How to Profit From Difficult Rare Earth Situation

 |  Includes: MCPIQ, REMX
by: Glenn Rogers

Hands up, all those who had heard about rare earth elements prior to this year. Hmm. I didn't think so.

Did you also know that there was a rare earth elements crisis prior to a recent dustup between Japan and China? The upshot of that dispute was that China threatened to stop supplying Japan with those same rare earth elements.

For those who have not been keeping up with this seemingly esoteric story, here's what it boils down to: China has the rest of the world by the "you know what" when it comes to rare earths. Why you should care? Because without them, many of the high-tech devices we take for granted wouldn't exist.

It turns out there are 17 rare earth elements (REEs) which are critical to the manufacture of numerous high-tech products such as colour TVs and flat-panel displays. REEs are used in petroleum refining and defense systems like missiles, jet engines, and satellite components. They are also essential for the manufacture of batteries and catalytic converters for cars. All in all, without rare earth elements we would be in deep doo-doo.

So here's the kicker. Currently, China produces roughly 95% of the global supply of rare earth elements and Japan is the largest importer. You can see why this recent dispute had people in Japan pretty concerned.

Of course, it worried people in Washington as well, since America's ever-expanding defense complex would be threatened if the U.S. could no longer have access to the Chinese product. But, there's good news. It turns out that both the U.S. and Canada have substantial amounts of rare earth elements. In fact, the U.S. used to produce REEs until the domestic cost got too high, at which point they outsourced this vital resource to China. Sound familiar? It's the same thing America did with its energy policy so that now, in addition to being dependent on other countries for its energy needs, the U.S. is also dependent on another country for rare earth elements.

How did we get to this sorry state? It turns out in mid-1980s China, in an effort to promote social stability through full employment, they began subsidizing a vast number of small mining concerns specializing in REEs. This initiative created low-cost production which drove most of the other world suppliers out of business and resulted in a monopoly for China. Countries like the U.S., Australia, Russia, and Brazil closed down rare earth mines, ceding the field to the Chinese.

Coinciding with this development, the technological revolution we've experienced over the last two decades has driven up the demand for these elements, which previously were primarily used in the manufacture of cathode ray tubes in old-fashioned television sets. Once we began producing catalytic converters, laptop computers, cell phones, etc. in huge quantities, along with the other essential products mentioned earlier, the demand exploded.

Of course, now that the Chinese control the production the prices are going up. In fact, the prices have tripled so far this year and if demand continues to ramp higher before alternative production comes on line...well, you get the picture. New REE mines are being developed in Australia and feasibility studies into developing economically efficient REE deposits are underway in the United States and Canada. However, it takes a long time to bring these projects online. Although rare earth elements are not all that rare, despite the name, concentrations that are economically feasible to extract are difficult to find. So we are looking at higher prices and continued vulnerability to China's whims for some time. Adding to our woes is the fact that Chinese domestic consumption is also increasing and that will dictate how much product the country is prepared to export to the rest of the world.

So how do we profit from this difficult situation? Until recently, the most popular vehicle for investing in this commodity group has been Molycorp Inc. (NYSE: MCP). The stock has been on a tremendous tear this year, rising in the last 52 weeks from $12.10 to a high of $40.90 (figures in U.S. dollars). Personally, I bought in at $18 and then sold at $28 after I saw the CEO interviewed on CNBC. In what seemed like a rare flash of honesty, he essentially signaled that the stock had gotten ahead of itself. Predictably, the market didn't notice - once momentum takes hold, it tends to overshoot, up or down. The stock continued to run, to my dismay, but reality finally prevailed in late October and the shares have now pulled back to the $30 range.

Molycorp owns the largest known deposits of REE in the United States. Located in Colorado, the mines were a major producer at one time but they were shut down because of low-cost production coming out of China and significant environmental issues. Because of the run-up in prices, Molycorp has been raising money, initially from an IPO last year and latterly from loan guarantees from the Department of Energy, and is beginning the process of getting back into production. In the meantime, the company has been refining and selling some inventory that they had on hand to take advantage of the higher prices. The company plans to ramp up its annual production to 40 million pounds of rare earth products over a three-year period, which will certainly reduce our dependency on Chinese production. As new Australian production comes online over the next few years, things may begin to come back into balance.

Molycorp recently reported a big jump in sales during the third quarter, from $2 million in 2009 to $8.4 million this year. The company said the growth was driven by a combination of increased sales volume and significantly higher pricing. Molycorp sold approximately 1.15 million pounds of rare earth oxide products in the quarter, a 44% increase from the 0.8 million pounds sold in the same period last year. The company said it realized an average sales price of approximately $7.31 per pound, compared to an average sales price of $2.45 per pound for the third quarter of 2009.

However, the big jump in sales wasn't enough to put Molycorp into the black. The company reported a net loss of $10.1 million for the quarter (14c per share, fully diluted) compared with a loss of $6.9 million (18c per share) last year. So if you invest here, you're buying future expectations, not current earnings.

Despite the run-up in the share price, I believe Molycorp is still a buy, particularly in light of its recent pullback. I think we could easily revisit the 52-week high of almost $41. However, I should stress this stock is for aggressive investors only.

Very recently, another way to play the rare earth market has emerged and this one comes with somewhat less risk because it offers diversification. On Oct. 27, Van Eck Global launched a Rare Earth/Strategic Metals ETF (NYSE: REMX). It aims to replicate as closely as possible the performance of the Market Vectors Rare Earth/Strategic Metals Index, net of expenses. This index is designed to give investors a means of tracking the performance of publicly traded companies primarily engaged in the producing, refining, and recycling of rare earth/strategic metals. To be included, a company must have the capacity to generate more than 50% of its revenue from rare earth/strategic metals-focused efforts.

This is not a pure play in rare earths - there aren't enough publicly-traded companies in the industry to create a decent portfolio. So in addition to rare earth producers, the ETF also has holdings in companies that mine titanium, molybdenum, and similar materials. The fund's holdings are global and include properties in China, Canada, Australia, and Brazil. Of course, Molycorp is a key position, but the ETF also owns shares in such Canadian companies as Thompson Creek Metals (TC) and Neo Material Technologies (OTC:NEMFF).

Because it's so new, it's hard to know where REMX will ultimately settle out. The first few weeks have been quite volatile. But as the fund settles down, this may be the best way to play the strategic metals commodities segment. So far, the ETF has generated strong volume and there is a high interest in the area, so I believe that it will trend higher alongside other commodity plays that have been doing well this year.

I should caution that this group of commodities, along with the rest of the sector, has tended to do well as the U.S. dollar has weakened and fears of a new spike in global inflation roiled the markets. If these conditions change, commodities may well experience a pullback. But over the next two years, my guess is that inflation is coming back and that commodities of various kinds deserve a place in everyone's portfolio - especially REEs.

Action now: Buy Molycorp Inc. if you are an aggressive investor and want to own a position in a single company that is in the process of becoming a major U.S. supplier of rare earth elements. The shares were trading at mid-afternoon on Friday at $30.34.

If you prefer to own an international portfolio of REEs and other strategic metals, choose the Van Eck ETF. It was trading on Friday at $20.17.

Disclosure: Long REMX