Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
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Tesla’s big bet on falling lithium is paying off
Peter Garnry
Chief Investment Strategist
Summary: When Tesla cut its prices by 20% in mid-January it looked like lunacy because the EV-maker operates at a 25% gross margin which would surely compress its margins. Higher inventories by Q4 were an approximate cause but it turns out that the real decision variable was a high risk bet by Elon Musk and the management team that lithium carbonate prices had finally begun falling from its highs. By the time Tesla made its decision lithium carbonate prices were already down 20% and has continued down since down 34% from the peak. Tesla's bet is paying off for now but risks to its margin remain high.
A risky bet by Elon Musk on lithium
When Tesla in mid-January announced that it slashed its prices across its various car models by 20% on average it was a big shock to the car industry as an abrupt price change causes big disruptions in the secondary market. Our initial thought was that a 20% price cut on average is a desperate move considering a gross margin of 25%. It would effectively erode the majority of Tesla’s profits.
The price cuts also led to angry customers that had just bought a new Tesla. Initially we thought that the price cut was to increase demand that had seen a negative impact from higher and more volatile electricity prices in many key markets. Tesla had also raised prices several times in the previous year increasing the price point. When Tesla announced its Q4 deliveries it was clear that inventory was building as deliveries were lower than production which is a bad signal of demand, but it also locks up capital on the balance sheet. While demand considerations were a key decision variable for Tesla something else was happening.
During several speeches in the late part of 2022, Elon Musk expressed his frustration with lithium carbonate prices saying lithium refinery margins were making it a ‘gold mine’ and urged entrepreneurs to enter the industry. Around mid-November the 99.5% lithium carbonate price out of China topped out at CNY 598,000 per tonne and by the time of Tesla’s price cuts the price on lithium carbonate had fallen 20%. This is when Elon Musk and the management made their big bet aggressively cutting prices. It has since worked out for Tesla with lithium carbonate price down 34% from the peak in November offsetting most of Tesla’s hit to its gross margin. However, in the case that lithium carbonate prices should rebound it will eat into Tesla’s gross margin.
One of the reasons why lithium carbonate prices are falling is of course extra supply coming into the market but also CATL’s, China’s largest battery maker, decision to dump prices as it is lowering its margin in its mining division to lower prices on its batteries and fuel demand even more.
EV adoption is continuing at a blistering pace
While we are still waiting for Q4 delivery figures from VW and BMW it is safe to say that EV adoption is acceleration at a blistering pace. By the time we get the Q1 2023 figures it will show that BEV (battery EVs) deliveries will have increased 10x in just three years. With Toyota’s new CEO recently saying that Toyota has made a mistake on hybrids and would chase the BEV technology to catch up with Tesla the whole industry will massively accelerate production in the years to come. Extrapolating the expected trend in EV adoption will create massive changes to our society.
Right now the current fleet of EVs is displacing around 1.5-2mn barrels per day of oil demand with passenger cars only being less than 20% of this displacement. The expected peak in oil demand from road transportation is expected in 2027, but with the current pace it could very likely earlier. By 2050 the oil demand from road transportation could be down more than 20mn barrels per day. If net-zero carbon is achieved then it is closer to 45mn barrels per day. These are some of the points that this transition will cause:
- Oil prices will likely remain high as oil and gas majors will adjust capital expenditures to reflect the rapidly declining oil demand.
- EVs will eventually lead to more stable electricity grids through V2G (vehicle-to-grid discharging) which will happen first in Europe, because the continent has the most advanced electricity grid in the world.
- Air pollutions levels in big cities will drastically improve potentially creating new biodiversity in cities
- Massive growth in electricity production potentially creating the second renaissance of electricity with the first growth phase happening 100 years ago. Electric utilities could transition away from boring stable growth to high growth companies.
- The transition will significantly increase the need for investments and thus add demand for capital underpinning the structural inflation outlook
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