Rare Earth Metals: Not for the Faint of Heart

September 30, 2013
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The froth in Rare Earth Metals makes other bubbles look tame. Rare Earth players like MCP, AVL and REE saw run-ups in the 400% range in 2010, thanks to a shortage potential tied to Chinese export quotas. When it became clear black market smuggling undermined the Chinese quotas, and that actual production from non-Chinese miners was years off, share prices crashed by 90% or more.

rare earth 100645866Now the froth is returning, with share prices spiking from beaten down levels. Opportunity exists for substantial upside — if risk appetite holds — but the rare earths group trades more on “blue sky” than anything tangible, and investors should proceed with caution.

The names covered in this report are:

MolyCorp (MCP) – Owner of the Mountain Pass rare earth mine, based in California, which resumed operations in August 2012.

Avalon Rare Metals (AVL) – a junior miner exploring and developing the Nechalacho Rare Earth Element Project at Thor Lake in Canada’s Northwest Territories.

Rare Element Resources (REE) - a junior miner whose Bear Lodge Project in Wyoming holds rare earth elements and gold deposits.

Quest Rare Minerals (QRM) – a small junior based in Quebec that is developing two rare earth plays, the Strange Lake Rare Earth Project and the Misery Lake Rare Earth Project.

Tasman Metals (TAS) - a Canadian junior focused on strategic metals and rare earths in Europe, particularly Scandinavia.

REMX - Van Eck’s rare earths/strategic metals stock index.

Rare Earth Elements are used in a number of applications, particularly high-tech ones, such as automotive manufacturing, wind turbine production and smartphones.

Up until 2009, when China announced export quotas on rare earth elements, few investors had the sector on their radar screen. As China tightened its quotas in 2010 and 2011, concerns about China’s de facto monopoly of rare earth production spurred investors into buying shares of rare earth miners, despite none of these miners actually producing rare earths at the time.

In the second half of 2011, as investors came to realize that Chinese export quotas were not being filled – in much part thanks to a thriving black market in rare earth elements that may have outnumbered official production over 2 to 1 – rare earth metals prices began to decline.

As Molycorp (MCP) had yet to reopen its mountain pass mine, and juniors AVL, REE, QRM and TAS were still very far from commencing production, it became clear to investors that rare earth mining shares had been bid up to levels far beyond even what speculative potential suggested. The result was a burst bubble and a lot of pain for heavily invested longs.

Considering some rare earths metals stocks declined over 90% peak-to-trough, rare earth miners have the potential allure of value stocks. A rash of stories involving shifts in production and demand are reviving interest in the sector and spurring a tentative turnaround.

Various news items now paint a bullish picture for rare earths pricing. These include Russian plans for a $1 billion investment in rare earth production; a decision by China’s State Reserve Bureau to buy rare earths to bolster strategic reserves; and the potential crackdown by Chinese authorities on the smuggling of rare earth elements.

An established player

MolyCorp (MCP) is the closest thing to a household name the rare earth sector has. MolyCorp’s Mountain Pass rare earth mine once supplied most of the world’s rare earth metals, but closed due to Chinese competition that had cheaper labor costs and looser environmental restrictions.

As Chinese export quotas began to push up prices, and the U.S. became aware of the dangers of China holding a monopoly on rare earth production, the U.S. government discussed subsidies for the reopening of the Mountain Pass mine. China’s willingness to use rare earths as a policy tool, such as its ban on exports to Japan during the Senkaku Islands dispute, has made the need for alternate sources clear. The Mountain Pass mine resumed operations in August 2012, in what MCP is calling Project Phoenix.

As the only miner of the group currently in its operational phase, MCP is perhaps the lowest risk, lowest reward candidate. Nonetheless, it is also the only miner likely to show positive earnings within the next two years. MCP began generating revenue following the Mountain Pass mine opening, but net margins are at -50%.

In June, an SEC investigation of MCP’s public disclosures led to no action against the company, which lifted an obstacle to continued share price increases. MCP has stated that it will not be able to fill the gap of China’s unfilled export quotas, as it is only producing 15,000 of the 19,050 tons of rare earth elements a year it is aiming for. While this may be disappointing in the short-term, it also highlights MCP’s potential for growth and means supply could be constrained and rare earth prices high enough to justify junior miners’ investment plans.

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Two promising juniors

Avalon Rare Metals (AVL) and Rare Element Resources (REE) have market caps of approximately $100M and $120M respectively. Both companies are going forward with plans to further explore and develop their properties. AVL and REE are in the process of tapping the market for $8 million each by issuing new shares. AVL’s Canadian projects and REE’s Bear Lodge Project in Wyoming are not operational mines yet, and positive earnings from the two companies are years off at this point.

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Nonetheless, both companies are included in Van Eck’s REMX index and are speculative ways to play a rebound in rare earth prices and the eventual need for more supply of rare earth elements outside of China.

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A couple longshots

Not included in the REMX index are the two most speculative picks of the bunch, Quest Rare Minerals (QRM) and Tasman Metals (TAS). QRM, which owns two rare earth projects in Northern Quebec, recently raised $2.7 million by issuing shares and now has a market cap of about $60M.

While QRM is facing issues with developing its properties due to permafrost, a major selling point for QRM is the important concentration of heavy rare earth elements (HREEs) in its properties, second only to TAS’ Nora Karr project in our group of stocks.

HREEs contain more of the rare earth elements that the U.S. Department of Energy deems critical, and could command an important price premium in the future. The DoE deemed the following HREEs critical:

  • Neodymium (Nd)
  • Europium (Eu)
  • Terbium (Tb)
  • Dysprosium (Dy)
  • Yttrium (Y)

MCP’s Mountain Pass mine consists of less than 1% HREEs while QRM has nearly 40% and TAS over 50%.

Tasman Metals (TAS) is perhaps the most speculative of the bunch. While TAS is a Canadian company, its area of focus is Scandinavia and particularly the Nora Karr project in Sweden. If successfully developed, the Nora Karr project would be the fourth largest HREE mine in the world, and by far the most important source of rare earth elements in Europe. However that is far in TAS’ future, and mining and energy projects in the European Union are fraught with political risk and onerous environmental regulations.

The early level of development and high concentration of HREEs at QRM, and particularly TAS, make them the most risky but also the most potentially rewarding stocks of the bunch. All five critical HREEs’ spot prices for metals and oxides have rebounded in recent months save for Europium metal.

What are the risks?

Beyond the lack of visibility into how likely to succeed the junior miners are, it is the rare earths story itself that makes investment in these companies so speculative.

The funds raised by junior miners, coupled with Russia’s commitment to investing in rare earth elements production, may inspire some confidence in the sector. The major reason for a rise in rare earth metals prices, however, has been China’s decision to buy rare earth elements for its strategic reserves. Such a decision is a clear positive, but will most likely be temporary in nature. The success of these junior miners, and even the more established MCP, depends on prices being sustainably high enough to justify competing with China. Short covering may also explain much of the recent upward move in rare earths stocks.

For the rare earth metals market to sustain all the potential increased supply coming from junior miners, demand for rare earth elements needs to keep growing at a steady pace. That means any slowdown in China or developed markets reduces the odds of junior miners’ projects ever seeing the light of day.

A more reasonable way to play economic strength?

REMX is Van Eck’s rare earths/strategic metals stock index. It was created in October 2010, when rare earths had become the investment fad of the day. Its 5 largest components are:

Iluka Resources, the Australian world leader in zircon mining.

Assore Limited, a South African miner of manganese, iron and chrome ores.

Molibdenos y Metales, a Chilean molybdenum processor, which owns a large stake in MCP and sees possibilities in rare earths.

Feramet, French manganese, steel alloy and nickel miner.

RTI International Metals, the leading U.S. producer of titanium mill products.

MCP is the sixth largest component of the index. The index additionally invests in AVL and REE, as well as Australian rare earth miner Lynas and Hong Kong-listed China Rare Earth Holdings Ltd.

As such, REMX offers a way to invest in a turnaround for rare earth producers, including the currently producing China Rare Earth Holdings, along with the wider universe of strategic metals producers. These companies depend on the same general macro traends as rare earth producers, but are typically more established and should be less affected by geopolitical considerations. Shares of REMX have dropped over 60% since peaking in the first half of 2011, but could be in the process of bottoming.

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REMX may be the safer way to bet on growing economic strength in China, the U.S, and even a recovery in Emerging Markets. Speculative upside could be substantial for those who get the timing right, particularly if the optimal scenario for the junior miners pans out… but a straight bet on the rare earths turnaround is a risky proposition indeed.



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