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Most investors are aware of rare earth elements because of the doubling, tripling, and quadrupling of rare earth element companies' share prices over the last six months, clearly reflecting investor enthusiasm with the sector.

Because anyone reading this article is aware of the supply/demand case for rare earth elements' - as well as China’s - dominance over the market, I will instead focus on highlighting the potential risk of buying a rare earth element company based solely on hype. In particular, my analysis will show that while Rare Element Resources (NYSEMKT:REE) and Molycorp (NYSE:MCP) share similar mineral ore (bastnasite) and mining techniques (open pit), and each stock has performed equally well, Rare Element Resources' stock price is comparatively overvalued.

Analysis Highlights

  • Using mill recovery rates comparable to Molycorp (65% vs 80%), REE’s annual production declines to 8,500 metric tons compared to an initial estimate of 11,400 (10,400 metric) tons result in an NPV of $42,000,000 at 2010 ore pricing, and an NPV of $367,000,000 at 2020 ore pricing using a 10% discount rate (see item 1 below).
  • According to the consultant that conducted the preliminary assessment of the Bear Lodge project, the 2015 start date is “pretty aggressive” and most likely would take an additional one to two years to develop. Additionally, the GAO estimates that an “exploration mine,” which REE is classified as in their 2010 annual report, can take between 7-15 years to bring a property fully online (see item 2 below).
  • REE claims infrastructure is already in place for the Bull Hill Mine while in fact the last 11 miles of road to the mining area is maintained in the winter and snowmobile access is given priority from March through December (see item 3 below).
  • The forecast of a 5% market share in 2015 (ex-China demand is anticipated 50,000 tons) is optimistic because of planned output increases by Molycorp (40,000 tons by 2013) and Lynas (OTCPK:LYSCF) (20,000 tons by 2013) (see item 4 below).

Summary

Based on the above mentioned information, as well as recent news articles identifying the CEO and CFO's participation in the operation of other businesses within a shared main office of 500 sq feet, I believe REE should be trading between $5-$7.50 per share.

*further analysis of each highlight can be found in the section “Assessing Materially Important Information Disclosed by REE”

Assessing Materially Important Information Disclosed by REE

1) Assumption : “ REE recoveries of 90% are assumed for the preconcentration based on preliminary bench-scale test work, however these results have yet to be confirmed with pilot-scale test. Metallurgical recovery to a concentrate is estimated at 90% from the preconcentrate, for overall recoveries of 90% times 90% or approximately 80% into the concentrate.” (Scoping Study Press Release, pg 12)

Reality : Molycorp uses a 65% Mill Recovery Rate in their feasibility study compared to REE’s 80% Mill Recovery Rate. Like REE, Molycorp uses open pit mining of bastnasite mineral ore. Although it is possible to achieve a 80% mill recovery rate and was achieved at Molycorp’s Mountain Pass Mine, according to the book, Extractive Metalurgy of Rare Earths, “The complex bastnasite ore was beneficiated using a double reverse gangue flotation followed by bastnasite flotation. A specially developed collector was used.” (Ferron et al. 1991)

Impact : Adjusting REE’s mill recovery rate to the more probable 65% rate which was used in Molycorp’s feasibility study, the annual production falls to 8,500 metric tons resulting in a NPV of $42,000,000 based on 2010 ore pricing ($13.71 per kilogram), and using 2020 ore prices ($20.35 per kilogram), REE’s NPV falls to $367,00,000 using a 10% discount rate. This is in stark contrast to REE’s assumptions in their base case scenario.

* Base case 1 & 2 from Scoping Study

Base Case 1

(scoping study)

Base Case 2

(scoping study)

Base Case 3

Base Case 4

Production Rate (tpd)

1,000

1,000

1,000

1,000

Mine Life(years)

15

15

15

15

Initial Capital (US$)

$87

$87

$87

$87

Operating Cost (US/ton)

$245

$245

$245

$245

Life of mine Sustaining Capital (US in Millions)

$88

$88

$88

$88

REO Recoveries to Concentrate

80%

80%

65%

65%

Annual REO contained in Concentrate (metric tons)

10400

10400

8500

8500

Annual Payble Value of REO (US n Millions)

$143

$178

$11.6

$172

Annual Operating Cashflow (US in Millions)

$50

$80

$22

$78

Life-of-Mine Cash Flow (undiscounted in Millions)

$598

$978

$290

$1,004

After-tax Net Present Value @ 10% (Millions)

$213

$380

$9

$367

After-tax Net Present Value @ 15% (Millions)

$131

$251

$42

$239

Base Case 1-Assumes REO pricing on historical 3 year average

Base Case 2- Assume REO pricing with a 25% increase from 3 year average

Base Case 3- Assumes comparable mill recovery rate of 65% as Molycorp and 2010 REO pricing

Base Case 4- Assumes comparable mill recovery rate of 65% as Molycorp and uses 2020 REO pricing


2) Assumption: Rare Element Resource’s feasibility study anticipates that the mine will be operational at 5400 metric tons per year in 2015, increasing to 10400 metric tons by 2018.

Reality :

  • There are also questions about the company's targeted production start date of 2015; even the company's fans think it might be a tad optimistic. We checked in with Michael Richardson, an independent consultant employed by John T. Boyd Co., which did the preliminary assessment of the Bear Lodge prospects. In Richardson's opinion, the start date is "optimistic" and, in fact, "pretty aggressive," given obstacles such as permitting. "My guess is you're looking at a year or two delay." (Barron’s)
  • “The April 2010 U.S. GAO briefing stated that, for a typical exploration-stage mine, once a company has secured the necessary capital to start a mine, government and industry officials said it can take from seven to 15 years to bring a property fully online, largely due to the time it takes to comply with multiple state and federal regulations.” (GAO Report, pg 13)
  • Rare Element has no known reserves and no economic reserves may exist on its properties, which could have a negative effect on its operations and valuation. Despite exploration work on the Company’s mineral claims, no known bodies of commercial ore or economic deposits have been established on any of its mineral properties. In addition, The Company is at the exploration stage on all of its properties and substantial additional work will be required in order to determine if any economic deposits exist on its properties.” (2010 Annual Report, pg 11)

Impact : Any delay to entering the market will reduce REE’s ability to gain the necessary market share through supply contracts that are vital for mine development and operation.

3) Assumption: “Infrastructure in the project vicinity is already well established with an excellent road and highway system, nearby railroads, nearby power lines, available water source, and skilled labor within several local communities” (2010 Annual Filing, pg 31)

Reality : “The Bear Lodge Mountains have a warm and relatively dry climate during summer, followed by cold winters with variable amounts of snow. Optimal field conditions extend from April to November. The Taylor Divide Road is not maintained during winter months, and snowmobile access is given priority from December through March.” (2010 Annual Report, pg 45)

Impact : The last 11 miles of road leading up to the potential REE target area are not maintained during five months of the year. These roads would most likely need to be paved and then maintained 5 months out of the year in order for REE to meet their production goals.

4) Assumption: “The economic model suggested by IMCOA and tested by Boyd envisions a 5% market share capture (10,400 tonnes of a 200,000-tonne REO market) specifically for cerium, lanthanum, neodymium and praseodymium. This assumes that 2 other mines, one in the USA and one in Australia, will go into production prior to Bear Lodge, and that IMCOA's projections of market growth will allow additional producers of the light and heavy rare earths to successfully market their products by 2015.” (2010 Annual Report, pg 29)

Reality : Expected demand outside of China is estimated at 50,000 tons by 2015. Molycorp anticipates producing 40,000 tons by 2013 while Lynas anticipates producing 20,000 tons by 2013 for a total of 60,000 tons.

Impact : With supply expected to exceed demand in 2015, a 5% market share would either be unattainable or economically not feasible because of lower REO prices from increased supply. Furthermore, companies including Toyota (NYSE:TM) (article) and GE (NYSE:GE) (article) are innovating their technologies to require less rare earth elements while Europe (article) and Japan (article) are both focusing on increased rare earth element recycling.

Source: Why Investors Should Be Cautious of Rare Element Resources