Knowing that ‘economics’ is not the only operative condition whenever China is involved will help us analyse these businesses better in the future.
“The rarest pistol in the world, Larry. A point 45 Luger,” said Gekko. “Only six of them were ever made.” Sir Larry Wildman scoffs off a congratulation before coming straight to the point with, “but rarer still is your interest in Anacott Steel.”
And we all know that ‘Blue horseshoe loves Anacott Steel’, right! The classic 1987 movie, Wall Street, directed by Oliver Stone which all of us must have watched several times.
The scene depicted a typical fight between two corporate raiders, quite a regular feature during the 1980s in the US. Towards the end of that scene when Larry leaves, Gekko’s protégé Bud Fox recites passages from the ‘Art of War’ that he has been reading up to fend-off competition.
Sun Tzu was a Chinese general and military strategist and his book is very well read and quoted. When practiced in the movies, it can be fun. But when it comes to real life, the costs involved are simply too large. China has often put its political objectives ahead of other considerations (economic and environmental) before taking ‘business decisions’, and when dealing with other countries. India has benefited due to this in the chemicals space but had to pay a decent price in the metals industry. Investments in these businesses can gain from a clearer perspective on how China operates.
Last Friday, the leaders of four Quad countries—India, the US, Japan and Australia—held their first virtual summit. Among other things on the agenda, Nikkei newspaper reported on Thursday, was an expectation of working together to secure rare earth metals.
The news article itself was inconspicuous and chances are that you might not have heard of rare earth companies (India has just one and it is not listed— Indian Rare Earths Ltd). But, without rare earths, a typical modern life will fall apart, literally!
The rare earth elements (or rare earth metals) are a set of 17 nearly indistinguishable metals. Despite the name, rare earths are not so much ‘rare to find’, as much as they are ‘rare to process’. A rare earth Cerium is the 25th most abundant element, more abundant than copper. But unlike bulk metals, they don’t occur in concentrates but are rather scattered, and it makes commercially mining these on large scale result in deforestation, contamination of land and water, human rights violation and a few elements are also radioactive.
Difficult and as polluting mining them is, not doing it is not an option—they permeate our everyday life. They are a critical element in digital technologies (vibration motors, electrical componentry, LED screens, speakers, etc.), Automotive (electric motors, AC compressor, braking systems, coolant system, etc), military (guidance and control system, communication and radar technology, electric motors) as well as clean energy (especially wind turbines). Essentially, without them, we cannot operate mobile phones, cars, electric vehicles, wind turbines, bombs, missiles, drones or radars.
Now that we know how important they are, let us look at where they naturally occur. USGS estimates total global reserves of rare earth at c120 million tons, of which 37 percent are in China, 18 percent each in Vietnam and Brazil, 7 percent in India and 4 percent in Australia. Here is the fun part: with 37 percent of rare earth reserves, China, in 2010, accounted for 97 percent of global mine production (120k out of 124k) of rare earths.
Given the environmental implications, the world was happy to let China do the heavy lifting. The former did not know, just yet, how rude a shock it was in for. On one Tuesday in September 2010, the then Chinese Premier Wen Jiabao called for Japan to release a captain who was detained after his vessel collided with two Japanese coast guard vessels as he tried to fish in waters controlled by Japan, but long claimed by China. Wen threatened unspecified further actions if Japan did not comply.
Later, the commerce ministry declined to comment on China’s trade policy on rare earths, saying only that Wen’s comments remained the Chinese government’s position. Until that time, Japan had been a major buyer of Chinese rare earths, using them for a wide range of industrial applications. Alarm bells started ringing loud and clear for the need to diversify the source of a material that virtually controls everyday lives. Things have improved over the previous decade and China now contributes only 58 percent to global rare earth mining.
That was not the first time that China had put national interest above environment and economics. By 2000, it was ready to start building infrastructure for the next generation and needed millions of tons in bulk materials (metals and cement). USGS estimated that China, in 2000, had just 2.8 percent of global bauxite reserves—a key material to make aluminium. Over the next fifteen years, global aluminium consumption more than doubled and China’s accounted for 80 percent of that—spectacular numbers. Despite that, the price of aluminium rose just 59 percent in those years, only marginally beating inflation.
Given such strong consumption growth, prices should have skyrocketed, but they didn’t, primarily on account of China’s make versus import decision. With hardly any bauxite and despite having to import coal to generate power (a key cost in aluminium), China’s aluminium production (at 10 percent of world in 2000) jumped to 50 percent by 2015. In addition, it decided to produce more than required and export the surplus, often at prices where global companies (including Chinese companies) lost money. Why, you might ask! Because the money that Chinese companies lost by selling aluminium was minuscule compared to the cost that China would have incurred had it imported aluminium from other countries (at 2-3x the price).
Over the past seven years, a similar story has developed in the chemicals space as well. In 2013, China passed measures for environment protection and set targets to reduce emissions and followed that up with shutdowns in many provinces. In addition, trade wars between China and the US, which started in 2018, forced a lot of western hemisphere consumers to start looking at India. India did well to develop a niche in complex chemistry (multi-step synthesis) and specialised in specific unit operations like fluorination. Indian chemical companies have benefited immensely—profits have risen three folds over the past seven years and analysts expect them to double over the next two. Stock prices have already skyrocketed, rising more than 20-30x over the past seven years.
In conclusion, I will say that we have historically been trained to evaluate capital-intensive businesses with a keen eye on unit economics. Geographies with the highest raw material resources tend to be among the lowest-cost producers and they acquire scale to become the largest producers and exporters of that commodity. Knowing that ‘economics’ is not the only operative condition whenever China is involved will help us analyse these businesses better in the future.
—Jigar Mistry is the co-founder of Buoyant Capital. The views expressed are personal
Disclaimer: Information in this letter is not intended to be, nor should it be construed as investment, tax or legal advice, or an offer to sell, or a solicitation of any offer to make investments with Buoyant Capital. Prospective investors should rely solely on the Disclosure Document filed with SEBI.
(Edited by : Ajay Vaishnav)