Graphite Update: Syrah's Giant Mine To Start ProductionGraphite Update: Syrah's Giant Mine Is About To Start Production Nov. 17, 2017 jaberwock Long only, value, special situations, growth at reasonable price seekingalpha.com/article/4125958-graphit...ine-start-production Summary World demand for natural flake graphite is growing rapidly, driven primarily by its use in Lithium-ion batteries. However, supply is also about to grow as a large mine in Mozambique begins production. The market will be oversupplied temporarily, but there is scope for new production in the higher flake sizes. Syrah Resources (OTCPK:SYAAF) will be starting production at its Balama mine in Mozambique later this year. In the base metals industry, Balamas 355,000 tonne per year capacity would be considered average, but in the graphite industry, it is a giant. In this article, I review the status of the Balama mine, the prospects for Syrah Resources and the likely effect on the balance of world graphite supply and demand. Graphite prices have risen 20 to 30% over the last six months, following a drop earlier this year. The price increase has been attributed to a combination of increased demand and reduced supply. In September, steel production, the biggest market for natural graphite was up by 5.6% year over year, increasing the demand for natural graphite for refractories and recarburisers. Graphite is also a major component of lithium-ion batteries. Historically, batteries have only been a small component of the overall graphite market, so a large increase in battery demand has only had a minor impact on demand for graphite. However, the torrid rate of growth in battery production for the automotive industry (as illustrated in the chart below) means that battery applications are quickly becoming a significant consumer of both natural and synthetic graphite. Another factor in the additional demand for natural graphite is the trend towards use of a higher percentage of natural versus synthetic graphite in batteries. Synthetic graphite prices have risen dramatically as a result of steel industry growth and a shortage of petroleum coke (the raw material for most synthetic graphite), so this trend is expected to continue. In addition to demand increases, supply has also been constrained by mine shutdowns and tighter environmental restrictions in China. However, the recent price increase may be short-lived, because of a huge increase in supply is expected in 2018. Syrah Resources is about to start production at its Balama mine in Mozambique. Mine and process plant development Syrah has been providing photographs of the progress at the site along with regular updates during the construction of the Balama project. In the latest report, dated October 31st, Syrah states the following: Construction is substantially complete. Front end commissioning and infrastructure is completed. First production of intermediate flake and fines product has been achieved. First production of bagged, saleable flake product is expected in the second half of November 2017. A video from October of this year shows a plant that is very close to completion. Production is about 3 months behind the earlier forecasts, which gave an expected start-up date in August of 2017. Capital costs are coming in at $US210 million versus an estimated cost of $US138 million in the feasibility study (published in July 2015). The 50% cost overrun is disappointing, but not a disaster. Syrah has been able to raise cash to cover the extra cost, which is not significant when amortized over the life of the mine. Future production Production for calendar year 2018 is expected to be between 160,000 and 180,000 tonnes with the production ramp up skewed towards the second half of the year. Calendar year 2019 production is expected to be between 250,000 and 300,000 tonnes subject to global market demand, with an eventual ramp up to the nameplate capacity of 350,000 tonnes per annum. The chart below gives a good indication of just how big this mine is, and how much of an impact it will have on the graphite market. The first year production will be four times higher than the next largest mine, and when the mine is operating at full capacity, it will be bigger than all of the next 20 largest mines together. It will also be in the lowest 25th percentile for operating costs, as shown in the chart below: Graphite market Many forecasts overstate the size of the overall graphite market because they include both natural and synthetic graphite, which are different products that compete in very few sectors. Reports from individual countries are often skewed because some countries report the amount of ore mined rather than the amount of graphite produced. The source I have used is a market study, which was published as part of the feasibility study for the Molo mine planned by Nextsource Materials (OTCQB:NSRC) in Madagascar. That study puts the 2016 world supply of natural graphite at 853,000 tonnes, with a forecast growth rate of 6.3% per year base case, 8.9% upper limit and 5.3% lower limit. The forecast demand is plotted below (blue lines), along with the forecast supply (yellow bars). The supply is based on an assumption of 3% per year growth from other sources, plus the impact of Syrahs production plans (170k in 2018, 275k in 2019 and 350k from 2020 on) In the high demand scenario, the market will be oversupplied from 2018 until 2021, and in the base-case scenario, it will be 2025 before market demand catches up with the extra supply from the Balama mine. As one of the lowest-cost suppliers, Syrah will have the option of lowering prices to drive other suppliers out of the industry (or at least curtail any expansion of production), or they could lower production to meet market demand. The scenario looks somewhat better if you assume no growth in the rest of the industry (graph below). Whatever assumption you make about growth in supply and demand, one thing is certain - the graphite market is moving into a position of oversupply for the next 3 to 4 years, which is likely to reverse the upward price trend and possibly bring prices down to below the levels seen earlier this year. Is Syrah a good investment? Syrah has made a bold move in building such a large graphite mine and processing plant. On the one hand, the company will be a very low-cost producer. On the other hand, selling such large quantities will be a major challenge. Bears will claim that the company has built a facility that is too big, and they will never be able to sell enough product to stay in business. Bulls will argue that the market is growing, and Syrah will be able to dominate that market and drive others out of business. The real story is probably somewhere between those extremes. Syrah recently raised $US86 million from an equity issue, which will be used to provide working capital and to start construction of a spherical graphite plant in the USA (more about that later). There is no shortage of cash, even if the high level of sales fail to materialise, bankruptcy is not likely since the company has no debt. The question is whether or not the future cash flows can justify the lofty valuation, Syrahs market cap stands at $AUS1.2 billion ($US960 million). A feasibility study completed in 2015 estimated operating costs at $US286/tonne of product, FOB port. This forecast has been updated to $US400/tonne in the first year (based on 140 to 160kt production) falling to $US300/tonne when the plant is at full production. The feasibility study in 2015 resulted in a post tax NPV10 of $1.125 million, based on an average graphite price of $US1,017 FOB port (an operating margin of $731/tonne when the plant is at full production). Graphite prices are determined by flake size and purity. The higher flake sizes are more valuable, and higher purity also commands a premium. The table below is taken from the website of Northern Graphite: Current graphite prices US$/tonne (94-97%C) Flake size Price % contained in Syrah ore Basket XL flake (+50 mesh) $1,750/t 8.5% $148.75 Large flake (+80 mesh) $1,150/t 12% $138 Medium flake (+100 to -80 mesh) $950/t 11.5% $109.25 Small flake (-100 mesh) $700/t 68% $476 Basket price $872/tonne Syrahs major problem is its poor flake size distribution. With 68% of product in the small flake category, its average selling price is going to be lower than most other operations. Based on todays graphite prices, operating margins will be around $572/tonne at full production, about 22% lower than the value used in the feasibility study. The post tax NPV will be closer to $US900 million, roughly equal to Syrahs market cap. Based on that, I conclude that Syrah is fully valued and there is not much upside to its current share price. Proposed spherical graphite products plant One possible value driver could be the proposed spherical graphite plant, which Syrah intends to build in Louisiana. Spherical graphite is a modified form of natural graphite that is used in the anodes of lithium ion batteries. A number of potential graphite miners are looking at adding spherical graphite plants to enhance the value of their mining projects. However, I am skeptical of this approach. In a previous article, I criticized both Alabama Graphite (OTCQB:CSPGF) and Graphite One (OTCQB:GPHOF) for using a proposed spherical graphite plant to make a non-viable mining operation look as though it was viable. There are several manufacturers of spherical graphite in Asia, and the capital required to build or expand an existing facility is relatively small. Raw material (graphite concentrate) can be purchased, so there is no real barrier to entry. In spite of the high rate of increase in demand, there will always be competition that limits prices and profits. In Syrahs case, I also question the proposed location of the spherical graphite plant. Syrah has already lined up potential customers in Japan and Korea. It does not seem to make sense to transport graphite from Mozambique to Louisiana for processing, and then ship it back to customers in Asia. What does this new mine mean for other potential graphite suppliers? It is possible to make small flakes from large ones, but it is not possible to make large flakes from small ones, so the oversupply will always tend to be in the smaller flake sizes, as reflected in the price table above. Syrahs product mix will very likely depress prices even further in the sub-100 mesh flake sizes, but not so much in the large flake sizes, so look for opportunities among companies that have a high percentage of large flakes in their concentrate. The table below compares the flake size distribution from Syrah, and four other potential producers. Northern Graphite (OTCQX:NGPHF), Kibaran (OTC:KBBRF), Magnis (OTC:URNXF) and Mason Graphite (OTCQX:MGPHF). All of the above companies have completed feasibility studies for their proposed mines. Since Masons product mix is very similar to Syrahs, it seems that Mason will be the one company to suffer most from an oversupplied market. I wrote about Mason two years ago. Since then, Masons share prices have climbed steadily, and graphite prices have fallen. Masons market cap now exceeds the NPV of the project, which indicates to me that Mason is now significantly overvalued. The progress of both Kibaran and Magnis has been stalled by changing regulations in Tanzania. I will take a closer look at them when the situation is more clear. Northerns progress seems to be stalled by a lack of financing. However, they have been doing more process test work and have been able to produce even better flake sizes and higher purity. They also claim to be able to reduce capital and operating costs compared to their feasibility study. I have Northern on my watch list awaiting an update on this claim. The graphite space is very crowded, there are nearly 200 companies with identified deposits in various stages of study. The ones that succeed will probably be the ones that can produce the high flake sizes, that do not compete with the giant Syrah mine. Disclosure: I am/we are long URNXF, KBBRF.