Rare Earth: Recent Chinese Moves Only Support the Investment Thesis

Jan.21.11 | About: Molycorp, Inc. (MCPIQ)

China’s Ministry of Land and Resources has invoked a seldom-used mining law to take direct control of 11 rare earth mining districts in southern China. The ministry said in a statement, posted on its website Wednesday and briefly mentioned Thursday by the state media, that rare earth mining in those districts, all at the southern end of Jiangxi Province, had been placed under its national planning authority. That step removes administrative oversight of mining from provincial and municipal control; local officials in southern China are widely suspected of collusion with crime syndicates responsible for illegal strip-mining and refining of rare earths.

This, in my opinion, is just a further move to consolidate the mining and production of REE by the Chinese government. This is merely another factor in the continued appreciation of the rare earth miners and refiners. I continue to be bullish on the sector and believe there is room for significant appreciation from today’s levels.

Factors influencing the rare earth thesis and my take on them:

Molycorp Inc. (MCP) and potential rivals in rare-earth mining are competing for advantage as lawmakers seek to revive U.S. production of the minerals used in products from “smart” bombs to wind turbines and mobile phones. The company, which is preparing to reopen a shuttered mine in California, wants federal loan guarantees to convert the elements into metals, alloys and magnets, said Jim Sims, Molycorp’s vice president for public affairs, in an interview.

I believe the government will give producers subsidies in the form of guarantees in order to increase -- or begin -- production. Why is this important? It helps level the playing field with state-run and/or controlled companies, and it helps lower the cost of capital for the involved companies.

Lawmakers have called the U.S. reliance on China as a supplier a weakness: Rep. Mike Coffman (R-CO) made the following statement on the House Floor during consideration of an amendment he has offered to the National Defense Authorization Act for Fiscal Year 2011. (Coffman’s amendment, which builds on the GAO report he pushed for in last year’s defense bill, would require the Department of Defense to develop a plan for establishing a domestic rare earth magnet capability.)

As rare earth magnets are currently used in many critical weapons systems, Coffman said, “The Department of Defense is facing a near-term shortage of key 'rare earth' materials necessary to support our defense weapon systems, and rare earth magnets are especially critical. Currently, over 97% of rare earth production is controlled by China. Today, the United States does not have a manufacturer of neodymium iron boron rare earth magnets, yet they are found in our precision guided munitions, ships, aircraft, and other critical weapons systems.”

There are critical defense uses and applications for rare earths which cannot be overlooked or understated. Think of the “reduce dependence on foreign oil” movement and then wrap it in a national security concern. Governments are not known to be overly price-conscious and will subsidize mining, production and refining of REE -- to the benefit of REE companies.

According to hybridcars.com, officials from Toyota (NYSE:TM) confirmed that a lack of rare earth materials was not a major or immediate concern. “This is something that we have to address as more manufacturing of electric vehicles and hybrids come online,” said Jana Hartline, Toyota’s environmental communication manager, in an interview with HybridCars.com. “Does that mean next week? No. It becomes a legitimate thing to consider when you talk about production in the order of millions over several years.”

Takeshi Uchiyamada, Toyota’s executive vice president for research and product development, told Bloomberg that Toyota is developing efficient, cheaper, lighter motors, along with advanced batteries and power electronics, as electric propulsion becomes increasingly important to the company and the auto industry. In 2012, Toyota will sell the RAV4 EV compact sport-utility electric vehicle with an induction motor supplied by Tesla Motors (NASDAQ:TSLA). That battery, and the one used in the Tesla Roadster and future Model S sedan, use a similar motor without rare-earth materials.

This will help mitigate the squeeze being felt by the auto companies, but will not be fully implemented for years. Interestingly, induction motors should be hitting their stride as rare earth projects come online. The basic rule of economics is if the price gets too high, substitutions will be found. This will inevitably be the case. I will say, however, that I am not looking to marry rare earth companies, but to merely invest in them.

The bottom line, in my opinion, is that rare earth prices will continue to go up as there are no viable options (substitution) at this juncture. In its simplest form, pricing is a function of supply and demand. The demand for REE continues to increase as the supply (in the near-term) continues to shrink. Is this factored into the equities of REE companies? Yes, it undoubtedly is, but the underlying fundamental (supply / demand) trends and technical (momentum / headline / political) trends point to continued appreciation.

Disclosure: I am long OTCPK:GWMGF.