Why Goldman Sachs Is Dead Wrong on Rare Earths

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Includes: AVL, GWMGF, LYSCF, MCPIQ, QSURD, STZYF
by: Matthew Smith

Over the past two weeks, the world’s stock markets have encountered significant headwinds. Nearly all sectors have been hit, including the red-hot rare earth element-focused plays. Make no mistake: A correction was in order due to the large run-ups in share prices, but the recent string of negative research reports and opinions to surface could not be further removed from fact.

Many in the media believe that this downturn is the result of a perceived earnings disappointment by Molycorp (MCP). The only disappointment is the fact that that story has legs and continues to pervade the investment news media. At this point, Molycorp’s earnings and revenues do not matter, believe it or not. The company is running at less than 10% of total future production and is still working on streamlining all of the mining and refining processes.

Instead, what investors should be focusing on is how the company is progressing to full production in Phase I as well as progress in its separation and manufacturing capabilities. The company stated it was both on schedule and on budget to bringing production online, which is the most important takeaway.

The earnings and revenue misses are not what caused the sell-off; rather, it was falling commodities, debt fears in Europe and the US, and skittish markets in general. The higher the risk of a security, the quicker it is sold during times of duress, whether it be factual or perceived duress.

The recent flurry of research reports and interviews declaring rare earths overextended has not helped the industry in the least. It would serve investors well to do some research on their own in regards to industry supply/demand ratios moving forward. If they did this, they would realize what a sham the Goldman Sachs (NYSE:GS) report really was.

Sadly, many times when you look at the big picture, you miss the important little details, such as rare earth production by element. To look at the rare earths in a deposit as a basket is quite fine, but to look at world production in that manner and draw conclusions about supply/demand imbalances is irresponsible.

Goldman Sachs is correct that with Mount Weld and Mountain Pass coming online, a large portion of the rare earths shortage would be bridged. However, this covers the light rare earth elements (LREEs) and hardly addresses the world’s heavy rare earth element (HREE) demand, which will only grow. The rare earths are not interchangeable or substitutes for one another, so to make the blanket statement Goldman did hardly makes sense.

The statement makes as much sense as saying ExxonMobil’s (NYSE:XOM) future looks bleak because the world will shortly be awash in natural gas via shale drilling, which will push oil prices lower. We know that statement has little basis, even though natural gas can be substituted for oil at various plants.

Now the world may very well be swimming -- or worse, drowning -- in Cerium and potentially Lanthanum in the future, but that will hardly have an effect on neodymium, praseodymium, europium, dysprosium, terbium or any of the other extremely in-demand heavy rare earth elements. In fact, the world will need to have a huge surplus of rare earths on a TREO basis in order to successfully supply the world’s demand for each individual element.

It sounds crazy, but it is not. Most REE deposits are composed of LREEs, with the HREEs making up less than 5% of the TREO (for the best LREE deposits). Even the very rare HREE deposits have a LREE composition in the 50% neighborhood. Thus in the future, many more tons of LREEs will need to be produced simply to meet HREE demand.

One fact that the world is missing out on is that rare earth prices are moving powerfully higher, even with Japanese car production having fallen off of a cliff. The Japanese earthquake and tsunami were supposed to hurt rare earth prices, but instead the world has watched prices continue to rise.

Molycorp and Lynas (OTCPK:LYSCF) are sure to be winners, assuming they can get into production without delays. They will both have state-of-the-art facilities and proprietary production techniques which provide a barrier to entry (if LREE prices fall, investors will not finance future LREE mines of other companies). However, while investors can use the next few years to take advantage of these high LREE prices via Lynas and Molycorp shares, it would be wise to begin to strategically take position in the HREE miners.

In future articles, we will cover the HREE deposits of the world in more depth; however, American investors have few choices on the big three exchanges (NYSE, Nasdaq and AMEX) for exposure to these plays. Avalon Rare Metals (NYSEMKT:AVL) up until today has been the only way to play the HREEs, but now Quest Rare Minerals (OTC:QSURD) trades on the AMEX as well. In a previous article, we covered Tasman Metals (OTC:TASXF), another HREE-focused companyl. Tasman will have a listing in the US shortly; within the next month is our guess.

For those investors willing to take on some additional risk, the pink sheets provide opportunity to gain exposure to a few companies that could be dark horses in the race to production of the HREEs. First is Stans Energy (OTC:STZYF), which has a former Soviet mine that supplied all of the USSR’s REE needs for decades. That mine has two years of ore waiting to be processed, a mining license, known metallurgy and a separation process that is proven. The company also is waiting to close on the facilities with all of the equipment to separate the REEs from the ore and get them to marketable quality as well as the infrastructure to deliver their materials to market (mainly a rail line).

The property has further exploration potential which could greatly enhance the resource, and a beryllium deposit is currently being evaluated with a JORC to come out in the future. Stans has some risk associated with it; however, the Russian government has aligned with management and is working with it to bring the mine back online in Kyrgyzstan. The company recently raised C$28 million via a secondary offering and will use these funds to perform a feasibility study and bring the mine back online. Stans could be the first HREE producer to provide significant HREE supply to the market, which is why we have previously written about it and hold a position.

Another potential HREE player is Great Western Minerals (OTCPK:GWMGF), a company that Molycorp tried to buy prior to coming public. MCP wanted to gain control of the company’s two subsidiaries, Great Western Technologies and Less Common Metals, which turn the rare earths into magnets and other highly valuable manufactured goods.

Great Western has control of the Steenkampskraal mine located in South Africa, which has a relatively small overall ore tonnage, but a very rich grade as it pertains to TREO. A lot of the Steenkampskraal production will go to GWG’s own needs as required by subsidiaries GWT and LCM, and some stockpiling we figure it will do for those two entities. GWG has not really stated whether it has the hydrometallurgy figured out for the project, but it did recently put out a press release giving investors a timeline for bringing production online in the near future.

The REE story hardly gets solved in the next few years across the board. The market will not be nearly as tight going forward, assuming both Lynas and Molycorp are able to bring their production online and the next wave after that is able to bring mines online in 2015 – which does not include the two dark horses we pointed out could beat those targeting this date. Doing your own due diligence in the sector is now a prerequisite to making investing decisions as information is beginning to be altered to justify personal opinions.

For those wanting to blindly trust the Goldman Sachs report, it should be noted that these are the same guys who wanted to sell out of Molycorp prior to the IPO, and did. That certainly was not a low to sell at, and they made plenty of money -- but they left more money on the table than they walked away with.

Disclosure: I am long HREEF.PK and QSURD.PK.