And it's a hanging curveball...
Since our visit to Mountain Pass (Molycorp's mine and processing facility in California) in April, several rare earth mining stocks have declined precipitously -- by over 50% -- as momentum-based investors who were focused on rare earth element prices have left the space and short interest has increased. Since our rare earth investment thesis has been based solely on fundamentals and not on sentiment or technical analysis, we have spent the last three months conducting an in-depth review of the sector in order to test our thesis and determine whether this is again, a buying opportunity.
As detailed in the following pages, the fundamental investment thesis on Molycorp is significantly stronger than it was in the spring when we assigned a $120 price target on probability weighted scenario analysis and a 1.0x P/NPV multiple. We have established a new year-end 2012 price target of $105/share based on a 0.75x P/NPV multiple for our Molycorp net present value estimate of $139/share. This NPV estimate is based on our internal rare earth price forecast and incorporates the cash flow generation from the oxide, metal, alloy and XSORBX product lines operating upon completion of Project Phoenix.
Contrary to broad market sentiment, the valuation of Molycorp will not be driven by the pricing of light rare earths such as cerium and lanthanum, but instead by the success of its alloy and water filtration products. Molycorp’s projected production of NdFeB alloys and XSORBX will account for over 75% of revenue through the life of the Mountain Pass mine based on current mineral reserves.
As a result, investors should focus on three main factors regarding the big picture earnings/cash flow generation power of Molycorp. The first is the company’s ability to execute on Project Phoenix on time and on budget, the second is the long term price of NdFeB alloy which is directly associated with the long term growth in demand for NdFeB magnets, and the third is the penetration of XSORBX into several different water filtration markets.
Our main conclusion is that the stock market dislocation has given those investors who did not understand the rare earth element story back in July 2010 when Molycorp went public a second swing at the same pitch – a chance to invest in a company that is executing its mine redevelopment plan on time, on budget, and fully funded while trading substantially below net present value per share even in the most rational bearish rare earth element pricing scenario.
For the convenience of Seeking Alpha readers, we have divided this report into three parts:
- Our Macro Perspective on the REE Sector
- Molycorp: Understanding the Misunderstood
- Valuation: Putting it All Together
Macro Perspective on the REE Sector
The critical question in determining the value of any REE mining concern is what will be REE prices over the next decade and the answer lies in understanding the motivations of China. The REE price increases that started in late summer 2010 came following the announcement of significantly decreased 2H2010 export quotas from China; because, over 90% of current REE production occurs in China, we must go back to 1992, and a quote from Deng Xiaoping, to understand the long term Chinese strategy regarding REEs.
“The Middle East has oil, China has rare earth.”
China’s approach to rare earths is in many ways what the OPEC nations should have done with their national resource endowment. It is important to recognize at the outset here that China is not a western style liberal democracy. The greatest priority of the Chinese government is economic growth with employment opportunities that increases China’s standard of living. Continued economic growth, increasing standards of living, and low unemployment are the best suppressors of public dissent against the government.
China has capitalized on its supply of rare earth element reserves to develop downstream sectors related to the manufacturing of goods containing rare earth elements, and thus vertically integrate into the midstream of the rare earth element supply chain in a way many OPEC nations failed to do so in the petroleum sector. Note that OPEC exports primarily oil and not gasoline and petroleum based products. China has done this through the implementation of export quotas that restrict the export of rare earth concentrate (banned) and rare earth oxides (quotas). The purpose of this policy is to ensure long-term manufacturing employment that will exist even after China’s economic rare earth reserves have been extracted. We would observe that at current production rates, IMCOA estimates China will consume 120,000 metric tonnes of REO in 2015 while current domestic production is only 130,000 metric tonnes per annum. This means that if the 2010-2015 domestic demand growth continues in 2016 China will become a net importer of rare earth oxides on a top down basis.
It is no surprise then that China is the largest consumer of rare earth elements in the world. The export quotas encourage downstream manufacturers of products containing rare earth products to move their facilities to China in order to take advantage of the cheaper rare earth element prices. Historically the premium for rare earth element exports was in the range of 20-50% over domestic Chinese prices. Had OPEC nations adopted a similar policy, they would have restricted the export of crude oil at higher prices while subsidizing the domestic use of crude oil at lower prices and placed no restrictions on the export of refined products such as gasoline in order to encourage refineries and chemical companies to move more refining capacity to their nations. Yet manufacturers have still been hesitant to move operations to China out of concern for the loss of their intellectual property.
This leads to one of the most interesting, but least discussed, dynamics that currently exist in the REE sector: China wants new production to come online outside of China and will establish a price environment such that new REE mining projects can attract capital for development. The reason for this Chinese position is that the manufacturing and industry inside China creating REE based products need a steady supply of rare earth oxides in order to continue to operate once Chinese reserves are exhausted. With some industry experts suggesting the Chinese reserves of some of the most critical REEs may only last for another two decades at most, China needs development of rare earth mining operations to start this decade in the rest of the world to ensure a secure supply for their domestic consumption.
The policy has been working very well in encouraging development. While there were very few rare earth element deposits in active development only a few years ago, there are now over 400 deposits identified and being developed worldwide according to Tech Metals Research. While maybe 1% of these deposits are economic after accounting for the impact of Mt. Weld and Mountain Pass, it is important to acknowledge that China’s objectives are not those of an upstream commodity producer but instead those of a midstream refiner and manufacturer when it comes to its rare earth element policy. Any refiner, smelter, nitrogen fertilizer producer, or chemical company will emphasize how critical their profitability depends on their fossil fuel or hydrocarbon input. If China’s reserves become depleted without adequate supply online internationally, the sectors of China’s economy dependent on rare earth elements for inputs will face skyrocketing input costs (China demand is greater than ROW demand) that will make the price hikes from 2H2010-1H2011 look like nothing and cripple their profitability and create a negative impact towards the three key objectives of the Chinese government – continuing economic growth, rising living standards, and low unemployment.
It takes several years to bring a rare earth mining operation into production, so for China to avoid this potential supply shock it needs to encourage the rest of the world to commence rare earth element mining operations to ensure a stable transition from Chinese reserves. For China the rare earth element export quotas are not a way to increase trade export revenue but instead a policy to ensure a new and growing sector of their economy will remain in business and keep its citizens employed.
Furthermore, high enough prices and low enough quotas will result in manufacturers reconsidering their hesitance on moving operations to China. One rare earth industry executive told us that at the peak of rare earth oxide prices in 1H2011, several rare earth end consumers began re-considering the possibility of moving their operations to China. So in the short run, higher prices may attract more end consumers to move operations to China and in the long run, higher prices are encouraging the development of mining operations outside of China that will be able to supply the Chinese market as Chinese reserves are exhausted.
The problem with this of course is that at high enough prices, demand destruction becomes relevant. The decline in rare earth oxide prices since the summer of 2011 has reduced the conversations regarding recycling and substitution to whispers versus their amplified volumes in the summer. Of course, the finest example of how astonishingly fearful the Japanese companies who are buyers of rare earth elements got (Japan being the largest consumer outside of China) was media reports openly discussing the exploitation of rare earth deposits thousands of feet deep on the Pacific Ocean floor with ore grades of approximately 0.1% TREO, or lower than any reasonably advanced project outside of China.
The decline in rare earth prices since the summer was a result of the general economic weakness in the second half of 2011, stockpile drawdown, plus the refusal to pay such high prices (and essentially wait out the producers until the asking price is lowered, a common game in the rare earth world according to Molycorp CEO Mark Smith on the 3Q2011 conference call).
For those needing more empirical evidence to support our view on the motivations of China’s rare earth element trade policy is to promote development of mining operations outside of its borders, we would point out that CNOOC (state-owned Chinese oil company) in 2005 tried to buy Unocal (who owned Mountain Pass at the time) and in another attempt a few years ago, China Nonferrous Metal Mining Group (state-owned Chinese mining company) tried in 2009 to acquire a majority stake in Lynas Corporation which owns the Mt. Weld deposit, but Australia blocked the deal. East China Mineral Exploration & Development Bureau (ECE) is the largest individual shareholder in Arafura Resources. Arafura published an ASX release on December 20, 2011 indicating there had been “consultations” between management and ECE in which ECE expressed willingness to further invest in the company to fund the development of the Nolans project.
2011 Quotas Not Being Filled Isn’t an Issue
The bears will point to the fact that reports are now out that China’s licensed exporters did not fill their export quotas in 2011 as a counterpoint to our thesis, but we believe there is a simple explanation. We have heard speculation that China restricts the export of certain critical rare earth elements such as Dysprosium, Terbium, and Neodymium. However, this was never publicly stated until the 2012 quotas were announced and differentiated between light rare earths and heavy rare earths. We also would observe that IMCOA projects that global HREE demand in 2015 will be 20,050 metric tonnes with 70% of demand coming from within China.
Take that 20,050 figure and assume it is the current global demand for heavy rare earth elements, and adjust for the fact that 56% of current rare earth demand is within China, we can come to the educated estimate that heavy rare earth element exports at most make up approximately 10,000 metric tonnes of rare earth exports from China. That means that the quotas are primarily filled by exports of cerium, lanthanum, neodymium, and praseodymium. Given that cerium and lanthanum demand are both individually greater than combined neodymium and praseodymium demand in the 2015 demand projections from IMCOA, we can safely say that the reason the quotas in 2011 were not filled was because cerium and lanthanum prices went to the moon and consumers were not willing to pay through the nose for product.
Bears will counter by pointing out that cerium and lanthanum prices have corrected severely in the last four months of 2011, but the quotas still were not filled. We attribute this to Chinese efforts to stabilize pricing to accomplish their objective of high enough prices to encourage mine development outside of China. Because China has set a floor price of $70/kg for cerium oxide exports, and the price of cerium has been below $70/kg most of the fourth quarter of 2011 (it is now trading closer to $40/kg), it is not economic to legally export it and as a result the quotas are not being filled. We would also note that the fourth quarter is historically
The Permanence of Elevated REE Prices inside of China
China will continue to foster an environment where prices are at such levels necessary to encourage mine development in the rest of the world. We therefore believe the current domestic Chinese prices, significantly below prices outside of China, are a conservative barometer of long-term prices outside of China over the next ten to fifteen years. Once adequate supply exists outside of China, the impact of Chinese policy on ROW rare earth element prices will be minimized.
The week after Christmas, China released its 2012 rare earth export quotas which the market has interpreted as negative for rare earth mining stocks after some prompting from the sell side analyst community. The quotas are effectively unchanged from 2011, which we are not surprised by. In 2009, rare earth demand outside of China effectively collapsed by over 50% which goes to our standing belief that rare earth elements are one of the commodities most sensitive to the global economy.
We note of course that the largest rare earth mine in China received its quota pending environmental approval by the end of July. Rare earth prices outside of China are still significantly higher than prices inside of China, so the key question for the owners of Bayan Obo is: are the increased profits from their export quota quantity greater than the increased costs (both up front and recurring) incurred from passing the environmental review? To consider this, we used the guidance Lynas management gave to analysts during their November analyst tour of the LAMP facility in Malaysia. Lynas management believes the operating cost of rare earth oxide production inside China is rising towards $20-25/kg according to a JP Morgan note. While we recognize Lynas is incentivized to hold that position since Molycorp has a slide in its corporate presentation showing its rare earth oxide production cost at $2.77/kg, China ~$5/kg, and Lynas ~$10/kg, the environmental reforms of rare earth mining inside of China have actually been a major theme in 2011.
In a $20-$25/kg operating cost world inside of China, current domestic Chinese prices make plenty long-term sense. We have found information on the operating economics of Bayan Obo incredibly difficult to locate and what we have found cannot be double verified, so we won’t use figures here except to point out that should rare earth production costs increase from $5/kg to $20/kg due to environmental reforms, than it is perfectly rational to say that the long term rare earth prices in China will increase in similar magnitude. The four-year trailing basket price for Bayan Obo in February 2009 was $320/tonne assuming 100% recovery rates and the TREO ore grade is 3.9%, according to Kaiser Research. Using current domestic prices inside of China, and the two deposits with similar ore grades outside of China (Bear Lodge and Nolans Bore), we find that the value of these deposits on a per tonne basis have increased by 484% and 402% respectively versus the $320/tonne figure used by Mr. Kaiser. While the distributions are probably different to some degree in terms of neodymium versus cerium and lanthanum, the increase in domestic Chinese prices is in line with Lynas management’s claim for new operating costs inside of China.
We think in most cases and particularly in the case of Bayan Obo that the environmental reviews will result in the quotas being granted. Still, it underlines the key story behind these quotas, environmental reforms are happening for real in the China rare earth mining industry and the cost curve is moving upwards as a result. We see this as strong evidence that a significant portion, if not all, of the domestic Chinese price gains over the last eighteen months are permanent on a top down basis.
We have seen some analysis suggesting that the export quotas differentiating between light and medium/heavy rare earth elements will further impair export prices for the light rare earths. The furthest they can fall however, is the domestic price inside of China. We say this because every exported tonne takes away a tonne from the market with the largest demand for rare earths and simply that if prices are higher in China, the quotas simply won’t be filled. The only way international prices fall below domestic prices inside China is a global economic collapse of Great Depression proportions and China implements a stimulus plan that involves purchasing domestic production of rare earths at a minimum price (in which case, our stock portfolios will be the least of our worries).
In some ways, what has happened with long term rare earth prices is what happened with oil in the past decade. Upon breaking above $30, oil has pretty much traded between $60 and $100 (primarily between $70 and $90) a barrel excluding the mania in first half 2008 and the financial crisis in 4Q2008 and 1Q2009. The reason oil has not corrected in price due to new supply coming online (cure for high prices is high prices), is because there simply is not enough $30 oil in the world to meet demand at that price. The cost curve was permanently shifted upward just how the environmental reforms within China have shifted upward the cost curve for rare earths.
This is the primary reason domestic rare earth prices have gone up inside China despite having a monopoly on the global production and export quotas to keep product within the domestic market. The result is that current domestic Chinese rare earth prices, give or take 20%, are the effective long term rare earth price for Molycorp once the global market achieves equilibrium.
ROW Supply Outlook
The Strategist ROW supply outlook is based primarily on the principals we discussed in early December 2011 on Seeking Alpha. The development of the rare earth supply chain outside of China is very fragmented and does not involve major mining players such as Rio Tinto and BHP. The reason is that this is an incredibly small market relative to copper, gold, iron ore, etc. As a result, the major mining companies face the same issues that major buy side institutions face when considering whether or not to commit significant resources to the rare earth element sector.
After Mt. Weld and Mountain Pass, the rare earth deposits with a potential production start date prior to 2016 are all owned by junior mining companies lacking sufficient operating cash flow to fund mine construction through existing operations. As a result, we must ask at what terms will external financing be available? Our view shared in December that projects will need to offer returns similar to those outlined in the Molycorp initial public offering (30%+ after-tax IRR, post-finance NPV/share above price of capital raise) earned us plenty of disagreement, and one junior rare earth company management team told us that they felt a 20% IRR would be enough to attract investors (our call notes are ambiguous to whether they were referring to post-tax or pre-tax). This same management indicated they expected most projects to be financed through a 75% debt/25% equity mix. We stand by our expectations of investors required a 30%+ after-tax IRR to be incentivized to perform due diligence on the rare earth sector and make capital commitments. We do not expect any of the junior rare earth element mining companies to achieve producer status before the end of 2015. For this reason, we think that pricing outside of China will remain robust relative to domestic rare earth prices inside of China through the end of 2015. Several projects will need elevated rare earth prices to attract capital and the development of some of projects in addition to Mountain Pass and Mt. Weld is critical to China accomplishing its policy objective of rare earth element supply coming from outside its borders, and so we see elevated rare earth prices going forward relative to domestic Chinese prices until a few juniors achieve producer status in 2016. Having said that, we have some comments on specific projects:
We do not see Arafura Resources securing the necessary financing to commence construction end of 2012 construction at Nolans Bore so that production commences in 2014. The Nolans Bore mining and Whyalla processing complex is projected to have a combined development CAPEX budget in excess of $1 billion. We do not believe that the project will prove robust enough returns to financial investors given a conservative rare earth price deck that assumes minimal contributions from cerium and lanthanum. We do note that a Chinese state owned enterprise is the largest shareholder of Arafura (17.5% stake), so there is certainly a motivated customer/shareholder who we suspect will be willing to put up the capital. But, for political reasons, and because of the precedent set by failed Chinese takeover attempts of Lynas, we do not think the Australian government will allow a Chinese state owned company to take a majority stake in Arafura. We expect the financing difficulties of Arafura to send a clear signal that the price declines that have been occurring since August 2011 were overdone. The question then is does a major miner step up and acquire Arafura with the blessing of the largest shareholder? Should that be the case, we still expect a delay but also we expect the supply from Nolans Bore to be sold into the Chinese market (purely speculation, but we could see ECE blessing the takeover contingent on securing a certain percentage of production in a binding off-take agreement) and thus not have a major market effect.
Steenskampskraal will not come into production based on the current timeline. As one industry insider put it to us, “That one actually has some promise, but I do not know how you do it with such a high thorium content”. While the thorium content is a potential concern, our primary concerns are far more simplistic. We think Great Western Minerals is trying to pull what we call a “Serra Pelada”. The company has no NI 43-101 compliant resource estimate for Steenskampskraal, and as a result, no feasibility study, and yet the company says they can have this mine into production in 2013. The company has less than $20 million in cash, but is looking at a CAPEX budget in the range of $100-$150 million (and we feel we are being generously low on those numbers). The stock market appears to have paralleled our thinking on this company as the stock price has gotten hit severely and the market capitalization is south of $250 million. Bottom line, we do not see this timeline happening as management says it will. This is a project long on promise, but we think will be short on the execution.
Dubbo will not come online with a REE concentrate by-product on a market changing scale. Alkane Resources is developing the Dubbo deposit in New South Wales with a target production date in middle 2014 with a potential small scale production of rare earth element concentrate as a by-product. We are not privy to the market dynamics for the primary products of Dubbo to the same degree of confidence we are regarding rare earth elements, so we will not speculate on those matters. But we will highlight that the rare earth element mineralization at Dubbo is contained within eudialyte for which extraction has proven difficult historically. Progress is being made, but we think the company will focus on its primary zirconium and niobium products instead of committing resources towards cracking the eudialyte puzzle (as industry executives have explained it to us, a silicate gums up the processing circuit) that Matamec and Tasman also both need to solve in order to prove their deposits economically viable. As a result, we don’t think Dubbo brings REE production online in 2014 (assuming current project timeline even holds up) unless prices have skyrocketed to the point that it dramatically improves project economics. Furthermore, given the projected REE concentrate production we do not believe it will be market impacting and we also have to wonder where the separating capacity will come from.
Lynas will receive its final license/permit to start up the LAMP facility in Malaysia. This is the critical question of 2012 for the rare earth element industry. In the event that Lynas does not get the operating permit, then they have to write off an investment totaling several hundred million dollars and then go raise the funds to build a new separation facility in a new location. While Lynas can currently produce concentrate at Mt. Weld, we have not been able to confirm there is the spare capacity outside of China to separate the concentrate at a scale where the operating cash flow could be used to pay for the new plant. But we think in the event of a permit denial it is very likely we will see an opportunistic takeover bid from a strategic buyer (and yes, we have a company not from China very much in mind as a buyer). But we expect the permit to be given and the LAMP will be up and running at Phase I capacity by the end of 2012. We will not speculate whether Molycorp or Lynas will be first to Phase I capacity, but will say for the sake of conservatism we assume in our valuations that both achieve it on December 31st, 2012 while Molycorp should achieve its October 1st target date. If we were forced to choose, we would say Lynas is at Phase I production run rate prior to Molycorp.
The best hope for heavy rare earth element supply in the 2012-2016 time frame is the Molycorp Mountain Pass prospect and the Duncan deposit at Mt. Weld. There are deposits that can adequately fill the entire rare earth element specific supply deficit remaining following the development of Mt. Weld and Mountain Pass main deposits. But those deposits will require CAPEX close to $1 billion and we don’t believe they can produce until the 2016-17 time frame. We own shares in one company that is developing one of these “one stop third mine solutions”, but we own it as much as a hedge against unforeseen events at Mountain Pass as a levered play on rare earth element demand. The truth is that most of these projects do not exceed our hurdle rates (and that is before we give the project economics the look under the hood that we gave to the Sarfatoq PEA in December). As a result, we think the first fresh heavy rare earth element “solution” to come online outside of China will be either Duncan or the Mountain Pass prospect, and we expect it by the end of 2014.
REE Pricing: Element by Element
The REEs consist of the fifteen lanthanides plus Yttrium. In many analyses, they are split into the “light rare earths” and the “heavy rare earths”. Here we will not focus on this delineation very much because frankly we think it does not offer any value to investors but plenty to some junior REE companies looking to make their projects appear better than they actually are. We will focus instead on the elements individually. A major question we must consider is what will be long term rare earth prices following 2016 and how much support China will provide to prices. We expect China to provide significant price support for reasons previously outlined and analyzed below.
We divide the rare earth price question into the 2012-2016 time frame (China supports prices to encourage development), the 2016-2020 time frame (new supply, and reduced Chinese price support, makes prices reflect economic supply & demand), and the 2021+ (new supply comes online as demand accelerates). The third time frame is critical because if you, as we do, believe that rare earths could be the petroleum of the 21st Century, then we have the potential to see major price increases in that time period as the ore grades available for mining are greatly diminished. Other than Mt. Weld and Mountain Pass, there are no current compliant (NI 43-101 or JORC) deposits with $/tonne in-situ values exceeding $3000 at late November domestic Chinese prices (assuming 100% recovery rates), so if you know of a third one that is not held by a public traded company or has not been disclosed by an end consumer, gives us an email. We have for the purposes of this price deck been conservative in the 2021+ time frame and treated it identically to the 2016-2020 timeframe.
Cerium and Lanthanum
The two most abundant elements in any REE deposit in the world, regardless of whether it is called a “heavy” deposit or a “light” deposit. While current spot prices have shown cerium oxide trading at $55/kg, news reports indicate that China has placed a ban on exporting cerium at a price less than $70/kg. These reports re-affirm our conviction that the days of 2009 rare earth prices are gone for good. We expect prices for cerium to fight support at around $20/kg through the 2015/2016 time frame assuming the global economy does not enter a protracted recession. We expect lanthanum prices to find support at similar levels, however our conviction is not as strong. In terms of price ceilings, we are expecting prices to oscillate between the $20/kg and $70/kg range and average $30/kg. We outline our reasons below.
The Issue of Demand Destruction
Our conversations with rare earth oxide producers indicate that when cerium oxide was priced at $150/kg earlier this year, demand destruction in the glass polishing industry was expected to be approximately 30%, but at the current price levels that demand destruction is expected to be more in the region of 10-15%. Further, we have been told that conversations of increased recycling by the glass polishing industry rare earth consumers have been greatly reduced given the correction in cerium oxide prices to current levels.
While we do not have nearly as strong a read on the lanthanum demand dynamic, we notice that with lanthanum prices having declined over 50% there is probably a similar situation playing out in the FCC catalyst markets. Plenty has been written about how WR Grace is re-positioning customers to products not containing lanthanum, but we believe those considerations will die down with lanthanum trading at only 100% above domestic Chinese prices. We have assumed $30/kg lanthanum during the 2012-2015 time frame.
The Issue of ROW Projected Supply
Some analysts have made the argument that the prices of cerium and lanthanum will collapse to levels even below 2009 levels (sub-$5/kg) for both cerium and lanthanum oxide. The argument goes that between Mountain Pass and Mt. Weld Phase I & II the rest of the world will be supplied with over 40,000 tonnes per annum of cerium and lanthanum oxide which will be more than enough to satisfy demand outside of China.
We frankly agree completely that the cerium and lanthanum oxide deficits will be resolved primarily through the development of Mt. Weld and Mountain Pass. The key issue that is not being considered however is that Mountain Pass and Mt. Weld do not cover the ROW deficits for every REE which means a third mine will be required.
Some would point to Steenskampskraal, but we continue to stand by our pessimistic views on that project. We have seen one bullish analyst suggest the potential for 10,000 tonnes per annum of production, but we have only seen a historical estimate indicating 30,000 tonnes of TREO and until we see an NI 43-101 compliant resource estimate or a major sophisticated investor step in with major project funding, we will stand by our pessimism.
After Steenskampskraal, the list of potential, reasonable prospects consists of Nolans, Nechalacho, Strange Lake, Bear Lodge, Zandkopsdrift, Kipawa, Sarfatoq, Bokan, and Norra Karr. None of these deposits are connected to companies that have ongoing operations such that they can fund the requisite CAPEX out of operating cash flow. As a result, we need to ask what internal rate of return investors will demand for providing mine development CAPEX. If we consider the conditions and terms of the Molycorp IPO, we expect investors to demand a post-tax internal rate of return of over 30%. Once a project with those economics stands out, we can start to discuss what valuation the fundraise will occur at.
Given how cerium and lanthanum will not be in extreme deficit after Mt. Weld and Mountain Pass are in full Phase II production, we must contemplate whether any of these above projects will stand out with economics robust enough to handle minimal revenue contribution from cerium and lanthanum. Given the declarations of several junior rare earth miners that they are “heavy rare earth companies” and the obsession with the HREE/TREO ratio, let’s consider for a second some figures.
After Mt. Weld, Mountain Pass, and Steenskampskraal (historical estimate), only Bear Lodge has a TREO grade greater than 1% after removing cerium and lanthanum from the equation. Let’s also take into consideration the proposed CAPEX involved to take each of these projects to mining stage with separation facilities. Nolans is a $1 billion project (to be fair, there is production of commodities separate from rare earths), and Strange Lake is also (if we include a separation facility). Nechalacho is going to come in with an estimated CAPEX probably at over $1.1 billion in the bankable feasibility study. While that may sound great for Rare Element Resources with its projected low CAPEX, their Bear Lodge project given its current resource is not a “one mine” solution to the deficits left over after Mountain Pass and Mt. Weld. While the company has suggested there are some heavy rare earth element prospects on the Bear Lodge property, our research indicates that those targets are very early stage quite similar in fact to the stage of Molycorp’s prospect near Mountain Pass. On top of this, we think the Rare Element Resources timeline is on the optimistic side.
At this point, we are talking about 2015/2016 before we see supply coming online other than Mountain Pass and Mt. Weld. Given this unfortunate reality, we have to suggest that there might not currently be a “third” ROW mine opportunity that fits the critical criteria:
1) Fills the element specific supply deficits remaining after accounting for Mountain Pass and Mt. Weld.
2) Offers financial investors returns similar to those offered by Molycorp in their initial public offering (based on the offering pricing and engineering study guidelines) while assuming minimal to zero revenue contribution from cerium and lanthanum
a. Please note the reason we make this assumption is because financial investors will look at the deficit/surplus for these elements and note that any surplus will result in prices crashing from current levels.
As a result, we are very confident in assuming cerium and lanthanum average prices for the next four years remain elevated above historical levels. We see cerium prices stabilizing above $20/kg and trading as high at $70/kg through 2016, and we point to the reports indicating China has set an export price floor of $70/kg for cerium oxide as a point of strength for our argument that China wants new supply coming online outside of its borders and will manipulate prices to encourage it.
By comparison to our estimate, cerium oxide and lanthanum oxide are trading at $19/kg and $17/kg respectively currently in China. We assume after 2015, that current domestic Chinese prices become the long term prices.
Heavy Rare Earths (Eu, Dy, Tb, Y)
Molycorp says they have an interesting prospect near their current Mountain Pass mine that they will start a drilling program on very soon. We expect that management will be keeping the market updated on this drilling program because Molycorp’s customers are very concerned about the heavy rare earth issue and want some clarity on future supply. Molycorp has also indicated they have three other prospects not currently affiliated with any publicly traded junior rare earth miner. These three projects are not nearly as far along as the Mountain Pass prospect given that when we asked management to even disclose the continent they were on they would not as they still need to secure the appropriate claims/permits/etc. in order to protect their interest in the prospects (that does not mean drilling any faster than the drill program on the Mountain Pass prospect). Now, obviously if this prospect near Mountain Pass is not an economic deposit we have to go back to the existing set of junior rare earth deposit options.
The key issue however is that Molycorp management has in their corporate presentations made it very clear that they are not interested in any of the current junior rare earth miners and their deposits. We pressed management on this issue when we last spoke with them given the fact that Mt. Weld and Mountain Pass will leave ROW deficits in some elements, and we understood management’s logic to be, based off our notes from that call, We’d have to pay a premium over market value and then sink somewhere between half a billion to one billion dollars of CAPEX to bring one of these projects online, the economics just do not work out for us at current heavy rare earth prices.
This is lack of interest from Molycorp is a serious problem, because as we look at the junior rare earth mining space we can count on one hand the companies that have a snowball’s chance in hell of being able to make it to producer status independently and attract financing. Given the higher internal rate of return that will be expected from financial investors versus strategic investors, the key route to financing development for the junior miners will be through being acquired and Molycorp is “not interested in any of the juniors”.
We at The Strategist believe that heavy rare earth prices will have to further rise in order to make the economics of some of these junior rare earth projects work. Given the possibilities beyond the junior rare earth projects mentioned previously and the Molycorp prospect near Mountain Pass, we have come to the conclusion that current spot prices for heavy rare earths such as Europium, Dysprosium, Yttrium, and Terbium are not at high enough levels to encourage the mine development desired by the Chinese.
The two junior projects that present the best “one-mine solution” to the structural supply deficits that will remain after Mountain Pass and Mt. Weld come online are Avalon Rare Metals’ Nechalacho deposit and Quest Rare Minerals’ Strange Lake B-Zone. Based on the headline internal rate of return on both projects most recent economic analysis, Strange Lake is a more economic project and we decided to dig a little deeper into the economics of Nechalacho. Case in point, the updated pre-feasibility study uses a price for mixed TREO concentrate of approximately $46.31/kg. This represents 25% of the Nechalacho basket price at spot prices, which is an appropriate discount of concentrate to separated products (we’d prefer 15% or 20%, but we’ll throw a bone on this one) but rather optimistic versus when we estimate that $8/kg of that price is attributable to cerium and lanthanum. We take away that $8/kg and we have just reduced TREO revenue by 17% and total revenue by 11%. In a rough calculation, that impairs the net present value of Nechalacho by approximately 13-14%. We do this because we believe that investors will not be assigning value to the cerium and lanthanum revenue stream given this new supply will push those markets into surplus and depress prices in the short term.
Strange Lake we are far more constructive on because we can take YE2011 domestic China prices, takeout any contribution from cerium and lanthanum, 64% discount on that figure and still end up with a TREO per tonne price equal to that assumed in the Preliminary Economic Assessment. For this reason, Quest Rare Minerals is one of the more interesting possibilities to be the third ROW rare earth mine after Mt. Weld and Mountain Pass in the event that the Mountain Pass heavy rare earth prospect is a bust. The two problems however are funding (Quest will need to raise somewhere between half a billion and one billion dollars to make the project happen) and time frame (Strange Lake B-Zone looks like it will be online at full production rate at the beginning of 2017). We also have had a separate junior rare earth company management point out to us that Quest assumes $0.072 per Kilowatt hour electricity costs which that management team described as “suggests Strange Lake is on top of a natural gas reservoir or right next to a pipeline”. We notice that power is 40% of the cost for the plant operating costs, so if that power cost estimate is on the low side, the project economics may be significantly impaired. So immediately we see that the Strange Lake B-Zone economic viability merits further investigation that is now on our list.
Given the low ore grade at Strange Lake and Nechalacho (both are sub-2% TREO, and after taking out cerium and lanthanum, both are sub-0.75% TREO), we foresee significantly higher heavy rare earth prices that will make one of these large scale projects economic such that they can raise the funds necessary to develop a mine and fill the supply deficits remaining after Molycorp and Mountain Pass. For the purposes of our price deck, we are assuming 100% current FOB spot prices for the four heavy rare earth elements. We expect heavy rare earth prices to rise until additional supply comes online which does not look likely until the 2016 time frame so we think current spot prices will sustain themselves until the end of 2015.
By comparison, Terbium, Dysprosium, Europium, and Yttrium all are currently at domestic Chinese prices 45-60% below ROW spot prices. We are using domestic Chinese prices after 2015. The primary downside risk to this prediction is an accelerated development timeline for the Duncan deposit or the Mountain Pass HREE prospect that brings either online by mid-2014 combined with new technology reducing the demand for heavy rare earths.
Neodymium and Praseodymium
Neodymium and Praseodymium are primarily known for their use in alloys and magnets. The demand growth for rare earth permanent magnets is a major pillar of the overall investment thesis. Molycorp is on record as stating that Neodymium Oxide prices greater than $100/kg makes NdFeB magnet usage in wind turbines not economic. Wind turbines are a major growth market for rare earth magnets, but the real driver here is in the automotive industry. Byron Capital Markets had a terrific analysis in its October update on rare earth elements showing that even at current NdFeB prices the rare earth permanent magnet based motor was still superior to non-rare earth motors. With that in mind along with our thesis on China’s willingness to keep prices elevated to encourage mine development, we are assuming that Neodymium Oxide prices will trade at $150/kg in the 2012-2015 time frame on the basis that at that price level mine development will be encouraged. After 2015, we are projecting prices stabilize around $100/kg onward, which is approximately the domestic Chinese price ($102/kg). We believe that knowing a secure supply of Neodymium is available at $100/kg, demand from consumers for neodymium based magnets and alloys will grow at a double digit growth rate and that as wind power technology improves the industry economics will make $100/kg neodymium oxide viable long term as a cost input.
Given the need for both Neodymium and Praseodymium in magnets, we are going to assume praseodymium is priced equal to Neodymium in our price deck on a metal basis and at a 20% discount on an oxide basis. Furthermore, we will be assuming that NdFeB alloys are priced per kilogram equal to the price for Neodymium metal per kilogram based off of the price forecast in Molycorp’s IPO prospectus that used three year trailing average prices. While we have not been able to locate a precise spot price for NdFeB alloys (and yes, we checked Metal-Pages.com), we have observed media reports saying alloy prices have not declined in similar scale to metal & oxide prices. We are assuming Neodymium metal prices at a 3% markup to Neodymium Oxide to account for production cost plus a 10% mark up before we adjust for the loss of mass involved in the oxide-metal process that requires approximately 1.16 kg of neodymium oxide to create a kilogram of neodymium metal.
These 2012-2015 projections on our part are significantly higher than the YE2011 domestic Chinese price for neodymium oxide of $102/kg and $87/kg for praseodymium oxide, but reflect discounts of 23% and 27% from YE 2011 FOB Spot prices for the oxides and 11% and 22% on the metals.
Samarium, and Everything Else
For the sake of conservatism, we are assuming Samarium and Gadolinium sell for domestic Chinese prices throughout the price deck.
Our price assumptions do not take into account the development of new uses for rare earths (a potential positive for Neodymium and Praseodymium prices) or recycling efforts (a potential negative for Terbium and Dysprosium).
The Strategist Base Case Price Deck
Upside & Downside Risks to Our Price Deck
Our price deck is vulnerable to the following downside risks:
1) Our assumptions for ROW supply prove conservative or demand growth is softer than anticipated.
2) XSORBX is not widely adopted as a water filtration system which leaves Molycorp vulnerable to the spot price of cerium oxide.
3) Wind power does not end up being economic at the $110/kg price level for Neodymium Oxide.
4) Our analysis of China’s motivations is incorrect
5) Economic collapse in China results in decreased domestic prices and thus impacts long term pricing
6) Global economic weakness negates the impact of the export quotas being segregated into LREE and MREE/HREE segments and our projected price increases for heavy rare earth elements do not occur.
Our price deck is vulnerable to the following upside events:
1) XSORBX proves to be a successful and widely adopted water filtration system that successfully penetrates markets such as for drinking water that command higher price points on a cerium oxide equivalent basis.
2) NdFeB magnet demand grows faster than anticipated as consumers recognize a secure supply outside of China being developed and incorporate the magnets into their business models.
3) Delays from junior rare earth projects and an improved global economy give pricing power to Lynas and Molycorp and prices rise as consumers scramble to secure product.
Why the Market for REE Miners is Inefficient
Normally, we are big believers in the argument that markets are efficient and price in information accurately given that fundamental research will result in purchases or sales of shares that will result in the market share price reflecting the intrinsic value of the underlying company. However, there are several reasons to believe that the market pricing mechanism for rare earth mining companies is not efficient or accurately represents the fundamental value of these companies.
First and foremost, there are only two companies in the industry with large enough market capitalizations and floats such that would interest institutional or hedge fund investors. Those two companies are Molycorp and Lynas, however both these companies are fully funded given the current budgets for their respective mine development projects.
The immediate consequence of this situation is that barring an equity issuance of significant scale (which is not expected in the next nine months given the published timelines for rare earth junior miners), it is not worth the major institutional investors time and commitment of resources to thoroughly investigate, research, and comprehend the REE investment thesis. As a result, we have not seen significant institutional research of the REE mining sector. The sector is trading based off of the sentiment of market participants who do not have an adequate grasp of the REE fundamental picture.
Secondly, the upswing in the share prices of rare earth companies in the first half of 2011 attracted momentum investors to the sector. They are now leaving and consequently short interest in the sector is at a high.
 Note that in 2011, China added to the quotas all ferro-alloy products containing more than 10% rare earth elements. (see slide 5) http://www.nytimes.com/2011/11/17/business/global/prices-of-rare-earth-metals-declining-sharply.html
 IMCOA information pulled from Great Western Minerals Group corporate presentation (November 2011) http://www.nytimes.com/2011/11/17/business/global/prices-of-rare-earth-metals-declining-sharply.html
 NY Times, “Prices of Rare Earth Metals Declining Sharply”, 11/16/2011 http://www.nytimes.com/2011/11/17/business/global/prices-of-rare-earth-metals-declining-sharply.html
 Morgan Markets, Fraser Jamieson: Lynas – Highlights from Malyasian site tour. 11/15/2011 https://mm.jpmorgan.com/PubServlet?action=open&doc=GPS-725588-0.pdf
 Kaiser Research, Rare Earth Resource Center: http://www.kaiserbottomfish.com/s/Education.asp?ReportID=362761
 Seeking Alpha, Jon Christian Evensen, “Questions to Ask Prior to Investing in Junior Rare Earth Companies” 12/13/2011 https://seekingalpha.com/article/313472-questions-to-ask-prior-to-investing-in-junior-rare-earth-companies
 With the exception of Molycorp (who has accelerated Project Phoenix), several rare earth miner has either faced a delay (Lynas in Malaysia), or pushed back their timeline in the last 12 months
 NY Times, “Prices of Rare Earth Metals Declining Sharply”, 11/16/2011 http://www.nytimes.com/2011/11/17/business/global/prices-of-rare-earth-metals-declining-sharply.html
 November 10, 2011 call with senior management
 Strange Lake B-Zone PEA page 24-7 available on SEDAR.com
 As a sidebar, and having spoken to several management teams, bankers, and analysts: the rare earth element mining sector is not a civil business. These management teams know that those that make it to producer status will capture significant gains, but that there is not enough chairs at the table for all of them. And as a result, off the record, the competition is absolutely fair game.
Additional disclosure: The facts in this newsletter are believed by the Strategist to be accurate, but The Strategist cannot guarantee that they are. Nothing in this newsletter should be taken as a solicitation to purchase or sell securities. These are Mr. Evensen’s opinions and he may be wrong. Principals, Editors, Writers, and Associates of The Strategist may have positions in securities mentioned in this newsletter. You should take this into account before acting on any advice given in this newsletter. If this concerns you, do not listen to or consider our opinions. Investing includes certain risks including potential loss of principal. The commentary of The Strategist does not take into consideration individual investment objectives, consult your own financial adviser before making investment decisions.