By: Andor Lips, Fund Manager, Commodity Discovery Fund
Published: 16 October 2017 09:59
Investing in the early chapter of the mining investment cycle.
Investing in the mining sector, where do you place yourself in the mining cycle? Interested in a commodity producer with stable production profile and cash flow, and with an understood risk profile, or focused on the capital intense phase when a new mine is constructed, or yet again, attracted by an exploration company that is aiming to find new mineral resources? All three options may be worth considering, but all three rely on a different investment rationale. They therefore each attract other types of investors, with different sources and quantities of capital to deploy and with different appetite for risk. In theory, all three options can yield attractive returns. Imagining a schematic Lassonde Curve, all three options outline situations where an appreciation of equity is theoretically possible.
From a high reward perspective, the first phase of the cycle has the greatest potential, and, when understood well, it also holds by far the highest level of excitement. There are significant risks involved, all of which are equally relevant and certainly require to be understood and quantified. Market knowledge, technical knowledge of projects, and years of experience in the behavior of this junior segment of the mining sector all contribute in improving the insights into these risks. Insights into these risks help to ascertain their probability to occur, and quantify their impact level if occurring, but also help in separating the uncertainties from the unknows that surround these risks, whilst identifying any mitigants to alleviate or reduce the potential risks. By this diligent approach and such enhanced assessment, the risk- reward balance for a diversified portfolio of selected propositions may shift slightly to start leaning in favor of the reward.
The strength of the Commodity Discovery Fund
The Commodity Discovery Fund in the Netherlands has been professionally active in this niche of “discovery investing” for about a decade. The Fund is of modest capital size (currently around CA$ 70mln) and has sustained very well over the 2011-2015 downturn (with net inflow from investors). The current size allows the Fund to make smallish investments (of less than $ 1mln) that are still material to the exploration budget of an exploration junior. Such investment does not weigh heavily on the invested capital of the Fund in case of disappointing exploration results, whilst in case of positive exploration results, the impact of stock price appreciation can still contribute materially to the Fund’s performance.
It is along the above strategy where the Fund manages the capital trusted by more than 600 retail investors through an open-ended mutual fund structure, with the right diversification across exploration and project risks and with a thorough estimate of the potential return on investment.
A portfolio of 30 core positions and 50 lighter positions is carefully managed on a daily basis, whilst in parallel the continuously evolving context of a few thousand juniors listed in Canada, UK, and Australia is being assessed. It is this dedication that the investors expect from the Fund, and which underpins the +70% annual performance of 2016. With the successful investment in companies that have made a material new discovery, the Fund has already seen 45 companies being subject of an acquisition by larger corporations in their pursuit of sustaining their production profile and maintaining their commodity reserve base.
Value creation in the discovery of new resources
It is that particular company that has made a world-class discovery, or that is on the right track to make such a discovery that is of most interest to the Fund, in its distinction from one junior to the other. It is the continuous consideration what projects have the potential to grow into a world-class discovery and what projects will make a tangible contribution to the future supply-demand balance of a respective commodity. These are the target projects in Discovery Investing where the value creation by discovering new resources is really materially relevant from a global economic perspective. These are also the projects that will develop “naturally” and can overcome risks because of the intrinsic quality and inherent economic importance of the new discovery.
The current energy revolution and its impact on resources use
Traditionally, the Commodity Discovery Fund has a strong focus on gold and precious metals, because in addition to value- creation through a new gold discovery or to the intrinsic value of gold reserves in the ground, the metal is also an attractive hard-asset investment as monetary and inflationary hedge.
While it still holds its gold focus, the Fund has expanded significantly over the past few years with a focus on other commodities. Base metals such as copper and zinc, whose demand is steadily increasing, while reserves are in decline and new discoveries are lagging behind. Uranium, with expectations that the metal will make a strong come-back within a decade, as soon as the uranium demand from a expanding nuclear sector in a growing world energy-mix beats the current supply.
From a similar point of view, the Fund has also considered which raw materials are expected to benefit most from the current energy revolution. Innovation in battery technologies has caused today’s electrical revolution, with a rapid growth of energy storage markets and of electric vehicles (EVs).
Battery costs have been decreasing faster than analysts’ expectations over the past years. This makes EVs even more cost-competitive, and analysts agree that cost parity with fuel engines will be reached by 2025. The advancement of battery technologies follows a similar 10 year timeline. The first- generation Li-ion battery with lithium-iron phosphate (“LFP”) technology is expected to quickly lose ground on the lithium- nickel-cobalt-manganese (“NMC”) battery. Given the first major wave of commercial implementation, NMC technology is seen as a major winner to be readily available at the cusp of this first wave, and both the battery manufacturers and battery users have put their cards on NMC.
The presence of lithium is crucial in these applications, but the relative mass is limited to only 6 to 8 per cent. Looking at the total amounts of metals in a NMC battery pack today, this contains: 38kg of copper, 11kg of nickel, 11kg of cobalt, 10kg of manganese, 4kg of lithium, and 24kg of graphite. Directly outside the battery pack, an additional 100kg of copper is needed for coils and inverters. In a ‘regular’ combustion engine car only 10 kg of copper is present. A next, more advanced, generation of NMC is expected to require over double the amount of nickel, at half the amount of cobalt and manganese.
There is evidently a lot of attention for lithium, also likely enhanced because the battery is referred to as “lithium battery”. But if the total metal usage is considered as presented in above analysis then the major metals involved are copper, and nickel, and to a lesser extend cobalt and graphite.
Anticipating the resource demand of the energy revolution
We expect the copper and nickel markets to be materially impacted by a scenario of rapid adoption of EVs and of the current battery technologies in energy storage. Copper and nickel top the list because of the lack of recent new discoveries, the capital intensity to build a world-size copper or nickel mine, and the generally long timeline between an initial discovery and production. Cobalt, graphite, lithium, and graphite, may have identified global resources and are far less dependent on new discoveries but are still vulnerable to a deficient upscaling of global annual output.
The total annual copper demand could surpass the 40 million tonnes within twenty years, against a total global production in 2016 of 23 million tonnes of copper. Also, another 1.8 million tons of nickel will be needed annually, on top of a total global market of 2 million tons of nickel today. Important to note that nickel for EV batteries will require a higher purity than the nickel used in the steel industry. The growth of the production of this high-purity nickel will have to triple in order to meet the expected demand in the coming years, and may initiate the separation into two separate nickel markets.
Considering that it takes the copper and nickel sectors at least 10-15 years after discovery to develop a mine, the possibility to double copper or nickel mining output at 20-year mark is limited and significant capital is required. Furthermore, the discovery of new copper and nickel resources in a tight time window seems to be a necessity and simplistically speaking; whatever is not yet discovered in 2020, will be too late to be mined in 2035. We already have taken several positions in starting and advanced explorers with exposure to these metals, but will continue to expand in the coming years.
About the Author
Dr. Andor Lips is Fund Manager of Commodity Discovery Fund since 2016. He has been working in the mineral resources sector since 1993, from exploration geologist for several companies and for the French government to Technical Director of Lydian International. Between 2010-2015 he worked as a senior banker in mining finance for ING Bank. Furthermore, he is a consultant for the European Commission. Andor is also a shareholder of the Commodity Discovery Management BV, the manager of the fund.
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