Rare Earth Stocks Poised for a Fall

| About: Molycorp, Inc. (MCPIQ)

Over the last few months, the price of Molycorp (MCP) zoomed from an IPO price of $14 to a high of $62.80. Prices of other rare earth stocks have followed similar trajectories. These stocks have become favorites of both the bulls and the bears. Much has been written about the future earnings potential of rare earth stocks with a lot of passion from both sides. A careful review shows that the projections from both sides are highly speculative without a solid foundation.

This article will avoid speculation and duplication of analysts’ reports. The point of this article is to use common sense to make money. To use the common sense approach, it is essential to understand the history.

The name rare earth metals is commonly refers to seventeen chemical elements, specifically the fifteen lanthanoids plus scandium and yttrium. These elements are used in manufacturing a wide variety of industrial products such as magnets, lasers, batteries, high refractive index glass, fluorescent lamps, and catalyst for oil refineries.

Gadolinite, a silicate mineral, which consists principally of the silicates of cerium, lanthanum, neodymium, yttrium, beryllium, and iron, was the first rare earth mineral to be discovered in 1787, at a quarry in the village of Ytterby, Sweden. Over the next 150 years, the world came to know of all the present day rare earth metals through a series of discoveries.

India and Brazil were the major sources of rare earth metals until 1950. In the 50’s South Africa became the largest producer of these metals. The USA took the lead in 1965 with large scale operations at the Mountain Pass mine in California. In 1998, chemical processing at the mine was stopped after a series of wastewater leaks. The mine closed in 2002 due to environmental issues and falling prices of rare earth metals. Prices of rare earth metals had been steadily falling as China emerged as a major competitor. China had the advantage of lax environmental standards and low wages in its huge mining operation in inner Mangolia. In 2009, China supplied approximately 96% of world’s rare earth metals.

In 2008, Chevron (NYSE:CVX) sold the Mountain Pass mine to privately held Molycorp Minerals, LLC. On July 29, 2010, Molycorp, Inc. sold 28,125,000 shares at $14 in its IPO.

Until September 2010, most people had never even heard of rare earth elements or rare earth metals. On September 22, 2010 China apparently banned exports of rare earths to Japan in retaliation for the Japanese arrest of a Chinese trawler captain in a territorial dispute. Due to the critical nature of the rare earth metals in the production of several key items, the matter gained immense publicity. Along with the publicity, stock prices of rare earth stocks, such as Molycorp, have skyrocketed.

In forming an investment thesis, the following facts are incontrovertible:

  • There are several misconceptions in the market: First, for the most part the name rare earth elements is a misnomer (most of these elements exist in abundance); second, there is a misconception that these elements are available only in China. Nothing could be further from the truth. Due to cheap labor in China, Western-world mines simply could not compete with the cost and went out of business.
  • Rare earth metals are more difficult to extract than the transition metals due to their similar chemical properties.
  • There are significant environmental considerations in mining and extracting rare earth metals, making the rare earth elements relatively expensive.
  • China knows that its leverage is only short lived as it will not be long before the world again starts producing rare earth elements in places other than China. Significant efforts seem to be underway in USA, Australia, Vietnam, Canada, Greenland, Soth Africa, Brazil, Estonia, and Russia.
  • Major research is underway to find substitutes for rare earth metals. There is every indication that this research will be successful.
  • Rising prices of rare earths will make extraction from non-mining sources, such as electronics waste and nuclear waste, more economical.
  • Emergence of other sources will take time, and in the meanwhile, there is a definite possibility that the prices of rare earths will spike up further.

To make money on rare earth stocks, due attention must be given to the following facts:

  • These stocks have small floats.
  • Short interest in these stocks is high.
  • These are very high beta socks.
  • These stocks are driven by a constant flow of news and rumors.

In situations like this, the ZYX Change Method is especially helpful to generate profits. For the sake of brevity, this article is not delving into five of the six screens of the ZYX Change Method. At this point, the following four recent developments constitute a trigger to take profits on long positions and initiate short positions:

Those inclined to short sell Molycorp are cautioned of the extremely high risk for the reasons stated above. Further, no one should consider selling short such a volatile stock without a disciplined risk control plan such as the one promulgated by the ZYX Change Method. If the objective is to make money, it is important to not get married to a certain point of view on a stock like Molycorp where the news flow continuously changes the landscape.

Disclosure: I am short MCP.