China's tight grip on rare earth elements supply may loosen as other deposits around the world come to fruition in 2012. In this interview with The Critical Metals Report, Jon Hykawy, head of global research with investment bank Byron Capital Markets, discusses the supply and demand fundamentals that are driving his predictions for the New Year.
The Critical Metals Report: Many analysts, including you, expected a shortage of heavy rare earths (HREEs), especially dysprosium, in the medium term. You no longer believe that's true. What changed your outlook?
Jon Hykawy: Dysprosium is used to increase the temperature range in which rare earth magnets can remain active. In high-power applications, dysprosium is used to make a motor that will be useful across a much broader range of climatic conditions and power outputs. Demand is going to be reduced to some extent by new engineering developments in the automotive and wind industries.
On the flipside, we were surprised by the announcements from Matamec Explorations Inc. (MAT:TSX.V; MRHEF:OTCQX) regarding the simplicity of the metallurgy and the low-cost nature of its deposit. There are also as many as four deposits outside of China - in Africa, the former Soviet states and in North America - that appear to be similar to the clay deposits that the Chinese leach to produce their HREE supply. Together, these could provide a sufficient supply of dysprosium, and we do not see other HREEs being in short supply beyond 2014.
We expected to find these clay deposits outside of China. There is no reason why they should be confined to China. The fact that four of these deposits have already been tentatively identified suggests that an awful lot more will be found as we look harder.
Tantalus Rare Earths AG (TAE:Fkft), for instance, has a deposit in Madagascar located in old volcanic calderas. It's a large deposit in its early days, and one Chinese state-owned enterprise has confirmed that it is analogous to Chinese ionic clays.
TCMR: You recently revised your price deck in October. In that new price deck, many of your long-term prices for rare earth elements (REEs) witnessed a decline, but many of your near-term prices witnessed increases. Is this a byproduct of the global economic situation, or is there more to it?
JH: It's a little more complex than that. All of our price decks, whether they reflect long- or short-term projections, are mediated by basic rules of economics. The fact that there is a slightly weaker economy now didn't really have any impact on our price deck as we move toward 2020. The supply situation that we envision has a much greater impact.
There will continue to be a very high availability of some of the light rare earths (LREEs) like lanthanum and cerium, bordering on dramatic oversupply. There could be as much as double what the world really needs in available capacity. The heavies coming into reasonable supply will push the long-term prices of those rare earths down. They'll still remain near the top of their historical ranges, but they certainly won't dramatically exceed those ranges.
The long-term prices we are projecting for some of the core magnet materials, like neodymium and praseodymium, actually rose because demand is being driven largely by the price that the wind industry is willing to pay. That break-even price for the wind industry is somewhere between about $80-90/kilogram (kg) of neodymium.
TCMR: What did you find most shocking in those price revisions?
JH: The one thing I had always thought that I would see is neodymium prices trending over time into the historical range and settling at around $40-50/kg.
A three-megawatt turbine can require two tons (t) of magnets. Companies can't market hundreds of these turbines without being very certain of the magnet supply. It will be necessary for the wind industry and rare earth companies to sign supply agreements that make availability concrete.
If there are supply agreements reached, our assumptions about $40-50 neodymium are shot to pieces. We forecast that neodymium prices could be in the $85-90 range towards 2020. Between our lowering some of the heavy rare earths prices and our raising of neodymium prices, that has a dramatic impact on the net present values (NPVs) of some of the companies in the space.
TCMR: You make the case that lower prices for REEs are ultimately good for juniors that are years away from production because high prices for REEs often mean that end users work even harder to find substitutes, which you define as demand destruction. Tell us a little bit about that.
JH: There's a saying in the commodities: "The best cure for high prices is high prices." There's not a single example in economic history where higher prices led to people wanting to buy more of something. It always drives the consumption down. It's happened in just about every one of the rare earths to date, particularly in some of the light rare earths because they've been the most affected by quotas from the Chinese and the resulting price increases.
For example, lanthanum is a decent catalytic material largely because it's been historically cheap. When lanthanum oxides are selling below $5/kg, companies use a lot of it because, for the money, it's the best you can find. It's been used in many different areas from automotive catalytic converters to fluid catalytic cracking catalysts that turn heavy oils into reasonable quantities of gasoline and diesel.
One of the companies that leads that space is W.R. Grace & Co. (GRA:NYSE), along with BASF Corp. (XETRA:EUR53.17) and the largest producer in North America, Albemarle (ALB:NYSE). Grace & Co. management said in a conference call recently that the company had moved away from using lanthanum in its catalysts for the petroleum industry and had moved back to formulations that contain almost no rare earths. The reason it was transitioning its customers to this product as quickly as possible was because it was a much higher margin product at the prices that it was paying for lanthanum at the time, which were quite high.
The good news from the point of view of the rare earths industry is that as prices come back down to something more reasonable and supply becomes more reliable, especially outside of China, there will be no reason for W.R. Grace and others not to move back toward formulations that contain lanthanum.
We've seen neodymium demand and prices decreasing as well. A good example is Toyota. Toyota uses rare earth magnets in the motors of its Priuses, but it has made the decision recently that its Rav 4 Electric will be built using induction motors that don't contain rare earths in a drive train that's been co-designed by Tesla. We believe the decision is less related to the price of the rare earths than the supply reliability. It's hard to rely on a material that has an uncertain delivery schedule.
TCMR: Companies are circumventing the rare earths to avoid not just pricing spikes, but also supply unpredictability?
JH: Absolutely. They are designing them out entirely. However, Toyota is working with Great Western Minerals Group Ltd. (GWG:TSX.V; GWMGF:OTCQX) and recently said through Toyota Tsusho America Inc. that it's negotiating a joint venture with Matamec. It is working very hard to guarantee the availability of rare earths to its supply chain. Do we expect it to move back toward the use of motors containing rare earths? Absolutely.
TCMR: Why did Toyota choose Matamec, which is a relatively new player in the space, over other more advanced Canadian REEs plays?
JH: We believe that the primary reason is the quality of Matamec's deposit and the simplicity and inexpensive nature of its metallurgy. Similar deposits have required very large quantities of high-concentration acid to dissolve the rare earths and to crack the eudialyte that was contained in these deposits and allow for the extraction of the rare earths. Matamec doesn't have that issue.
Toyota Tsusho established the value of its 49% stake in Matamec in November. Toyota will be responsible for financing the entire Kipawa project in southwest Quebec. Matamec will then pay back its 51% portion of that in a manner to be determined over time. That is a huge plus for the company because it pushes a $180 million (M) capital expenditure off into the future. That's always very positive for NPV.
TCMR: Especially in the current market.
JH: Exactly. It also reduces the risk of the project considerably because a very large Japanese company will bring the required debt and equity to the table and be paid back out of cash flows in the future.
TCMR: What's your 12-month target on Matamec now?
JH: It's $0.95.
TCMR: In August, Frontier Rare Earths Ltd. (FRO:TSX) set an off-take agreement with Korea Resources Corp. (KORES) for the rights to buy up to 40% of rare earth production from the Zandkopsdrift mine in South Africa. Have the terms of off-take agreements become more favorable for larger end-users since the KORES agreement?
JH: No, the terms seem to still be largely market driven. The surprise for me, given the discussions of off-takes that are going on, is that there really has never been any willingness on the part of the large end users to contemplate paying a premium above market for guaranteed supply. In essence, they're coming in and they're providing financing and expertise, and that is buying them the right of first refusal on large quantities of material. That seems to be acceptable to the more-advanced juniors in the space. Juniors are taking the idea to heart that they need to be in production as rapidly as possible with an established partner and are forming the off-take agreements that they believe they need to make that happen.
TCMR: Is there one company that has what we might call the sweetest off-take agreement?
JH: Of the off-takes that are roughly finalized, the most favorable to the junior involved is the Frontier-KORES agreement. A good chunk of the value of the Zandkopsdrift project and Frontier stake that may be acquired will be established by NI 43-101 studies. Feasibility studies tend to overvalue the project to some extent. Frontier has done itself a service by keeping value within the company itself.
TCMR: What's your target on Frontier?
JH: We have a $3.25 target on Frontier.
TCMR: Great Western Minerals is Byron Capital Markets' top pick in the REE space. The firm recently participated in a financing for the company. Does that limit your objectivity on that name?
JH: That's a fun question, but no. We make our picks and do the work on a fundamental basis irrespective of our involvement with a company.
For example, I had a Buy recommendation on Molycorp Inc. (MCP:NYSE) when it did its initial public offering. However, I transitioned to a Sell when I felt the value of Molycorp had gone too high. Now that things have fallen off, we've transitioned back to a Buy recommendation because there's value there.
There is no direct drive between what I do on the research side and what our bankers do. If my clients believe that my objectivity has been spoiled and that I'm touting deals for the sake of pushing some revenue through the door, we quickly would have no clients at all.
We participated in the Great Western deal because Great Western is our top pick in the space, because we do believe there's a great deal of value there and because we would be happy to have our clients own a stock where we are fairly certain that the returns are not going to embarrass us.
TCMR: In a Dec. 1 research report on Great Western, you noted that the company's latest round of financing was not sufficient to complete mine construction and required processing plants. However, you expect additional non-dilutive financing. What form will that financing likely take?
JH: There are two possibilities. GWG's prospective partner, Aichi Steel of the Toyota Group, may provide financing in the form of debt. There's also the prospect for non-dilutive financing in the form of off-take agreements - cash payments up front for guaranteed supplies of material and even perhaps material at a discount later.
TCMR: Who are the likely players to come forward for those agreements?
JH: It could be an entity like Toyota Tsusho that will take the material and sell it within the Toyota group and to outside entities. It could be a group like Albemarle or a BASF, which needs lanthanum and cerium for its catalytic materials, but have been buying those materials from Ganzhou Qiandong Rare Earth Group Co. Ltd. (GQD) (which GWG has partnered with on a solvent extraction joint venture). Knowing that the quality of material out of GWG will be the quality of material that GQD has always produced, there may be a number of offtake partners emerging soon.
TCMR: You recently raised your 12-month target price on Rare Element Resources Ltd. (RES:TSX; REE:NYSE.A) to $18.75 from $17. What informed that decision?
JH: Our price deck was the sole motivation. Understand that Rare Element has a "light" deposit so it produces a fairly large quantity of lanthanum and cerium. We have decreased our long-term prices on lanthanum and cerium because of what we believe is building supply. But Rare Element has a deposit that is probably one of the better, if not the best, sources of neodymium and other magnet materials in the world. As a result of us raising our long-term prices on neodymium, the NPV of the company came up substantially. Rare Element is being ignored to some extent by the rare earths market and investors, but that probably won't persist. Someone's going to notice relatively soon that this is a very cheap way to secure a long-term magnet materials supply.
TCMR: Is there an update on its Bear Lodge project in Wyoming?
JH: There will be updates coming. It certainly completed drilling and we're waiting on some drill results and resource updates shortly.
TCMR: Your price deck changes led to you halving your 12-month target on Ucore Rare Metals Inc. (UCU:TSX.V; UURAF:OTCQX) to $0.65 from $1.30. Nonetheless, you still have a Speculative Buy rating on the junior. Tell us about that dramatic revision.
JH: That was motivated by the fall in our HREE prices and the belief that dysprosium and terbium will potentially be in oversupply in the future because of new types of deposits and technological changes.
Ucore wasn't the only company that suffered that change. In fact, our Matamec price at the time was halved as well. We still think that Ucore has the right address. It is an HREE deposit in the US. We think the US, specifically the Department of Defense, has a very vested interest in making sure that there is a heavy rare earths supply within its borders. State and federal governments are very supportive of this project. It's a straightforward project in the sense that access is good, capital expenditures should remain reasonable and it's more than economical, even with our long-term price deck.
TCMR: What themes do you expect will dominate the REE space in 2012?
JH: There's an interesting beginning of the year shaping up. Chinese quotas will be announced in the early part of 2012. We don't expect dramatic changes in the supply. If anything, the quotas will likely be ratcheted down, but the driving argument there will be that we have not used all of the 2011 quotas. In fact, there still remains substantial export quota for use in 2011. We might even see the export quotas on lanthanum and cerium rise to some extent to try to bring those prices back into a more reasonable range and encourage their use.
The rare earth industry will build up outside of China in 2012. I expect the re-establishment of mining operations in South Africa at Steenkampskraal and the startup of operations at Molycorp. Hopefully, there will be the eminent approval of the Malaysian facility for Lynas Corp. Ltd (LYC:ASX) early in 2012. I think it's going to be a very interesting year.
TCMR: Fascinating. Thanks, Jon.
Jon Hykawy is currently with the research team at Byron Capital Markets, with a specialized focus in the lithium and clean technology/alternative energy industries. Jon holds both a Ph.D. in physics and an MBA from Queen's University and has been working in capital markets as a clean technologies/alternative energy analyst for the last four years. He began his career in the investment industry in 2000, originally working as a technology analyst. His current area of focus is the lithium sector, ranging from availability and production to lithium battery technology. He has extensive experience in the solar, wind and battery industries, conducting significant research in the areas of rechargeable batteries-ranging from rechargeable alkaline to lithium-ion to flow batteries.
1) Brian Sylvester of The Critical Metals Report conducted this interview. He personally and/or her family own shares of the following companies mentioned in this interview: None.2) The following companies mentioned in the interview are sponsors of The Critical Metals Report: Frontier Rare Earths Ltd., Matamec Explorations Inc., Rare Element Resources Ltd., Ucore Rare Metals Inc. Streetwise Reports does not accept stock in exchange for services.
3) Jon Hykawy: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. Jon Hykawy was not paid by Streetwise for participating in this story.
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