The most significant issue currently facing the rare earth industry does not relate to export quotas, or new supply, or many of the other issues touted in the media. Rather, it relates to prevailing negative expectations and perceptions. In the Alchemy of Finance, legendary investor and founder of the Quantum Fund, George Soros, stated;
"In fact, markets are almost always wrong, but their bias is validated during both self-fulfilling and self-defeating boom/bust sequences. Only at inflection points is the prevailing bias proven wrong".
Declining prices have become a self-fulfilling prophecy.
The expectation of falling prices is the number one issue weakening demand for rare earths. Declining prices causes consumers of rare earths to purchase hand-to-mouth. The logic is simple. There is no reason to buy in advance when prices will be lower at a later date. It is optimal to buy at that later date. When an entire market has this mindset it creates a self-reinforcing downward price cycle, where falling prices lead to deferred purchasing, causing prices to fall further, to infinitum or so it may seem.
In 2010 and 2011 when faced with the possibility of inadequate access to rare earths, companies built up huge stockpiles. For approximately the next two years, companies subsisted off these stocks and demand waned. This is what caused the initial increase and decline in prices. Inventories have been depleted, however conservative purchasing patterns on an industry wide basis have caused prices to continue to decline. The probable reason for this is because prices have been falling so rapidly and drastically for an extended amount of time, it has become ingrained into people's thinking that rare earth prices are going to fall forever. That is not the case.
There is a huge amount of what I like to call "deferred demand". If all of the companies buying hand-to-mouth decided to rebuild their inventories there would be a strong resurgence of demand and prices would vault upwards, though not to the extent witnessed in the last cycle. What would cause this? Simply put, the expectation of rising prices because increasing prices creates demand now to take advantage of the low prices. It all begins with a thought, or belief as to what the future holds. I realize the view that prices are about to move upwards is at loggerheads with the majority of people who purchase rare earths on a regular basis. Likely, what one does not realize is that he or she is part of a buyers strike that is about to crumble.
Take the statement "Rare earth prices are going to rise". The truth of that statement depends entirely upon the truth of statement; while that may seem obvious, it is actually much more complex. The statement is expressing an opinion or belief that relates to the future and the future as described by this belief (that rare earth prices are going to rise) is contingent upon whether a critical number of people share this same belief.
The catalyst for the initial change in expectations and increase in prices lies in the industrial policy of China. It has become clear, the Chinese government is implementing a plan to increase rare earth prices.
The Chinese State Council has recently approved the formation of a rare earth "group". The plan has only been approved "in principle" with an official announcement to be made in the near term according to the source in the report. The plan was presented to the State Council by the Ministry of Industry and Information Technology (MIIT). The group will consist of six large producers, China North Rare Earths Group (Baotou), China Minmetals Corporation, Aluminum Corporation of China (Chinalco), Ganzhou Rare Earth Group, China National Nonferrous Metals and Xiamen Tungsten Co. This group will account for over 85% of the rare earth production in China. According to North Square Blue Oak Analyst Frank Tang;
"China has almost completed the state consolidation of rare earth mining and is now starting to consolidate its processing industries" (The Wall Street Journal).
The formation of the group should facilitate communication between the six producers to plan policies, such as current prices and output. It will likely operate, in many ways, similar to that of a cartel. With such a small number of producers dominating a great majority of supply, controlling output to the benefit of prices becomes a much easier task. Since the State Council of China controls almost the entire world's supply of rare earths, with the exception of illegal producers, overproduction is capable of being contained.
The Chinese State Reserve Bureau (SRB) is expected to purchase certain rare earth elements in the near term;
"The expected purchases would include 4,000 tonnes of praseodymium-neodymium oxide, 500 tonnes of praseodymium oxide, 500 tonnes of neodymium oxide, 1,200 tonnes of dysprosium oxide and 300 tonnes of erbium oxide, the China Securities Journal reported, citing a source at top producer Inner Mongolia Baotou Steel Rare-Earth," (agmetalminer.com).
The State Reserve Bureau is known for intervening in markets on behalf of the State Council to achieve desired goals. Analyst at Baichuan Information, Du Shuaibing, stated the purchase is expected to be at prices above market levels in order for the purchase to be "successful". He added the intent of the purchase was to balance supply and demand and lead to expectations of higher prices (Chinadaily.com). The expectation of rising prices would shift the conservative purchasing patterns and the reluctance to rebuild inventories that has been weakening demand. The largest producers have quoted prices well above market prices up to 380,000 RNB per ton of neodymium oxide in November, as well as offering to buy rare earths in the open market at these inflated prices (Metal.com). This phenomenon is similar to that of State Reserve purchases in the past and one would expect the purchase by the SRB to be around this price level. I anticipate this to play an important role in giving Neodymium/Praseodymium (NdPr) prices upward momentum.
The Chinese government has also made a concerted effort to put an end to illegal production of rare earths. Illegal production and mining directly undermines the goals of the State Council. It counteracts the intent to control production, raise prices and protect the environment. Numerous government agencies have launched enforcement operations over the past two years. As recently as yesterday (1/8/14), a new joint crackdown by eight government agencies has been announced (Metal-Pages.com).
To summarize, rising rare earth prices are a highly probable outcome. The industries that are large users of rare earths such as automobiles, smartphones, laptops and tablets, home appliances, and petroleum refining are all performing well. Rare earth inventories are at a low level and uncertainty relating to price direction has led to deferment of restocking. If prices start moving upwards, I expect volatility as users start purchasing forward, although nowhere near the extent witnessed during 2011. An executive at an emerging North American producer stated
"My view is that as Chinese actions to reduce illegal mining, processing and smuggling bears fruit and that consumers exhaust their stockpiles built during uncertain times in last two years, you will see market tighten up and prices rise" (Metal-Pages.com).
In my opinion, the best way to speculate on rare earth prices is an investment in Molycorp (NYSE:MCP). I expect the production ramp up over the course of 2014 to coincide with a strong recovery in the rare earth market. There is significant insider ownership and management is running the company conservatively. Molycorp is expecting to be free cash flow positive by late 2014, not factoring in any increases in selling prices. I view this as a rare opportunity with a favorable risk/reward profile. Over approximately the past year and a half I have developed a high degree of confidence in this investment hypothesis. With call options trading for pennies, a large short interest and inherent volatility in the stock any move upwards could be very profitable and accelerate quickly.
Molycorp is one of only two non-Chinese rare earth producers and the most vertically integrated rare earth company in the world. For more information visit www.molycorp.com
Disclosure: I am long MCP, . 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.