Events Trader #29: A long-term play on the end of the 'Age of Oil'

17th November 2009

• A long-term play on the end of the Age of Oil'
• Why demand for lithium is set to surge

Dear subscriber,

Welcome back. Today I want to talk about an interesting way to play the desire to find new forms of energy, whether that's because people are worried about climate change, or because there are fears over oil running out.

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As others have pointed out in the past, the "stone age" did not end because we ran out of stones. It ended because mankind found a better technology to replace the old stone tools. In a similar way, I expect the "oil age" to end not because we run out of oil, but because we find better technologies which will allow mankind to harvest new sources of energies such as wind, solar, tidal, nuclear (possibly based on the fission of elements such as thorium, which do not produce radioactivity) and other forms of power generation.

The problem with these technologies, is that most (other than nuclear) produce power when it's available, rather than when it's needed. That means we need to develop a large network to store all the surplus energy before it is consumed.

What the future could hold

My vision of the future is that we will have a blend of all these renewable energies, coupled with a smart grid' that distributes electricity more efficiently, alongside lots of energy storage units. These units could be giant batteries housed in warehouses, or a fleet of battery-powered electric cars which are recharged at night and can also be used to power your domestic appliances. Either way, you'll still need to develop batteries to store the electricity when produced.

So on the one hand we can expect to see increased energy production via renewable sources, and on the other we will have growing demand for more intelligent energy distribution and better storage. How can we make money from this?

Well, in my view, alternative energy stocks are already in a bubble. Even if a few clear winners emerge, you could still end up like investors in the internet sector in 2000. Even those who backed long-term winners still ended up losing money (indeed, those who bought Amazon at the peak of the market have only recently broke even).

In the alternative energy sector, you could probably back companies which produce thin-film solar cell technologies, but I believe that you should steer clear of anyone manufacturing other types of solar cells or wind turbines, as their design needs to be simple and therefore can be copied. Upgrading to the smart grid could be a tricky one to play, as the task of doing so will probably be done by existing operators such as National Grid in the UK, and purer plays on the sector have already risen dramatically in price. So I reckon our best bet is to focus on energy storage or batteries.

As you know, there are many different types of battery. Disposable batteries, the most common type, are zinc carbon or alkaline. You also have the lead-acid batteries used in cars. However, the most promising technology is the lithium-ion battery. You have one of these in your mobile phone for example. This type of battery has the most energy density, and could very well be the basis for the next generation of energy infrastructure, and for electric cars.

Existing battery producers are vulnerable to change

Let's take a quick look at the existing battery producers. The two largest plays in the sector are Energizer (US: ENR) and Spectrum Brands (OB: SPEB) (which produces the Rayovac brand). Both focus on producing disposable batteries. But I think a seismic shift is coming in the next few years. The ordinary disposable battery will go the same way as old analogue camera and film producers - they will become nigh-on extinct. To get an idea of what could happen, just have a look at Eastman Kodak's share price over the last 20 years.

I'm basing my assumption on a simple observation. A new generation of rechargeable batteries has come onto the market in the last two years. These nickel-metal hydride batteries cost slightly more than ordinary branded ones (£5 versus £3), but they last longer, and being rechargeable, you can get at least a few years' use out of them.

So you'd expect this type of rechargeable, high-density battery to become dominant, which could well lead to the sector shrinking. This would hurt the sales and above all the profits of companies that are producing the old-style batters.

This will be difficult to play in the stock market, as it will happen over the course of a few quarters if not years, and it would be hard to remain short over such a long period of time. On top of that, Spectrum Brands has just re-emerged out of Chapter 11 protection, and could deliver a few decent quarters.

Lithium the best play on the future of batteries

Going back to the original argument, I think the lithium-ion battery could be the dominant force in the future. But unless we have some major breakthroughs, the technologies involved in the production of this type of battery are pretty much known, and the product has now been commoditized (in other words, producers have to compete on cost rather than any other benefits).

Given this, if you consider the huge growth in lithium demand that's expected to come on stream once electric cars are being produced, then the balance of power lies not with the battery producers but with the lithium miners.

Lithium is can be found more or less everywhere in small concentrations. It is usually found in minerals and brine, but because of its high reactivity and the afore-mentioned low concentration it can be quite expensive to extract. Almost all of the current world production of lithium come from the giant salt flat fields that straddle the borders of Bolivia, Argentina and Chile in South America.

It is currently produced by electrolysis of brine pools which contain the metal and potassium chloride.

Which lithium miners can you buy?

As you can imagine, the list of potential plays is quite thin. There are two main companies that mine lithium and both have substantial amounts of other assets and are not pure plays. Sociedad Quimica y Minera de Chile (US: SQM) is the first. The company is based in Chile, but trades in New York and is currently trading at $39 a share, having been as low as $1.84 in 2002. The other miner is FMC Corporation (US: FMC) which is based in the US and produces an array of chemical compounds, including lithium.

There are also a couple of small exploration companies which might be of interest. The first is Orocobre (ASX: ORE) , a small Australian company which is trying to develop various mining projects in Argentina focusing on lithium, boron and other minerals. The second is Latin America Minerals Holding (CN: LAT) , which holds a 31% equity stake in Lithium Americas; the company is based in Canada and is trying to develop mining projects in South America with a focus on gold , lithium and other minerals.

Strategy and risks

For now, let's wait. I expect markets to be choppy next year and this volatility could provide an entry point. As you can see, some of these stocks have performed really well over the past few years on the back of the mining boom, and could prove extremely volatile. On top of that, the risks involved in the two explorers are extreme. You could lose all your capital. As you know, investing in small exploration companies that look for resources is incredibly dangerous, as most such ventures run out of capital and fail.

This is a long-term trade, and once we decide to buy we will leave the position open for a long time. If you trade this type of disrupting' story, the risk is that you sell too soon.

I will study these companies in more detail and will let you know what I think and what I have found out. I will also look for new opportunities and new names in the sector. If you have a strong view on the subject, I would love to hear your opinion just contact me at eventstrader@f-s-p.co.uk.

Riccardo Marzi

Events Trader

Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Some shares recommended may be denominated in a currency other than sterling. The return from such shares may increase or decrease as a result of currency fluctuations. Please seek independent personal advice if necessary.

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