The rare-earth sector enjoyed the strongest month yet in August since awakening in late April as media buzz about security of supply issues expanded into the mainstream. Even the New York Times has taken note through a Sept. 1, 2009 article ("China Tightens Grip on Rare Minerals") that quotes prominent sector observers such as Jack Lifton and Dudley Kingsnorth but reveals a latent knowledge gap by placing Avalon's Thor Lake project in northwestern Australia rather than Canada's Northwest Territories.
The trigger occurred on Aug. 18, 2009, when Arafura Resources Ltd., an Australia developer of a rare earth deposit that is now controlled 25% by a Chinese state-owned mining company, broadcast far and wide news that China's Ministry of Industry and Information Technology had published a draft report entitled "Rare Earths Industry Development Plan 2009-2015" which outlines plans to further tighten control of the supply of rare earth oxides and their downstream products. The draft report apparently includes a plan to ban outright the export of dysprosium, terbium and ytterbium, though since then Chinese officials have back-pedaled on this proposal.
These rare earth elements belong to a group classified as "heavy," which usually occur together in meaningful quantities in peralkaline intrusive complexes such as Thor Lake, Strange Lake, Bokan, and Kipawa, the flagship projects of Avalon, Quest, Ucore and Matamec, but not in carbonatite intrusive complexes such as Mountain Pass, Mt Weld, Bear Lodge, and Hoidas Lake, the flagship projects of Molycorp, Lynas, Rare Element and Great Western. Although there have been rumblings for several years in end-user circles about long term security of supply problems involving rare earth elements, this overt sign that Chinese officials are also thinking hard about the problem has ignited serious interest in companies with rare earth deposits outside of China.
My KBFO Rare Earth Index reveals that the half dozen initial members enjoyed a bullish phase from early 2007 until the market crash in September 2008 which reached its nadir in January 2009 when investment bankers pulled the plug on Lynas Corp's Mt Weld project by withdrawing a $100 million convertible debenture financing that results in the collapse of an even larger senior loan facility. The index came alive again in April 2009 when Lynas agreed to a combination equity debt financing from a Chinese government owned company which would finance the completion of the Mt Weld construction plan and give the Chinese company majority control of Lynas. This proposal has attracted the scrutiny of Australian regulators whose concern about foreign ownership has intensified amid the rising media buzz about rare earths and Chinese machinations involving mining giant Rio Tinto and iron ore prices. Since then the Rare Earth Index has gained more than 700% with help through the addition of six juniors with advanced rare earth projects, significantly outperforming gold and the TSXV during this period. This remarkable gain is due in part to the very low stock prices of the recent additions created by the Crash of 2008, but volume is flowing into the Australian and Canadian listed members of the Rare Earth Index at current prices and there is every indication that this market activity is just the beginning of a Rare Earth Mania.
We have admittedly tracked a surprise "green shoots" rally in senior equities which in my view is based on a lot of wishful thinking about the speed with which the American consumer will bounce back, and as we head into the fall I am concerned that this senior stock dead cat bounce will start to sag and potentially drag down our small rare earth sector. Barring another catastrophic financial crisis, I do think gold will continue to hold its head up and mount what may finally be an enduringly successful assault on the $1,000 milestone, which could shore up market interest in non-gold speculative resource juniors even while the senior equity rally fizzles. But I wish to make the case that the members of the Rare Earth Index are participating in a Rare Earth Mania that has barely begun and can flourish regardless of the troubles that may emerge in other sectors.
Some market observers have been dismissive of the rare earth juniors and even suggested that they make good short-selling candidates. Because Rare Earth Mania is still in its infancy there is a lot of volatility in this sector that can be exploited by nimble traders. But it would be foolish to put a serious rare earth short position in place, because these stocks are literally a tail wagged by a very big dog whose nature was made crystal clear in August through the Chinese draft report on China's plans for the rare earth sector. One could argue that the draft report is a trial balloon floated by China to gauge international reaction to a policy that can be interpreted as trade protectionism. Judging by the broadening of media coverage the report spawned one ought to be concerned that the Chinese will retreat from the plan and perhaps even pull off a "gotcha" on non-Chinese mine developers who have benefited from the rare earth media buzz. But I think the Chinese are serious, if only because the rare earth sector is still quite small in value terms, all things considered, and not worth working up western manufacturers and militaries into a tizzy. Most of the Chinese light rare earth production comes as a byproduct of the giant Baiyan Obo iron mine, while its heavy rare earth production comes from the south China ion adsorption clays. Baiyun Obo has huge reserves that could conceivably supply the world for centuries, but there are physical throughput constraints related to the logistics of mining a single deposit which would prevent Baiyun Obo from completely supplying annual demand during the next few decades, particularly if new technologies emerge and large scale commercialization of "cleantech" applications such as wind turbines and hybrid or electric vehicles occurs. With regard to the light rare earths such as lanthanum and neodymium China appears to be pursuing a policy of forcing manufacturers of goods that require these rare earths as inputs to base their component manufacturing facilities in China.
This indirect form of economic protectionism will not sit well with free market ideologues who prefer raw materials to be extracted and sold on global markets to the highest bidder. The famous quote from Deng Xiaoping that "rare earths will be for China what oil was for Saudi Arabia" is viewed as a warning when it gets repeated in articles about rare earth supply, but it is a somewhat incoherent statement by China's former leader. Oil is a bulky energy fuel that has to be transported to the location where the work is to be done and at current consumption rates represents an annual market worth $2 trillion at $75 per barrel oil. It is not conceivable that Saudi Arabia would insist that all its oil production has to be burned on Saudi soil, though in the long run when oil's role as a transportation fuel has shrunk to diesel and its primary use is as an input for the plastics industry, it will likely be the case that Saudi Arabia will restrict the export of crude oil in order to supply a domestic diesel refining and plastics industry. Rare earths, in contrast, are an incremental raw material input for manufactured goods whose annual demand has a value in the order of only $1-$2 billion. That is a puny amount and raises the question as to why such a fuss is growing in the media about the security of rare earth supply.
Rare earths have special properties which new technologies tap to bestow efficiencies and functionalities onto physical goods such as super magnets and energy efficient lights. They accomplish this in a way where there is no substitute outside the rare earth element group itself, and they do this by being a tiny physical input to the end product which also represents a fraction of the product's final cost. The suppliers of rare earths thus have pricing power in that they could quadruple the price without affecting the end-product's demand, which could conceivably boost the annual value of rare earth oxide production into the $5-$10 billion range. Because China currently supplies more than 90% of the world's rare earth production it has a near monopoly that should enable it to boost prices by restricting supply. But China has strategic and economic reasons not to pursue a cartel strategy.
China is dealing with a new problem in the form of reduced export demand for consumer goods arising from the collapse of the global real estate bubble and the locking of the home ATM machine. Offsetting that drop is a transformational demand arising from the retail sector's desire for goods that are more efficient and have a smaller global impact, as well as from a state level desire for alternative energy based infrastructure. So while a new frugality pervades the consumer consciousness with regard to the consumption of "stuff" for which the advertising manufactured "need" has collided with the disappearance of debt financing and long term economic uncertainty, there is a willingness to make "infrastructure" related purchases which offer cost efficiency, durability, and to some degree an emotional dividend arising from making a choice that involves short term personal sacrifice in return for creating a generalized good. Nowhere was this more apparent than in the American Cash for Clunkers program where consumers traded in their oil industry endorsed gas guzzling
Detroit pigs for new cars with significantly higher fuel efficiency in the lower price category and hybrid cars with the cachet of a lighter overall footprint in the higher price category. "Infrastructure" spending from the personal to institutional scale will be the driving engine of the global economy for the next decade, and China knows it, because that is what it is pushing at its own domestic level. China thus looks at its near monopoly in rare earth supply as a way to achieve its economic goal of becoming a primary supplier to the rest of the world of manufactured "infrastructural" goods which derive their "cleantech" virtue from rare earth inputs.
China is also very keen to pursue its strategic goal of transforming its own economy into one with a smaller environmental footprint and lower energy import dependency. It is no secret that the 2008 Beijing Olympics shocked China into an intense awareness of how its production and energy consumption processes were polluting its environment, and that China is well aware that its access to raw materials from around the world depends on the approval of the eyes in the sky of the world's military hegemon, the United States, a nation whose overwhelming status as the world's biggest economy is on a relative long term diminution track that is bound to generate political crankiness down the road. During the past year China has adopted a new resolve to clean up its environmental act and develop energy infrastructure which does not depend on burning coal or gasoline. China admittedly has no interest in signing onto global climate change control agreements, and with some justification argues that developing nations should not have to meet the same emission control standards as nations who developed their own economies to their current mature condition by trashing the global environment. But China's long term commitment to emission control is already in the bag, because not only is China wary of dependency on foreign oil and the geopolitical stresses that "peak oil" will engender in the coming decades, it has no desire to celebrate the eventual achievement of its "manifest destiny" as the greatest nation ever in a cesspool. So while the sunset economies of the west bicker about religion, "liberal" science, and the right to bear arms and have no health insurance, China's central command leadership will bludgeon its masses into accepting a green economy.
China's ambitious nuclear energy plans stand in sharp contrast to the reluctance in North American and Europe to construct new nuclear power plants. The UraMania that played out from 2004-2008 reflected the growing realization that the existing uranium supply infrastructure cannot meet future demand for uranium as fuel for nuclear energy. The problem has not disappeared, but the market has become more aware that the need to solve it is not immediate, and the best uranium deposits located in many parts of the world will eventually be brought into production to meet projected demand growth. While there is some similarity between rare earths and uranium in that uranium's use as a fuel represents less than 5% of the cost of building and operating a nuclear power plant, and thus have a degree of demand inelasticity to higher prices, they differ in that uranium's long term demand growth depends on the construction of new power plants, which have approval and development timelines that are much longer than uranium mine development timelines. In contrast, rare earths have open-ended application and commercialization potential, especially given that the world is experiencing a new wave of funding for advanced materials research, and is struggling for alternative solutions to the dual problem of climate change and fossil fuel dependency. It is thus possible for annual demand to grow more than tenfold over the next 20 years, and that would strain China's own supply capacity, especially with regard to the heavy rare earth elements which are mined from low grade clay deposits that have an erosional origin. In other words, more of these deposits are not going to be found by drilling "deeper". Unlike uranium, the future demand for rare earths is "wild", difficult to quantify, and, to a large degree a function of projected supply. China's proposed ban on the export of dysprosium, terbium and ytterbium has less to do with its economic manufacturing goal than it does with internal concern over the security of its own heavy rare earth supply.
The so-called "heavy rare earth elements" represent less than 5% of global production by weight, but may represent as much as 40% of the value of annual production. They are expensive because they are rare in concentrated form, their demand is not overly sensitive to price, and because they are typically tied up in complex minerals from which their extraction is expensive. While the light rare earth neodymium is becoming well known as the magic ingredient that makes the magnet in a wind turbine or Prius hybrid "super", the addition of dysprosium to a neodymium based magnet enables the magnet to retain its magnetism under high temperature conditions such as you might find under the hood of a Prius. During the eighties when the United States was last concerned about rare earths the applications for many of the heavy rare earth elements were largely of a military nature and global demand was small. During the nineties Chinese production of both light and heavy rare earth oxides flooded the world with the result that existing operations such as Mountain Pass were shut down and lower grade deposits outside China on which companies like Unocal, Hecla and Iron Ore Company had conducted feasibility studies were shelved and in most cases either allowed to lapse or revert to their original private owners. Chinese light rare earth production was cheap because it benefited from being by-product production of the Baiyun Obo iron mine, and the heavy rare earth production, although involving very low grades, was cheap because the clay deposits did not require cracking of the complex mineralogies that characterize bedrock deposits of a magmatic and/or hydrothermal origin. Because of an apparent super-abundance relative to global demand China allowed inefficient and environmentally destructive production methods which recovered less than 50% of the ionic clay deposits' HREE content. The draft report's proposal to consolidate mining and processing operations reflects a sudden awakening to the reality that not only are these ionic clay deposits finite, but they are conceivably inadequate to serve long term global demand. By shutting down inefficient operations and banning the export of certain heavy rare earth elements, China would extend the life of its HREE resource and assure security of supply for its domestic needs. And if in doing so the car manufacturers have to source their super magnets from China based production facilities, so much the better for China's export economy.
The rare earth market is presently very small, and even if it grows five-fold, it will still be too small to justify policies guaranteed to annoy China's trading partners and raise the specter of protectionism. The "how could they" tone of rare earth media coverage misses the mark. China's actions with regard to rare earth supply are completely defensible, and it is nonsense for media pundits to grumble about it righteously. The rare earth media buzz is now largely focused on China's supply restriction plans and the potential impact that might have on the green economy, which makes this an issue of anticipation rather than immediate trouble. The crunch is probably still 4-6 years down the road, which also happens to be the time needed to bring an existing rare earth deposit into production. Unfortunately, because business and policy strategies have long implementation timelines, the time for action on the rare earth security of supply front is now or never. There is thus a risk that Rare Earth Mania will be a flash-in-the-pan that is only a vague memory a year from now, much as I suspect will be the case with the lithium buzz making the rounds.
The lithium buzz is based on a misguided expectation that large scale commercialization of lithium-ion battery based plug-in hybrid and electric vehicles will start to happen in a year or two, and the delusion that there is a security of supply problem with lithium. A car sized lithium ion battery will not be ready for large scale commercialization for at least another five years, by which time Bolivia may have gotten its act together with regard to developing its very large lithium brine resources. Because of the ubiquity of gas stations and a reluctance among consumers to accept the range restrictions and recharging cycles for the first generation of electric vehicles, I expect an ordinary hybrid such as the Prius and its other Japanese competitors to dominate the car market during the next decade. The urgency to develop security of supply for rare earths, which are necessary for electric vehicles and have applications unrelated to the viability of the lithium ion battery, is high and immediate. Car manufacturers need to know right now whether or not in five years they will have a non-Chinese supply of rare earths for their components, which is why companies such as Toyota and Mitsubishi are already developing relationships with junior companies that have rare earth projects.
Deng Xiaoping's declaration that "rare earths will be for China what oil is for Saudi Arabia" is simply false. China does not have a monopoly on rare earth deposits. All it has had is a production cost advantage which is disappearing as the need to expand supply to match growing global demand develops, and as China adopts policies which serve its own strategic and economic goals. There are significant rare earth deposits that include the heavy rare earth elements outside of China, and most of these happen to be owned by publicly traded resource juniors which either found them or acquired them when their development economics were hopelessly weak. These are few and far between, though in the long run if rare earth oxide prices move substantially higher and stabilize at those levels, global exploration will uncover abundant new resources. But that is a big and improbable "if". Unlike the case with uranium deposits which occur in a variety of grades and sizes all over the world, significantly enriched rare earth deposits only occur in regions geologically conducive to the development of carbonatite or peralkaline intrusive complexes. The key idea here is that of a major system which allowed for the concentration of rare earth elements; rare earths are ubiquitous in the earth's crust at background levels or as localized showings in other geological complexes. But they are rare in high grades and locally large tonnage.
If Rare Earth Mania takes off as I expect, within a year there will be more than a hundred juniors yapping about this or that rare earth showing, just as happened with UraMania in 2004-2008. Some of these early stage exploration efforts may pay off with a major new discovery (for example, Quest's Misery Lake project which I visited in late August as part of my Strange Lake trip), but we probably will not know before 2011. The exploration timeline for a rare earth project is as bad as that of the diamond exploration cycle because of the critical importance of developing an optimal metallurgical process; don't expect a grassroots rare earth project to be a mine before 6-10 years from now even if Rare Earth Mania stays hot for more than a year or so. Exploration waves during the sixties, seventies and eighties investigated most of the more obvious intrusive complexes, with the result that historical resource estimates exist for a couple dozen rare earth deposits in the world.
The next phase for the rare earth media buzz is the recognition that these deposits exist and need to be raced into production. Because rare earths are similar to industrial minerals which are sold through private supply channels there are no commodity markets for futures speculation as is the case with base and precious metals. There are thus no obvious ways to profit from all this rare earth media buzz, with the resulting risk that the media and its public will lose interest in this story. However, there is money to be made by investing in the dozen or so juniors which are in a position to bring an existing deposit into production over the next 4-6 years. During the next year I expect another dozen such serious projects to show up under the control of resource juniors. If we are to have a Rare Earth Mania of the sort envisioned by mass market specialist Jim Dines, who declared himself the Original Rare Earth on Memorial Day weekend in May, it will have to be because the market recognizes that these juniors hold the solution to a very serious problem, and the key to that solution is fast-track financing to develop these projects. The juniors that own these rare earth deposits will be the mouse that roared.
I have assembled a dozen Australian and Canadian listed juniors into a KBFO Rare Earth Index with January 2, 2004, as the starting date. Because of the limited number of advanced rare earth projects that could be acquired by juniors, I doubt the number of Rare Earth Index members will more than double over the next year. I have added companies to the index when it became clear that the company was making its advanced rare earth project its primary focus, even though it may have owned the deposit for several years. I have included Neo Materials in the index at the start because, although it has neither an advanced rare earth project nor had rare earth production, it has been the only Canadian company focused on the sourcing of rare earth oxides in China for downstream processing since the early nineties. Furthermore, the changing strategic and economic goals of China are forcing Neo Materials to seek control of rare earth supply outside of China, which means before long it will have an advanced rare earth project. Historically we have seen cases where a raw material producer wanders down the supply pipeline to become involved with the production of value-added downstream products. Very rarely have we seen a downstream manufacturer wander upstream to become a producer of the raw materials it needs for its downstream operations, largely because mining is best left to mining companies. But the rare earth space is unusual in that processing rare earth ore is the primary challenge facing any rare earth mine, first to crack the rare earth oxides out of the minerals in which they are embedded, then separate the individual oxides from the concentrate, and finally to refine the oxides into pure metals that can be incorporated into alloys and other products. The in-house skill set of a downstream processor is thus more relevant to a rare earth mining operation than ore extraction, which is an off-the-shelf skill set.
The development of rare earth deposits is the key to Rare Earth Mania, but the money making potential does not stop with the sum of the net present value of all the rare earth deposits that become mines. In fact, the net present value of all those deposits calculated as standalone raw material producers according to economic logic will likely in most cases be negative. That will not, however, stop Rare Earth Mania from assigning very high valuations to the rare earth juniors as they advance their projects. These high valuations will derive from a strategic premium associated with the downstream business opportunities that control of rare earth supply will deliver. While the size of the annual rare earth oxide market may grow fivefold to $10-$20 billion during the next 20 years, the size of the rare earth linked economy could grow much bigger. The big Japanese and European manufacturers are very much aware that their ability to participate in this business, much of it related to the "infrastructure transformation" that has just begun, hinges on non-political security of rare earth supply. Just as the Chinese government is now moving to lock up its control of domestic rare earth production in order to benefit its "downstream" national interests, so we will see end-users take steps to lock up control of rare earth production in "free market" jurisdictions such as Australia, Canada, the United States, Greenland and Scandinavia in order to benefit their own "downstream" corporate interests. Russia is not in the running because of foreign ownership restrictions and the likelihood that will restart rare earth production from its Lovozero project as a loss leader to supply its military needs. India also has a history of government control and a complex mine development process. Central Asia, South America and Africa have countries with rare earth potential, but they have high geopolitical risks that include nationalistic Chinese style control.
We are close to seeing the media grasp that the solution to the rare earth security of supply problem is to put these deposits outside of China into production. All of these projects faces serious challenges and require heavy injections of risk capital without any promise of a positive return from the price and demand projections for the next five years. It is thus no surprise that the early stages of Rare Earth Mania have attracted a fair bit of skepticism, often from executives of rare earth juniors worried that their competitors will such up all the investment capital. If I were looking at these projects from the perspective of ten years ago I would indeed have to publish a "thumbs down" on all of these projects. But I would argue that today the circumstances are special in that the size of the rare earth market is poised to grow dramatically larger so that it could accommodate quite a few of the race to production contenders in my Rare Earth Index, but only if the end-user industry becomes convinced that we are dealing with a serious race to production with multiple finishers whose mines constitute the security of supply redundancy industry needs to justify long range commercialization plans which depend on the availability of rare earths.
As Rare Earth Mania evolves we will see a dynamic of sector consolidation emerge which will broaden the audience to include Wall Street, whose Goldman Sachs already has earlybird stakes in Lynas and Molycorp which are currently too small to merit this investment banking giant's attention, but, should Rare Earth Mania really catch on, would serve to qualify Goldman Sachs as hardly a "johnny-come-lately" when its analysts discover the rare earth sector. The Rare Earth Mania, however, will likely last less than two years, largely because the field of potential players is small and most of them will be swallowed by larger entities at very high valuations made possible by strategic logic trumping economic logic.
*Disclosure: John Kaiser owns shares in some rare earth juniors and has recommended many of the companies to his subscribers at prices much lower than current levels. He does not receive compensation in any form from either the rare earth industry or the rare earth juniors.
John Kaiser writes the Kaiser Bottom-Fishing Report. He has written extensively about speculative Canadian issues, is frequently quoted by the media, and is a regular speaker at investment conferences. He specializes in high risk speculative Canadian securities with an emphasis on the resource sector. He is one of the few independent analysts with an in-depth knowledge of diamond exploration. More information about his service can be found at www.kaiserbottomfish.com.