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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
- 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 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.
- 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.
- 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!
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!