Could graphite be the 'next big thing' for commodity traders?

Preparing for opportunity

Advances in automotive battery technology are making graphite the next big thing for commodity investors. Graphite is the critical material for the new generation of batteries, even more than lithium or rare earths. In this special interview with The Mining Report,Focus Graphite President and Chief Operating Officer Don Baxter explains the eyebrow-raising supply/demand picture of the graphite industry, the attractive financials of the Lac Knife project and the significance of the graphite industry's first offtake agreement, including what it means to investors looking to understand an unfamiliar but well-positioned market.

MANAGEMENT Q&A: VIEW FROM THE TOP

The Mining Report: The recent news from Tesla Motors about its plans to build the largest battery factory in the world has generated a lot of investor excitement. Can you give us your perspective on the role of automotive battery technology as the driver of global graphite demand?

Don Baxter: As a starting point, the graphite industry today is about a half million tons per year of natural flake graphite. It is used in everyday products across many industries including steel, automotive and technology. Graphite touches our lives every day. Graphite is in the brake pads in our cars and has many other common applications. But that is not where the excitement in the graphite industry comes from.

The big interest in graphite comes from the growth in lithium-ion battery technology. Sales of electric and hybrid vehicles are increasing every quarter and companies like Tesla are spending heavily on battery technology. Graphite is one of the key materials needed to build a lithium-ion battery. In fact, a lithium-ion battery contains 10 times more graphite than lithium. The most critical material for a high performance lithium-ion battery is graphite, not lithium.

With the accelerating growth of electric and hybrid vehicles, the additional graphite demand from the automotive battery sector could exceed a million tons a year by 2020. That is not including the half million tons that are already used. The world is going to need a lot more graphite. China controls close to 80% of the world's supply right now. That makes battery makers very uncomfortable.

TMR: A tripling of current graphite consumption in less than six years?

DB: Yes. The traditional uses for graphite in the steel and automotive industries will continue because there aren't a lot of substitutes in those applications. In the entire battery segment, we are seeing more and more lithium-ion batteries taking over the market space. Lithium-ion batteries are now the battery of choice in most consumer goods, from laptops to cell phones to power tools and more. Not only are the number of applications growing, but also the size of each battery is getting bigger. Inside a lithium-ion battery, the battery component that is made from graphite is the anode. Anodes can be either synthetic or natural graphite, but synthetic is extremely expensive at approximately $20,000/ton ($20/Kt), compared to battery-grade, natural flake graphite at approximately $8/Kt. Not only does natural flake graphite have a cost advantage, there are several performance characteristics that are better for natural than they are for synthetic.

TMR: What grades or types of graphite are used in the battery sector?

DB: A producer will make a run-of-mine (ROM) product, which is all the different graphite flake sizes at various carbon grades. In the case of our Lac Knife property in Quebec, all of our products (large, medium and fine flake graphite) are 98% carbon. That is a very pure concentrate for ROM production, especially with the fine flake size.

In our case, we'll be able to take our lower valued product, the ROM fine flake, and enhance it by sizing, shaping and purifying. In technical terms, we will micronize and spherize the fine flake graphite to create a battery-grade product with a much higher value than the ROM fine flake. In that case, we will have taken a product that we normally would have sold for $900/ton and turned it into a product worth $8/Kt. Even with an increased all-in cost for that value-added processing of between $1,500 and $2,000/ton, it is a significant margin increase.

TMR: Is the processing of the material at Lac Knife different than at other mines?

DB: Graphite from varied locales behaves differently during processing. The key thing with Lac Knife is that we can divert our fine size material, which is extremely high purity carbon at 98%. That means our purifying step is only from 98% to 99.95%. Other mines typically have much lower carbon grades, say 90% or less. Lower grades make the initial purification step much more difficult. Producers may be able to physically size and shape the graphite, but the purification is the challenge, if it's possible at all. Lac Knife is unique in that we can divert our high-grade fines to battery applications.

TMR: Are the upgrading to battery grade and the associated much higher revenue products included in the initial financial models on your website?

DB: No. All of our current financials are based on run-of-mine product, which is the market that is here today. The Industrial Minerals publication out of the U.K. publishes prices for different sizes and grades of graphite flake and we base our economics on those figures. The analysis shows that the Lac Knife deposit is profitable at today's market prices. That said, we think that we are at the bottom of this price cycle, so we're basing our economics on current market prices.

Based on today's prices, our economics show great potential, even with what appear to be low market prices. Additional upside will come from value-added processing, which we are advancing in parallel. Once we have the capital expenses (capex) and operating expenses for the value-added processes, we can then add that into our overall economics. There is a tremendous upside based on the high margin of the value-added processing, but it will be a gradual process to get that part of the business up and running because it is dependent on the initial ROM production.

If everything works out, we would start off with several thousand tons a year going through the process of making battery-grade graphite. Over time and with expansion, we could increase our ability to produce battery grade and spherical graphite as the market demands it. Ultimately, could we put all of our flake into it? Maybe, but for starters, we are basing our project build on conventional mining, which in the case of Lac Knife is a high margin project. Additional margin from value-added processing is a long-term option.

TMR: So are you saying that the prefeasibility study does not and the full feasibility study will not reflect any additional revenue or expense from the potential production of spherical or battery-grade graphite by Focus Graphite Inc. (FMS:TSX.V; FCSMF:OTCQX; FKC:FSE)?

DB: Correct. While we are working in parallel with the design of our value-added processing and our ROM processing, the former is not likely to be ready at the time of the overall mine feasibility design. But it will be close. In a sense, the value-added projects keep us as an innovator and a development-stage company longer, so that investors will have a more interesting news flow and more upside over a longer time period.

TMR: Graphite has been an investment theme for a few years. There are a lot of companies that are moving toward production. Is the market looking at a tidal wave of graphite coming on-line soon?

DB: I don't think so. At the end of the last economic cycle everybody suddenly noticed graphite. The market went from two companies, Northern Graphite and Focus Graphite Inc., to 50 or 60 companies. There may now be as many as 135 different companies and probably several hundred graphite projects at various stages. However, the leader board is pretty small. There's a long lead time from grassroots exploration to production. In many cases these graphite properties, once you get into the metallurgy, just may not work. I don't see a tidal wave of new mine supply coming to market. I see possibly two or three new producing mines in the next three or four years.

TMR: What will that new supply do to the market?

DB: The market can handle that quite well. We expect to see prices trending up through 2016. As demand returns, we have to remember that there were no new mines built in the last economic cycle, so the problem is going to be that much more acute. The time to be building to reach that demand is now. We are excited that Lac Knife shows extremely good economics now, at the bottom of the market. It will get even better as prices start to tick up. By the time we're in production, which should be mid-2016, prices could possibly be as much as $1,000/ton higher than today.

Investors need to keep in mind that with so many components to a graphite deposit, they have to look at each opportunity very carefully. When the market evaluates all the deposits out there, many won't make the cut and a lot of those companies will just disappear.

TMR: Can you give us an overview of Lac Knife and what makes it a standout project?

DB: The Lac Knife deposit is a 9.5 million ton Measured and Indicated resource at 15% Cg (graphitic carbon). It has excellent infrastructure with road, rail and seaport links and immediate access to the electrical grid. The deposit is at surface and will be a low cost, open-pit mine. The low cost mining method is critical. Another important feature of a commercial graphite deposit is a good distribution of large, medium and fine flake in the ore; that is a feature of Lac Knife. We have demonstrated in our pilot plant that we can recover a potentially economic proportion of the large, medium and fine flake graphite at extremely high-grade carbon. We're able to remove the flake from the rock while preserving its size and keeping it clean.

The nature of the Lac Knife deposit allows us to produce a high-grade concentrate based upon our ROM crushing, grinding and floatation process, entirely by mechanical means. Our ROM production does not have a purification step through a third party. We're able to get the Lac Knife flake extremely clean—even the fine sizes. Most deposits can't do that.

TMR: The financials based on the prefeasibility study or Preliminary Economic Assessment showed about a $126 million ($126M) capex, including a $25M contingency and a nearly 40% internal rate of return (IRR). Can you give us an overview of those financials?

DB: The $126M capex is low for a mining project if you compare it to copper, nickel or gold, which many investors are more familiar with. Compared to those same industries, the IRR is fairly high. Taken together, it is a compelling and unique combination in the graphite industry. A lot of people don't understand graphite, but they understand a good investment and a high rate of return.

Because we think we are now at the price cycle bottom, the project looks extremely good. The net present value at an 8% discount rate comes in at $317M in pretax numbers with a short 2.4-year payback. From a mining industry perspective, that's pretty inviting.

TMR: What is the significance of the offtake agreement that Focus recently signed?

DB: The offtake agreement was a first in the graphite industry. There have been some long-term relationships, but as far as having an offtake agreement directly with an end-user, the agreement is historic.

The significance of the offtake agreement is that it demonstrates we can sell our product. No one asks gold, nickel or copper producers if they can sell their product. For those minerals, there are active commodity markets. Not so in graphite. If I am talking to mine financiers about a graphite project, the first thing they will say is, "How will you sell it?" The offtake agreement removes much of that uncertainty and is proof that we can sell our product.

The offtake agreement has a 10-year term and was signed with a Chinese conglomerate. This further underpins what we've been saying about the Chinese domestic graphite supply situation. Even within China, people are concerned about a reliable supply. The agreement has a 20,000 ton per year (20 Ktpa) minimum offtake with provisions for up to 90% offtake. Potentially up to 90% of our production could be spoken for. Prices will be set based on current market prices, so if prices rise as we expect, our upside will be protected. The material is all FOB Québec, so we are not paying to ship it to China.

The offtake agreement has had several follow-on positive effects. It has increased the urgency to line up supplies for some battery manufacturers, companies that may have been a little slow out of the gate but are now suddenly nervous about the availability of supply given the growth prospects. Another positive effect of the offtake agreement is that it leaves us room to advance our value-added processing goals. And the offtake agreement advances the company toward production in that it makes the whole financing step that much easier.

Next page: The role of financing

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