Reflexivity in the Rare Earth Market
George Soros has said when he discovered a reflexive relationship in the market his mouth began to water like one of Pavlov's dogs. In short, reflexivity can be described as a relationship between a situation and an outcome, where there is no clear cause and effect, but the two are intertwined. The rare earth industry is one of the largest consumers of rare earths. The industry can be divided into two segments. The upstream market consists of the mining and sale of raw materials or rare earth oxides. The downstream market processes these oxides into finished composites that have been customized for end users.
Demand for finished composites has been weak due to falling prices, which creates hand-to-mouth purchasing patterns by end users. During its Q4 2012 earnings call, Molycorp (MCP) has stated that "the anticipation of falling prices creates very conservative purchasing patterns by our customers." This causes downstream processors to be stuck with slow-moving, high-cost inventories of raw materials or oxides. As this inventory is being worked through, demand for rare earth oxides has fallen. This is because the downstream rare earth processing industry is a very large consumer of rare earths. The prices for finished composites are based on a percentage of the raw material costs, often quoted in high purity oxide form on websites such as Metal-Pages.com.
Falling prices have contributed to weak demand and conservative purchasing from end users. The effect of this is inventory in the downstream segment being sold very slowly. This in turn causes weak demand and declining prices for raw materials, resulting in declining prices for finished composites as well (because finished composites are based on a percentage of the oxide cost). As I previously stated, falling prices have contributed to conservative purchasing by end users and the process starts over.
Essentially, enough hand-to-mouth end-user purchasing has to occur in order to deplete downstream inventories leading to increased internal demand for rare earths within the industry. This has been a slow process, but here lies the shift to break out of the self-reinforcing downward cycle. Molycorp has recently stated its Zibo processing facility in China has finally worked through its inventory. This signals downstream processors are beginning to restock material. The restocking of raw material leads, as expected, to increased demand and prices for rare earth oxides, which positively affects the prices of finished composites.
The demand for finished composites will begin to increase as prices move upward and hand to mouth purchasing shifts to normalized purchasing patterns. Increased demand from end users stimulates demand throughout the entire supply chain and creates a self-reinforcing cycle the other way. The weak internal demand from the downstream processing segment due to slow moving inventory was the sludge in the gears, if you will, but it appears that is abating. This may seem like circular logic (and it largely is) but if you understand the preceding paragraphs, you understand the current situation in the rare earth industry.
I will structure the following by making a false statement and then explaining reality as it relates to the statement.
The collapse in prices is a supply side issue.
The decline in prices the past two years has not been caused by China easing its export controls (as a Reuters article recently reported) or the additional supply from Molycorp. Stagnant demand is the key issue. In 2010/2011, when faced with the possibility of inadequate access to rare earths, users built up huge stockpiles. The sense of panic and surge in demand shows the critical nature of these materials. While prices got a boost at the time, these large buyers were then out of the market for a period of time, causing demand and prices to fall.
The glut in cerium is of major concern.
No rare earth mining company in the past 25 years has been sold out of cerium. It is essentially a byproduct of mining lanthanum and neodymium, which are the key elements driving the industry. The gains in other segments will far outweigh any losses on unsold cerium. Also, Molycorp has internal demand for a portion of the cerium it produces due to its use in catalyst composites and SorbX, a proprietary and patented water treatment product. Molycorp has entered into an agreement with industry leader Univar for the distribution of Sorbx.
Molycorp is diluting shareholders to stay afloat and avoid bankruptcy.
Molycorp is raising capital for expenditures at its Mountain Pass facility. Insiders have purchased a large amount of shares from the past two offerings. Large, investment banks such as Goldman Sachs, JPMorgan, and Morgan Stanley have been underwriting these offerings. There is obviously optimism from those with greater information.
China is going to flood the market with rare earths.
China has no intention of flooding the market and would prefer to do just the opposite. The Chinese government wants industry consolidation and greater control to limit production. The reasons vary, but relate to environmental concerns, scarcity of certain rare earths, and promotion of its own processing and manufacturing industries. The WTO may force China to ease its export controls, but under no circumstances will China flood the market. Also, Molycorp can go toe to toe with any rare earth producer in the world due to their low cost production profile, meaning Molycorp will never be "run out of business."
In my view, an investment in Molycorp presents a very asymmetric risk/reward opportunity. If I am correct about the recovery in rare earth demand and prices, Molycorp is a highly leveraged way to play it. It is one of the -- if not the -- most volatile stock on the NYSE.
The only downside risk at this point is Chapter 11, which I view as a near impossibility. Even assuming no increase in rare earth demand, Molycorp will become cash flow positive in the near future and their stock price will appreciate, albeit not as much as if the industry does recover. This is due to the final stages of its Mountain Pass facility being completed and commissioned resulting in increased production and lower costs. Insiders have a very high degree of confidence in the company as well, further minimizing my view of the possibility of downside risk.
Molycorp's business has very attractive margins. If you plug hypothetical volumes and prices into an operating model, $0.45 quarterly EPS by this time next year is not off the table. There is a huge short interest in the stock. Approximately 50 million of the 240 million shares outstanding are sold short. The company plans to double production during 2015 through the implementation of "phase 2." These factors could cause a major shift in the supply and demand for the stock of Molycorp and allow it to trade at a high multiple.
Disclosure: I am long MCP. I own LEAP call options on MCP stock. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.