China's REE Market Dominance

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Includes: GM, LYSCF, MCPIQ
by: Ben Kramer-Miller

Summary

The Chinese have come to dominate the REE market through calculated long-term planning.

The implications of this dominance continue to be overlooked as REE prices are low, reported supply exceeds demand, and foreigners can access the REEs they need.

These points are temporary and serve to minimize the extent to which REE-market dominance can be used as an economic weapon.

As a result of this confluence of factors, the REE space remains among the best contrarian trades out there.

With rare earth element (REE) prices low and several individual REEs "oversupplied", we find very little prima facie incentive for investors to deploy capital in the sector. The lousy projected economics of most proposed projects only exacerbate the difficulty found in developing a viable REE business. A closer look at the space reveals that large sectors of the economy depend on a ready supply of a wide variety of REE products, and their absence would put any economy at a notable disadvantage. Without REEs we would not have small computers, cell phones, microwaves, sensors, radars, MRI machines, advanced telecommunications networks or a variety of other things.

This reality has only just begun to sink in for Americans, although it hasn't fully hit home. A bubble in REE prices and the frenzy surrounding the Molycorp (OTCPK:MCPIQ) IPO started a dialogue 5-7 years ago. Unfortunately, the industry's loudest cheerleaders were on Wall Street and Bay Street, which is in large part why there isn't yet a viable project in the West. The story rears its head every once in a while (e.g. the 60-Minutes piece), but it is more or less confined to niche government agencies and a handful of investors.

The Chinese have a much better appreciation for the necessity of REEs and of the value in improving REE recovery processes. More importantly, they understand the aforementioned reality that REEs are essential to large sectors of the economy: they have effectively used their REE-industry dominance in order to force companies to locate their manufacturing facilities in China.

It is this reality that has forced U.S. corporations to manufacture products in China, thereby making these corporations (and the institutions dependent upon them) dependent upon continued friendly trade relations between the U.S. and the P.R.C. China benefits whether this is interpreted as a competitive move on the geopolitical chessboard or as a utilitarian maneuver designed to exploit a natural advantage for its broader economic benefit. The latter is demonstrable: Jiang Zemin has said, "Improve the developments and applications of rare earths and change resource advantage into economic superiority." - 1997.

It is probably no coincidence that this is the same year in which China implemented its 973 Program, a state-funded research program focused on technology and industrial development that included REE-industry research. 10 years later Zhao Shuanglian, vice chairman of the Inner Mongolia Autonomous Region, said that REE exports would be restricted in order to attract global industry to Inner Mongolia and to turn Baotou into an industrial center. A particular example of a company that was impacted is W. R. Grace. In 2007, W. R. Grace - a U.S. catalyst producer - lost access to the REEs it needed to produce catalysts in the U.S. As a National Institute For Advanced Studies report put it:

In 2007, as a part of flexing its muscles, China cut of RE supplies to W R Grace, a large US producer of catalysts for the petroleum refining industry. In the same year, it set in place a rationing policy for RE that favoured domestic producers. This was a message to various global companies that if they wanted access to RE material, they needed to set up shop in China to get preferred treatment. Since W R Grace eventually did set up shop in China, this policy seems to be working as far as China is concerned. Such a plan's viability is contingent upon there being sufficient REE resources available, and it is no coincidence that the world's largest REE mine - Bayan Obo - is located in Inner Mongolia.

We cannot be sure whether the Chinese want to simply secure supplies and Western technology for themselves, or whether there is a geopolitical imperative to dominate the global REE market. There is certainly circumstantial evidence of the latter given Chinese attempts to acquire major REE projects outside of China (e.g. Mountain Pass, Mt. Weld) and local governmental objections to these acquisitions. However, we note that given China's size and consequent material voracity that the goal of global REE market dominance is not necessarily the primary intent: the more mundane goal of securing supply of REEs may justify taking such an aggressive approach, even if it has broader implications. Ultimately, it doesn't really matter, as the geopolitical fallout is real whether intended or not. A power's access to materials and technology has always been integral to its ability to thrive or its propensity to perish, and China's control and understanding of REEs is sufficient to give it an inherent advantage over other global powers so long as these materials remain essential to modern industry.

Evidence that the Chinese are at least willing to use this material advantage for political ends comes in the infamous "Japanese fishing boat" incident, although we note that the etiology of the sharp decline in Japanese REE imports in the subsequent months is debatable. The generally accepted narrative is that the Chinese cut off REE exports to Japan in retaliation for imprisoning a Chinese boat (Minjinyu 5179) captain. In the months following the incident, Chinese exports to Japan plummeted, although the timing could be coincidental. Regardless of the "true" reasons behind these events, the Chinese are intent on gaining control of as much of the world's REEs as possible, and even if it hasn't used its existing advantage as a tool of economic warfare, there is little doubt that it could.

This isn't simply the result of the proclamations of a bureaucrat attempting to relocate industrial production to Inner Mongolia. It is the culmination of decades of R&D and other tactical investments. Chinese ambitions in the REE space become apparent as production of iron ore began at Bayan Obo, which is also host to the largest REE deposits in the world and the current largest producer of REEs (as a by-product of iron ore). The discovery goes back to the 1930s when researchers determined that in addition to containing large amounts of iron ore, the Bayan Obo deposit contains significant quantities of REEs and niobium. Actual REE production began at Bayan Obo in 1957. Since then, the Chinese have opened several laboratories and research institutions dedicated to the study of REEs.

  1. The General Research Institute for Nonferrous Metals, established in 1952. Note that this institute covers other nonferrous metals.
  2. The Baotou Research Institute, established in 1963.
  3. The State Key Laboratory of Rare Earth Materials Chemistry and Applications affiliated with the Changchun Institute of Applied Chemistry.
  4. The CAS Laboratory of Rare Earth Chemistry and Physics, established in 1987.

It is critical to note that while the Chinese have control over substantial REE resources, their advantage over potential competitors is their ability to extract REEs from ore bodies efficiently. In fact, one of Molycorp's major problems was that despite the size of the Mountain Pass deposit (not to mention the high ore grade), it failed to efficiently recover the REEs from Mountain Pass ore.

With this in mind, the extensive research into REE chemistry has certainly paid off, and only the Chinese are able to supply the full suite of REE compounds, metals, alloys and key input products (e.g. magnets, lasers, ceramics, phosphors).

Over the past 20 years, we've seen the Chinese active in REE financings and acquisitions. This started with the buyout of Magnequench - a subsidiary of GM (NYSE:GM) that owned a patent on Nd-Fe-B permanent magnets. The subsidiary was bought out in 1995 by China National Non-Ferrous Metals Import & Export Corp. (CNIEC), San Huan and Sextant MQI Holdings, and when the Chinese were allowed to do so, they closed the Indianapolis facility.

Chinese officials wanted to make sure that not only were REEs made in China, but that intermediary products were made there as well. This foreshadows the aforementioned goal of turning Inner Mongolia into an industrial power house and the cutting off of W. R. Grace's REE supply in order to force it to relocate its manufacturing facilities to China.

However, the Chinese were also interested in securing positions in REE companies with major deposits outside of China. In 2005, the China National Offshore Oil Company (CNOOC) placed a bid for Unocal, which held Mountain Pass at the time. The above-cited National Institute of Advanced Studies report on China's REE market dominance claims that the real goal was to acquire Mountain Pass and that Unocal's other assets were not the main target. Given China's voracious appetite for oil, this probably isn't the case, especially considering that Mountain Pass was worth only a small fraction of the $18.5 billion price tag, and considering that Unocal had Asian oil assets. Given Mountain Pass's size and potential to supply the REE market, we cannot rule out that Ucocal's ownership of Mountain Pass was a deciding factor. Chinese interests have also tried to purchase Lynas Corp. (OTCPK:LYSCF), and they now own a minority stake. Chinese interests also control a minority stake in Arafura, which has a large LREE project - Nolans. It will be very expensive to develop and is likely not an economic project in this market environment.

The Bottom Line

China's achievements in growing its REE production, developing its REE processing technologies, and of coming to dominate critical value-add industries such as magnet production has placed several Western companies at great risk insofar as they are dependent upon China to supply them with REEs. For now this isn't a problem. However, long-term demand for REEs is growing, meaning that even if China has no hostile intentions, it could cut off various groups from the market in order to favor those with the highest priority. The now defunct quota system favored Chinese companies operating in China, then foreign companies operating in China, and then foreigners.

The need for an independent source of REEs is a top priority, although market conditions hardly reflect this. Given the lousy economics of the vast majority of the proposed REE projects, it stands to reason that market forces reflect a fully-supplied market that does not require additional supply. After all, when a material's essentiality is met with relative abundance, criticality doesn't appear to be an issue. Yet we can't conclude that supply meets demand simply because the former exceeds the latter quantitatively, although market prices seem to presume this to be the case. When we look at REE supply from a practical standpoint, that is, from the standpoint of supply-risk mitigation and of growing political tension between the United States and China, it looks very favorable from an investment standpoint, regardless of where REE prices are. The fact that share prices are down 95%+ from their peaks bolsters this sentiment.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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