Photo:bibliogrrl, Creative Commons, Flickr
It looks like the glass is always half full at chip equipment giant Applied Materials (AMAT – Last trade $21.04). The company’s Chief Technology Officer, Winfried Hoffmann, said in a recent Reuters interview that he expects tight supplies of polysilicon, a key component in solar cell production, to ease from this year. He projects that the market for solar power will grow by 25%-30% over the next 3-5 years due to the lower costs associated with expanded polysilicon supplies.

This might sound dramatic, but the uncertainty surrounding polysilicon supply threatens the fundamental economics of solar power for the rest of the decade. Growth of solar will undoubtedly be stunted if polysilicon supplies remained tight. The main risk is that large solar panel makers will be exposed to soaring prices for the material and will have to pass them on to consumers, making investment in solar panels unattractive for the average consumer. To read more about the problem, click here, here, here and here.

So much has been said about the polysilicon supply problem, but still the analyst community remains divided. AMAT sees polysilicon supplies easing this year while others, like Jeff Osborne at CIBC World Markets, say that supply/demand equilibrium won’t be reached until after 2010. The lack of consensus on the supply issue provides a great opportunity in the near-term if you buy into the right scenario. But, as is usually the case, a higher potential return comes at the cost of greater risk.

What does the market think of the supply issue? To demonstrate, I have constructed two indices, both made up of five U.S.-listed solar companies. The first index (Index A) is constructed with companies that would do well if the polysilicon supply shortage lasts longer than expected. This index includes polysilicon suppliers and companies that have developed technologies that use smaller amounts of the material to build solar panels. The second index (Index B) consists of companies that would do well if tight supplies of polysilicon have to ease sooner than expected. I have weighted the return achieved since the start of the year, according to market cap. This might seem like a crude methodology, but it proves an interesting point.

It seems the market is willing to pay more for companies that will do well if polysilicon supply problems persist, but it would be incorrect to jump to the conclusion that the market thinks the supply problem is here to stay. Other possible reasons for the premium attached to companies that benefit from the polysilicon shortage:

(1) Investors want to invest in solar technologies, but want to protect themselves against the worst-case scenario of extended supply problems. As a result, they are willing to pay more for this kind of protection.
(2) Given the current need for upstream materials, an “upstream fat, downstream thin” trend is taking root, with higher margins upstream attracting investors.

We will discuss ways to profit from these trends in Part 2.

Disclaimer: I do not own any of the stocks mentioned above. I do not own a solar panel.