Making sense of the emerging rare earth mania

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 away 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 militaryhegemon, the United States, a nation whose overwhelming status as the world's biggest economy is on a relative long term diminution trackthat 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 insigning 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 isalready 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 acesspool. 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 nuclearenergy plans stand in sharp contrast to the reluctance in NorthAmerican and Europe to construct new nuclear power plants. The UraManiathat played out from 2004-2008 reflected the growing realization thatthe existing uranium supply infrastructure cannot meet future demandfor uranium as fuel for nuclear energy. The problem has notdisappeared, but the market has become more aware that the need tosolve it is not immediate, and the best uranium deposits located inmany parts of the world will eventually be brought into production tomeet projected demand growth. While there is some similarity betweenrare earths and uranium in that uranium's use as a fuel represents lessthan 5% of the cost of building and operating a nuclear power plant,and thus have a degree of demand inelasticity to higher prices, theydiffer in that uranium's long term demand growth depends on theconstruction of new power plants, which have approval and developmenttimelines that are much longer than uranium mine development timelines.In contrast, rare earths have open-ended application andcommercialization potential, especially given that the world isexperiencing a new wave of funding for advanced materials research, andis struggling for alternative solutions to the dual problem of climatechange and fossil fuel dependency. It is thus possible for annualdemand to grow more than tenfold over the next 20 years, and that wouldstrain China's own supply capacity, especially with regard to the heavyrare earth elements which are mined from low grade clay deposits thathave an erosional origin. In other words, more of these deposits arenot going to be found by drilling "deeper". Unlike uranium, the futuredemand for rare earths is "wild", difficult to quantify, and, to alarge degree a function of projected supply. China's proposed ban onthe export of dysprosium, terbium and ytterbium has less to do with itseconomic manufacturing goal than it does with internal concern over thesecurity of its own heavy rare earth supply.

The so-called"heavy rare earth elements" represent less than 5% of global productionby weight, but may represent as much as 40% of the value of annualproduction. They are expensive because they are rare in concentratedform, their demand is not overly sensitive to price, and because theyare typically tied up in complex minerals from which their extractionis expensive. While the light rare earth neodymium is becoming wellknown as the magic ingredient that makes the magnet in a wind turbineor Prius hybrid "super", the addition of dysprosium to a neodymiumbased magnet enables the magnet to retain its magnetism under hightemperature conditions such as you might find under the hood of aPrius. During the eighties when the United States was last concernedabout rare earths the applications for many of the heavy rare earthelements were largely of a military nature and global demand was small.During the nineties Chinese production of both light and heavy rareearth oxides flooded the world with the result that existing operationssuch as Mountain Pass were shut down and lower grade deposits outsideChina on which companies like Unocal, Hecla and Iron Ore Company hadconducted feasibility studies were shelved and in most cases eitherallowed to lapse or revert to their original private owners. Chineselight rare earth production was cheap because it benefited from beingby-product production of the Baiyun Obo iron mine, and the heavy rareearth production, although involving very low grades, was cheap becausethe clay deposits did not require cracking of the complex mineralogiesthat characterize bedrock deposits of a magmatic and/or hydrothermalorigin. Because of an apparent super-abundance relative to globaldemand China allowed inefficient and environmentally destructiveproduction methods which recovered less than 50% of the ionic claydeposits' HREE content. The draft report's proposal to consolidatemining and processing operations reflects a sudden awakening to thereality that not only are these ionic clay deposits finite, but theyare conceivably inadequate to serve long term global demand. Byshutting down inefficient operations and banning the export of certainheavy rare earth elements, China would extend the life of its HREEresource and assure security of supply for its domestic needs. And ifin doing so the car manufacturers have to source their super magnetsfrom China based production facilities, so much the better for China'sexport economy.

The rare earth market is presently very small, and even ifit grows five-fold, it will still be too small to justify policiesguaranteed to annoy China's trading partners and raise the specter ofprotectionism. The "how could they" tone of rare earth media coveragemisses the mark. China's actions with regard to rare earth supply arecompletely defensible, and it is nonsense for media pundits to grumbleabout it righteously. The rare earth media buzz is now largely focusedon China's supply restriction plans and the potential impact that mighthave on the green economy, which makes this an issue of anticipationrather than immediate trouble. The crunch is probably still 4-6 yearsdown the road, which also happens to be the time needed to bring anexisting rare earth deposit into production. Unfortunately, becausebusiness and policy strategies have long implementation timelines, thetime for action on the rare earth security of supply front is now ornever. There is thus a risk that Rare Earth Mania will be aflash-in-the-pan that is only a vague memory a year from now, much as Isuspect will be the case with the lithium buzz making the rounds.

Thelithium buzz is based on a misguided expectation that large scalecommercialization of lithium-ion battery based plug-in hybrid andelectric vehicles will start to happen in a year or two, and thedelusion that there is a security of supply problem with lithium. A carsized lithium ion battery will not be ready for large scalecommercialization for at least another five years, by which timeBolivia may have gotten its act together with regard to developing itsvery large lithium brine resources. Because of the ubiquity of gasstations and a reluctance among consumers to accept the rangerestrictions and recharging cycles for the first generation of electricvehicles, I expect an ordinary hybrid such as the Prius and its otherJapanese competitors to dominate the car market during the next decade.The urgency to develop security of supply for rare earths, which arenecessary for electric vehicles and have applications unrelated to theviability of the lithium ion battery, is high and immediate. Carmanufacturers need to know right now whether or not in five years theywill have a non-Chinese supply of rare earths for their components,which is why companies such as Toyota and Mitsubishi are alreadydeveloping relationships with junior companies that have rare earthprojects.

Deng Xiaoping's declaration that "rare earths will befor China what oil is for Saudi Arabia" is simply false. China does nothave a monopoly on rare earth deposits. All it has had is a productioncost advantage which is disappearing as the need to expand supply tomatch growing global demand develops, and as China adopts policieswhich serve its own strategic and economic goals. There are significantrare earth deposits that include the heavy rare earth elements outsideof China, and most of these happen to be owned by publicly tradedresource juniors which either found them or acquired them when theirdevelopment economics were hopelessly weak. These are few and farbetween, though in the long run if rare earth oxide prices movesubstantially higher and stabilize at those levels, global explorationwill uncover abundant new resources. But that is a big and improbable"if". Unlike the case with uranium deposits which occur in a variety ofgrades and sizes all over the world, significantly enriched rare earthdeposits only occur in regions geologically conducive to thedevelopment of carbonatite or peralkaline intrusive complexes. The keyidea here is that of a major system which allowed for the concentrationof rare earth elements; rare earths are ubiquitous in the earth's crustat background levels or as localized showings in other geologicalcomplexes. But they are rare in high grades and locally large tonnage.

IfRare Earth Mania takes off as I expect, within a year there will bemore than a hundred juniors yapping about this or that rare earthshowing, just as happened with UraMania in 2004-2008. Some of theseearly stage exploration efforts may pay off with a major new discovery(for example, Quest's Misery Lake project which I visited in lateAugust as part of my Strange Lake trip), but we probably will not knowbefore 2011. The exploration timeline for a rare earth project is asbad as that of the diamond exploration cycle because of the criticalimportance of developing an optimal metallurgical process; don't expecta grassroots rare earth project to be a mine before 6-10 years from noweven if Rare Earth Mania stays hot for more than a year or so.Exploration waves during the sixties, seventies and eightiesinvestigated most of the more obvious intrusive complexes, with theresult that historical resource estimates exist for a couple dozen rareearth deposits in the world.

The next phase for the rare earthmedia buzz is the recognition that these deposits exist and need to beraced into production. Because rare earths are similar to industrialminerals which are sold through private supply channels there are nocommodity markets for futures speculation as is the case with base andprecious metals. There are thus no obvious ways to profit from all thisrare earth media buzz, with the resulting risk that the media and itspublic will lose interest in this story. However, there is money to bemade by investing in the dozen or so juniors which are in a position tobring an existing deposit into production over the next 4-6 years.During the next year I expect another dozen such serious projects toshow up under the control of resource juniors. If we are to have a RareEarth Mania of the sort envisioned by mass market specialist Jim Dines,who declared himself the Original Rare Earth on Memorial Day weekend inMay, it will have to be because the market recognizes that thesejuniors hold the solution to a very serious problem, and the key tothat solution is fast-track financing to develop these projects. Thejuniors that own these rare earth deposits will be the mouse thatroared.

I have assembled a dozen Australian and Canadian listed juniors into a KBFO Rare Earth Indexwith January 2, 2004, as the starting date. Because of the limitednumber of advanced rare earth projects that could be acquired byjuniors, I doubt the number of Rare Earth Index members will more thandouble over the next year. I have added companies to the index when itbecame clear that the company was making its advanced rare earthproject its primary focus, even though it may have owned the depositfor several years. I have included Neo Materials in the index at thestart because, although it has neither an advanced rare earth projectnor had rare earth production, it has been the only Canadian companyfocused on the sourcing of rare earth oxides in China for downstreamprocessing since the early nineties. Furthermore, the changingstrategic and economic goals of China are forcing Neo Materials to seekcontrol of rare earth supply outside of China, which means before longit will have an advanced rare earth project. Historically we have seencases where a raw material producer wanders down the supply pipeline tobecome involved with the production of value-added downstream products.Very rarely have we seen a downstream manufacturer wander upstream tobecome a producer of the raw materials it needs for its downstreamoperations, largely because mining is best left to mining companies.But the rare earth space is unusual in that processing rare earth oreis the primary challenge facing any rare earth mine, first to crack therare earth oxides out of the minerals in which they are embedded, thenseparate the individual oxides from the concentrate, and finally torefine the oxides into pure metals that can be incorporated into alloysand other products. The in-house skill set of a downstream processor isthus more relevant to a rare earth mining operation than oreextraction, which is an off-the-shelf skill set.

The developmentof rare earth deposits is the key to Rare Earth Mania, but the moneymaking potential does not stop with the sum of the net present value ofall the rare earth deposits that become mines. In fact, the net presentvalue of all those deposits calculated as standalone raw materialproducers according to economic logic will likely in most cases benegative. That will not, however, stop Rare Earth Mania from assigningvery high valuations to the rare earth juniors as they advance theirprojects. These high valuations will derive from a strategic premiumassociated with the downstream business opportunities that control ofrare earth supply will deliver. While the size of the annual rare earthoxide market may grow fivefold to $10-$20 billion during the next 20years, the size of the rare earth linked economy could grow muchbigger. The big Japanese and European manufacturers are very much awarethat their ability to participate in this business, much of it relatedto the "infrastructure transformation" that has just begun, hinges onnon-political security of rare earth supply. Just as the Chinesegovernment is now moving to lock up its control of domestic rare earthproduction in order to benefit its "downstream" national interests, sowe will see end-users take steps to lock up control of rare earthproduction in "free market" jurisdictions such as Australia, Canada,the United States, Greenland and Scandinavia in order to benefit theirown "downstream" corporate interests. Russia is not in the runningbecause of foreign ownership restrictions and the likelihood that willrestart rare earth production from its Lovozero project as a lossleader to supply its military needs. India also has a history ofgovernment control and a complex mine development process. CentralAsia, South America and Africa have countries with rare earthpotential, but they have high geopolitical risks that includenationalistic Chinese style control.

We are close to seeing themedia grasp that the solution to the rare earth security of supplyproblem is to put these deposits outside of China into production. Allof these projects faces serious challenges and require heavy injectionsof risk capital without any promise of a positive return from the priceand demand projections for the next five years. It is thus no surprisethat the early stages of Rare Earth Mania have attracted a fair bit ofskepticism, often from executives of rare earth juniors worried thattheir competitors will such up all the investment capital. If I werelooking at these projects from the perspective of ten years ago I wouldindeed have to publish a "thumbs down" on all of these projects. But Iwould argue that today the circumstances are special in that the sizeof the rare earth market is poised to grow dramatically larger so thatit could accommodate quite a few of the race to production contendersin my Rare Earth Index, but only if the end-user industry becomesconvinced that we are dealing with a serious race to production withmultiple finishers whose mines constitute the security of supplyredundancy industry needs to justify long range commercialization planswhich depend on the availability of rare earths.

AsRare Earth Mania evolves we will see a dynamic of sector consolidationemerge which will broaden the audience to include Wall Street, whoseGoldman Sachs already has earlybird stakes in Lynas and Molycorp whichare currently too small to merit this investment banking giant'sattention, but, should Rare Earth Mania really catch on, would serve toqualify Goldman Sachs as hardly a "johnny-come-lately" when itsanalysts discover the rare earth sector. The Rare Earth Mania, however,will likely last less than two years, largely because the field ofpotential players is small and most of them will be swallowed by largerentities at very high valuations made possible by strategic logictrumping economic logic.

*Disclosure: John Kaiser ownsshares in some rare earth juniors and has recommended many of thecompanies to his subscribers at prices much lower than current levels.He does not receive compensation in any form from either the rare earthindustry or the rare earth juniors.

John Kaiser writes the Kaiser Bottom-FishingReport. He has written extensively about speculative Canadian issues,is frequently quoted by the media, and is a regular speaker atinvestment conferences. He specializes in high risk speculativeCanadian securities with an emphasis on the resource sector. He is oneof the few independent analysts with an in-depth knowledge of diamondexploration. More information about his service can be found at www.kaiserbottomfish.com