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Beware Rare Earths - China's Saber Rattling Can Be Deceptive

by: Tim Worstall

There's muttering - from China - that China might try to use their control of rare earth production during the trade war.

This, sadly, doesn't mean that all rare earth investment opportunities we might get offered are valuable - or even valid.

Last time around, in 2010, there was an explosion of fraudulent investment offers.

China Might Try To Use The Rare Earth Weapon

As we all know there's a trade war going on between the US and China. Or more accurately, between the Trump Administration and China with the US consumer as the inevitable loser. Such wars always bringing out speculation as to which weapons will be deployed. Given that China currently produces some 80 to 85% of the world's rare earths perhaps they'll try to leverage that control?

Rare earths are Xi's ace card in 'Long March' of trade war

Well, sorta. Maybe.

Last week, Xi Jinping decided to ditch subtlety. Beating the drum of Chinese nationalism in order to garner attention and support for facing down his country's trade war with the US, the president sent a stark message: Beijing is ready for a long fight.

In visits to a rare-earth metals production plant, and a memorial to the Long March, Xi's actions were the Chinese equivalent of wrapping himself in a Union flag and drinking tea from a mug with Winston Churchill's face on it.

One of the lesser known facts here is that President Xi's extended family has significant ownership in China's rare earth production system. So self-denying action is unlikely - and a ban on exports would very much be self-denying.

China's Tried This Before Of Course

Another reason to think they'll tread carefully is that China has tried this before, back in 2010. And as I pointed out back then - while it was still happening - it wasn't going to work:

If rare earths are so precious, why isn't the United States working harder to collect them? The main reason is that, for these last 25 years, China has been supplying all we could eat at prices we were more than happy to pay. If Beijing wants to raise its prices and start using supplies as geopolitical bargaining chips, so what? The rest of the world will simply roll up its sleeves and ramp up production, and the monopoly will be broken.

Four years later Marginal Revolution pointing out that I did in fact get that right:

Bonus points to Tim Worstall, economist blogger and rare earth dealer, who in 2010 at the height of the crisis pointed out that rare earths were neither rare nor earths and China's monopoly had been won only by low prices that accrued to our benefit.

Well, that's my ego polished for the day.

However there's an important point here. That worry over Chinese export bans allowed both Molycorp (OTCPK:MCPIQ) to reopen the Mountain Pass mine and Lynas Corp. (OTCPK:LYSCF) (OTCPK:LYSDY) to gain financing for their Malaysian processing plant. Which is great, obviously. Except both effectively went bust again as soon as we got the long term market response to that China action. Molycorp properly bankrupt and Lynas had a capital raising so dilutive that the effect on initial shareholders was much the same.

The point we as investors have to note being that short term actions as part of this - or other - trade war don't necessarily make a profitable long term space for a business in rare earths.

Be Wary Of Rare Earth Offers Therefore

It's entirely possible that if there is another Chinese export ban then there will be profitable opportunities. Riding Molycorp up then selling before the bust was a most profitable exercise. But I suggest that they will be plays on market sentiment, not the beginnings of proper world class mining enterprises. The market is simply too small to support another large scale producer if China returns to the export market.

Well, in my opinion it is.

Be Especially Wary Of Direct Investment In Rare Earths

One of the things that that last boom brought was a series of boiler houses offering to sell rare earths direct to retail investors. There were several in the UK, I know of at least one each in S Africa and Dubai and no doubt there were others - the operation looks like it was franchised. The pitch was that rare earths are going to be in short supply - possible - and that therefore owning some amount of them as physical stock would be a good investment. This was not so.

Partly the idea failed because the prices at which the rare earths were sold were horribly high. One rough price estimation I made at the time was that the investment opportunity was to pay £5,000 for about £700 worth of material. There's got to be a heck of a movement in the underlying price to make that work.

But the real reason it wouldn't work is because of the structure of the underlying market. There simply is no liquidity in it. There's no terminal market where tonnages can be sold to whomever. Everything is always direct to the end user. Further, the investment opportunities were in a few kg here and a few kg there. Which also just isn't how the market works. Those big users, the battery makers say, want tens to hundreds of tons of homogenous material, not a kg or two here and there from retail investors.

The whole idea of the investment opportunity was so ridiculous that it was obviously and clearly a scam. So much so that I've spent part of the past few years providing expert witness testimony in trials - all of which have ended in convictions.

Really, Don't Buy Physical Or Retail Rare Earths

I would suspect that if rare earth prices bounce again off the back of any China action then we'll see a revival of this scam. So, from experience, just don't do it. Retail investment in physical rare earths is not and never will be, outside a very limited professional circle, a good idea.

That's all a little outside the usual investment fare here but worth pointing out.

Well, What Should We Do?

If - and note this is an if - China does restrict rare earth exports then there will be many stories about how this or that prospect now makes sense. This plan to mine, that one. My opinion is that none of them will make sense in the long term. What opportunities there are will be a matter of game theory, market sentiment. If enough other people don't believe me then a stock price might well have a boom. But to profit will be getting the market timing right, not a result of investing in a long term prospect.

Mountain Pass still exists and is operating again but it's privately owned. Lynas Corp is producing but they've a significant problem with their processing plant:

The country's new Pakatan Harapan government has threatened to discontinue the operating license of Australian miner Lynas Corporation unless it adheres to strict conditions for its rare earth refinery in Kuantan, which it has run since 2012. These include orders to remove and dispose of more than 451,000 tons of water leach purification residue, a radioactive substance produced in the mining process. The firm has been given a September deadline.

Lynas has responded by threatening legal action against the Malaysian government, but Yeo Bee Yin, the minister for energy, science, technology, the environment and climate change, has insisted the restrictions on the facility are within the nation's sovereign rights.

Matters environmental are indeed within sovereign rights and even within what may be done under WTO trade rules. I've no idea which way this will turn out but having this sort of argument with the permitting government isn't usually thought of as good news.

The Takeaway

Don't, whatever you do, succumb to the idea of buying rare earths retail or physically. Keep an eye on Lynas as a solution to that Malaysian permit would be very good news indeed. Other rare earth stock opportunities will be about market timing and sentiment, not underlying investment basics.

For the real point here is that rare earths just aren't rare enough for anyone to ever gain an exploitable lock on their production. Thus profits are going to be rare in the industry.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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