Have Australian fund managers got their lithium call wrong?
Rio Tinto’s $10 billion Arcadium Lithium takeover has the bulls excited again. But hedge funds believe the move signals a major shake-up and more pain ahead.
Rio Tinto’s $10 billion deal to buy Arcadium Lithium earlier this month was a jolt of confidence in a commodity that sorely needed it. Stocks had been sliding – along with the spot price – as the investor hype about lithium’s future began to fade.
The arrival of a $165 billion resources giant changed that. And fervour around which other producers would be targeted by big cashed-up players has since ignited a rally. UBS sales trader Sujit Dey has been telling clients to avoid shorting lithium on renewed China stimulus and the prospect of more deals – and has identified Hancock Prospecting, Norwegian energy firm Equinor and ExxonMobil as potential acquirers with deep pockets.
An Arcadium Lithium project in Argentina.
But the reality is that Rio Tinto’s move may not really be the validation that lithium bulls have been hoping for. In fact, hedge funds that have profited by shorting stocks in the sector are ready to do so again.
Rio Tinto’s acquisition, they believe, is a specific and strategic investment that complements existing exposures. Effectively, Rio Tinto is taking the view that the brine producers will mine lithium at a lower cost, due in part to new technology and relegate the hard rock producers to marginal swing producer status.
The miner also stated it is accelerating production that otherwise would have been constrained by balance sheet issues, adding to the oversupply. That may not bode well for the prospects of companies most favoured by Australian fund managers, such as Pilbara Minerals, Liontown Resources and Mineral Resources. It may also prompt some soul-searching among Australia’s largest superannuation funds and active managers.
Have they got their lithium calls wrong in the short term – missing out on Arcadium’s doubling – but also in the long run through overexposure to hard rock miners?
“While many have suggested this deal is positive for the sector … I actually think the opposite,” Justin Lindquist, head of hedge fund clients at Barrenjoey Capital Partners says.
“Supply is coming on that the market didn’t expect, Rio is setting up a truly integrated business for decades to come and those higher producers that aren’t fully integrated are going to be collateral damage in the short term.”
Rio Tinto also not running with the bulls
Rio Tinto itself isn’t exactly bullish in the short term, The miner says the lithium market will be oversupplied until the end of the decade, which some analysts take to mean that carbonate prices will remain at or near a marginal cost of $US11,000 per tonne. That’s below most consensus estimates that assume prices will recover to around $US19,000 per tonne by 2028.
Rio Tinto’s slide deck that accompanied its acquisition announcement has been studied at length. In particular, a slide showing the cost curve in 2035 and where its assets sit has appeared in countless sales and trading notes.
In meetings with investors, Rio Tinto executives said they’d spent considerable time understanding the cost curve before making its move. A big thick block of grey that dominates the third and fourth quartile is likely Pilbara, Liontown and Mineral Resources.
Those are the stocks most favoured by Australian investment firms and super funds. But investment firm Martin Currie, which manages around $6 billion of Australian assets, has called out the obsession with these “local hard rock” plays.
The fund bought into Arcadium in the weeks before the Rio transaction on the basis that it was a high-quality asset trading at a compelling price, and was rewarded when Rio Tinto agreed to pay a 90 per cent premium to take it out.
The extent to which the stock was shunned by Australian investors is remarkable. Since Arcadium’s shares are quoted in Ireland and on the ASX, it’s easy to track the decline in interest. The share of securities quoted in Australia has halved from 60 per cent at the start of the year to 35 per cent.
Martin Currie senior research analyst Chris Schade says the Arcadium share price was trading at a material discount to its assessment of net asset value, while other stocks in the market traded at or near fair value. That suggests there aren’t exactly screaming buys out there.
By their estimate, the market will remain in oversupply for the next three years, although there is a supply response as projects aren’t able to get funding. “The market is sending a very clear signal – we don’t need lithium in the near term,” says Schade.
A game changer or an anti-climax?
Another major talking point of the transaction is the potential application of a new process called direct lithium extraction. Depending on who you talk to, direct lithium extraction is either a total game changer that could be compared to the way shale changed oil – or a complete non-event.
Last year, Goldman Sachs analysts said the method had the potential to significantly increase the supply of lithium from brine projects – doubling production, improving returns and increasing sustainability benefits.
Their view was that the technology would widen rather than steepen the lithium brine cost curve with the average project sitting within the second or third quartile, expanding supply at that production cost.
While Rio Tinto has been developing its own direct lithium extraction technology, it is Arcadium’s capability that is of strategic value and could be applied to its existing deposits. The benefits, however, were pitched more as a means of making production more sustainable and using less land, rather than materially improving the economics.
Is direct lithium extraction overhyped or a revolution that will alter the cost curve and accelerate projects coming to market?
“With most of these things, the truth lies somewhere in the middle. But the reality is we need improvements in technology to deliver the growth that is needed,” says Schade.
Where there appears to be consensus is that Rio Tinto has finally done a big deal that makes sense.
According to Blackwattle Investment Partners’ Ray David, the Arcadium acquisition could turn out to be one of Rio Tinto’s finest, in contrast with massive top-of-the-cycle bets on Canadian aluminium group Alcan and Riversdale Coal that dusted tens of billions of dollars of shareholder wealth.
If the name of the game is to own tier-one, low-cost assets with long reserve lives in stable jurisdictions, then Rio Tinto’s purchase of Arcadium ticks three of the four boxes with some sovereign risk in South America, which is where most brine projects are situated.
Rio Tinto, David says, is using a strategy that works well in the board game Monopoly – start strong, buy quality assets and swoop when competitors weaken.
“There is no other buyer of lithium assets given weakened balance sheets from overdevelopment,” he says. “Rio knows that the sun has set on China steel consumption, while lithium demand is still nascent. Buying low-cost lithium assets such as Arcadium at current lithium prices makes total sense to us as Rio Tinto shareholders.”
While Martin Currie’s Schade is cautious about the outlook, he says there’s been a mood shift in the attitudes of management teams that have been forced to temper their unbridled optimism.
The posture has shifted from one in which the outlook was so positive and bouts of volatility were ignored to the realisation that times are tough and hard decisions have to be made.
“Lithium is the metal for the transition,” he says. “The transition is happening, but not as fast as the hype hoped for 18 months ago.”
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