Rare Metals Crunch

There is an ongoing movement to phase out the fossil fuel industry and replace it with everything electric. This book talks about some of the key things needed to make that happen but are overlooked - and that is the rare earth metals. These metals go in the power-train of an electric car, or to manufacture power magnets which go in electric vehicles. 

As one can imagine - these materials will need to be mined from the Earth. They are spread across the globe across different countries from Angola, DRC in Africa to Kazakhstan in Central Asia to the biggest producer of them all - China. Access to these materials is a must to have the electric movement succeed. And there are many different caveats around this! The author does a decent job of explaining them.

Is Mining Rare Metals Environment Friendly?

Currently, cities in East China/Mongolia (Bataou, Dahlia) are the poster-childs of how “clean energy” is not clean. These cities sit on top of reserves of rare metals but the cities are full of the toxic sludge containing Hydro-sulfuric acid used to wash and clean the deposits to extract the minerals via the process. BBC even did a report on this in 2005.

Worth remembering - after extraction there is an elaborate process to extract the metal which consumes thousands of gallons of water. This is where the concept of EROI (Energy Return on Investment) comes in. EROI is the ratio that measures the amount of usable energy delivered from an energy source versus the amount of energy used to get that energy resource.

Can recycling of Rare Metals compensate for mining?

The answer is NO as of today based on the technology available. Even Apple - the company with abundant capital and resources is only able to manufacture products only with 20% of recycled materials. Rest of the materials like Tungsten etc - it sources from suppliers around the world. Apple's Environmental Progress Report 2021

Role of China

If for Oil - OPEC produces 41% of it, then for rare metals China today produces 95% of them - such is its vast influence on it. 

The Western Hemisphere has only two mines left- one in Australia (Lynas) and another one in California (Mountain Pass). Rest of the mines in Europe had to shut down as China dumped the market with so much supply that mining became a highly unprofitable endeavor.

Also, China has instituted export controls (export duty) on rare metals to thwart foreign companies relative to its domestic companies. Due to these export duties, input costs of foreign companies increase as China is the only major supplier today. Other countries in the Southern hemisphere like Indonesia have also followed suit by limiting exports of raw materials as they too try to climb up the value chain.

Another factor has been the vociferous movement against mining in the Western world which has resulted in a sharp drop in public approval for the mining industry resulting in shut-down of mines all across Europe and the U.S.

Criticism

However, the biggest question mark/criticism of the book is that the EPA website classifies some of the claims made in the book as myths. Let's analyze them -

One is that EVs are not bad for the environment even though the electricity generated to charge them may exacerbate carbon emissions. Power plants rely on fuels like coal/nat.gas/nuclear-power/solar etc to generate electricity. It's easy to guess which fuels are most in vogue as of today. The EPA's claim - may create carbon emission feels like a cop-out. And no mention of how much electricity demand a household with two EVs will generate (answer is - charging two EVs will double a house's electricity consumption). Overall, I'm not convinced by the first claim on EPA website that it won't result in more carbon emissions.

Same goes for the claim on battery manufacturing. Materials used for battery manufacturing have to be mined which is not an environmental friendly process. And the argument Recycling EV batteries can reduce the emissions associated with making an EV by reducing the need for new materials 
- doesn't make sense as explained further above.

Final thoughts - 

At this moment in time I agree with the author’s assessment that the public doesn’t realize that trading oil fields for rare metals deposits means more mining of rare metals deposits and mining isn’t an environmentally friendly process either. And we haven’t discussed at all about how the vast demands of electricity would be met when every vehicle would be electric. Western development model seems to be mired in some contradictions. Dreams of a green and more technologically advanced world doesn’t seem to be that clean.

Changing Investment Climate

In the last 10-15 years, asset valuations have jumped up quite a bit leading to lot of prosperity and also helping some people build unheard-before wealth. This has had resulted in people thinking of themselves as better-than-they-actually-are investors and also lulled everyone into believing this is how assets/investments actually work. A bit of roller-caster but in the long term everything goes up and to the right. 

As we come out of Covid pandemic the fiscal stresses are laid bare and inflation is on a run. This has already roiled the equity markets YTD but not so much the real estate market. The housing market has had double-digit returns in the last two years. Yes, there are valid reasons behind it and people expect the housing market to continue to rise without breaking a stride. 

However, there are three key reasons why investment climate won't be the same as the last decade - 

1. Interest Rates are going to rise

To combat inflation the main tool central banks have is to hike the interest rates and try slow down the red-hot economy. This sometimes works and sometimes has an unintended effect of bringing the economy to a halt instead. For the purpose of equity investments, in the Discounted Cash Flow (DCF) models - the interest rates are the denominator. And as the interest rates go up the price derived from the model goes down. Not just the model - it's how it happens in real world too. Investors naturally prefer to go after risk-free returns than to risk it on a company/asset. 

We have had an abnormally long period where interest rates were artificially low and it played a big role in jacking up the valuations and asset prices. Clearly, we all have now become addicted to it and would like for it to continue forever. This is where the reality check happens or will happen! Lower Interest rates are supposed to stimulate the economy only for a short period instead of being a permanent feature. 

Housing Market and era of low interest rates

This period has already propped up the housing market by much - housing is now the biggest asset class globally. And it has generated socio-political quandary of its own. 

No politician or central banker want to be responsible for the "reality-check" - withdrawing low interest rates and a downward spiral of re-evaluation of asset prices. 

Reasons are a bit hidden but clear once you see them! 

Older people vote more often and their net-worth is tied to the "propped-up" asset prices. So, if any politician even tries to streamline or fix the housing market - they immediately become unelectable. Infact, one can argue that the secret of stability of society is "housing prices always go up"! 

Yes the next generation will pay for it as they will have to deal with the high housing prices and the fact that wages haven't (and most certainly will not) matched pace with the appreciation in housing prices.

 2. Corporate Tax Rate is going to increase

Free Cash Flow (FCF) is determined as the money a company has left after fulfilling all it's obligations (taxes, expenses etc). For past decade or so, corporate tax rate has remained low with one or two exceptions. But now as countries face burgeoning deficits, money shortfalls for projects and public backlash against wealthy entities - corporate tax rate for sure won't remain the same. It only has to go up from here resulting in lower FCF for the company and lesser pie to be shared with investors and thus, lower valuations.

3. Quantitative Easing is over. Quantitative Tightening starts now

We have had a long period of Quantitative Easing since 2008-09 with a few minor blips i.e Central Banks have printed money to keep the market liquid. Coupled with low interest rates - access to capital was cheap and easy. However, bills are now coming due. National deficits, runaway inflation requires Central Banks to step back, stop injecting liquidity and  instead start withdrawing the surplus liquidity sloshing in the system. This would look like selling bonds, higher interest rates. With less liquidity - access to capital would now become expensive and hard. Its impact on the economic activity would be inevitably visible. At the end, lower valuations and much slower appreciation of assets. 

What should investors do? 

In my view, investors need to retrain their mental models and unmoor it from the past. After-all, past performance is no guarantee of future success. What just happened might not happen again soon in the future. So investors may need to turn far more rocks than before for investment opportunities which can withstand turbulent times and still give them healthy returns.

Quest for Energy

I really enjoyed reading this marvelous book from Daniel Yergin. He actually wrote a Pulitzer Prize winning book called the The Prize: The Epic Quest for Oil, Money, and Power. I watched its documentary by the same name in which the author Daniel Yergin narrates it. Amazing watch. Below are my thoughts on the book

Oil has been the backbone of the world's industrialization and development. There have been quite a few panics around the supply of oil (peak oil/ Hubbert’s peak).

But every time there was a solution - new discovery of oil, or better efficiency during oil production and processing etc which saved the day. When an oil field is discovered estimates are often on the low side. With more research proven reserves increase.

Additionally, it is also true that the vehicles of today are much more fuel-efficient than before and since transportation is the biggest consumption of oil it has had an impact.

Due to discovery of oil elsewhere - North Sea, and new sources like tight oil, shale gas have helped to reduce OPEC’s dominance in the oil market. World daily oil production is 110 million barrels per day (mbd).

Oil’s biggest enemy

Oil’s biggest enemy is high oil prices. High oil prices result in lower demand, glut and also provides for more focus and funding on renewables. Eventually, an equilibrium is arrived at and oil prices fall. This cycle has repeated itself many times. Oil prices have risen to great heights and collapsed. And with its collapse the efforts on alternatives like renewables fizzle out.

Another factor that has reduced OPEC’s control over the prices is its financialization. Trading of oil futures and contracts, and hedging is done by anyone at the mercy of oil prices like airlines and even countries whose economies rely on oil prices. Heavy trading happens at NYMEX (New York Mercantile Exchange).

Almost every country is trying to diversify their energy sources away from oil - coal/natural gas/hydropower, solar. Also, in order to achieve that it is possible there are tensions and maybe clashes between nations.

Qatar is betting big on LNG. LNG is compressed into a liquid at very cold temperatures and then stored in special containers, shipped over sea and re-gasified and given to consumers.

NUCLEAR POWER

NUCLEAR POWER	Operational Reactors	Reactors under construction	Reactors Planned	Total capacity of all
China	55	18	43	117,450 MW
U.S.A	92	2	11	101,662 MW
India	22	11	32	45,820 MW

Numbers from Wikipedia. May not be precise but directionally correct

Oil’s Fault Lines

Oil’s importance has resulted in multiple conflicts in the past and still has the potential to ignite a conflagration. Circa 2004, China came out of nowhere to shock the oil industry with a huge spike in demand thanks to its rapid urbanization. Because it was late to the game, China was willing to pay a premium to get access and offer value add. It has been especially effective in African countries. Chinese oil companies have acquired abandoned oil fields in Africa and put in money to develop those oil fields.

Couple of Straits (Strait of Hormuz in the Persian Gulf and Malacca Strait in South China Sea) hold significant importance because of the immense volume of tankers that flow through them.

Electricity

Electricity is very different as it’s one second here and another second there. Oil can be stored in tanks, grain in silos, natural gas in underground caverns - but electricity can’t be stored. It is a business with virtually no inventory.

Power utility companies generate electricity using a fuel depending on the constraints of region and geography. It can be coal/oil/nuclear power/wind etc or a combination of them. It is too risky for an utility to overcommit to just one source/approach because of technological advancements/fuel costs/public opinion - thus they diversify.

Electric power is the most capital intensive major industry. No utility is going to sink money into a plant only for a decade. A power plant is supposed to operate for decades. However, there exists a wide gap between the needs and the expectations people have. In my research - I found multiple power utilities have accelerated the retirement of their coal powered plants in the last couple of years but still the public perception doesn’t acknowledge this progress.

It was eye-opening to read about the California power crisis in 2000-01. My impression was that it was solely due to the unscrupulous power company called Enron. But turns out there was more to it. Because of excessive regulation utilities weren’t allowed to pass on increased costs to users (residential/industries) as the government prohibited them. Thus, the demand-supply equation was totally off-balance.

Renewables

In the last 50 years, many times the pendulum swung in favor of renewables as oil prices shot through the roof and it swung back towards oil as prices collapsed and both funding and research in renewables dried out. Wind/Solar may be free and intermittent sources but there are costs associated to harness it in large volumes, put it through the grid and deliver to the customers. And still keep a backup around for any inadvertent circumstances.

Also, it may be easy to say switch to renewables but there has been stubborn opposition towards them. Opposition to nuclear power plants was predictable to me but I was surprised to read about opposition to even offshore wind. Cape Wind project was supposed to setup offshore wind farm in the ocean but some residents claimed that the project would ruin scenic views from private properties as well as views from public properties like beaches, as the turbines would be only 4.8 miles from shore and therefore would decrease property values, ruin popular areas for yachting, and cause other environmental problems! Anyways, finally in 2021 a different offshore project got green light (Vineyard Wind)

My Takeaway

Like it or not, oil would be around for at least a couple of decades as a sudden transition as some activists are demanding is going to give a serious jolt to the world economy and people’s lives. And the world is just not ready to switch to renewables yet because renewables unit economics’ is not at par with oil & gas. Infact, the United States electric regulator (FERC) said in 2022 in a report that the electric grid cannot handle every household plugging in two electric cars at night. Then there’s the separate topic around rare earth metals and their extraction process.

The best way forward in my view is to encourage utilities to move to renewables where possible and move towards fuel efficient vehicles and public transport. And hope technological advancements and market forces make renewables an attractive option than traditional fuel sources.