Is The Pentagon Handing China The Keys To U.S. Defense?

by: Stephen Leeb

Editor’s Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

One thing that most worries me about the U.S. is our complacency. This country remains at the top of the heap by almost every measure, but Americans have an unfortunate tendency to take our standing for granted. We're by no means guaranteed to keep it.

The world faces scarcity of many resources. Recently U.S. complacency has grown glaringly evident particularly as relates to metals known as rare earth elements, aka rare earth. Certain of these elements are essential to make permanent magnets-unlike those made from more common metals like iron and cobalt-which don't quickly lose their charge and in turn, are critical to most alternative energies, including wind turbines and hybrid cars, and for key advanced defense technologies. To stay competitive in the 21st century, the U.S. needs access to rare earth elements. Alas, China has a rare earth monopoly that could leave us in the cold.

Yet, in a startling departure, some commentators now contend that we need no longer worry about rare earths. Wall Street Journal editorial writer Joseph Sternberg recently argued that China's dominance in rare earths has declined as soaring rare earth prices early in this decade spurred development of new mines everywhere from Greenland to Canada to Sweden. He confidently so asserts based on a recent Pentagon report to Congress, arguing that a Department of Defense partnership with Molycorp, the largest miner of rare earths outside of China, has significantly eased U.S. reliance on Chinese rare earths, and that China's overall share of global production dropped to about 80% from 95% earlier.

Similarly, a Scientific American article by highly respected environmental security specialist Saleem Ali holds that, with the U.S. now in the game, China's rare earths dominance won't last. He applauds the U.S. Department of Energy's January 2013 Critical Materials Institute launch; shortages of lithium plus other items are far more serious, he writes. Bolivia has a near-monopoly on Lithium, which is critical for batteries.

Unfortunately, such commentaries miss the big picture and underestimate our serious difficulties. To understand, consider some basic facts about rare earths.

1) Rare earths broadly speaking divide between heavy and light and are not created equal. Of 17 rare earth minerals, the five or so considered heavy are truly rare and China continues to control nearly 100% of their production worldwide. For practical purposes, only China can process heavy rare earth from mining raw ore to manufacture final wind turbine components.

2) Heavy rare earths are critical to a technological society. While lighter rare earths find uses in some electronic devices, the heavy ones must be used in a wide range of important new technologies, including hybrid engines, wind turbine motors and highly specialized defense components.

3) Access to rare earth ore is just the start. Producing finished magnets involves a long arduous multi-stage process, including: mining and separating ore, refining ore into oxides, producing metals from oxides, refining metals into magnet alloy powders, and making those alloy powders into magnets. Executing each stage requires enormous expertise and equipment.

4) China not only has the largest percentage of known and accessible heavy rare earth deposits, it's also the only country currently capable of processing heavy rare earth through all stages so as to obtain permanent magnets. China's dominance, in other words, extends to the entire complex supply chain that transforms ore into a usable commodity. (While Japan is also a significant producer of permanent magnets-it makes around 23% of the world's magnets, almost all for its own consumption, compared to China's 75%-Japan doesn't itself mine or produce rare earths. Rather, it manufactures magnets from Chinese materials.)

In short, Molycorp does not hold the game-changer status suggested by the Pentagon. Firstly, Molycorp resources, while large, contain predominantly light rare earths. Secondly, it's low on one of the few light rare earths-neodymium-both important for permanent magnets and found in short supply. Indeed, this represents the most typical composition of most rare earth deposits outside of China.

Molycorp's recent purchase of Neo Material Technologies, a leading rare earths processor and developer of permanent magnet powder, does not help much. Despite Neo Material's Toronto address, its facilities are located in China. Moreover, Neo Material Technologies will not get Molycorp much permanent magnet powder. Its natural resource deposits contain no heavy rare earths ore.

While Molycorp's willingness to pay $1.3 billion for Neo Materials-more than the former's entire current capitalization-strongly testifies to the value of any segment of the supply chain, to us it looks like a wasteful purchase. Without the heavy rare earth raw materials, the added capability could prove worthless. We find it strange and frightening that the Pentagon believes this company can provide the components necessary for some of our most advanced weapons.

Molycorp has not made the U.S. self-sufficient in rare earths and it never will. The unfortunate reality is that for now and for the foreseeable future, the U.S. remains almost completely dependent on China for these essential commodities. This dependency could hurt U.S. world standing in multiple ways. It will ultimately short circuit any drive to renewable energies as we cannot manufacture in any quantity either hybrid cars or wind turbines and other motors. Finally, from the pentagon's view point, our dearth of heavy rare earth supply could cripple our ability to make sophisticated defense equipment. Rare earths are no subject to warrant complacency.

We have, nevertheless, not entirely lost hope. Other potential longer-term means exist to obtain permanent magnets. We could find ways, via nano technology for example, to make magnets with smaller quantities of rare earth. We could also establish an international consortium, including China, to mine and process rare earths. (It might be in China's interest as China may prove unable to produce enough permanent magnets from its ore to satisfy its own burgeoning renewable energy needs.) In any case, neither will occur if our current level of complacency persists.

Meanwhile, we do see a few worthwhile investments in rare earths. Avoid Molycorp, but one could consider taking fliers on three Canadian mines (albeit all extremely risky) with above-average concentrations of heavy rare earth ore. These are Rare Elements Resources (NYSEMKT:REE), Ucore (OTC:OTCQX:UURAF) and Great Western Minerals (GWG.V), each with tiny market values, under $100 million. Spread the risk by buying small quantities of shares in all three-and don't invest more than you can afford to lose.

A related investment possibility is FEI Co. (NASDAQ:FEIC) New magnet capabilities will depend partly on such nanotechnologies as those in which FEI leads. It has grown rapidly in the entire nano space, and its stock price has escalated, but based on our favorite PEG metric (the P/E ratio over growth) it looks reasonably priced, at only 1.5. A more speculative nano play is NVE Corp., a company with a small market cap of under $300 million-and expertise in spintronics, potentially useful for development of nano-based rare earth powders. While few analysts follow NVE, it does sport a "real" P/E of about 25. We (guess)timate its growth in a range that gives it a PEG ratio under 1. Finally, General Electric (NYSE:GE) represents probably the world's leading materials research player. Even a major breakthrough in nano rare earth technology would not dramatically move GE's needle, but it could nevertheless add to the company's long-term growth. GE sells at a relatively modest P/E of 15 and its 3.4% yield adds to its appeal.

Disclosure: I 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.