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We have witnessed a fair share of bubbles over the past 15 years: internet stocks, housing, crude oil, and Chinese stocks. We have had some success in identifying "bubbles" in individual stocks and warning the investment community about specific issues (including HUSA at $20.35 see here and PCBC at $5.11 see here). Possibly the most voracious bubble in recent memory is occurring with Rare Earth Element ("RE" or "RE elements") stocks. We have done some work framing the opportunities and risks within the RE elements space. After sifting through the hype, we believe there is tremendous risk in RE stocks and highlight Rare Element Resources (AMEX: "REE" $12.74/ TSX: "REC") as a potential short opportunity, or at least a stock investors should avoid.

Rare Element is a Canadian based company that owns the Bear Lodge mine located in the northeastern corner of Wyoming. The stock price is up over 500% since early July and over 65% in the past three days. With the euphoria of the strong move in RE element stocks, speculators have bought first and asked questions later. We believe Rare Element investors will wish they had done more diligence before piling into a company with a potentially worthless plot of land. We believe Rare Element is a heavily promoted stock with questionable management and massive risks to a business plan that under the rosiest scenario will not be at full production until 2015 or 2016. By that time, we expect the world could suffer from a glut of RE supplies. As a result, we believe current investors face at least 70% downside from current levels.

Rare Earths - Not That Rare

"Rare earth elements" are 17 minerals on the periodic table. The elements are used in various applications, typically in miniscule quantities. There is a reason many investors had not heard of the RE elements since middle school science class. Simply, rare earth elements represent a very small market. According to the USGS, a mere 124,000 tons of RE were consumed worldwide representing a market size of LESS THAN $2 BILLION (source: Reuters and USGS).

Over a year ago, stories began to appear about China's dominance in RE mining with 97% of the world's production and exploration efforts in South Africa, Brazil, Canada and the United States (see this story dated September 2009 here). As with most hyped spaces, this story has been recycled on a daily basis by news agencies, internet chat rooms, and even company IR firms. Following the IPO of MolyCorp (NYSE: MCP) in July and recent Chinese export quotas, RE element prices and stocks have skyrocketed. China is now using its market clout in RE as a political statement, increasing export quotas and withholding exports to Japan. The result has been a further spike in RE element prices.

We believe elevated RE prices are a temporary phenomenon for two reasons. First, we believe China will likely concede and begin exporting RE elements again as political pressures mount. The Chinese have a history of flooding markets with a massive supply of raw materials or end products, and could resume exporting and crush RE prices at any time.

Second, the term "rare earth" is a misnomer. According to the USGS: "despite their name, most rare earths are not particularly rare." The USGS estimates that the total worldwide reserves of RE are 99 million tons, or 800 years of supply at current consumption rates.

Tons of Rare Earth Reserves

China

36,000,000

United States

13,000,000

Soviet Union

19,000,000

Total Worldwide

99,000,000

Source: USGS

In addition, most rare earth consumption takes place in China, which consumed 65% of supply according to the USGS. Most of the goods produced in China with RE element inputs actually end up as exports to the rest of the world (and these products are not subject to any quotas). Japan consumes another 26% of supply, meaning these two countries consume over 90% of worldwide supply. According to the USGS, the U.S. imported less than 7,000 tons of RE in 2009 and actually exported a greater quantity than it imported. (see here .pdf).

When MolyCorp's Mountain Pass mine is running in 2012, management has stated that they expect to produce 20,000 tons of RE. This represents THREE TIMES the amount of RE imported to the U.S. in 2009. The U.S. Geological Survey estimates that China's Bayan Obo mine has more than 40 million tons of RE elements (see here), which is enough to supply the world for over 300 years alone. Congress and the U.S. military have also expressed concern for RE element needs for certain weapons. We estimate that the demand by the U.S. military is likely less than 1,000 tons a year, and will easily be addressed by Mountain Pass.

Tons of RE elements extracted

China

120,000

India

2,700

Brazil

650

Total Worldwide

124,000

Tons of RE elements consumed

% extracted

China

80,000

65%

Japan

32,000

26%

Other

8,000

6%

Source: USGS

We expect the world to be awash in RE supply when/if Rare Element's Bear Lodge is producing in 2015 or 2016. Currently, the worldwide demand for RE outside of China is a meager 44,000 tons, and only 12,000 tons excluding Japan. While we view RE elements as a growth market, we believe RE recycling and RE alternatives could mute market growth. We reviewed plans for six public companies in the RE space, and combined, they plan over 82,000 tons of production of RE per year [Lynas (OTCPK:LYSCF) (22k), Arafura (20k), MCP (20k), Avalon (AVARF.PK) (5k), Quest Rare (5k), Rare Element (10K)]. This represents almost two times the current demand outside of China and excludes massive private projects in India, Brazil, South Africa, Australia and the US. One estimate suggests that over a year ago there were 120 RE element mining projects globally at various stages (see here). And this was BEFORE the recent spike in prices. Given the massive expansion of worldwide RE mining, we expect the world to experience a glut of RE elements by the time Rare Element's mine is up and running. As a result, we believe it is a faulty assumption to extrapolate "bubble" pricing into future projections.

Red Flags at Bear Lodge

Turning our attention to the tiny Canadian speculative outfit, we could not help but find the ticker amusing: REE. Sadly, we had immediate memories of the pain Internet.com created near the top of the dot.com bubble. Rare Element currently has a market cap of over $400 million. Their latest financials show about $10 million of assets and zero revenues. They had $5 million of cash on balance sheet at their last filing. According to their last 20-F, Rare Element has two full-time employees and five part-time employees (see here). This "exploration and development" company has spent less than $7,000.00 over the past three years (see here). The management team has put out a steady stream of press releases, but we have little doubt that these promotional releases will ultimately be irrelevant for Rare Element until we are much closer to the middle of the decade.

The name of the property where Rare Element is conducting its RE element testing is Bear Lodge, located in the northeast corner of Wyoming. Spartacus Capital, the predecessor company to Rare Elements, acquired the Bear Lodge mine in 2002 for less than $1 million. The company expects production of the plant to begin in 2015. According the Rare Elements own documents, over the past 38 years, three highly sophisticated mining companies, MolyCorp, Hecla Mining (HL), and Duval Corporation, owned and explored Bear Lodge for RE elements. After 44 drill holes, none these sophisticated miners continued to drill, all choosing to abandon their efforts and eat the sunk costs. We believe one of the reasons is the low ore grade of Bear Lodge. According to Rare Element's investor presentation, Bear Lodge has an ore grade of 3.5%, less that half of MolyCorp's Mountain Pass (8.2%) and a third of Lynas' Mount Weld (13.6%). Based on our research (we ask readers to conduct their own research on this topic), this makes Bear Lodge's prospects for successful operation extremely dependent on RE element prices staying at existing levels. If our earlier assumption is correct (along with the apparent conclusion of three highly sophisticated miners), and prices of RE elements normalize, it will be uneconomical to mine Bear Lodge (assuming the asset even possesses enough to participate in the future of this over supplied market). So while many RE stocks have increased significantly on higher RE prices, most, including Rare Elements, will never be in a position to take advantage of today's prices.

Given the abundance of RE elements worldwide, access to RE may not be that problematic, but processing RE elements into usable raw materials is expensive, difficult and environmentally destructive. In fact, Mountain Pass was originally shut down not only due to a flood of cheap RE elements from China, but also for environmental concerns. To justify Rare Element's lofty current market cap, we believe prices of RE not only need to stay extremely high, but Rare Element must build processing capability. A Bryon Securities report estimates this would cost Rare Elements $350 million. In addition, Rare Elements would have to overcome significant permitting and environmental concerns, along with significant start-up expenses. With two full employees, a tiny balance sheet, and prospects for significant dilutive equity deals, common sense suggests something does not pass the smell test.

We put little value on Rare Element's other projects: gold mining at Bear Lodge and Eden Lake. Eden Lake is a property Rare Element acquired recently for less than $1 million. Rare Element management also claims potential for gold mining. Earlier this year, Newmont (NYSE: NEM) walked away from a JV they had with Rare Elements on this property for a sum total of $27,000 worth of paid expenses (6/8/2010 filing outlines the termination of their JV). Newmont will receive a net smelter royalty should anything be found, but cut their losses on development and exploration (they spent almost $3 million in development and refused to spend more). So Bear Lodge was basically given to them for free by Freeport in exchange for a net smelter royalty, which they repurchased for a total of $50,000 from Freeport and Newmont. Given the sophistication of Newmont, we believe gold project offers little value.

Red Flags Around Management

The quality of a management team is extremely important for any small cap company. But when your management bench is as small as Rare Element's, assessment of management is vital. We found it curious that Rare Elements shares its address in their filings (325 Howe St., #410, Vancouver, British Columbia, Canada V6C 1Z7) with at least six other businesses (Pacific Opportunity Capital run by Chairman and CEO Donald Ranta, CFO Mark T. Brown and Secretary Winnie Wong; Animas Resources [ANI.V]; Tenant Payment Systems; Avrupa Minerals LTD. [AVU.V] formerly Everclear Capital; Cordova Industries; and Sutter Gold Mining Inc. [SGM.V].

Our concern was already elevated given the commingled nature of the office address, but nothing could have prepared us for the shock of seeing management's bios and history. Most management teams we talk to are consumed with running one company. We believe it is a significant red flag that critical members of Rare Element's management team are engaged with more than five companies currently. It is our understanding that Rare Element's secretary Winnie Wong and CFO Mark T. Brown are principals of something called Pacific Opportunity Capital LTD that shares office space with Rare Elements. Mark T. Brown's bio in the 20-F lists 18 companies where he is the current or former CFO or director. Almost all of these companies are Canadian-traded penny stocks. A simple google news search reveals that Mark T. Brown has issued press releases for at least three other companies in the past two weeks, including Pitchstone Exploration, Avrupa Minerals and Tarsis.

Chairman and CEO Donald E. Ranta was previously with Greenstone Resources, a mining play that is currently trading in the penny territory. Mr. Ranta is also on the board of Avrupa Minerals, along with the CFO Mark T Brown and secretary Winnie Wong. Secretary Winnie Wong was (until recently) also the secretary of Portal Resources [PDO.V], an oil and gas penny stock. She is also the CFO for something called Avrupa Minerals, currently trading in the 41 cent range in Canada. Then there’s Apoquindo Minerals, of which she is also the corporate secretary, and there is Animas Resources LTD [ANI.V] of which she is CFO (another 43 cent stock). She’s also been associated with Fox Resources as their CFO, Deal Capital as President, and Mediterranean Minerals as CFO.

Conclusion

One recent rational voice in RE elements is the CEO of Neo Materials [TSX: NEM], Constantine Karayannopoulos. As a company with 85% market share in processing neo powders, Karayannopoulos is heavily incentivized to promote RE elements. However, in several recent presentations, he has expressed concerns around the bubble in RE elements. By way of background, Neo Materials has exclusive access to mine heavy rare earths at the Pitinga mine in Brazil, a fact investors have seemed to overlook when comparing NEM's stock to other RE names. On September 15, 2010, Karayannopoulos stated:

It's very, very dangerous for people to be committing hundreds of millions of dollars to projects that will take another five years or more to see the light of day.

He went on to caution, as if he were specifically alluding to Rare Elements:

At the end of the day, rare earths are not that rare. Bubble economics aside, there just isn't enough value in the ground to justify digging the stuff up and processing it.

While it is refreshing to hear a CEO talk candidly about the market, we believe Karayannopoulos warning to investors has gone unnoticed.

We have recently begun our research on Rare Element Resources and are disturbed by the red flags we have found. We believe momentum investors face significant risk in speculating in shares at unjustifiable price levels. We view Rare Element's stock as the definition of the greater fool's theory. When it breaks, there will not be one reasonable investor to provide liquidity to the sellers on the way down. If RE element prices remain high in five years, Bear Lodge could have some value. If we are correct and RE prices drop given a glut in supply, the Bear Lodge mine could be worthless. We expect to report back after conducting further due diligence.

Disclosure: Short REE

Source: Rare Element Resources: Potential Short Opportunity