Look to Lithium's Bright Long-Term Future

Lithium prices have plummeted over 50% since their early 2018 high as new supply has rushed into the market. The shares of Albemarle ALB, SQM SQM, and Livent LTHM now trade well below our fair value estimates as they price in lower-for-longer lithium prices. Low prices will continue through 2020, caused by a demand decline due to the COVID-19 pandemic and ongoing oversupply. However, we see a light at the end of the tunnel. By the end of 2021, the lithium market will return to balance as demand growth resumes from increased electric vehicle adoption and other batteries and eats up new supply.

The 2020s will be a transformational decade for lithium, as we expect demand to grow over 6 times 2019 levels. Additional higher-cost supply will be needed to meet this demand. While there may be further price volatility in the near term, we forecast long-term prices will settle at a marginal all-in sustaining cost of $12,000 per metric ton, as high-quality lithium needed in EV batteries grows to account for 80% of total demand. Our top picks to invest in higher lithium prices are cost-advantaged narrow-moat Albemarle, SQM, and Livent, as our above-consensus lithium price forecast leads our fair value estimates to be at the top of the Street. All three stocks currently trade in 5-star territory. For investors who can look past near-term growing pains and uncertainty, we see significant risk-adjusted upside.

Prices Are Nearing a Cyclical Bottom, While Market Expects Lower for Longer
Lithium is in the early phases of a once-in-a-century demand transformation. We expect increasing need for high-quality lithium used in electric vehicles and grid storage will result in demand growing over 6 times from 2019 to 2030. Nearly all the growth will come from batteries, creating a mix shift toward more expensive-to-produce, high-quality lithium chemicals. However, the supply response will be lumpy, creating boom and bust periods where lithium prices will swing wildly above and below the long-term marginal cost of production that typically informs commodity prices.

Over a longer period, commodities that have seen significant rises in demand tend to see prices grow sharply in real terms as higher-cost supply comes on line. The prices of copper and iron ore, two commodities that saw major demand growth over the last 20 years, have increased (in real terms) amid China's economic rise. Although driven by different factors, we expect the same for lithium.

In our view, 2020 will mark the bottom of the current cycle. The lithium market is currently in oversupply and prices are falling. Further weighing on prices, the coronavirus-related economic slowdown is likely to result in a demand decline in 2020. However, supply will also fall in 2020 as all major producers are likely to both reduce production in 2020 and delay new supply. As a result, we do not see a lasting effect on lithium prices. As demand returns in the second half of 2020, we expect prices to stabilize in 2021 and meaningfully rise by 2022.

As lithium prices rapidly change, so do lithium producer stock prices, as the market tends to assume that current prices remain in perpetuity. This leads to periods when producer stock prices are significantly undervalued or overvalued.

There are four stages in a commodity price cycle.

Demand exceeds supply. Prices are above the long-term marginal cost of production. Many projects look attractive, encouraging significant capacity expansion. Producer stock prices are probably rising and may exceed intrinsic value.

New supply enters production. As supply rushes into the market, prices begin to fall but remain above the long-term marginal cost of production. Most producers will likely outearn their cost of capital, albeit at a narrower margin. Most projects in development still look attractive, encouraging continued capacity expansion. Producer stock prices are probably leveling off.

Supply exceeds demand. Supply growth has far exceeded demand growth. Prices fall below the all-in sustaining cost of production and will probably bottom out around cash cost of production for higher-cost supply. High-cost producers do not earn their cost of capital, may not be profitable, and may shut down. Most projects no longer look attractive and new supply investment slows. Producer stock prices are likely falling and well below intrinsic value as the market assumes oversupply will linger. This phase marks the best buying opportunities for long-term investors.

Demand growth sops up new supply. Prices begin to rise and eventually balance around the all-in sustaining cost of higher-cost production. Producer stock prices are probably beginning to move close to intrinsic value.

While the cyclicality applies to lithium, we do not view lithium as a typical commodity. The key difference is that there are multiple noninterchangeable lithium products. The mix shift toward higher-quality lithium will push the cost curve higher.

Demand Will Grow Over 6 Times Through 2030

• Lithium demand will grow over 6 times from around 300,000 metric tons in 2019 to roughly 1.9 million metric tons in 2030.

• Demand will fall over 5% in 2020, versus our previous forecast for 15% growth, due to the coronavirus-related economic slowdown, but growth will resume in 2021.

• The largest growth driver will be greater electric vehicle and hybrid adoption due to the number of autos sold globally each year.

• Future annual demand from other batteries, including grid storage, nonauto transportation, and consumer electronics, will exceed total 2019 lithium demand.

• Batteries will grow from just under 60% of total demand in 2019 to over 90% of total demand by 2030. A greater proportion of batteries will require higher energy density, driving the need for high-quality lithium to over 80% of total lithium demand, up from a little over 30% in 2019.

Costs Will Rise as Massive Demand Growth Can Only Be Met With Lower-Quality Resources

• We forecast a long-term lithium carbonate price of $12,000 per metric ton in 2020 real terms. Higher prices will be driven by growing demand for high-quality lithium and the need for higher-cost supply.

• Long-term prices will be set by nonintegrated lithium producers, which will make up an increasing portion of supply. As nonintegrated producers must use increasingly poorer-quality feedstock, the marginal cost of supply will increase from higher processing costs.

• To meet the nature of the new demand, supply will need to shift to the increasingly high-quality product used in batteries. This will make high-quality lithium--the most expensive to produce--a growing proportion of total lithium, permanently shifting the cost curve higher.

• The lithium cost curve should be based on a producer's all-in sustaining cost, as this represents the true cost of production over a cycle. We view cash cost as understating true economic cost.

• We see production delays for many new entrants, as greenfield projects tend to face some delay. As demand growth sops up new supply, we see the market returning to balance in 2021.

Albemarle and SQM Stand Out

• Lithium producer stock prices have fallen since late 2017 due to lower lithium prices and concerns about lower long-term prices, creating attractive upside for all the lithium stocks we cover.

• Our top lithium producer picks are Albemarle and SQM because of their combination of cost-advantaged lithium production and lower risks.

• Albemarle produces lithium at the lowest-cost assets globally for carbonate at the Salar de Atacama in Chile and hydroxide at Greenbushes in Western Australia. The company's bromine and catalyst businesses also offer investors competitive advantages that underpin our narrow moat rating.

• SQM also produces lithium at the Salar de Atacama, giving it the lowest carbonate production cost globally. The company's low-cost specialty fertilizer and iodine production also carry cost advantages that underpin our narrow moat rating.

• Livent is a pure-play cost-advantaged lithium producer. We like the stock's valuation, but the company carries higher risk than Albemarle or SQM because of its reliance on a single asset and production strategy. The elevated risk underpins our very high uncertainty rating.

• We caution investors that many new entrants to the industry carry additional company-specific risks that could ultimately outweigh lithium's favorable demand growth.

This information was published April 17 as part of the lithium Basic Materials Observer, which is available to Morningstar's institutional clients.