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  • Rare Earths enthusiasm is misplaced

    For up to minute thoughts, feel free to follow @hedgefundinvest on Twitter, and visit hedgefundinvest.net.  Thank you.

    I want to discuss an industry that I find fascinating, and a study case for misinformation and hysteria. It has to do with rare earths, and the amount of money plowing into stocks like $MCP, $REE, $AVL, Lynas (Australian).  Rare earth elements (REEs) are an interesting bunch, and do have value to industry.  But the story that is being weaved is quite a story.
    The story to be long these stocks is impeccable. Among oft quoted points include the following:

    • China controls 97% of REE production. -- Yes, this is true, but it is 97% of production, not supply. The reality is that China controls maybe 30-40% of REE reserves. Furthermore, many of China's REEs (along with other companies) are by-products of mining. Especially as it relates to LREEs.  Finally, there are tons and tons of REE deposits in Russia, Africa, and Brazil that can be mined less expensively than in the US and Australia. (Certainly the US.) REE mining and refinement is a dirty, slightly radioactive (not kidding) business. Good luck on having no hitches while doing this in California (of all states).
    • China has implemented quotas, and has continuously tightened them.  China has tightened quotas to stop "illegal mining" and environmentally degrading REE processing. -- This is the point being trumpeted by China. And it is a valid point. One reason why MCP's Mountain Pass mine shut down is because of environmental degradation. That, and REEs were just not that high in demand. On the counterpoint, it will be very hard to imagine that China will have more stringent standards than the US, Canada, or Australia.  The costs required for MCP to be inline are enormous. Not only is the mine not finished, but there is no refining capacity nearby. This is key.
    • REEs are necessary for the world, including being used in iPods, wind power, Toyota Prius, and just about anything technological. -- Yes, but it is used in tiny quantities. iPods use 20 cents. Most electronics use trace amounts (very very little), and Japan has pushed forward an initiative to not be so reliant on using rare earths. They want to reduce their reliance dramatically. Furthermore, it is HREEs needed in this capacity, not LREEs.
    • In addition to being a current net exporter that is tightening, China is expected to be an importer of REEs in 2015 time range. -- Based on several discussions with friends in China, this is apparently fabricated. Especially given the current level of high stockpiling.  The folks in China often mention that REEs were too low, as there wasn't sufficient demand, and one laughed about the hysteria behind it. This person thinks that once the "politicking" dies down, China will come into WTO compliance and loosen its hold on REEs.
    • REEs are necessary for US military, and as such, the US needs to acquire sources from outside of China. -- Small amounts, nothing like 40,000 tons, but more like 4,000. And this could be bought on the open market and stashed.

    But these points, repeated and repeated, are just simply the outer skin of this investing onion.  Peel back a few layers, and the following become clear:

    • The real shortage based on China's mining is not light REEs (LREEs), but heavy REEs (HREEs).
    • Avalon ($AVR) is supposedly a heavy rare earth, but there is little in the way of construction and mine. This mine will take some time to come online. In the meantime, who knows where prices will go.
    • Two main western producers, Molycorp ($MCP) and Lynas (Australian), have not really counted the impact on pricing that the other's mine will have. Listen to the latest conference call.
    • The World Trade Organization (WTO) has recently told China that it should not have quotas on raw materials like nickel, zinc, etc.  While this does not pertain to REEs, it does not bode well for China. Furthermore, China is stockpiling REEs for a strategic reserve. This also makes China look bad. The bottom line is that China will be forced to play properly -- the REE market just isn't that big.

    The Underlying Cause for Renewed Optimism for REE stocks - Pricing

    • If I look at metalpages.com; I see REE prices skyrocketing. This is for REEs that are subject to the quota, and shipped out in unfinished form. However, if looked at from a finished product standpoint, REEs are much less. All China wants, in essence, is for manufacturers to use Chinese REEs to build some intermediate item using them within China. Can't blame them, can we? The price increases within China, upon further digging, show that prices are slightly up. This is not posted on metalpages.com. (Incidently, the site is sponsored by JPMorgan, who is one of the lead underwriters of MCP, and has an interest in seeing the stock as high as possible.)
    • While the quotas have contributed to the sky high prices, upon further digging (including talking to a Japanese friend in the raw materials industry -- Japan is the largest purchases of REEs), many Japanese trading houses and others have been stockpiling REEs themselves, temporarily pushing prices higher. This reason, among others, is why JPM and MCP management do not think prices will stay here. The CEO famously said on CNBC that REE prices are in a bit of a bubble. He's recanted, but one can't help but wonder what his sincere thoughts were at the time.
    • Now if there is a long term shortage, one would imagine that MCP/Lynas would hedge at these higher prices with customers. They haven't, because customers are reluctant to

    The Two Main Players - Molycorp and Lynas

    Molycorp:

    • Despite 4 upgrade attempts (2 by JPM, 1 by MS, and 2 by the "kingmaker" Dahlman Rose, the stock remains rangebound. What's going on? Distribution. Everyone who bought in the $50 secondary offering is using the retail crowds enthusiasm to sell into it. Barring any significant news (e.g. WTO news, material changes by China's minerals ministry, etc.), further upgrades by the sellside should have minimal impact. Continuously pointing out how cheap these stocks are could result in sounding shrill. But sellsiders on stocks have done crazier things.
    • Dept. of Defense Loan - Really? A few hundred million is a potential issue for company with this market cap? Kinda a ridiculous discussion point. Seriously, the owners can fund it directly post their amazing windfall. But they haven't. Why? It's time to exit...
    • Bank Loan - Let it elapse. Really? They claim to have found cheaper financing. The equity valuation would certainly suggest it would be available, at the very least in the form of converts (which they have done). Still, financing should be done and locked in. A possible hypothesis is that the banks stepped back when calculating the risk of the project, including refining and transportation.
    • After listening to the conference call last night, one could walk away hearing a perfectly spun story, with significant inconsistencies and unanswered questions. The "is this a good investment?" feel spiked downward. The call was very light on details, and the financial results are nothing to speak of. This, like the stock JOE, is based on some unknown future value. As such, it should be priced as an option on cash flows. And I look at this option, and you've got to expect that there will be tremendous cash flows in the future.  Suspect holders today will be very different in a few months from now... selling at lower prices.
    • If one gets a chance, one should read the transcript of MCPs last call. The stuff they use is not used in anything "green" or "gadgety." Cerium is used in water purification, and most of MCPs REEs are used in boring, low-tech industry. WR Grace is a large customer. They do boring, but necessary, chemical manufacturing.
    • The bottom line: MCP is trading at an unwarranted premium to Lynas. Why? Simply because it is listed in the US. Lynas is listed in Australia. Why is there no arb? Because institutional players are not really sizing this trade up. It's too small for large funds.

    Lynas

    • Lynas is superior to Molycorp on virtually all levels. It will finish its mine first, has put in place refinery capacity in Malaysia, and is closer to Japan, the number one country for REE imports.
    • Lynas stock price, however, is quite volatile, and it seems that there is some level of concern how "real" the rare earths story is.

    All others:

    • The other REE companies are relatively small, highly shorted, and trafficked by daytraders.
    • Having a trading call is difficult near-term, but suspect that many of these won't even ever build mines. The economics will not warrant it.

    The trades:

    • If you are bearish on REE stocks, you'll have to be nimble in ducking in and out. MCP, REE, and others are often hard to borrow, but at the right moments, worth the cost.
    • If you are looking for an arb, and believe the course of events in REEs, the hedged trade is long Lynas and short MCP.  This would be volatile, but under all scenarios Lynas is better positioned, and cheaper. Remember that Lynas is closer to Japan, and hence will have lower shipping costs. They also are one step ahead of MCP in that they are putting a refinery in Malaysia. It appears trying to locate such a refinery in Australia is difficult due to environmental concerns. Additionally, Malaysia provides for cheaper labor. On all counts that one can think of, Lynas is the winner between the two.
    • If you like REEs, and are concerned, reduce risk... trim positions. These are highly volatile stocks based on highly volatile prices that are dubious in nature. It's a wonderful story, but so was uranium a few years ago.
    • If you like REEs, and are balls-to-the-wall long on REE names, all I can say is good luck!

    One of these is mispriced if they are equal, but Lynas is actually better!

    Breakdown of value of HREE composition:

    HREE Kilogram of THREO insitu
    Grade Percentage HREEs Per Value Per
    Distribution Tonne of Ore Tonne of Ore
    MOUNTAIN PASS 9.30% 0.40% 0.372 $104.16 -- NOTE HOW LOW THIS IS, IT IS LOWEST QUALITY, HIGHEST ABUNDANCE REE
    MT. WELD 8.10% 1.63% 1.3203 $461.16 -- LYNAS' MINE IS MUCH HIGHER QUALITY
    NOLANS BORE 2.87% 2.44% 0.70028 $210.11
    NECHALACHO 1.82% 19.96% 3.63272 $695.47 -- 6X Molycorp, much better than Molycorp
    BEAR LODGE 3.62% 3.53% 1.27786 $400.95
    LOFDAL 1.86% 15.70% 2.9202 $553.26
    ZANDHOPSDRIFT 4.60% 7.04% 3.2384 $726.00
    HOIDAS LAKE 2.57% 3.94% 1.01258 $271.85
    STEENKAMPSKRAAL 16.74% 7.66% 12.82284 $2,093.17 -- 20X Molycorp, much better than Molycorp
    KUTESSAYII 0.41% 3.94% 0.16154 $412.37
    KVANEFJELD 1.07% 7.66% 0.81962 $206.83
    STRANGE LAKE 1.16% 48.71% 5.65036 $900.18
    FORTE ENERGY 2.39% 11.60% 2.7724 $529.77
    BOKAN MOUNTAIN 0.76% 47.29% 3.59404 $1,140.88
    RED WINE 1.06% 5.95% 0.6307 $658.53
    DUBBO 0.76% 93.64% 7.11664 $300.54

    I welcome thoughts!

    Mar 11 2:41 PM | Link | 1 Comment
  • Why BP and RIG are probably good longs - 6/12/10
    Controversial, but why $BP is probably a good long here. It's all about probabilities. First, let's discuss $RIG. Anyone following my calls made on $RIG probably know that it probably will fair well under most scenarios. Why? They have limits on damages resulting from rig explosion due to arcane US laws. Now, I often hear in the marketplace "these laws will be turned over, or repealed." Really? I don't know about that. The law is the law, and the US has a long history of honoring law and contracts. Secondly, and perhaps more importantly, $RIG is indemnified by $BP for all spill related costs. As the CEO has mentioned numerous times, unless $BP chooses not to honor contract law, $RIG won't be net out of pocket for these cleanup costs, nor the loss of business liabilities that could arise. I make my living on contract law by being a market participant. If a corporation promises me something in writing, I expect them to make good. If not, I'll sue them. That's not fun, nor cheap, but that is the system. The one caveat is that the public market has not seen the actual indemnification language in the contract (as far as I know). But the $RIG CEO has made his stance and interpretation here very clear. Note: This was also disclosed in the 10Q in very clear language. Where could this go wrong? If the BOP is found to be defective, and if it is defective through gross negligence or criminal conduct. I have a few friends (only a few... :-) that are lawyers, and all say in all circumstances, these are VERY HIGH thresholds to prove. They've cited numerous cases where it is very difficult to prove. I have a hard time believing that $RIG was grossly negligent. Certainly not criminal... it just doesn't make sense on all fronts. Okay, so this is the Achille's heel of the long $RIG call. So that is $RIG liability. Let's not forget the operations portion, and what the moratorium means in terms of cash flow. Clearly the moratorium is hurting all drillers. I believe, because of jobs and US oil supply, that it is not in the best interests of America to keep this moratorium. It is clearly a political ploy by extremists (both left and right) to push Obama. These issues fade with time. The comparison to Katrina is flawed on so many levels that it is not even worth discussion. In the end, I don't think there will be a 12 month moratorium (as discussed by the brilliant $GS analyst covering the sector), and won't even be a 6 month moratorium. Anger will dissipate, the focus will be the economy, and keeping jobs growth and oil prices low. Which brings me back to $BP. The recent bankruptcy rumor in the market place 2 days ago, I believe, was engineered by traders and circulated for a nice, quick, profitable trade. How did they do this? Buy protection, buy puts. Get a few other actors involved. Seize the moment where anti $BP rhetoric is high, and push it even further. Create fear. Sell puts and close CDS positions for a quick profit. Go watch the World Cup. It's that easy. (Well probably not that easy, but not difficult to do when playing off of fear.) Fear and greed are the undoing of investors. Always. Now, a few things have happened since then that give investors hope that the worst is behind $BP from a TRADING standpoint: 1) Bankruptcy fears have hit the name, CDS blew out, and now has contracted. Could anyone come up with a better downside scenario, and have it abate? No. That's about as bad as it could get. Bankruptcy would suck, and those with fresh memories of Lehman, Bear Stearns, etc. don't want to be caught in nonsense like this. There is a huge difference that these comparisons overlook. Lehman, Bear, and others had low quality (uncertain quality?) assets. $BP, on the other hand, has top tier hard assets that are worth a mint or two. Anyone would love to have their choice, cherry picked assets. So, go buy the debt, at the very least, if you can. CDS is already contracting. The company has low leverage. It's the furthest thing from a bank. As a matter of fact, all the things that make banks weak investments in this environment are the things that make $BP strong and desirable. Bottom line: $BPs operations are largely intact, and the company produces solid cash flows with high quality assets. 2) UK Gov't involvement is key. Now the the UK gov't has stepped in to protect BP, Obama's rhetoric will receive int'l pressure to stop cracking the whip on $BP. Media is circulating that 1/6th of orphans, widows, pensioners, and lepers collect $BP dividends to make ends meet. I personally don't buy the number, but the concept/model holds true. The UK gov't will do everything it can (gingerly of course), to protect $BP, as it is a national champion. They have, effectively, said enough is enough. Bottom line: $BP now has political will supporting it, albeit from the UK. 3) The dividend discussion is almost a non-issue at this point. If it doesn't get cut, great, upside. The stock is yielding 10%+. That's nice to have in a portfolio where the world is going crazy, and no one knows what the next short term moves are. If the dividend gets cut, much as the market is pricing now, we may see a little dip in the share price, but only a little. The stock has much bigger issues than the 2Q and 3Q dividends. Bottom line: Dividend is is the leaves of the tree. Step back, take a look at the tree. If possible, step back and take a look at the forest. 4) There is an end in sight for putting the larger cap on the well, and capturing most, if not the flow. This could stop the bleeding, and allow the focus on remediation and cleanup. 5) This point, perhaps the most important, is what is this going to cost $BP in terms of liabilities. There are several types of liabilities. a) Loss of the RIG - This is covered by $RIG and not $BP (unless, once again, this is found to be criminal/grossly negligent). b) Cleanup & Remdiation costs - $BP has vowed to pay for all cleanup costs, and market should believe them. How much could this be? A few billion dollars. Let's say $5 BN. To date, costs on this front have been about $1.5 BN. Personally have a hard time seeing this triple, but let's be conservative. c) Compensatory Damages (Loss of jobs and lost revenue due to moratorium) - This clearly should not be a $BP liability. This came about from government action, and not $BP. I find it very unlikely, and hard to believe that $BP will be on the hook for a gov't imposed moratorium. The proximate cause (legal term - en.wikipedia.org/wiki/Proximate_cause)for foreseeability is nearly impossible. It's basically saying $BP should have known that a blowout would cause 6 months of total loss of revenue/wages for all deepwater rigs in the GoM. Really? Please, let common sense prevail here. d) Punitive Damages - This is the worrisome part of the liability situation. If the US gov't looks to punish BP, this is where it comes from. Estimates range from $8 to $12 BN. If Exxon Valdez (adjudicated in by the US Supreme Court!), it is 1:1 on compensatory damages. Could it be more? Not if someone is willing to throw out a Supreme Court ruling. (Wasn't the Exxon Valdez captain drunk? Wouldn't that be considered criminal/grossly negligent?) e) Loss of tourism - Sketchy that $BP will be on the hook for this. There is no law that requires them to pay for all of this. I think $BP will pay something nominal. But this is getting out of hand. Tally it up. $CS comes out with $40 BN. That's high. Given the loss of EV to $BP, it's nowhere near that. A few other things: these losses are tax deductible, and they will be paid out over many years. I have a hard time analyzing the market volatility on the stock -- it's nearly all emotional. But I can do the math -- it's nearly all rational. Having said that, $BP might be a buy of a lifetime. The downside is pretty low vs. upside. Lose 10% to make 40%? Sounds like a bet to me. Last point: I bear no love for $BP. I bear love for making money. I truly think the way $BP cut corners and put pressure to do things on the cheap is reprehensible. But that's all emotion. And emotion has not place in long-term, thoughtful investing.

    Disclosure: Long RIG
    Tags: BP, RIG, GoM
    Jun 20 1:45 PM | Link | Comment!
  • The Race to Devalue Your Currency - 6/1/10

    On Tuesday 1st June 2010, @hedgefundinvest said:

    The race to devalue your currency
    Been talking to fellow buyside individuals, and the consensus is that the world is bound by unsustainable debt. (Believe it or not, there are those that may disagree on this point, but I digress.)

    What's a country to do when its government and people are heavily indebted? When exports are shrinking? Print more money -- weaken the value of debt (vs other currencies), and shift the earning power to future income streams by devaluing everything now.

    The U.S. did this (sort of) not too long ago, post 2008. Europe is doing it now. China will have to find a way to keep up if it is to keep its export machine on. It becomes a race to debase.

    While this is hardly a new theory, it brings up some interesting game theory. Who moves next? By how much? How do they do it?

    Invariably, there are losers in this. Who loses? Anyone who holds the debt. This is why we saw, and will continue to see, sustained spreads for European sovereigns. It's just not worth it like it used to be.

    The conundrum comes to US spreads. How is it that UST demand continues unabated? This demand probably comes from those that think future growth (near term) will be dampened. Well, yes, that may be the case, but this condition would not continue in perpetuity. I don't know when, but 10 year UST are hardly attractive. At some point, this will be a beautiful short. Yields can only go so low!

    Now onto gold. Gold is the only currency that governments cannot print. So, suffice to say, I can understand if every government is motivated to print money to fight deflation/debt burden, then gold should trade up.

    This thinking has become conventional wisdom amongst the hedge fund community. Hence the piled gold trade. I'm coming around to seeing the thoughts behind this, but the mitigating factor will be inflation, and how to combat it. That requires higher rates. Higher rates make gold unattractive. (It doesn't generate interest, like other currencies.) Then we may see the great gold sell off.

    The world is out of whack at the moment, fueling volatility and speculation like we haven't seen in a while.

    It's gonna be a bumpy ride.



    Disclosure: No positions
    Jun 20 1:42 PM | Link | Comment!
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