The eruption of media anxiety last summer about the future of rare earth supply has awakened market interest in a dozen or so Australian and Canadian resource juniors who had already acquired or discovered rare earth deposits, and it has unleashed a scramble to track down other forgotten deposits outside of China and explore for new deposits. We created the KBFO Rare Earth Index to track the market performance of companies with the more advanced projects. The steep 691% gain posted by the index in 2009 prompted many observers to talk about a "rare earth bubble," which is to suggest that valuations are excessive and unsustainable.
In a scenario where China is able to boost its production of light and heavy rare earth oxides and export them at prevailing prices to meet substantial demand growth beyond 2015, only a few deposits outside of China are likely to be developed as economic mines. The rare earth junior price increases, however, are premised on speculation that China will not be able to boost production to meet optimistic demand growth and maintain current cheap prices. While it can be argued that the giant Bayan Obo mine in Inner Mongolia could supply the world indefinitely with all the light rare earths it needs, the same cannot be said about the heavy rare earths derived from the ion adsorption clay deposits in southern China.
Unlike peralkaline intrusive-related systems which can host substantial rare earth mineralization at depth, these relatively low-grade clay deposits are a weathering product similar to a nickel laterite which exists as a thin skin at surface. The heavy rare earth elements (REEs) which typically occur in association with yttrium have undergone an explosion of applications during the past couple of decades. During the Cold War, Western companies such as Unocal and Hecla explored extensively for REE deposits and found a fair number of peralkaline systems with a broad distribution of rare earths that included the heavier elements, including the Strange Lake deposit in Labrador, now held by Quest Uranium (QUC-V). When these deposits were last explored, there were limited markets for many of the elements present. As markets evolved, the newly discovered Chinese clay deposits came onstream and amply fulfilled the world's growing needs at cheap prices made possible because this material was easily excavated and the recovery process settled for 50% of contained metal, with the rest simply flushed into local river systems.
The juniors who make up the KBFO Rare Earth Index had the foresight to acquire non-Chinese rare earth deposits that had been abandoned after the end of the Cold War because of high capital and operating costs that rendered them marginal at the prices established by Chinese rare earth exports. In acquiring these deposits, they were making a speculative bet that the economics of developing them would change. So far, this bet has not paid off in terms of dramatic price increases for rare earth oxides which boosted the revenue side of the discounted cash flow equation. Significant price increases are not likely for another few years. What has changed is the expectation about future demand and a recognition that physical supply may simply not be available as a result of political developments.
Unlike gold, rare earth oxides have a utility whose cost will affect utilization demand. So there is little chance that rare earth prices can undergo a severe price spike that is sustainable. However, rare earths are incremental inputs to technologies and goods whose final value is substantially higher than the cost of the rare earth input, and, in so far that there are no substitutes for the functionality added by the rare earth, demand will not be affected by a doubling or tripling of rare earth prices.
A recent example of this phenomenon would be the case of molybdenum, an incremental but critical input which bestows strength and corrosion resistance on steel products, such as gas pipelines. China supplied a good portion of the US$2-billion annual market for molybdenum in 2003, when molybdic oxide was priced at less than US$3 per lb. Much of that supply came from numerous inefficient and highly polluting small-scale operations, which the Chinese decided to clean up and consolidate in 2004. The result was a tenfold molybdenum price spike above US$30 per lb. which nobody took seriously in terms of pushing new primary molybdenum mines into production, but which the copper producers exploited by high-grading the molybdenum-rich portions of their deposits.
Nevertheless, molybdic oxide hovered above US$30 per lb. for several years, feeding a demand whose annual value had swollen into the US$10-15 billion range. Not until the global economic collapse of 2008 did the price drop, and even today, molybdic oxide remains above US$10 per lb. That's three times the level to which the world had become accustomed before the Chinese decided to curtail inefficient supply at the same time that infrastructure-related demand for molybdenum as an input surged. Does this perhaps remind anybody of the situation facing rare earth oxides, another "puny" market worth less than US$2 billion?
It is premature to talk about a rare earth bubble, but the conditions are ripe for a rare earth mania where the market suddenly suspends its focus on the poor economics spelled out by current rare earth demand and prices, and starts to focus on the strategic logic that end-users are forced to embrace as they mull their long-range product commercialization and marketing plans.
If a major automaker, for example, wanted to scale up production and marketing of its hybrid vehicles, it would have trouble doing so. In the current context of China curtailing the export of rare earth oxides in order to serve its national agenda -- or perhaps in an imminent context where the escalation of tensions between the United States and China over issues such as Taiwan, Internet censorship, and Iran's nuclear ambitions leads to a disruption of trade flow between China and the rest of the world -- the automaker would need to secure a non-Chinese supply of rare earths.
But such an approach is fraught with uncertainty. Hybrid automakers cannot turn to the mining industry, because the mining industry traditionally looks at current demand and links demand growth and commodity price projections to the business cycle, not to disruptive developments such as the emergence of China as a manufacturing powerhouse, paradigm shifts such as green consciousness, or brand new technologies with huge commercial implications. The economic logic the mining industry will apply to the rare earth sector leads to a simple conclusion: there is no predictable way to make money developing a rare earth deposit outside of China. Precisely because the mining industry is not in the business of making speculative guesses about how the future will unfold, it will fall upon the giants at the bottom of the supply chain, who have the marketing infrastructure to shape demand trends, to make the capital investment that assures them secure supply of the raw material inputs that are critical to their multi-billion-dollar production plans.
In that vein, Toyota Tsusho Corp., a trading house 22%-owned by Toyota, has already announced that it's partnering with Orocobre Ltd. (ORE-A) at the Salar de Oloraz lithium-potash brine deposit in Argentina, in return for a secure lithium supply for its future lithium-ion based battery generation of plug-in hybrids.
About half the companies in the KBFO Rare Earth Index have published JORC or National Instrument 43-101-compliant resource estimates which have an in situ value in excess of US$50 billion on a 100% recovery basis using four-year average prices for the 15 rare earth oxides available commercially. The other half are working on projects whose apparent tonnage footprints and indicated grades suggest another US$50 billion in contained material. With broad brushstrokes, one can state that about $100 billion worth of rare earths is controlled by 14 juniors whose combined market capitalization hovers around $2 billion. If these deposits were all developed, the world would no longer have a security of supply problem with regard to rare earths. And, given that half of this market capitalization is represented by Australia's Lynas Corp. (LYC-A) and its light rare earth-dominated Mt. Weld deposit, it is a stretch to characterize these valuations as a "bubble."
One might imagine that given the media attention to the rare earth problem, these juniors would have no lack of access to capital to push their projects through the development cycle, particularly if downstream giants like Toyota were to get involved. But such is not the case, and a big reason is the complexity of evaluating the fundamentals of REE projects.
Rare earth roadblock
A rare earth project must undergo the normal stages of the mine development cycle, starting with grassroots exploration and ending with commercial production. What many people do not understand is that metallurgy, or establishing the optimal recovery process for the deposit, is always an issue in rare earth deposits because REEs not only occur within a complex mineral, but usually within a number of complex minerals in close spatial association with each other.
While assay results give a reliable mea- sure of the content of each REE within a piece of rock, they do not reveal anything about the minerals that contain these elements. In order to extract the rare earths from a mineral, the mineral must be "cracked" through a process that initially involves crushing and grinding, and then progresses to various chemical and energy-intensive processes. If a rare earth deposit consisted of a single mineral, developing the ideal "cracking" process would be straightforward. Unfortunately, rare earth ore typically consists of various minerals, each of which lends itself to different "cracking" processes. Sometimes these processes interfere with each other, or put one "recovered" REE back into another form that has a new cracking threshold. In such situations where the REEs go around in mineralogical circles they are, in effect, not recoverable. Before the metallurgist can even begin to develop a recovery process, the geologists must deliver a detailed description of the quantitative and spatial distribution of the different minerals that constitute the ore. In addition to grade control, a rare earth deposit must thus also include a mineral control, information that is too complex and detailed to show up in a typical news release or even in a technical report.
A junior may work out a process that recovers a reasonable percentage of the contained elements, but the cost may be equal to or higher than the market value of the recovered metals. So while we can talk about a dozen or so juniors controlling more than $100 billion worth of rare earth oxide pounds in the ground, it may cost more than $100 billion in chemical and energy processing costs to extract those pounds, not to mention the capital cost of establishing a mining and processing facility. Not only are investors in the dark in economic logic terms until these numbers are known, but they also remain in the dark in terms of strategic logic, where a downstream operator might pay an ownership premium for the privilege of establishing an upstream operation whose losses are offset by the downstream profits made possible by the secure availability of critical upstream inputs.
Assuming a junior can come up with a plausible recovery process that establishes the relationship between extraction cost and the recovered value of the target metals, which presumably leaves in place a profit margin, the next stage is normally the negotiation of an offtake agreement, without which a rare earth project has historically had zero chance of attracting production financing. There are no commodity markets for rare earth oxides, just an army of intermediaries trying to match upstream processors with downstream users. In the current environment where the production cost structure is unreliable due to uncertainty about medium-term energy and chemical process input costs, and the future price of rare earth oxides hinges on what a downstream manufacturer has up its sleeve, and what technologies get commercialized, a rare earth developer has no rational basis on which to enter a price-based offtake agreement. And because there are no established markets with transparent price discovery mechanisms for rare earths, an offtake agreement cannot be linked to a spot price.
The exit strategy for the juniors who advance a rare earth project through the prefeasibility stage thus hinges on what competing downstream manufacturers are willing to pay to control a rare earth resource large enough to produce for many decades and whose production capacity can be scaled up if global demand does indeed undergo bursts of exponential growth.
--The author is a California-based newsletter writer. Visit his website at www.kaiserbottomfish.com to learn about evaluating rare earth projects.
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