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The Economics of Stock Analysis: Solar Stocks

May 9th, 2008 · No Comments

These solar energy stocks, like our present favourite Trina Solar (TSL) are terribly volatile as one look at the graph will testify. What is behind that? 

In a curious contrast with its wildly gyrating stock price, Trina sold already almost all of its projected 2008 output, and contracted most of its inputs. Something weird is going on here.

So what drives Trina Solar (and solar stocks in general), our favourite solar play? Why are their stock prices so volatile whilst their businesses seem a paragon of stability?

Let’s list as many stylized facts from the sector as we can think off, that’s usually a good place to start:

  • Demand is rising exponentially.
  • Barriers to entry are relatively low, so there is also a number of new firms coming on-line.
  • Although there seems to be a dominant design, there are rival technologies (most prominently from so-called thin-film producers like FSLR).
  • There is still a good deal of innovation in the sector.
  • A big part of the cost (at least those of the solars using most current technological approach) is formed by a single ingredient, polysilicon.
  • Polysilicon is in short supply and it’s more or less a commodity (meaning there are not too many ways in which the polysilicon from one producer can be distinguished from that of another in terms of performance or quality).

Just listing a few of the characteristics of a sector enables one to describe a few phenomena that any observer of the sector will instantly recognize:

  • Since it’s in short supply and it’s (near) commodity characteristics, polysilicon prices must have really increased.
  • Producers of polysilicon must have handsomely profited.
  • Since polysilicon is in short supply, securing its supply must be a crucial variable driving share prices.
  • High polysilicon prices have provided an opportunity for rival technologies that do not depend on it.

It turns out, these are all born out by reality. Polysilicon prices recently peeped through the $500 barrier, while it cost something in the order of $30 to produce, a good indication of it’s price volatility (more on that later), and how well producers must have done (witness the performance of the shares of WFR).

If companies depending on it announce long-term secured supply contracts, their share prices invariably shoot up, and FSLR, a player which uses a rival (thin-film) technology which does not depend on polysilicon (but cadmium-tellurium, if you must know) is indeed the best performing solar.

But it gets more interesting still if one considers another crucial stylized fact, this time not of the solar sector, but that of polysilicon.

  • The barriers to entry into the polysilicon sector are relatively low.

Now, here we have a near commodity, which is not terribly complicated to produce (just how easy is a hotly debated topic), and there are large incentives to do so, as it can be sold for more than a ten fold multiple of its cost on the spot markets.

That can only mean one thing. The technical means are available to anyone, the motive is in place, so supplies will increase and will lead to a dramatic fall in the price of polysilicon (at least on the spot markets, it depends on the provisions in the long-term contracts how this will be reflected in these).

Moving from a shortage and high polysilicon prices to a world in which there is a glut and prices are low will have very interesting consequences, which we’ll leave for a follow-up. One conclusion will be clear though. Expectations on when that happens will be an prime driver in the shareprices of solars.

The main message will be clear, a little economics goes a long way.

Tags: Economics of stock analysis · Solar sector · TSL