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On September 7, 2010, the Japanese coast guard detained the captain of a Chinese trawler, Zhan Qixion, whose vessel rammed into Japanese coast guard patrol boats off of China's Diaoyu Islands. China claimed that Qixion was being held illegally, while Japan accused the captain of "obstructing public officers" when they tried to detain him; the incident eventually led to tensions between the two countries. China's foreign ministry issued a terse statement demanding the immediate release of the captain, without any precondition. The article, "China and Japan in Staredown," framed the matter:

The Diaoyou Islands are a group of disputed and uninhabited islands controlled by Japan since 1895 but also claimed by the Republic of China (Taiwan) and the People's Republic of China ... Japan's decision to detain Qixion was a de facto claim of sovereignty over the Diaoyou Islands. However, since Japan's economy is largely dependent upon China, Japanese officials released the captain on Saturday September 25th ... Whether the recent dispute will set precedence for how China deals with other countries in the region remains to be seen.

Molycorp in the Catbird Seat

By the end of September, China responded by refusing to export rare earth minerals to Japan. The minerals are used in the manufacture of high-tech equipment like hybrid cars and smartphones. In October, China, which controlled over 90% of the market for rare earth minerals, denied rare earth shipments to Europe and the U.S. The action set off an international manhunt for rare earth deposits, putting Molycorp (NYSE:MCP), and its Mountain Pass mine containing rare earth deposits in the catbird seat. A decade earlier, the Mountain Pass mine was the world's largest producer of rare earths; however, China began ramping up production in the 1990s, which caused a drastic decline in rare earth prices, and presaged the shutdown of the Mountain Pass mine.

The October 2010 Chinese embargo caused rare earth prices to skyrocket and created a renewed interest in rare earth producers. Molycorp's share price stood at $13.22/share on August 2, 2010, and rose to $35.51/share after the Chinese embargo materialized. Backed by $1 billion in capital from private equity firm Resource Capital Funds, in October 2010, Molycorp attempted to capitalize on the rare earth shortage. Its earnings and share price also increased. In 2011, the company earned $153 million in operating income on $397 million in revenue, up from a $51 million operating loss on $35 million of revenue in 2010. Its stock reached a peak of $74.22 in April 2011 - a windfall for Molycorp investors who held on to the shares after the Mountain Pass mine reopened.

The Pain Ahead

However, the increase in the price of rare earths and expected profits from their manufacture attracted new entrants. The article, "China Rare Earth Industry Being Squeezed From All Sides," reiterated the strain on rare earth prices due to the increase in suppliers:

The market is expected to undergo drastic changes soon as some international companies are set to begin low-cost, high-volume production before the end of the year. The increased competition will likely cause dramatic adjustments to rare earth prices in the next one or two years ... Rare earth suppliers in China will face greater risks of steep drops in both prices and profits amid slower sales that will bring a sweeping reshuffling to the industry.

Declining rare earth prices have since ravaged Molycorp's earnings and stock price. Through six months ended June 2012, the company achieved an operating loss of $51 million on revenue of $189 million. According to Molycorp's 2012 second quarter 10-Q, it sold "1,169 mt of rare earth products at an average price of $45.92 per kilogram as compared to sales of 973 mt at an average price of $77.60 per kilogram during the corresponding period in 2011." This would imply a rare earth price decline of approximately 40% year-over-year. The company's stock price was $13.00/share on September 21, 2012, reflecting its reduced business prospects.

As rare earth producers around the globe have entered the industry, the supply shortage of October 2010 no longer exists. Given the rapid decline in rare earth prices and the pain ahead for the U.S. economy, and potential for mass layoffs if losses do not subside, I am bearish on Molycorp and the rare earth industry as a whole.

Source: Molycorp And 'The Pain Ahead'