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Dot-com deja vu muddies the rush for rare earths

Various rare earth samples are shown in this undated handout image.

Rows of moss-covered concrete bricks block the opening of the Monmouth rare earth mine in Canada, keeping curious hikers from entering the long-abandoned shaft.

From the early 1940s to the late 1970s, a now-defunct company called Amalgamated Rare Earth Mines explored the site for uranium and a then-obscure cluster of 17 elements known as rare earths.

The mine, 340 km (215 miles) north of Toronto, never went into commercial production and by the early 1980s the company abandoned the project, scared off by an aggressive Chinese campaign to corner the rare earth market.

Two decades after the Monmouth mine shut, China accounts for 97 percent of the world's rare earth ore production, empowering Beijing in a way that was unimaginable in the 1980s.

Rare earths have become crucial components for some of the world's consumer and industrial icons: the Toyota Prius, General Electric wind turbines, the Apple iPhone and hundreds of other devices.

Until recently, the global dependency on China for rare earths was a well-kept secret. But word started to spread fast after Beijing cut export quotas by 70 percent for the second half of 2010, sending prices of some oxides -- the purified form of rare earth elements -- up as much as 850 percent. The need for alternative supplies from outside China suddenly became obvious.

Dozens of companies all around the world are now aiming to fill the coming void in supplies, and investors have poured billions of dollars into their projects.

Rare Element Resources, which owns a promising rare earth deposit in the U.S. state of Wyoming, is a good example. Its shares have risen almost 400 percent in less than 90 days, and over 2,000 percent since April 2009. In that time, the 495,000 shares belonging to one director have jumped in value to more than C$5.4 million ($5.4 million) from C$247,500.

But the bricks that seal the entrance to Amalgamated's long-abandoned Canadian mine should serve as a cautionary tale to rare earth investors.

Current Chinese policies, which are driving up prices of oxides as well as company share prices, could shift, leading to a big industry shakeout. Holdings worth millions of dollars could turn worthless overnight, leaving burned investors with a painful sense of deja vu.

"There's a dot-com aspect to a few of these mines," said Christopher Ecclestone, a strategist with Hallgarten and Co in New York. "These stocks are going up because the products are going up in price, but none of these companies have any products to sell."

The common refrain in interviews with industry executives, analysts and mineral experts is that only about a half dozen non-Chinese producers will emerge from the rubble.

"Some of these stocks will be found to be nothing more than a pile of dirt," Ecclestone said. "And it's not because the product isn't there; it's just going to be that they're never going to be developed."

While the odds of emerging as a successful producer are long, the winners are likely to be those with the right mix of specific rare earths in their deposits, the downstream processing know-how and the contacts to make it in a demanding industry.

With literally hundreds of exploration companies and junior miners to chose from, the challenge for investors is separating the real players from the pretenders playing the rare earth buzz to make a quick profit on the stock market.

The speculative nature of rare earth stocks, coupled with the intense investor demand to own them, has prompted fund manager Van Eck Global to launch an exchange-traded fund focused on rare earths and minor metals.

But even the buffer of trading a group of rare earth miners instead of just one doesn't guarantee a safe ride for investors.

"Everybody's standing up, waving the flag, and shrieking it's rare earths, because that pushes the valuation up," said Byron Capital Market analyst Jon Hykawy. "When the Chinese change their quota system, we will see the bubble rupture."

That bubble, which has seen the average share price of the top juniors in the sector rise 145 percent in six months, is one of the main risks facing investors.

Even BlackRock, the world's largest money manager, says the "jury is still out" when it comes to the long-term investment potential for rare earth mines outside China.

"The ability to bring on production quickly in the higher-price environment means that the longer-term sustainability of those prices are questionable," Catherine Raw, a fund manager in BlackRock's natural-resources division, told Reuters.

Regardless of the red flags, analysts and industry observers agree that more suppliers are needed, no matter what policy China pursues.

"Whether the Chinese are restricting supply or not, there's going to be a need for new deposits," said Ecclestone. "The Chinese do not have a boundless supply of rare earths."

If new supplies of rare earths do not come online within the next 10 years, a global shortage would likely develop with far-reaching consequences: wind turbines will not be built, electric vehicle production will grind to a halt, and mobile phones would have to triple in size.

The issue even carries national security implications because of the rare earth content in many advanced military weapons, not to mention the economic threat that shortages would present. The problem is, getting new sources of supply into production is not that easy.

NOT-SO-RARE RARE EARTHS

Rare earths, despite their name, are not that rare. In Canada alone, there are at least 26 publicly traded companies that have rare earth projects in some stage of exploration.

Not all rare earth deposits are created equal, and good quality, economically feasible deposits are scarce -- a risk factor that some investors may have overlooked.

"People just don't fully understand what's involved in going from having a few holes in the ground to actually being a producer," said industry expert Dudley Kingsnorth from a rare earth industry event in Perth, Australia. "You've got to build it, and you've got to start it up, and the expertise outside China to do that is limited."

Every rare earth mine contains all 17 elements locked into a mineral that needs to be broken down, or cracked, usually using acid. The cracked rare earth concentrate then needs to be processed again, to separate the individual rare earths, which are then purified into oxides.

With the current quota system, China does not distinguish between the individual rare earth oxides but limits the total tonnage of exports across the board. That has led to Chinese companies exporting as much as possible of the high-value heavy rare earths like dysprosium, instead of low-value light rare earths like cerium.

Because no one is exporting cerium, the prices for the oxide, which is used in catalysts and glass polishing, has jumped to about $53 a kilogram this month from $4 a kg in 2008, according to Asian Metal, a firm that tracks industry prices.

"The price fluctuations recently have been the lights," said Asian Metal analyst Phil Arnheim. "I think, as long as we have the export quota system in place, there's going to be a premium on those materials."

With prices for light rare earths soaring, projects like Molycorp Inc's Mountain Pass mine in California are looking very attractive to investors.

But most analysts believe China will eventually change its quota system to restrict the rare earths individually. Because China has an abundance of light rare earths available through the Bayan Obo project in Mongolia, changing the quota system would likely trigger a sudden flood of cerium and lanthanum on to the market.

That's a big risk for Molycorp. If the price of lanthanum oxide were to drop back down to around $7 per kg, the value of a five-year contract the company recently announced with W.R. Grace would tumble from more than $750 million to about $100 million.

Molycorp Chief Executive Mark Smith, speaking at an industry event in Washington, D.C., said he is confident that the price at which his company could sell the oxides will stay up across the board, based on supply and demand.

"The entire world outside of China needs about 50,000 tonnes of product a year ... All that China is exporting right now is about 30,000," he said, adding the oxide prices "are real and we think that they are very sustainable as we move forward."

While the long-term price of the light rare earths remains open for debate, it is a given in the industry that quotas will continue to tighten the supply of heavy rare earths like terbium and dysprosium, sending prices soaring.

Dysprosium oxide, used in hybrid vehicles, lasers and nuclear reactors, is already selling for $284 a kg and that is projected to rise to over $400 in the next couple of years, according to Asian Metals.

The already tight supply will only get tighter, as analysts anticipate that the heavy rare earths mined in southern China's ionic clays could run out within 15 to 20 years, which could lead to even higher oxide prices.

While this is good news for miners with deposits rich in heavy rare earths, having valuable minerals in the ground doesn't necessarily mean big benefits for investors.

Even if the non-Chinese mines were to go into production today, the miners would not receive hundreds of dollars per kilogram of material they produce.

"Eighty to 90 percent of the value is in the processing and that is the great secret of the rare earth space," said Ecclestone. "Basically, when you pull it out of the ground, it's not worth a damn."

It is the processors, who separate the rare earth concentrate into refined oxides, and build relationships with end users, who are making all the money.

MINE TO MARKET

A life-size terracotta Warrior watches over the vast lobby at the Neo Material Technologies head office in Toronto. That's where Chief Executive Constantine Karayannopoulos has spent the last 17 years building up a rare earth empire.

His company buys rare earth concentrate and separates it into individual oxides in China. Then it transforms those oxides into highly specialized rare earth alloys and magnetic powders, using facilities around the world.

Neo Material is one of just a handful of companies that work closely with technology companies like Samsung and Canon to make rare earth products specific to their needs. The qualification process for working with a new client usually takes one to three years, Karayannopoulos said.

"It's not as simple as digging it out of the ground and putting it on a truck and out it goes," said Karayannopoulos. "The basis of what we do is our ability to separate rare earth elements from one another and then to add a lot of value using material technology skills."

Taking rare earths from minerals in the ground to a separated oxide to a powerful magnet used to rotate a wind turbine is a long and complicated process. To get terbium oxide, worth about $615 a kg, it takes over 30 days of processing.

"I think the markets are completely unaware of what it takes not only to bring a rare earth mine into production," said Karayannopoulos, "but also to achieve levels of production, and quality of production, that will allow you to sell your products to people who are willing to pay for them."

In the second quarter of 2010, Neo Material sold just over 3,100 tonnes of separated rare earth oxides, rare earth compounds and magnetic powders. The company posted a quarterly profit of $16 million on revenue of $79.2 million.

Revenue for the 12 months to the end of the second quarter was $261.2 million on 11,719 tonnes of high-value rare earth product and magnetic powders -- that is about $22.29 per kg for highly processed rare earth products, which usually sell at a 75 percent premium over concentrate.

Contrast that to junior miner Avalon Rare Metal Inc, which plans to sell unprocessed rare earth concentrate for $21.94 a kg, according to its prefeasibility report.

Rare earth concentrate sells for about $4 a kg in China, and while analysts estimate it could be worth between $10 and $20 in the United States or Europe, there are currently no facilities outside China to process it.

Neo Material is investigating building a separation plant in Latin America, said Karayannopoulos, adding that his company would look to non-Chinese sources of concentrate to supply it.

"Ultimately, it is in the best interest of our company to be able to get raw materials from other folks, not just our Chinese suppliers," he said. "So, to us, this global diversification of the supply chain is good."

"PANIC" FUELS BOOM

In 2008, global demand for rare earths was about 123,000 tonnes. By 2015, demand is forecast to be about 200,000 tonnes a year. This expected growth, coupled with the recent export cuts from China, has end users of rare earths scrambling for supplies, according to Jim Engdahl, CEO of Canada's Great Western Minerals Group Ltd.

Clients "are exceptionally anxious -- I guess the word could be just about in panic mode," he said. "We're getting calls daily from non-clients who want product from us."

Great Western buys rare earth oxides from China and sells rare earth-based metals and alloys to major magnet manufacturers around the world.

The Saskatoon, Saskatchewan-based company also owns numerous rare earth properties in Canada, and is developing the Steenkampskraal mine in South Africa.

It plans to double production of rare earth products at its processing facility in Britain by 2013, when Steenkampskraal is projected to come online.

That expansion will start to relieve some of the tension in the multibillion-dollar industries that rare earths support, like the permanent magnets used in electric cars.

"Now we're probably talking about $100 billion worth of products built off the back of the capabilities and properties of these rare earths," said Hykawy.

He estimates the motor in the average Prius hybrid uses about 193 grams, or about 7 ounces, of neodymium and 24 grams of dysprosium, while the fully electric Nissan Leaf uses about 421 grams of neodymium and 56 grams of dysprosium.

"We believe that the electric vehicle is going to be a dominant form of transportation in decades to come," Byron Capital's Hykawy said, adding that demand for the magnetic rare earths is set to jump almost 800 percent by 2015.

Even with new mines coming online within the next five years, analysts are forecasting a shortage of heavy rare earths terbium and dysprosium by 2015, and a very tight supply of light rare earths neodymium and praseodymium.

The impending shortage has Bart Gordon, chairman of the U.S. House of Representatives Committee on Science and Technology, and other politicians calling for the U.S. government to fast-track domestic rare earth production.

Since rare earths are used in many U.S. military applications, from the tiny motors in guided missiles to night-vision goggles and lasers, Gordon calls China's dominance of the industry "a real problem."

Legislation has been introduced in both the Senate and the House to increase investment in, and boost the production of, rare earths in the United States, a move that has sent valuations surging for miners with U.S. projects.

Over the past three months, Molycorp has risen over 200 percent to a high of $40.90 a share. It has a market cap of almost $3 billion, despite operating at a loss since launching in June 2008.

Using consensus analyst estimates, Molycorp is currently trading at 70 times above its expected 2010 revenue of $31.9 million. By comparison, a composite group of mining companies currently trades at an average of 2.5 times above expected 2010 revenue.

While the numbers are shocking, Neo Material's Karayannopoulos sees Molycorp in a different class from the hundreds of junior miners who dot the landscape. His company has signed an agreement with the Colorado-based giant to buy rare earth concentrates once its massive California mine comes online.

"If Molycorp gets up to their design ... they'll be producing 40,000 tonnes of light rare earths at Mountain Pass," said Karayannopoulos. "At a 40,000 tonne output, they could be producing 1,000 tonnes plus or minus of heavy rare earths."

"It could be enough to supply the United States, which is not a big buyer of heavy rare earths.

RUMBLINGS OF RISK

China is home to only about a third to one-half of global rare earth reserves, but it produces 97 percent of the world's supply.

"Over time, the percentage could shrink to less than 50 percent," said Michael Komesaroff, an analyst with Australian-based Urandaline Investments, pointing to the new mines coming online outside of China.

The first project out of the gate is likely to be the Mount Weld mine operated by Australia's Lynas. It is set to start producing up to 22,000 tonnes of rare earths annually by the end of 2011.

Like Molycorp's Mountain Pass, Mount Weld is a high-grade, light rare earth project. And like Molycorp, Lynas has a huge market cap, about $2.4 billion, despite not having any revenue at all.

While basic economics suggest that both companies are overvalued, Byron's Hykawy is maintaining a "speculative buy" rating on the stocks for now.

"It's a freight train. I mean, people are investing in it right now who don't know mining from a hole in the ground," he said. "Do you want to jump in front of that speeding train?"

The big risk going forward is that if China releases its quotas for 2011 and removes restrictions on the sale of cerium and lanthanum -- a scenario that Hykawy sees as a virtual certainty -- "the light deposits like Molycorp and Lynas are going to be impacted."

The other big concern is that neither Lynas nor Molycorp has substantial deposits of terbium and dysprosium, two of the heavy rare earths that are in high demand. This has created a supply hole that many of the exploration companies are focusing on filling.

"A lot of these Canadian companies are focusing entirely on heavy rare earths," said Asian Metal's Arnheim, who manages the Beijing-based company's Pittsburgh, Pennsylvania, bureau. "I think that makes sense."

To address the growing market for heavies, Neo Material is moving forward on its Pitinga project in Brazil, which will recover heavy rare earths from the tailings of a tin mine in the Amazon basin.

The project, with Brazilian miner Mineracao Taboca, will cost about $100 million to bring to market. Mitsubishi Corp is a partner in the development of the project.

Great Western's Steenkampskraal mine, which is projected to come online in early 2013, will cost just C$30 million, including the construction of a separation facility in South Africa.

That compares with the C$729 million Avalon needs to bring its massive Nechalacho mine into production in Northern Canada.

Nechalacho, like Quest Rare Minerals Ltd's Strange Lake project in northern Quebec, is a heavy rare earth deposit with a higher than normal concentration of dysprosium and terbium.

The implied value of a heavy rare earth deposit has boosted Avalon's market cap to $350 million and Quest's market cap up to almost $250 million.

But both projects are located in remote regions of Canada, with no infrastructure in place. The deposits are also very low grade and locked in syenite, an unproven mineral for rare earth extraction.

Analysts say the price tag of developing such a project is too steep for a junior miner, suggesting the only way projects like Nechalacho or Strange Lake will make it to market is if a major end user like Toyota Motor Corp were to buy out the company and develop the mine at a loss.