Under the Radar: Pencil this in

It’s difficult to find a graphite stock on the ASX, but a few have drawn our attention for the right reasons.

PORTFOLIO POINT: It takes a sharp eye to find a graphite stock on the ASX, but while you may have missed the boat on Syrah Resources, there’s a few others worth a look.

Of all the carbon-based minerals we invest in – petroleum, coal, diamonds – graphite is definitely the most obscure.

Known to the majority of people as the main ingredient in 'lead’ pencils (or perhaps as the key element in those golf clubs you paid an extra $500 for and still can’t swing properly), graphite has played a far more important role in the modern era than is typically realised.

Indeed, it’s possibly the major reason you’re reading this article in English, not en español. It was the graphite discovered in 1555, in Northern England’s Lake District, which was later used in refractories to build rounder and smoother cannons to successfully repel the Spanish Armada. The region’s famous pencil industry, led by Cumbria-based Derwent Cumberland, also grew out of the same discovery.

And the unique properties of graphite – a substance that is not only highly heat resistant, but is exceptionally conductive, self-lubricating and very, very strong – are making its use important in another technological revolution: the global transfer to cleaner sources of energy.

Beyond the irony of a carbon-based mineral being used to make other carbon-based minerals redundant, the overwhelming use for graphite remains in steel production. The United States Geological Survey (USGS) estimates that refractoring and crucibles comprised 33% of demand in 2011, while steelmaking and founding comprised another 26%. Of the rest, 7% of graphite went into brake linings and batteries, with lubrication accounting for a further 5% of demand. In China, meanwhile, where the vast majority of graphite’s production and demand is currently located, we can safely assume that steelmaking comprises the majority of end-use as well, despite the dearth of reliable statistics.

It is for this reason that, despite the interest of many people I know, I haven’t been bullish on graphite to date. Several months ago, I was told about a small company called Syrah Resources Limited (SYR), then a 17-cent graphite stock that had recently acquired a graphite/vanadium project in Mozambique.

“Yeah right,” I privately thought when two friends told me about it over lunch. It’s all well and good to have a lot of graphite, but what happens when those Chinese blast furnaces stop building the steel columns that go into empty apartment buildings? Last night, Syrah closed at 67.5 cents, having hit as high as 85 cents in late February on announcement of several other acquisitions in eastern Africa.

This is what regret looks like'¦
Source: Stock Doctor

I caught up with these – now much wealthier – friends recently and this time vowed to myself that I’d no longer ignore the graphite story. A word of caution, however: past performance does not guarantee future results.

It is true that most graphite is ultimately used in making steel and that most of this steel is made in China, but it is the future use of graphite, particularly flake graphite, which is exciting.

There are, broadly speaking, three types of graphite found: amorphous deposits (i.e. associated with coal); lump or vein graphite, which occurs in fractures and often comes from ancient hydrothermal deposits; and crystalline flake graphite, which comprised some 90% of the Cumbria deposits discovered in Elizabethan England. Whereas Chinese amorphous deposits, much of them located in Heilongjiang province – famous for its soot-clogged cities and periodic coal mining disasters – are ample for the kinds of blast furnace and refractoring applications graphite is largely used for, only graphite with a 80 micron crystalline flake can be used in newer applications such as lithium-ion batteries, without resorting to highly-expensive synthetic graphite.

We thus have a situation where there is a decoupling in the market between amorphous graphite, lump graphite and flake graphite. And whereas the graphite market slumped on the twin forces of cheap Chinese amorphous powder and perhaps the relative decline of pencil use globally, since 2009 worldwide demand has begun to regrow, and even China is now finding itself importing flake graphite from, of all places, North Korea.

With the exception of North Korea opening up – and Western geologists going in to discover the Hermit Kingdom has more flake than a fish and chip shop (unsurprisingly, the USGS doesn’t have statistics on North Korea) – what this means is that those countries and companies that hold good reserves of flake graphite will be in a very good position over the coming years. Even if the Chinese fixed-asset investment bubble does implode (and I will be writing more about this on Monday, in light of today’s GDP figures), flake graphite prices may still stay relatively high, though the bubbly levels they’re currently exhibiting may constitute an additional word of caution.

Price range for graphite with an 80 micron mesh (USD/tonne)
Source: Northern Graphite; Canaccord Genuity

While I may have missed the boat on Syrah, there are a number of other listed companies with either flake graphite in pre-production or exploration phase. And with much of this graphite located in Canada and Europe, unsurprisingly the Toronto Venture Exchange (TSX-V) is full to the brim. Toronto-based broker Canaccord Genuity lists 19 of them, with Ontario-based Northern Graphite (TSX-V:NGC), at a market cap $C138 million as of last night's close, being by far the largest.

For investors who prefer to stick to Australian stocks, the pickings are slimmer, but ASX-listed Archer Exploration (AXE) and Strategic Energy Resources (SER) both hold ground in South Australia which is prospective for flake graphite of high metamorphic grade. Both are definitely at the smaller end of the small-cap spectrum, with market capitalisations of $23 million and $77.5 million respectively, but trading volumes in both have increased significantly in the last few months, presumably on the success of Syrah and the names on the TSX-V. And whereas both companies' share prices are elevated on a five-year basis, Strategic Resources is well down from its peaks in early 2011, when drilling commenced at its Uley project located 23 kilometres from Port Lincoln on the Eyre Peninsula.

Still room for further price appreciation?
Source: Stock Doctor

Despite the relative downtrend in its share price, Strategic’s Uley project is much closer to production than the more speculative exploration targets of Archer.

Indeed, the project is one of the world's biggest coarse flake graphite deposits, with an indicated resource of 4.3Mt (million tonnes) at an average grade of 9.4% graphitic carbon and a lower cut-off grade of 3.8%. And for those who don't speak rock, this is a world-class deposit located in a country that wasn't at civil war a few decades ago (unlike Mozambique, where Syrah’s project is based) and, more to the point, it's located adjacent to existing infrastructure. Uley even has its own plant, which is being recommissioned, with a peak production capacity of 14,000 tonnes of graphite concentrate per annum.

But the problem for Strategic is that since late March, 80% of Uley is now held in a spun-off subsidiary Mega Graphite, Inc., an Ontario-based company that is planning a (delayed) listing on the TSX-V amidst the recent resignation of CEO Paul Ogilvie. While this may appeal to some risk-takers with international accounts, the more integrated portfolio of Archer may seem a better choice.

Archer retains total ownership of 19 tenements covering 9,500km2 of South Australia's West Roxby, Eyre Peninsula, Leigh Creek, Burra, Wilmington and Australia Plains regions. Within its Eyre tenement portfolio, it has 100% right to minerals other than uranium at the 816km2 exploration licence 4693 (Whildhorse Plain), located near the site of its first-priority target, Sugerloaf, which sits within exploration license 3711, Carappee Hill.

Archer’s portfolio'¦
Source: Company website

And Archer’s Eyre Peninsula holdings'¦
Source: Company presentation

Based on the long-term outlook for graphite and as a purely speculative punt (Archer also holds targets for magnesite, manganese, copper, gold and uranium), the company definitely holds attractions. Archer assesses Sugarloaf as an outstanding prospect, but Campoona in the northwest corner of Wildhorse Plain has been increased as an exploration target from between 24Mt and 37Mt to between 40Mt and 70Mt at a grade of 10-12%. To put that into context, Canada’s Northern Graphite has a total resource estimate of 53.7Mt at a grading of 1.87%.

And while obviously this is all exploration targeting, there could nevertheless be significant short-term upside from current levels once additional drill results for Campoona are released.

It is difficult to place a valuation on Archer, with early-stage exploration prospects being the underlying investment thesis. Nonetheless, with a highly attractive portfolio of geological assets, the company could be well positioned for a long-term boom in flake graphite prices, notwithstanding the misgivings I have over lower-grade graphite in general.

As a ratio of use in a lithium-ion battery, there is between 10 and 20 times more graphite than lithium (for a prospective lithium stock meanwhile, see Under the Radar: Grey gold). Estimates for lithium-ion battery demand hold that graphite required for this application alone could come to between 800,000 and 1 million tonnes per annum. With graphite production globally topping out at approximately 1.1Mt per annum, 40% being from flake, what this incentive for future production could mean for prices is self-explanatory.

With its unique chemical and physical attributes, graphite has applications in other high-tech products as well, such as touchscreen tablets, solar thermal collectors, vanadium redox batteries, proton electrolyte fuel cells and photovoltaic cells (see Under the Radar: Little ray of sunshine for a profile on an intriguing solar stock). Graphite also has a major role in pebble-bed nuclear reactors (the so-called “next generation” of nuclear plants), whereby the 'pebbles’ are made of pyrolytic graphite with embedded uranium. China, which aims to build 30 pebble-bed reactors by 2020 (it currently operates a prototype and is building two commercial units), hopes that this more modular system of nuclear power will provide it with the ability to produce greener energy, without the inherent design flaws of Fukushima and older-style nuclear reactors.

Either way, the outlook for flake graphite is promising, despite the risks to aggregate graphite demand arising from lower steel construction in the medium-term. And while it’s certainly a high-risk stock at an early stage of its business model, Archer holds perhaps the most attractive way to play this dynamic.

Having missed the boat on graphite once, I wouldn’t want to miss it again.

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