The Critical Metals Report: There is much speculation in the rare earth elements (REE) realm about China's export quotas in 2012. Is Gabelli & Company expecting further quota cuts?
Brian Chin: The trend is clear that China has been reducing its quotas over the last six years. In 2009 export quotas were set at just over 50 thousand tons (Kt), which was subsequently reduced by about 40% to a little over 30 Kt in 2010. Quotas were slightly lower in 2011.
Even if we assume quotas for 2012 remain constant, a gap remains between global supply and demand. It's clear that China is trying to control and restrict supply coming out of China. In addition to reducing quotas, China is consolidating the industry to control production. Baotou Steel Rare Earth recently announced a suspension of its REE processing in an effort to stabilize spot prices.
TCMR: What is China's reasoning behind these policies? Do you think China wants to restrict its rare earth sector for domestic use only?
BC: China's export reductions seek to encourage domestic production of higher-value, end-use products. Prices for rare earth oxides within China average 50% below export prices, which certainly benefits companies operating within China. Some are even predicting that China will become a net importer of rare earths as soon as 2015. That means the country would not export any of its rare earths.
TCMR: One of the key drivers in this segment is electric vehicles (EVs). The Chevrolet Volt, for instance, uses about seven pounds of REE magnets. What other major end uses drive REE demand?
BC: Electric cars are obviously one of the key end markets for rare earths, but there are many other end-use products. Traditional uses involve catalytic converters, and there are other highly specialized applications as well—for example, REEs are used in car windows to reduce UV exposure. Technology-driven uses include a myriad of products, such as magnets in gearless wind turbines as well as a variety of smaller electronics such as iPhones, Blackberrys, etc. Because rare earths are used in such a wide range of markets, REE use is not overly dependent on any individual market.
TCMR: We recently learned that Lynas Corp. (LYC:ASX) will delay production at its Malaysian plant until 2012. This isn't the first delay. What's going on there and will the delay affect REE prices?
BC: Lynas originally projected that its processing plant in Malaysia would be running in the second half of 2011 but cited delays in its equipment orders that pushed back completion by about three months. In addition, there's been local opposition to the plant that has delayed licensing from the Malaysian government to import ores the company extracts out of Australia. The company claims that even if Lynas is unable to secure the permit, it will still be able to process ore from its Mount Weld deposit with another partner, but it's obviously an overhang on the stock.
TCMR: There are approximately 300 REE projects in the world. Molycorp Inc. (MCP:NYSE) is now producing some light rare earths (LREEs), and many other companies are frequently reporting new resource estimates. Total REE demand for 2011 was forecast at around 40 Kt, and actual demand fell well short of that. How are these companies going to make money?
BC: The simple answer is they won't. Since the boom in REE prices, there's been a scramble to find new deposits. But the fact is that many of these projects contain low ore grades and are in remote locations that will require tremendous capital investment. It's not hard to find rare earths in the ground, but it's hard to find them in a high enough concentration and grade to make projects economically viable. Understanding the metallurgy in each of these different deposits is not an easy task, as it varies considerably. Developing a separation process is also a very complicated undertaking. I don't see a lot of these projects coming into production.
Having the first-mover advantage is very important for these REE companies because the market isn't very large, but there is going to be demand from customers looking for secure sources of supply outside of China. The companies that are going to be able to get to production first and secure supply contracts are the ones that are going to be successful.
TCMR: Dacha Strategic Metals Inc. (DSM:TSX.V; DCHAF:OTCQX) has taken a "middleman" approach to the rare earths market by acquiring and stockpiling REEs in Asian warehouses. The model, however, assumes that limited supplies will continue to push REE prices higher. Prices have fallen dramatically in recent months, and more companies are scheduled to start producing rare earths in 2012. What's the shelf life of Dacha's model?
BC: Different governments around the world—Japan, Korea, the U.S. and the E.U.—have considered stockpiling. Supply is tight right now, and although there will be some additional supply coming online outside of China in 2012, many projects are years away from production. Dacha's model has some credence for at least the near-term, until additional supply comes on-line outside of China.
In general, I think the challenge with Dacha's model is the off-loading. If they have off-take agreements already in place, then it shouldn't be a problem. But if the company just stockpiles and has no buyers, then the value of the company is just in the material reserves. It takes buyers to realize that value.
TCMR: Dacha has an inventory of heavy rare earths (HREEs), most of which are in high demand, and says its inventory is worth roughly $120 million (M). But Dacha needs to make sales each quarter—doesn't that put the REE buyers at an advantage?
BC: The demand is there. The reason prices have gone down recently is people are waiting on the sidelines hoping that the prices are going to go down further. At the same time, especially within China, because of the export quotas, companies need to unload their quotas by the end of the year or else they risk not being assigned a quota for the following year.
TCMR: You wrote a positive research report on Molycorp in April, when its shares were trading at about $72. Molycorp now trades at less than half that, even though it has started to produce some rare earths from stockpiles. What's your view now?
BC: In late April I actually downgraded the stock to a hold because of the run up in the stock price at the time and the fact that it was trading near my Private Market Value (PMV) for the company and didn't provide enough margin of safety. I still think Molycorp is the best way to gain exposure to the rare earths industry. The company has a high-grade ore body in a convenient location. These are two keys to a successful REE project. In addition, Molycorp used to be one of the dominant REE producers, so it has expertise. I think its mine-to-magnet strategy will allow the company to realize incremental value across the supply chain. When it comes into production in 2012, it's going to be the lowest-cost producer in the industry. That adds an extra layer of safety to the company, given how volatile prices have been.
TCMR: The knock on Molycorp's past deposit is its lack of HREEs like terbium, yttrium and dysprosium. Molycorp says it's exploring an HREE deposit near Mountain Pass. What do you know about that?
BC: Molycorp recently announced that it was looking at four potential rare earth deposits with a composition skewed more towards the HREEs. All four of the deposits have high ore grades greater than 4% and can be processed at Molycorp's Mountain Pass facility. The company realizes that because its deposit is more LREE-rich, having a complementary HREE deposit would be beneficial.
TCMR: Molycorp's trying to get a few different loan agreements with the Department of Energy, but has so far been unsuccessful. Is that a red flag for investors?
BC: In speaking with the company about that, I think it was trying to get those loans back when it was still looking to get fully financed for its project. Since then, it has been able to work out a number of different agreements with suppliers, and it was able to secure alternative funding on its own.
TCMR: Aside from Molycorp, what are some other companies that have piqued your interest?
BC: Quest Rare Minerals Ltd. (QRM:TSX.V; QRM:NYSE.A) Strange Lake project in Quebec and Avalon Rare Metals Inc. (TSX:AVL; NYSE.A:AVL; OTCQX:AVARF) Thor Lake project both have large resource estimates and compositions skewed toward HREEs. Strange Lake has a resource estimate of approximately 230 million tons (Mt) at 0.9% ore grade, and Thor Lake has 315 Mt at about 1.4% ore grade.
TCMR: Quest just added George Potter to the company. Potter was in a senior executive position with AngloGold Ashanti Ltd. (AU:NYSE; ANG:JSE; AGG:ASX; AGD:LSE). When he came on board, Quest's share price was not far above $2 and now it's well over $3. The market seems to like the move. What are your thoughts?
BC: It's positive that the company was able to bring in people with good experience, and it has a very large resource estimate at its Strange Lake site. The problem is that it is in a very remote location, and it's going to take a lot of capital to get the infrastructure in place to build up a mine.
TCMR: Nonetheless, in Canada, those two projects always seem to take center stage when rare earths are discussed. Matamec Explorations Inc. (MAT:TSX.V; MRHEF:OTCQX) Zeus Project may beat both of those companies to production. How did Matamec come out of nowhere to lead the race?
BC: I wouldn't say that it's leading the rare earth race per se, but it's another contestant in the race. Matamec has a very attractive composition weighted toward the more valuable HREEs and a resource measurement of 16 Mt but at a relatively low ore grade of 0.5%. It is projecting that it will be in production by 2016. A lot of questions remain, including whether it can actually be economically feasible to mine and process with such a low ore grade.
TCMR: In comparison with Avalon and Quest, Matamec is much closer to infrastructure and established mining camps.
BC: That's one of the key things for a project's feasibility, and in this area Matamec has an advantage.
TCMR: Matamec has seen recovery of 95% of REEs from its ores, so that is certainly a positive as well.
BC: That is definitely another important thing. Metallurgy varies from deposit to deposit so recovery is important.
TCMR: Matamec will soon release a preliminary economic assessment on the Kipawa deposit; do you expect that study to boost the share price?
BC: If the company has a positive study that shows it can extract and process REEs and that its resources are there, then that should be positive for the company, even given the volatility in the markets.
TCMR: What do you make of that volatility? Since August or so, the share prices across the board have often been halved or worse.
BC: Uncertainty in the macro-environment has hit the commodity and REE space harder than the rest of the overall market. Investors are a little skittish, and there has also been a lot of news about companies seeking different ways to substitute REEs, whether it's electric cars or other end-use applications. However, I was in Japan recently meeting with companies, and the demand is still there. REEs have unique properties that allow for lighter, more efficient and smaller end products. In the near term, there is going to be volatility and uncertainty in the overall global environment, but in the long term, alternative suppliers need to come on-line to supply the rest of the world's markets, and their ongoing rare earth needs.
TCMR: You studied Applied Value Investing at Columbia Business School. Are you seeing a lot of value in this space right now?
BC: Depending on your risk tolerance, I do see value in the space. Right now a lot of the stocks are trading at discounts to their intrinsic value. Molycorp is the best positioned in the space—I have a 2012 PMV of $67 and it is currently trading at a pretty steep discount to this.
TCMR: What are your top three picks in this space?
BC: I like Molycorp. That would be my first choice. Lynas, even with its problems, would be my second choice because of its high-grade ore deposit. Third is tough; there are a bunch of projects in Canada and Australia that are all vying to become that other supplier in this space. But they are all many years away from getting into production, so I think it's hard to choose one of them.
TCMR: You prefer the near-term producers with high-grade deposits?
BC: Yes, and then I would go with a deposit that is heavily skewed toward HREEs.
TCMR: Thanks you for your insights, Brian.
Brian Chin joined the firm in 2010 as a research analyst covering Natural Resources. Mr. Chin began his business career as an investment consultant and then became an investment banking analyst focused on mergers and acquisitions for middle-market healthcare service companies. Mr. Chin graduated from Amherst College with a Bachelor of Arts in economics and received a Master of Business Administration from Columbia Business School with a concentration in applied value investing.
Want to read more exclusive Critical Metals Report articles like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators and learn more about critical metals companies, visit our Critical Metals Report page.
DISCLOSURE:
1) Brian Sylvester of The Critical Metals Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Critical Metals Report: Dacha Strategic Metals, Quest Rare Minerals and Matamec Explorations Inc.
3) Brian Chin: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None.
Brian Chin: The trend is clear that China has been reducing its quotas over the last six years. In 2009 export quotas were set at just over 50 thousand tons (Kt), which was subsequently reduced by about 40% to a little over 30 Kt in 2010. Quotas were slightly lower in 2011.
Even if we assume quotas for 2012 remain constant, a gap remains between global supply and demand. It's clear that China is trying to control and restrict supply coming out of China. In addition to reducing quotas, China is consolidating the industry to control production. Baotou Steel Rare Earth recently announced a suspension of its REE processing in an effort to stabilize spot prices.
TCMR: What is China's reasoning behind these policies? Do you think China wants to restrict its rare earth sector for domestic use only?
BC: China's export reductions seek to encourage domestic production of higher-value, end-use products. Prices for rare earth oxides within China average 50% below export prices, which certainly benefits companies operating within China. Some are even predicting that China will become a net importer of rare earths as soon as 2015. That means the country would not export any of its rare earths.
TCMR: One of the key drivers in this segment is electric vehicles (EVs). The Chevrolet Volt, for instance, uses about seven pounds of REE magnets. What other major end uses drive REE demand?
BC: Electric cars are obviously one of the key end markets for rare earths, but there are many other end-use products. Traditional uses involve catalytic converters, and there are other highly specialized applications as well—for example, REEs are used in car windows to reduce UV exposure. Technology-driven uses include a myriad of products, such as magnets in gearless wind turbines as well as a variety of smaller electronics such as iPhones, Blackberrys, etc. Because rare earths are used in such a wide range of markets, REE use is not overly dependent on any individual market.
TCMR: We recently learned that Lynas Corp. (LYC:ASX) will delay production at its Malaysian plant until 2012. This isn't the first delay. What's going on there and will the delay affect REE prices?
BC: Lynas originally projected that its processing plant in Malaysia would be running in the second half of 2011 but cited delays in its equipment orders that pushed back completion by about three months. In addition, there's been local opposition to the plant that has delayed licensing from the Malaysian government to import ores the company extracts out of Australia. The company claims that even if Lynas is unable to secure the permit, it will still be able to process ore from its Mount Weld deposit with another partner, but it's obviously an overhang on the stock.
TCMR: There are approximately 300 REE projects in the world. Molycorp Inc. (MCP:NYSE) is now producing some light rare earths (LREEs), and many other companies are frequently reporting new resource estimates. Total REE demand for 2011 was forecast at around 40 Kt, and actual demand fell well short of that. How are these companies going to make money?
BC: The simple answer is they won't. Since the boom in REE prices, there's been a scramble to find new deposits. But the fact is that many of these projects contain low ore grades and are in remote locations that will require tremendous capital investment. It's not hard to find rare earths in the ground, but it's hard to find them in a high enough concentration and grade to make projects economically viable. Understanding the metallurgy in each of these different deposits is not an easy task, as it varies considerably. Developing a separation process is also a very complicated undertaking. I don't see a lot of these projects coming into production.
Having the first-mover advantage is very important for these REE companies because the market isn't very large, but there is going to be demand from customers looking for secure sources of supply outside of China. The companies that are going to be able to get to production first and secure supply contracts are the ones that are going to be successful.
TCMR: Dacha Strategic Metals Inc. (DSM:TSX.V; DCHAF:OTCQX) has taken a "middleman" approach to the rare earths market by acquiring and stockpiling REEs in Asian warehouses. The model, however, assumes that limited supplies will continue to push REE prices higher. Prices have fallen dramatically in recent months, and more companies are scheduled to start producing rare earths in 2012. What's the shelf life of Dacha's model?
BC: Different governments around the world—Japan, Korea, the U.S. and the E.U.—have considered stockpiling. Supply is tight right now, and although there will be some additional supply coming online outside of China in 2012, many projects are years away from production. Dacha's model has some credence for at least the near-term, until additional supply comes on-line outside of China.
In general, I think the challenge with Dacha's model is the off-loading. If they have off-take agreements already in place, then it shouldn't be a problem. But if the company just stockpiles and has no buyers, then the value of the company is just in the material reserves. It takes buyers to realize that value.
TCMR: Dacha has an inventory of heavy rare earths (HREEs), most of which are in high demand, and says its inventory is worth roughly $120 million (M). But Dacha needs to make sales each quarter—doesn't that put the REE buyers at an advantage?
BC: The demand is there. The reason prices have gone down recently is people are waiting on the sidelines hoping that the prices are going to go down further. At the same time, especially within China, because of the export quotas, companies need to unload their quotas by the end of the year or else they risk not being assigned a quota for the following year.
TCMR: You wrote a positive research report on Molycorp in April, when its shares were trading at about $72. Molycorp now trades at less than half that, even though it has started to produce some rare earths from stockpiles. What's your view now?
BC: In late April I actually downgraded the stock to a hold because of the run up in the stock price at the time and the fact that it was trading near my Private Market Value (PMV) for the company and didn't provide enough margin of safety. I still think Molycorp is the best way to gain exposure to the rare earths industry. The company has a high-grade ore body in a convenient location. These are two keys to a successful REE project. In addition, Molycorp used to be one of the dominant REE producers, so it has expertise. I think its mine-to-magnet strategy will allow the company to realize incremental value across the supply chain. When it comes into production in 2012, it's going to be the lowest-cost producer in the industry. That adds an extra layer of safety to the company, given how volatile prices have been.
TCMR: The knock on Molycorp's past deposit is its lack of HREEs like terbium, yttrium and dysprosium. Molycorp says it's exploring an HREE deposit near Mountain Pass. What do you know about that?
BC: Molycorp recently announced that it was looking at four potential rare earth deposits with a composition skewed more towards the HREEs. All four of the deposits have high ore grades greater than 4% and can be processed at Molycorp's Mountain Pass facility. The company realizes that because its deposit is more LREE-rich, having a complementary HREE deposit would be beneficial.
TCMR: Molycorp's trying to get a few different loan agreements with the Department of Energy, but has so far been unsuccessful. Is that a red flag for investors?
BC: In speaking with the company about that, I think it was trying to get those loans back when it was still looking to get fully financed for its project. Since then, it has been able to work out a number of different agreements with suppliers, and it was able to secure alternative funding on its own.
TCMR: Aside from Molycorp, what are some other companies that have piqued your interest?
BC: Quest Rare Minerals Ltd. (QRM:TSX.V; QRM:NYSE.A) Strange Lake project in Quebec and Avalon Rare Metals Inc. (TSX:AVL; NYSE.A:AVL; OTCQX:AVARF) Thor Lake project both have large resource estimates and compositions skewed toward HREEs. Strange Lake has a resource estimate of approximately 230 million tons (Mt) at 0.9% ore grade, and Thor Lake has 315 Mt at about 1.4% ore grade.
TCMR: Quest just added George Potter to the company. Potter was in a senior executive position with AngloGold Ashanti Ltd. (AU:NYSE; ANG:JSE; AGG:ASX; AGD:LSE). When he came on board, Quest's share price was not far above $2 and now it's well over $3. The market seems to like the move. What are your thoughts?
BC: It's positive that the company was able to bring in people with good experience, and it has a very large resource estimate at its Strange Lake site. The problem is that it is in a very remote location, and it's going to take a lot of capital to get the infrastructure in place to build up a mine.
TCMR: Nonetheless, in Canada, those two projects always seem to take center stage when rare earths are discussed. Matamec Explorations Inc. (MAT:TSX.V; MRHEF:OTCQX) Zeus Project may beat both of those companies to production. How did Matamec come out of nowhere to lead the race?
BC: I wouldn't say that it's leading the rare earth race per se, but it's another contestant in the race. Matamec has a very attractive composition weighted toward the more valuable HREEs and a resource measurement of 16 Mt but at a relatively low ore grade of 0.5%. It is projecting that it will be in production by 2016. A lot of questions remain, including whether it can actually be economically feasible to mine and process with such a low ore grade.
TCMR: In comparison with Avalon and Quest, Matamec is much closer to infrastructure and established mining camps.
BC: That's one of the key things for a project's feasibility, and in this area Matamec has an advantage.
TCMR: Matamec has seen recovery of 95% of REEs from its ores, so that is certainly a positive as well.
BC: That is definitely another important thing. Metallurgy varies from deposit to deposit so recovery is important.
TCMR: Matamec will soon release a preliminary economic assessment on the Kipawa deposit; do you expect that study to boost the share price?
BC: If the company has a positive study that shows it can extract and process REEs and that its resources are there, then that should be positive for the company, even given the volatility in the markets.
TCMR: What do you make of that volatility? Since August or so, the share prices across the board have often been halved or worse.
BC: Uncertainty in the macro-environment has hit the commodity and REE space harder than the rest of the overall market. Investors are a little skittish, and there has also been a lot of news about companies seeking different ways to substitute REEs, whether it's electric cars or other end-use applications. However, I was in Japan recently meeting with companies, and the demand is still there. REEs have unique properties that allow for lighter, more efficient and smaller end products. In the near term, there is going to be volatility and uncertainty in the overall global environment, but in the long term, alternative suppliers need to come on-line to supply the rest of the world's markets, and their ongoing rare earth needs.
TCMR: You studied Applied Value Investing at Columbia Business School. Are you seeing a lot of value in this space right now?
BC: Depending on your risk tolerance, I do see value in the space. Right now a lot of the stocks are trading at discounts to their intrinsic value. Molycorp is the best positioned in the space—I have a 2012 PMV of $67 and it is currently trading at a pretty steep discount to this.
TCMR: What are your top three picks in this space?
BC: I like Molycorp. That would be my first choice. Lynas, even with its problems, would be my second choice because of its high-grade ore deposit. Third is tough; there are a bunch of projects in Canada and Australia that are all vying to become that other supplier in this space. But they are all many years away from getting into production, so I think it's hard to choose one of them.
TCMR: You prefer the near-term producers with high-grade deposits?
BC: Yes, and then I would go with a deposit that is heavily skewed toward HREEs.
TCMR: Thanks you for your insights, Brian.
Brian Chin joined the firm in 2010 as a research analyst covering Natural Resources. Mr. Chin began his business career as an investment consultant and then became an investment banking analyst focused on mergers and acquisitions for middle-market healthcare service companies. Mr. Chin graduated from Amherst College with a Bachelor of Arts in economics and received a Master of Business Administration from Columbia Business School with a concentration in applied value investing.
Want to read more exclusive Critical Metals Report articles like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators and learn more about critical metals companies, visit our Critical Metals Report page.
DISCLOSURE:
1) Brian Sylvester of The Critical Metals Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Critical Metals Report: Dacha Strategic Metals, Quest Rare Minerals and Matamec Explorations Inc.
3) Brian Chin: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None.
