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Let's not mince words – China's policy of choking off the world's access to rare earth metals will ultimately fail.

Although China has clearly created a tizzy in the markets because of its policy to slowly strangle its export quotas of rare earth metals, it would be more surprising if this move does not go down in the books alongside the Hunt brothers' attempt to corner the silver market and other market-cornering maneuvers. Maybe this is really not all that unexpected; after all, China is not necessarily up to date on all of the details about how free markets operate.

The Problem

As has been reported many times in many places, China happens to sit on top of a very large percentage of the world's rare earth elements. Actually, that's not really the story. China reportedly holds about 37% of the world's reserves but is responsible for about 97% of the world's supply because the central government kept supporting rare earth producers at a time when Western mining companies shut down their rare earth operations because of low prices.

In any event, rare earth elements are key components in many technological devices. Lanthanum features in battery electrodes and refining catalysts, cerium goes into many ceramics, neodymium is vital in magnets used in many technological applications. So on and so forth. Said differently, companies ranging from Apple (AAPL) to General Electric (GE) to Johnson Controls (JCI) and Toyota (TM) have all designed products on the basis of ongoing access to affordable rare earth metals.

With China now apparently looking to cut its export quota by 35% from the prior period and rare earth metal prices at very high levels, that is clearly a threat.

Or is it?

The Solution

Economics 101 tells us that when prices rise two things happen – sellers look to increase the amount they can supply and customers look for alternative or substitute products. That is precisely what we are seeing now.

A host of mining companies, including Molycorp (MCP), Lynas (OTCPK:LYSCF), Avalon (AVL) and Rare Element Resources (REE), have stepped up and advanced plans to open or reopen mines that can produce rare earth elements in economic quantities. Now it is certainly true that it takes years to bring a mine online, but there is ample capital right now willing to back these companies and at least some of those mines will open in the next few years. At that point, China will face the reality that it has alienated a lot of trading partners for no durable purpose.

At the same time, rare earth users are doing what companies often do when faced with high prices – looking for substitutes. In the short run there are no easy swaps for europium or ytterbium or other such materials, but that is not the case for the long term. LED makers are already looking at ideas like semiconductor nanocrystrals as an alternative to cerium and europium and it stands to reason that Philips (PHG) and other makers will adopt them if rare earth prices go too high. Likewise, companies like Hitachi (HIT) are developing motors that use ferrite magnets instead of rare earths.

Last and not least, there are other intermediate steps being taken. When platinum soared a few decades ago, sharp thinkers rushed to junkyards to strip the platinum out of catalytic converters. Likewise, electronics recycling activity is picking up as a means of recycling those rare earth components.

It should also be noted that China's restrictions are export restrictions, suggesting that companies can source production to China to get around the rules. Perhaps that is really China's ultimate goal. China's rulers probably know they cannot win the low-cost-labor game indefinitely, so maybe this is just one more way to convince or coerce the likes of Johnson Controls or General Motors (GM) to produce in China - “come to China and you'll get the resources you need."

The Bottom Line

Markets have a way of sorting out shortages. The oil crisis led to more fuel-efficient cars and other less famous temporary shortages led companies to innovate around the problem. This will almost certainly happen with rare earth metals as well. That is not to say that rare earth metal miners are a bad idea; many are expensive but the three to five year prospects look bright for the underlying metals. What is does say, though, is that China is going to discover that the profit-motive and creativity of capitalism is ultimately stronger than its unilateral trade policy.

Source: China's Rare Earth Policy Will Ultimately Fail (And What That Means for Metal Miners)