How to screw a promising industry

Today I sold all of my Azure Minerals (ASX: AZS) stake into a very active market, for a tidy profit on a position I built in several parcels, including the recent capital raising, and the post capital raising slump in the share price. 

I cannot do anything but praise Tony Rovira and his team.

Azure Minerals and SQM are a perfect match.

You might think I am happy to sell, but I am not.

I am as angry as a cut snake.

The recent market shenanigans in the scuppered Liontown (ASX: LTR) takeover bid by Albemarle (NYSE: ALB), which saw interests associated with Gina Rinehart acquire a blocking stake, which then collapsed the deal, now seem to be playing out with Azure Minerals. Reinhart has now accumulated 18% at or around the bid price of $3.50. 

This looks like it will succeed as a nil-premium blocking stake, on a well-structured deal, that is recommended by the Azure Minerals board.

I am not angry with Ms Rinehart. This is a free market for trading stocks.

Anybody with a trading account can step up and buy.

Who am I so angry with then?

I am as angry as anybody possibly could be with the Australian Government.

Why?

Is this not the government with the much-vaunted Critical Minerals Policy? Are they not going to make us Australians wealthy with a host of shiny new industries?

Superficially, yes. 

However, as I have warned repeatedly in this place:

When you restrict the markets into which a product can be sold, you reduce deal tension, promote a market for influence, and deliver a poor negotiating position for the seller. In my view, this is bad for industry development.

Practically, I think that the Australian Critical Minerals industry will grow slower as a direct result of the Policy Whispering activity of the Australian government.

That is what makes me mad. 

This deal will likely break on a filibuster. That is why I sold. 

This note just explains my reasons.

I do not want to offend business teams who I think are doing a splendid job.

The target I have in focus is poorly framed and poorly executed government policy.

China Challenge policy whispering

What do I mean by the phrase policy whispering? 

Let's illustrate with a quote from this article in the AFR: Rinehart crashes Azure Minerals $1.6b Chilean buyout. That article reports speculation that interests associated with Reinhart have moved to build a potential blocking stake for the acquisition of Azure Minerals by SQM.

That newspaper (correctly in my view) reported:

... SQM isn’t just facing a potentially uneven grip on Azure. The federal government’s Foreign Investment Review Board could also pose a problem for the transaction.

For those who don't know, the Foreign Investment Review Board, is the federal agency that vets takeover and buyout offers for this stated objective:

Australia's foreign investment laws ensure that foreign investments are in our national interest.

Ostensibly, the job of this agency is to knock back investment proposals from foreign entities that are not deemed to be in the national interest of Australia.

This could be for any of a number of sound reasons.

However, under pressure from those voices who advocate for an economic decoupling or de-risking of Australia from Chinese influence, there has been a succession of deals that were blocked, to prevent change of control transactions to China, or even capital raisings.

Nobody is suggesting that the Liontown takeover fell over because of anything FIRB did or might have done. That takeover collapsed because of an on-market raid by Rinehart.

These are delicate matters, and the reporting was considered:

Albemarle appears to have decided over the weekend that it could not work with Mrs Rinehart in the kind of partnership arrangement envisioned by Australia’s richest person and her private company.

That is their decision. They walked away. The share price collapsed, and a capital raising was then done at a steep discount to enable management to proceed with building the mine.

You might say, what of it?

Rinehart lost money on the 19.99% blocking stake her vehicle took, so she lost money also. That is absolutely true, so there is little point in getting angry at Gina.

However, we must ask, when folks drop a bundle on aggressive trading strategies, what the ultimate game plan may be. I am not a mind reader.  Ms. Reinhart is a billionaire. She, like anybody, is entitled to drop money on paper losses in the stock market. Life is uncertain. The stock market is doubly so.

What I cannot abide is signaling by a Federal Minister such as this: China may be cut from critical minerals deals. This is not an actual formal policy. It is this policy whisper:

Resources Minister Madeleine King says “like-minded” foreign investors will be welcome to invest in Australian critical minerals projects, as those developing the next generation of Australian mines warn against excluding China.

What Minister King thinks about SQM buying Azure Minerals is not at issue. The Minister is entitled to think what she thinks. 

The job of adjudicating takeovers lies with the FIRB.

Any Australian government that is serious about maintaining the independence of the Foreign Investment Review Board would be actively reminding the market that Australia is not a place where it is essential to gauge how "alike" your mind is to the current thinking of the Minister.

A sensible government would remind the market that FIRB has a job to do.

However, in the rapidly emerging world of "China Challenge Policy Whispering", it is enough to simply suggest that a potential foreign acquirer may be suspect due to their connections to end markets in China, or China-based processing activities.

The Minister does not need to actually do anything to block a deal.

We must now read her mind to see which foreigners are actually "like-minded" enough.

Nod nod. Wink wink. 

The reality of China as the dominant buyer

I will take it as accepted that China dominates many critical minerals markets. Approximately 97% of Australian sourced lithium ore goes to Chinese buyers, or foreign firms that own plant in China. Two of these are the Chilean giant SQM (NASDAQ: SQM), and the US giant Albemarle. They both have operations worldwide, including in Australia.

This simple fact leads to headlines like: Lithium giant distances itself from billionaire’s attack on China wherein a difference of opinion, on the operating conditions in China, was reported between Mineral Resources (ASX: MIN) CEO Chris Ellison, and their partner Albemarle's CEO Kent Masters. The matter-of-fact response from Mr Masters was:

“We have different views of the geopolitical risk between Australia and China. They’re [MinRes] an Australian company, we’re a US company,” Mr Masters said. “The lithium business is a significant business in China, and we’ve got a significant footprint there and our customers all operate there for the most part.”

All is fair in love and war, or disagreements between business partners.

What we can now assume is that Mr Ellison and Mr Masters are not like-minded investors when it comes to the China Challenge, of having one dominant buyer for the product. They disagree about where the stuff should go.

We don't know if Mr Ellison is "like-minded" with Ms King, but we can safely assume that the globe-trotting Mr Masters is not like-minded with at least one of them.

There has been no reported public difference of opinion between Chilean giant SQM and any of their business partners in Australia. We are disinclined to try and guess with whom, and about what question, they may be most like-minded. I don't actually care.

Forgive me for being blunt:

Business is not an activity best served by finding whose opinions most closely match your own. The business of business is to create viable product, find buyers, and deliver value to the customer, and other stakeholders.

Australia has viable spodumene, the major global hard-rock source of lithium, and China is set up to both buy and process the material to produce battery chemicals for world markets.

I think it is fair to state that I, most probably, am not like-minded with Minister King. Since I am an investor, I am not sure if that makes me welcome in the Australian market for stocks. 

Luckily for me, I am Australian. I am not a foreigner. Minister King can go jump!

Until Ms. King locks me up, I will buy or sell whichever stock I want.

In my view, anybody who is trying to fund and build a mine should do the same with their product. Those who disagree with that advice can go broke. Your decision.

The (ugly) Game Theory at work

You may recall the engrossing biopic a Beautiful Mind about the troubled genius and mathematician, John Forbes Nash Jr., who shared the 1994 Nobel Memorial Prize for Economics, for his contributions to game theory.

You can read the Nobel committee citation for Nash's work, and his co-winners in:

Equilibria in the theory of non-cooperative games.

I won't go into the gory details; I will just show how Gina Reinhart is using this theory well.

The bloodless Wikipedia explanation of game theory describes it thus:

Game theory is the study of mathematical models of strategic interactions among rational agents.

Clear as mud, huh?

We need to bring the theory to life to explain in what manner the Albanese Government made game theory the arbiter of the ultimate outcome for our Critical Minerals Industry.

To do that, we need to at least know the name of the principal concept. The basic idea of game theory was developed by Hungarian genius John von Neumann. He also worked out the basic principles of digital computation that we use today, the so-called Von Neumann architecture.

For those who saw the movie, a Beautiful Mind, you will already know that all of this innovation happened at the start of the last Cold War, back in the 1950s. This was a fun time for anybody who was good at mathematics, since the Cold War presented many strategic puzzles.

The historical figures are all the stuff of legend.

True to the form of genius, they were borderline crackpot. Some proponents of game theory in the context of global nuclear warfare, such as Herman Kahn, were splendid movie material.

We do not, generally, love mathematicians for their person, but for their ideas.

Herman Kahn had some ideas that only Dr Strangelove could love.

You will appreciate that I am not really trying to explain much about game theory to you. The whole purpose of this introduction is to prepare you for a small shock:

Game theory is about finding the least bad outcome in zero or negative sum contests. You should expect its findings to make you a little queasy.

The particular kind of game solved by Nash, to find the legendary Nash Equilibrium, is that where the players do not actively co-operate, and their options are fully known, but where there is a well-defined equilibrium outcome. 

Ergo, somebody "loses less", in some sense.

The Nash Equilibrium

In a moment, I will show the Gina Reinhart version, but let's start with the textbook:

If two players Alice and Bob choose strategies A and B, (A, B) is a Nash equilibrium if Alice has no other strategy available that does better than A at maximising her payoff in response to Bob choosing B, and Bob has no other strategy available that does better than B at maximising his payoff in response to Alice choosing A.

Not clear as mud. Murkier than the muck at the bottom of a tailings dam.

I warned you that you would feel queasy and uncomfortable, so now you are.

The Nash equilibrium, which applies only in certain circumstances, is a situation where you ought to feel uncomfortable. Essentially, it says that the options open to the players are no better than their first strategy. Everything is made rigid by the rules of the game.

This does make sense in the context of events like nuclear war, where there are not really any winners, but some party might come out less damaged than the other one. The best way to ensure that is to have more and better weapons than your opponent.

This example is not strictly a Nash equilibrium, in the formal sense, but you will appreciate the tension. Either you have an arms race, or you stop. You can stop in one of two ways: you could have a war; or you could formulate a treaty. Non-cooperative games are like that.

The idealised game that Nash solved does not really appear in the real world, as competitors can evolve a change in the collective rules of the game to achieve better outcomes.

In the world of business strategy, this is called a win-win outcome.

The first Cold War was a zero to negative sum game. 

The USA "won" by having Russia "lose" and the World "benefited" from massive arsenals of nuclear weapons. I guess you could be happy that our side "won", but it was not without a massive cost in conflict and avoided, or arrested, national development.

It seems that we are in a new Cold War now, so game theory is back with a vengeance.

The Global Critical Minerals Great Game

The Great Game was a nineteenth century name given to then strategic stand-off between the British Empire and the Russian Empire. This was a period of colonial expansion, where each of the two great powers concentrated on putting "pins on the map" to control natural resources.

The United States never did invade Australia, so the Fort Queenscliff deterrence clearly worked! If they came via submarine that would be a problem. Good thing we are buying theirs!

I am joking, of course, but you get the idea.

When game theory animates geopolitics, then, as now, nations will spend a lot of time, energy and money building a bunch of things they may never ever need.

This is the cost paid by those who want to play games.

Once you are in such a game, especially a global one, it is devilishly difficult to transcend the rules of the game, as the players themselves have chosen to set them in rigid fashion.

For those who do not love the dismal science known as economics, game theory is often treated as a foolish exercise in self-limiting strategy played by those who lack the imagination to go exercise their freedom of choice and alter the rules of the game, for mutual benefit.

I am a physicist by training, not an economist, but I do not criticize them for this insight:

Game theory, although self-limiting, has many cogent applications in real life because the human social animal is prone to enforce a social order based on rules of membership. You must play by the rules, or you are out of the game.

If you are a social animal like me, who does not like rigid games, then you will soon find that you are not part of the accepted social order, because you ignored the rules-based-order.

You may have done something foolish, like propose a win-win settlement to conflict.

In some domains of the human condition, this is not acceptable, and will fall foul of the rules of the game, which consist entirely of circumscribed solutions where one party must lose.

I only need to say that, and you know I speak clear and present truth to actual current power.

However, you know you cannot "like" my article because that is against the social rules.

Q.E.D.

Important social theorem. Short and elegant proof.

How is Gina playing the Great Game?

The most important rule of the current Global Critical Minerals Great Game is that all critical minerals are created equal. We love them all to bits, and we urgently need them.

The second most important rule is that not all buyers of critical minerals are created equal.

There are good buyers and there are bad buyers.

Minister King has not made any formal policy announcement on this front, at least not that I am aware of, but has made a clear policy whisper to all and sundry:

China is to be deemed a suspect buyer and investor in our mineral projects.

You might contend that I play fast and loose with the rules of evidence.

I guess you don't read newspapers much.

Once we have partitioned the world into good buyers and bad buyers, then we will know how to spot who is a "like-minded" investor. They will be the people who agree with you on your chosen definition of who, exactly, is a good buyer, and who is a bad buyer.

Once you are done, you will know who your business can actually sell minerals to.

Unless you are like me, you probably don't want to fall foul of social norms and conventions, and so you must consider China to be a "bad buyer". I accept your decision as socially wise but doubt your prospects of successful minerals investment. Here is the tricky bit:

China is variously 50% to 90% of the buying market for critical minerals.

Once the rule says: don't sell to bad buyers, you have a substantially smaller market.

Suppose I agree to only sell my wares to folks who like baroque chamber music played doof-doof style at volumes above eleven? It could well take me a while to find such a person. If I did, I would recommend therapy.

Now that the Australian policy whisper has spread far and wide:

Don't trust China. Don't sell to China. Don't accept investment from China,

we can observe that all deal tension for capital raising in Australian projects has vanished.

Gina Rinehart is, by definition, a good buyer, and a good investor, because she is Australian.

Australians, who wish to play by the rules of the game, now know what those rules are.

This morning, we had this gem of public speculation:

Tianqi Lithium, China’s biggest producer of lithium, owns a 23 per cent stake in the Chilean giant, according to SQM’s company filings of April 11, 2022.

The august organ of policy whispers, then continues:

FIRB has barred a series of lithium deals linked to Chinese money this year, including a takeover Alita Resources – the owner of the Bald Hill lithium mine – by a China-linked company.

The sticking point:

Tianqi already owns a 26 per cent stake in WA’s Greenbushes lithium mine, which boasts the highest grade and largest spodumene deposit in the world. The US battery chemical giant Albemarle owns the remaining stake.

What to do?

SQM, Tianqi Lithium and Albemarle are all actively doing business together!

Shock horror!

That proves that they are like-minded investors, but (most) probably of the suspect kind.

Rinehart can happily buy at the same offer price of any party, acquire a blocking stake, and then see the deal collapse in the present murkiness of active policy whispering.

The government created this situation by amending the FIRB-Protocol with some helpful fuel for speculation. Investors should be "like-minded". There is no explicit statement that they cannot be Chinese, but a dog whistle is heard by every dog, and the cats are no wiser.

What to do?

I am taking off my advice hat.

You need, as an investor, to decide what you will do, personally.

I do not propose any rule as to what that should be, so I am not providing you any advice.

What did I do?

This morning I checked the order book for Azure Minerals and saw over 5,000,000 shares bid openly on a bid price of $3.50 which is the offer price for the Azure bid from SQM.

Since I know game theory well, I sold my entire stake into that bid.

This is about as close to a Nash equilibrium solution as things can ever get in a marketplace.

Normally, any deal breaker would need to bid well over the money to ward off a top-quality suitor like SQM. They have the expertise. They have the balance sheet. They have the processing know-how. They have the end-market relationships to move product.

The problem is that all of those connections are with China.

Incidentally, that is exactly the list of things that an investor like me is looking for.

I want to put money into companies that are serving growth markets, with a strong pipeline of future opportunity. I can do that by buying SQM in the USA, which I have already done.

Why then am I selling Azure?

Simple.

The policy whispering is now so intense that any suitor that has any connection to China, even if completely minor, will be labelled with public innuendo as not being "like-minded".

Gina knows that.

She can happily bid $3.50 for 19.99% and have folks like me sell to her. She knows the game theory, and she knows that I know the game theory. Once the deal is tied up, it becomes a Liontown II, and investors must reckon with a break in the stock price.

When this game is up, through this round, the message will become crystal clear.

Foreign capital should stay out of developing Australian critical minerals.

This is fantastic for a local player who is prepared to lose around 35% on paper, for a blocking stake of 19.99%, so as to secure a cheaper price down the track. The takeover rules impact on how the strategy must be played, to be legally compliant, but it is fairly clear, nonetheless.

I am not angry with Gina for doing this. 

How else could I sell to her?

I reserve my anger for the Australian government.

This is phenomenally bad industry policy in action.

The reason is exactly as I related in my article: Where do the separated rare earths produced by Lynas actually go? I made my point crystal clear:

Purposefully limiting your end market reduces competitive deal tension on selling your final product, limits your growth opportunity, your sources of financing, and your operational flexibility. It just adds to business risk.

If the Australian government continues to scare off capital, this industry will stall.

For savvy players like Rinehart, who can get close enough to the Minister to decode the full dog whistle, these are buying times. Once global capital is scared off, prices will get very cheap.

This is an effective strategy from government to screw a promising industry.

Place everything off limits to the connected and knowledgeable global capital.

Watch the life go out of the junior mining sector.

Do it all with one single policy whisper: 

Be like-minded or go away.

This policy is proving very effective at bringing prices down.

Down to the level of the most like-minded player.