre: share price since listing
Source: Stock Doctor

Nonetheless, Orocobre is most certainly a speculative-grade stock. Yet while lithium prices are expected to remain suppressed for the next few years, according to Canadian research group TRU, beyond that the company may prove to be a substantial and economic supplier in an increasingly important commodity.

As with all mining companies operating offshore, investors should be cognisant of sovereign risk and Argentina’s government has been exhibiting signs of resource nationalism recently. Still, with other brine-based lithium deposits opening up in Chile, the country’s traditional regional rival, it is hoped that the positive investment environment for Orocobre so far will remain.

Electric vehicles won’t replace petrol-powered cars anytime soon, and I remain bullish on oil at the same time (see Fuel for thought), but as an emerging theme and a commodity type that is relatively immune from a reorientation in China’s growth model (indeed, increased consumption as a share of Chinese GDP should only support electric vehicle spending there), lithium holds interest. Considering its suite of low-cost projects in development, Orocobre seems a relatively attractive way to play this thematic, albeit with the usual risks that go along with any pre-production mining stock, especially one that operates offshore.

I’m unwilling to place a valuation on the company, considering that cash flow projections are still fuzzy at this stage, but I believe that accumulating the stock under $2 per share will provide positive returns in the long term.