Investment Ideas for Rare Earth, Strategic Metal Exposure

by: Alex B. Gray

As an investor, I think understanding what you don’t know may be the most profitable trait one can have. However, the temptation to stray into these areas is always pulling us towards industries we may not fully understand in an effort to not miss the next 10-bagger.

For the last year the media have flooded us with news and discussions about rare earth elements and strategic metals including precious metals. Of course, all of this interest sent related stocks soaring as both knowledgeable and ignorant investors have jumped on the rare earth bandwagon. I have yet to take a material position in this asset class, but I do believe there is room for exposure to these commodities in my portfolio.

We know that China produces 95-97% of the rare earths and intends to use this position as a political football when dealing with other developed nations. Of course, the key word here is production. While China currently produces 95-97% of the rare earth elements, it has a much lower stranglehold on the world's deposits. It is difficult to predict how China may handle its current dominating position, but I believe they will use some restraint as the tables may turn in the years to come as production increases around the world. China did not produce any material quantities of rare earth elements until the 1980’s and gained its current position by subsidizing the mining and neglecting the environmental consequences.

These actions by the Chinese government made the mining of rare earth elements uneconomic throughout the rest of the world. However, at current prices, new exploration and existing mines around the world are in the process of being reactivated. However, the time it takes to get these mines online should support prices in the near-term unless China decides to dump rare earth elements on the market which is unlikely. There is a certain amount of political risk premium built into the current market prices which could be eliminated if China reduces its limitations on exports.

When I have a limited knowledge about a certain industry or asset class I tend to either stay away or begin a long process of research studying the industry and looking for investments where I can take advantage of the knowledge of others. With the latter in mind, I decided to go on a search for investments where I may be able to take advantage of the knowledge of skilled and experienced executives, while limiting my direct mining risk in a particular commodity. I also wanted an investment that if rare earth prices trended down, it had other assets that would support the price of the stock.

What I came up with is a handful of unique small-cap companies. It is important to note that I am not endorsing any of the companies below and further research is necessary, however I did want to share some of my preliminary results. I also consider each of these companies speculative in nature.

U.S. Energy Corp. (NASDAQ:USEG) is a diversified company with strategic investments in various natural resources including oil, natural gas, geothermal, real estate and the strategic metal molybdenum. Even though the company derives the majority of its revenue from oil and gas, it is the exposure to molybdenum that sparked the interest to include U.S. Energy in this article.

The company owns a combination of surface and mineral rights in approximately 9471 acres at Mount Emmons near Crested Butte, Colorado that is believed to contain significant molybdenum deposits. The company has entered into an agreement with Thompson Creek Metal Company (TC) to develop this property. Thompson Creek may earn up to a 75% interest in the project for an investment of $400 million. As with many of the rare earth and strategic mining companies, actual production could be well into the future and may never occur.

The company’s primary revenue assets fall within its oil and gas segment. The company has small leasehold acreage positions in southeast Texas, Louisiana and the Williston Basin in northeastern Montana and in North Dakota where it is partnered with Brigham Exploration (BEXP). In addition, the company recently announced it has entered into an agreement to earn a 40% working interest in 6,200 net acres located in Kern County, California with Cirque Resources, LP.

The company also owns interests in geothermal, uranium and real estate. Its exposure to geothermal is through a 22.8% interest in the private company Standard Steam Trust, LLC (SST) based in Denver, Colorado. SST has approximately 90,000 acres of Bureau of Land Management state and fee leases in six prospect areas located in three states. SST intends to explore and develop these properties in order to sell them to utilities or other investors to get a return on its investment. The company sold its uranium assets to Uranium One (OTC:SXRZF), but could still receive up to an additional $27.5 million plus royalty payments totaling up to $12.5 million if certain conditions are met.

The company also holds a uranium royalty interest in Rio Tinto’s (NYSE:RIO) Jackpot uranium property located on Green Mountain in Wyoming. Lastly, the company has a modest real estate exposure through its ownership of a 216-unit apartment complex in Gillette, Wyoming as well as various other real estate located in Fremont County, Wyoming.

The company has approximately $40 million cash and marketable securities and total liabilities of only $12.67 million. The company reported a small loss for the quarter ended June 30, 2010 primarily due to dry hole costs recorded in the amount of $3.4 million.

The play on the strategic metal molybdenum is most likely still several years away from producing any real revenue, but you have the oil, gas, and cash to keep you company while you wait.

Pinetree Capital Ltd. (OTCPK:PNPFF) is a self-described diversified investment, financial advisory and merchant banking firm focused on investing in early stage micro- and small-cap resource companies. Its primary exposures are in precious metals (46%), potash, lithium and rare earths (18%), uranium and coal (17%), base metals (16%), oil and gas (7%) and other technologies (6%).

As of June 30, 2010 the company had a net asset value of $2.19 per share and recently traded in the $2 range representing a slight discount to book value. However, much of its portfolio consists of public companies so this value changes on a daily basis. A few of its investments include Ucore Rare Metals (OTCQX:UURAF), African Gold Group (OTC:AGGFF), Cline Mining Corporation (OTCPK:CLNMF), Bontan Corporation (OTC:BNTNF) and fellow investment company 49 North Resources (OTC:FNINF).

It is important to note that its investments are made up of very small companies whose valuations can have wild swings to both the upside and the downside. An investment in Pinetree would require fair amount of due diligence on the companies held in its portfolio and in the decision makers at Pinetree.

Strategic Metals Ltd. (OTCPK:SMDZF) is an interesting company that is primarily a junior gold exploration company located in Canada which also has several royalty interest and an investment fund that contains the shares of other resource companies. At June 30, 2010, the company had a book value of approximately $33 million, which consisted primarily of its large cash and marketable security holdings of $31.4 million. The stock currently trades at nearly 4 times its June 30, 2010 book value.

While the assets of this company are tied more closely to gold, I believe all of the noise around rare earths has helped propel this stock higher. A major pullback in rare earth prices may have an negative impact on price of this stock, but very little impact on the value of the underlying assets. If the share price pulls back on a drop in rare earth prices in a strong gold price environment, this stock may be an attractive option.

The share structure of the company has changed significantly in the last couple of months through a private placement and the exercise of share purchase warrants. The company should be releasing its third quarter results soon which will make the new capital structure more clear at that time.

Dacha Strategic Metals, Inc. (formally Dacha Capital, Inc.) (OTCPK:DCHAF) is a unique Canadian investment company that acquires, stores and trades the physical strategic metals with a focus on the rare earth elements. The company has been acquiring these rare earth elements in China and then exporting them to warehouses located in Singapore and Korea. This model totally eliminates the risk of mining rare earth elements.

The company recently announced that it has executed the sale of 20,000 kilograms of 99.99% pure Gadolinium Oxide for $1.18M which was 25% above replacement cost and resulted in a 237% gain in the value of the Gadolinium Oxide held in inventory. The company believes this transaction is confirmation of its business model to acquire, store and trade in the rare earth element market.

Lutetium and Dyprosium Fe represent more than half of the market value of its current inventory. As of October 15, 2010 the net asset value of the company was $0.43 per share which is close to the stocks recent trading price.

If you are looking for a pure play on strategic metals with a rare earth element concentration, this is as close as it gets.

Aberdeen International, Inc. (OTCPK:AABVF) is a Canadian investment company and merchant bank that specializes in private and small-cap resource companies. The company’s goal is to be an early investor in undervalued resource companies and unlock value by taking an active role in the management of its portfolio companies. The company also receives revenues from gold royalties that provide cash flow and will participate in the rise in gold prices.

If you liked what you read regarding the aforementioned Dacha Strategic Metals, Aberdeen may be a way for you to indirectly participate with the potential success of Dacha and limit the downside of failure. In 2009, Aberdeen purchased 11% of Dacha with warrants that could increase ownership to 19.9% and is one of its largest public holdings. Aberdeen’s portfolio is highly leveraged to precious metals, but also gives the investor exposure to rare earths, potash, coal and other commodities.

As of July 31, 2010 the company announced its investment portfolio and cash on hand was valued at $0.69 per share and shareholders equity of $1.12 per share. The company’s stock recently traded at $0.57 per share.

If you are not comfortable with the risks associated with small-cap companies, you may be better off getting your exposure through the new MV Rare Earth/Strategic Metals ETF (NYSEARCA:REMX) or one of the major miners such as Rio Tinto (RIO), BHP Billiton (NYSE:BHP), Vale S.A. (NYSE:VALE) or Anglo American (OTCPK:AAUKY).

Disclosure: No positions at the time of this writing.