Kiril Mugerman: Graphite investors should look for large flakes, small resources

Kiril Mugerman: By “black gold,” I was referring to both the rush-in exploration for graphite and to the potential high demand for it. I still believe in strong demand for graphite, and that could result from the proliferation of electric vehicles, new modes of power storage, graphene and many other applications.

TMR: Are new applications behind graphite demand?

KM: For new growth in demand, our main focus remains the increased use of graphite in batteries and energy storage. As for the more traditional demand, because graphite is a unique material, it is used in many different applications that contribute to a steady growth in demand over the long term. It’s used in refractories like crucibles and in blast furnaces, for friction materials like brake linings and pads in cars, as well as in lubricants, electrodes, steel making and nuclear reactors. Construction materials, industrial paints and heating and heat conductivity systems that use graphite are all already being used in the industry.

As far as exponential growth in demand goes, electrification of vehicles and energy storage are the two technologies most likely to accomplish this.

TMR: Graphene has been described as a material with almost unlimited potential. Do you think that’s true or hype?

KM: The potential is certainly there. I’ve had the opportunity to visit some of the private companies in this field and see some samples and applications they are working on. It’s fascinating. Unfortunately, it’s still in the R&D stage, and it’s too early to say which applications will become reality.

TMR: What’s your forecast for graphite supply and demand?

KM: Chinese growth slowed down over the last 18 months, and the steel industry slowed down with it. So, of course, demand for graphite for the steel industry declined as well. But as we expect to see increased growth from the BRIC countries (Brazil, Russia, India, China), we should see short-term demand increase by 1–2%.

In the longer term, we model a 2.5% annual growth in demand and a 2% annual increase in production.

TMR: So graphite supply will not meet demand.

KM: We do expect some supply shortages. To balance that, we forecast four new mines to go into production between now and 2020, with average production per mine of 20,000 (20K) tons per year. In total, we see a shortage of 80K tons per year by 2020.

TMR: China is responsible for 70% of world production of graphite. Can the West depend on China for graphite?

KM: For now, definitely. If no mines open up in the next five years, China will still be able to increase production. However, the fact that we depend on China doesn’t necessarily mean we should. Many end-users have said they do prefer to have other options.

TMR: You wrote in November 2013 that graphite prices are “still looking for a bottom.” Why is that the case?

KM: We suspect it’s a result of weaker demand, increased production leading to the 2012 peak in prices and, of course, stockpiling.

TMR: Will this trend change, and, if so, when?

KM: First, we want to see some stabilization in prices. If prices level off more or less where they are right now, that would be a positive. It will persuade end-users that they can resume larger-volume buying, which would reverse the trend.

TMR: You also noted in November 2013 that in the 18 months since May 2012, the number of Western graphite companies and projects had effectively doubled from 36 to 73 companies and from 98 to 176 projects. How many of these companies and projects could be serious contenders?

KM: Of those 176 projects, we have isolated 17 that we actively track, and these are spread between the top four categories in our graphite pyramid diagram. Those projects are run by 16 companies.

TMR: Is it true that graphite projects can be brought to production much quicker than precious or base metals?

KM: This was the view presented in 2012 by many junior graphite companies. They argued that graphite projects require simple flotation and very basic beneficiation. But these companies discovered that this was not the case because many management teams lacked experience in industrial minerals. We see two main challenges industrial miners usually face. First, detailed end-user product specifications significantly affect the product asking price. Second, companies need to find buyers; there is no central graphite exchange or a refinery to buy a company’s entire output. So sales and marketing is a major risk when it comes to graphite.

Many graphite companies floundered with projects that required a lot of metallurgical processing in order to understand what kind of material they would be supplying and how much quality they could preserve. That delayed several projects significantly. In addition to that, because the projects tend to be fairly small, you need to keep capital costs low in order to keep the project economic.

TMR: There’s a great deal of confusion among investors regarding the relative importance of flake versus vein graphite. Could you provide some clarity here?

KM: Sure. Vein graphite is a niche market supplied exclusively by Sri Lanka. It differs from flake in its crystal structure, which gives it properties that allow end-users to use it in specific applications. Flake graphite is the more traditional material with a wider variety of uses.

Because industrial minerals’ end-users buy graphite based on its various properties, they cannot simply change their input materials without either having to tweak their production line or make decisions that affect the end product.

TMR: There is also confusion regarding the question of graphite purity.

KM: All graphite can be purified to 99% by either the wet chemical method or the dry thermal method. It’s only a question of cost.

End-users will often purify the concentrates they buy to the exact specification they require. They might decide that graphite purified to 99% by the miner is too expensive, and they won’t pay the premium. They might decide instead to settle for 94%, 96% or 98% purity and perform the additional purification themselves. Graphite miners will say that they intend to produce at 99%, but they still need to find buyers willing to pay the premium.

TMR: Is it particularly expensive for producers to bring their graphite up to 99% purity?

KM: I don’t think we have seen any costs officially declared by any of the juniors, but we expect that reaching 99% purity could add a significant portion to the operating costs.

TMR: So when graphite companies tout their particularly high purity, is this an empty boast?

KM: A junior that announces 99% purity does not stand out because, as I mentioned, end-users can do this themselves. To find a project that will be able to mine graphite directly at 98% or achieve 99% from floatation, that’s a different story. That demonstrates a potential low-cost operation that could sell at a premium.

TMR: In your evaluation of advanced-stage graphite projects, what criteria distinguish the best projects?

KM: We look at flake distribution and purity levels. The former is somewhat of a proxy for the latter. Larger flakes will tend to have higher purities. With both larger flakes and higher purities, companies can command higher prices. That’s the first criterion and a very important one.

Second, we look at the annual production the company is targeting. Many companies have issued studies suggesting they can produce 50K or 80K tons per year. But considering that the market for flake graphite is anywhere between 400K and 500K tons per year, that is a lot of product being added to the market from just one mine.

TMR: So you prefer smaller projects?

KM: We prefer a project that can give us 20% internal rate of return (IRR) at 20K tons per year instead of a project that will produce 80K tons per year, because being in industrial minerals means you must sell those 80K tons to a multitude of customers. As I mentioned earlier, unlike precious metals mines, you cannot ship all of it to one refinery that will buy it from you. The marketing risk becomes very high for projects that must sell a very large amount of product in order to reach high rates of return.

TMR: Is flake graphite typically mined in open pits?

KM: All current graphite projects in development will be targeting open-pit operations.

TMR: So, putting infrastructure questions aside, is there much variance in mining costs among the advanced projects you’ve examined?

KM: There are two factors to consider. First, strip ratio. Favorable geology will allow some projects to have low strip ratios, whereas projects dealing with much steeper geological structures will have high strip ratios.

Second, grade. For instance, a project like Northern Graphite Corporation’s (NGC:TSX.V; NGPHF:OTCQX) Bissett Creek in Ontario, will have to process many more tons to produce that graphite. Their costs will definitely be higher than a project that has, let’s say, 15–20% graphite.

TMR: So why do you name Northern Graphite as one of your favorite graphite companies?

KM: From the beginning, Northern Graphite has remained the most advanced project among the Canadian juniors that we’ve been following. The company did have some permitting issues over the last couple of years, but that has been taken care of. All the graphite produced at Bissett Creek will be 95%+ purity, so Northern Graphite will definitely target the premium markets. And it will produce only 18K–20K tons per year, so Northern Graphite only needs to sell a relatively small amount of graphite to reach its revenue targets.

TMR: What are Bissett Creek’s financials?

KM: According to the company’s October 2013 preliminary economic assessment, the after-tax net present value (NPV) will be $150 million ($150M), with an after-tax IRR of 22%. The waste-to-ore ratio is 0.24, and mill recovery is 94.7%. Initial capex is $101.6M.

TMR: How does Northern Graphite intend to pay for Bissett Creek?

KM: That’s a hard question. In my opinion, a graphite company at Northern Graphite’s stage needs to attract an offtake partner. The market will appreciate seeing end-users, such as an industrial minerals company, participate in the development of this project. In addition, Northern Graphite has been working to produce battery-quality graphite in-house, from its concentrate. This could allow Northern Graphite to attract a higher valuation for its material and help it secure a development partner.

TMR: What’s your rating for Northern Graphite?

KM: We rate it a Speculative Buy with a target price of $1.50.

TMR: You also follow Tasman Metals Ltd. (TSM:TSX.V; TAS:NYSE.MKT; TASXF:OTCPK; T61:FSE), which is primarily a rare earth elements (REE) company.

KM: Yes. Tasman Metals has the Norra Kärr REE project in Sweden. Last December, the company announced its intention to merge with Flinders Resources Ltd. (FDR:TSX.V), which has the Woxna graphite project in Sweden (scheduled to begin annual production of 10K tons in Q3/14). Since the initial announcement, there has been little news. So it’s too early to say whether Tasman will become a graphite company as well.

Having a combination of different industrial minerals, such as rare earths, graphite, tungsten and vanadium, is a good thing, in our opinion. The tricky part is getting started with one mineral, generating cash flow and then diversifying into other minerals, thus becoming a diversified industrial minerals company. Should Tasman and Flinders merge, they might be able to achieve this.

TMR: What’s your rating for Tasman?

KM: We rate it a Speculative Buy with a target price of $1.75.

TMR: You mentioned the advantage of diversity in industrial minerals. What about Energizer Resources Inc. (EGZ:TSX.V; ENZR:OTCQX), which is in Madagascar? That company’s original flagship was its Green Giant vanadium project. But in the last 18 months, it has pushed its Molo graphite project to the forefront. What do you think of Energizer’s prospects?

KM: Energizer is now focusing entirely on graphite. The company has presented a fairly ambitious plan to produce over 80K tons of graphite annually. My worry with Molo is infrastructure. With such high production volume, we expect marketing and logistics could be major risks. That said, based on metallurgical results the company published in 2013, we expect that Energizer will most likely scale down Molo based on improved flake distribution, which could improve the project significantly and reduce these risks.

TMR: Can you comment on some other graphite companies?

KM: Sure. Mason Graphite Inc. (LLG:TSX.V; MGPHF:OTCQX) has a very interesting deposit in northern Québec, Lac Guéret. Its experienced management team is targeting 50K tons annually. Mason will be able to supply the full spectrum of graphite, from minus-150 mesh to plus-50 mesh. But as with all large projects, marketing will present a challenge.

Syrah Resources Ltd. (SYR:ASX) also has a very interesting graphite-vanadium project, Balama in Mozambique. The company has the largest resource and the largest market capitalization in the graphite sector. Those advantages have resulted in very ambitious plans, in my opinion. The company intends to produce 220K tons annually, which is essentially half of current global flake production. We are following the Balama story closely to determine how it affects and develops the graphite market.

Focus Graphite Inc.’s (FMS:TSX.V) Lac Knife project in northern Québec has been in development for some time. I see it having some problems with infrastructure, although the company did produce improved metallurgical results last year. Focus has also announced an offtake with a Chinese company, although the company hasn’t provided many details on the pricing or the terms of the agreement.

TMR: All the companies we’ve talked about are aiming to produce flake graphite. Is there any news in vein graphite?

KM: Canada Carbon Inc. (CCB:TSX.V) has the past-producing Miller mine in Quebec. The company announced some compelling results recently. I haven’t had the chance to visit the project yet, but I did receive some samples. From what I’ve seen, it is indeed vein graphite at Miller. It’s early stages still, as the company has more lab work ahead of it. We are keeping an eye on that story.

TMR: Because vein graphite is currently mined in Sri Lanka, this would differentiate Canada Carbon from everyone else, right?

KM: Correct. That’s why are we are so interested in that company.

TMR: Many people in the graphite sector believe there will be a massive cull of the 73 junior companies. Do you agree?

KM: I’d say that is most likely. Many juniors will probably abandon graphite and go into precious metals, uranium or base metals exploration. A lot of juniors moved into the graphite sector because of peak prices in 2012. We’ve seen similar migrations to REEs and uranium. It’s just a question of time before we are down to a good 20–30 companies that will focus on a few main projects.

TMR: Kiril, thank you for your time and your insights.

Kiril Mugerman is a mining analyst with Industrial Alliance Securities Inc., based out of Montreal, Canada. He joined the IAS team in September 2011 and currently specializes in precious metals, industrial minerals and fertilizers with focus on graphite, rare earths and specialty fertilizers. He graduated from McGill University with Honors in earth and planetary sciences, after which he worked with Gold Fields Ltd. in mineral exploration and advanced projects development in West Africa, Central Asia and Latin America.

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