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 Wed Feb 22, 2012
Index Member Comment: Frontier's Zandkopsdrift PEA represents another major milestone Canadian rare earth juniors
    Publisher: Kaiser Research Online
    Author: Copyright 2012 John A Kaiser

 
Frontier Rare Earths Ltd (FRO-T: $1.22)

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Index Member Comment - February 22, 2012: Frontier's Zandkopsdrift PEA represents another major milestone Canadian rare earth juniors

Frontier Rare Earths Ltd joined the ranks of major rare earth supply contenders on February 21, 2012 when it published a preliminary economic assessment (PEA) for a 20,000 tonnes per annum TREO output operation for its Zandkopsdrift carbonatite deposit in South Africa. The PEA envisions open-pit mining at a rate of about 3,000 tpd to mine 1 million tonnes of ore annually along with an average 3 million tonnes of waste during the proposed 20 year mine life. The mine will target ore with a 2% TREO cutoff grade for which an updated 43-101 resource estimate now lists a combined indicated and inferred tonnage of 20,540,000 tonnes at 3.04% TREO for the Central Zone. At a lower 1% cutoff the tonnage more than doubles with a grade range of 2.08%-2.28%, but this would likely include mineralization other than the supergene enriched monazite for which a metallurgical flowsheet has been developed. The cracking facility will be located at the mine site where ore will undergo crushing, fine grinding, flotation, sulphuric acid baking, and acid leaching to produce a 99% mixed rare earth carbonate that will be trucked 300 km to a dedicated separation facility at Saldanha Bay on the coast.

The PEA is a milestone for Canadian listed rare earth juniors in that it includes a separation facility whose capital cost is estimated at $703 million out of an overall capital cost of $1.077 billion which includes a 15% contingency. Unlike Molycorp and advanced ASX listed rare earth juniors, Frontier has isolated the capital and operating costs associated with the separation stage. The separation cost is estimated at $156/t ore feed, or about $7.80/kg of recoverable rare earth oxides. The mining, cracking and shipping cost at the mine site is $134.96 per tonne or $6.64/kg of recoverable rare earths. This works out to $291.41/tonne or $14.44/kg TREO. Given that the Zandkopsdrift basket price in late 2009 was $12/kg FOB spot and $10/kg domestic spot, it is understandable why deposits like this were available for staking. Frontier intends to recover the uranium (60-70 ppm) and thorium (215-235 ppm) contaminants at the Zandkopsdrift mine site during the final acid leaching stage and dispose of it by blending it with the mine tailings. Overall recovery of mine head grade is expected to be 67%.

Based on the rare earth distribution of Frontier's latest resource estimate Zandkopsdrift is expected to produce about 92% light and 8% heavy rare earths. Because of limited pricing information and demand Frontier has chosen not to include in its economic analysis the 148 tonnes of the heavy rare earths holmium, erbium, thulium, ytterbium and lutetium it is capable of producing. It does plan to recover these more obscure rare earth oxides and stockpile them as a mixed oxide concentrate for future sale or separation if demand develops. In my discounted cash flow model simulation of Frontier's PEA parameters I have included them using the market prices established by Avalon in 2009, prices that do not reflect the 2010-2011 price bubble which is still deflating.

While the bulk of Zandkopsdrift heavy rare earth output will consist of yttrium, its true significance will be its output of europium, the phosphor responsible for the color red in lighting applications. Europium is very weakly represented in zirconium silicate based peralkaline systems such as Strange Lake, Dubbo, Nechalacho, Norra Karr and Kipawa which represent the future for heavy rare earth production outside of China's ion adsorption clay deposits. As the europium projected 2016 supply chart for europium illustrates, Zandkopsdrift would be the primary europium source outside the Chinese clay deposits, followed by Mt Weld and Nolans Bore.

Zandkopsdrift is expected to produce 20,000 tonnes of separated rare earth oxides annually by 2016 if the mine achieves startup during H2 of 2015. Work is already underway on a prefeasibility study (PFS) which Frontier expects to complete in Q4 of 2012. A definitive feasibility study for both the cracking and separation facilities along with mine approval is expected in Q4 of 2013. Given management's history of under-estimating timelines for its Zandkopsdrift project, and the sector's perfect record in taking much longer to achieve post-PEA milestones than projected, it is unlikely that Zandkopsdrift will be in production by 2016 even with the assistance of KORES if it stays involved after completion of the DFS by acquiring another 10% direct interest in the project. However, for now I am giving Frontier the benefit of doubt. Frontier has about $38 million working capital left which it deems sufficient to pay for delivery of a DFS, and it also stands to get an additional cash injection if the non-binding deal with KORES is formalized by a decision to pay 10% of Frontier's "enterprise value" based on the 15 day average post-PEA price, subject to a minimum of $2.39 per share, which would inject about $24 million into Frontier's treasury.

An agreement with KORES was announced in November 2011 with terms that are very good financially for Frontier if the deal goes ahead. The deal would also provide Frontier with access to Korean technical expertise for the design of the separation facility. Completion of the first step of this deal during the coming months will be an important milestone for Frontier and the credibility of the Zandkopsdrift PEA. Under the terms of the agreement KORES would have the right to purchase another direct 10% interest in Zandkopsdrift based on the DFS valuation, as well as a 10% equity stake in Frontier based on the post DFS market price. Because DCF model based rare earth project valuations are very sensitive to the future rare earth price deck, it will be interesting to see what base case price deck the DFS adopts, and what influence KORES will have on this decision. The PEA generated a $3.65 billion after-tax net present value using an 11% discount rate and a basket price of $58.23/kg, which, if acceptable to KORES and unchanged after completion of a DFS, would require KORES to pay about $365 million to Frontier for an additional 10% interest in Zandkopsdrift. On top of that KORES would arrange the debt financing portion of the capital cost. These terms seem much more generous than the terms Toyota has negotiated with Matamec for the Kipawa project.

On this DFS valuation basis Frontier would also be owed 21% of the NPV by the BEE stakeholders, which would amount to $767 million. Of course the BEE has no way of paying this amount, so it would be recorded as a debt to be paid back by the BEE's share of project cash flow. The only BEE winner is the 5% organizer of the BEE who is fully carried and pays nothing for his 5% stake. This allows Frontier to claim it has a 95% "economic interest" in Zandkopsdrift rather than the 74% equity interest it holds as a result of complying with South Africa's BEE law. Ironically the BEE will then have to come up with its 21% share of the $244 million capital cost for the mine site portion of the project; the BEE interest does not extend to the separation plant whose ownership will be split 80% and 20% between Frontier and KORES if the latter acquires 20%. The $767 million figure mentioned as to what the BEE will owe Frontier is thus inappropriate. The NPV will need to be broken down into two parts. The first part will be the mining operation which will produce a mixed oxide concentrate that will be "sold" to the separation entity owned 80% and 20% by Frontier and KORES. How much cash flow Sedex, the corporate entity that owns the mining operation and whose profits are subject to a 28% mining tax, will make depends on the price assigned to the concentrates.

In the case of Toyota's offtake arrangement with Matamec regarding the Kipawa concentrates the price was defined as a 30% discount from whatever turns out to be the separated oxide price basis. The separation plant will apparently be owned by a Swiss entity and its profits will be subject only to a 7.5% tax. Obviously it is in the interest of Frontier to shift the profitability of the Zandkopsdrift production into the Sandalha Bay separation facility in order to minimize the cash flow subject to the 28% mining tax and 26% BEE stake. Needless to say the South African tax authority will have a keen interest in how the transfer pricing is designed; the company is relying on how transfer pricing is handled for platinum production, but that may be a misguided reliance because refined platinum has a commodity market based price and the mechanics of refining platinum are well known and competitively priced. I admit I do not really understand how the taxation of separated rare earth production will work in South Africa, so I am accepting guidance from Philip Kenny that the effective tax rate for the overall Zandkopsdrift operation will be 14.5%, while making a note that this number may very well end up higher. With regard to South Africa's new mining royalty tax, for my DCF model I have assumed the royalty will apply to "refined" rare earths, meaning "separated" rate earths, and used the EBITDA for the overall operation and the sales value of the separated oxides to determine the royalty payable. The royalty hits the 5% ceiling for refined products at a basket price of about $33/kg, which happens to be the current "Toyota 2016" basket price for Zandkopsdrift's output. On the assumption that the BEE will get stuck owing 21% of a DFS based valuation that equals or exceeds the eventual value of the operation, and that KORES would also pay that price for its 10% post DFS purchase, I have fudged Frontier's "economic net interest" as 85% to reflect the 5% carried BEE stakeholder and the 10% KORES will pick up for about $25 million which is a fraction of what the PEA suggests Zandkopsdrift its worth.

The post-PEA period is generally the sweet spot for rare earth juniors because the metallurgical flowsheet is based on bench scale experiments and the cost figures are skewed towards the optimistic side. The more detailed work required at the PFS stage tends to unearth all sorts of devils that drop recoveries, boost costs, require expensive extra studies, and generally push out projected timelines. A classic example is Arafura Resources Ltd which has spent AUD $145 million on Nolans Bore since 2000 and has declared it will need to spend AUD $250 million to deliver a DFS, of which it still needs to raise $70 million. The need to spend an extra $100 million was discovered in 2011, the year the DFS was supposed to be completed. Arafura, which published an Australian style PFS in 2007 that projected annual output of 20,000 tonnes of separated rare earths which until recently the company projected would start in H2 of 2014, shocked the market on February 16 with an announcement that the managing director and other key directors had abruptly resigned. (Australian style = disclosure which is incomplete, lacking in detail, and not supported by a publicly available technical report - a grave deficit in the reporting requirements of the ASX which is a good reason to avoid any ASX-listed company seeking to advance a project beyond delivery of a JORC resource estimate). Arafura was viewed as the candidate next in line to deliver a meaningful supply of light rare earth oxides after Molycorp and Lynas, and had even attracted the financial backing and technical support of a Chinese shareholder in 2010 who is now stuck with 17.5% and obligated to chip in more cash with every financing to maintain its stake or risk sending the stock into an all out death spiral.

During January deluded ASX officials took Arafura management to task for supposedly leaking positive information suspected as fueling a price and volume spike when in fact the likelihood is that Arafura is sitting on negative information about the viability of its flowsheet to which it has only vaguely alluded to as "issues" requiring "refinement", a 1 year delay in its DFS and a staggering extra $100 million in work unlikely related to mine-site feasibility work. In my February 8, 2011 Index Member Comment on Arafura I showed how leveraged the value of Nolans was to soaring domestic and FOB rare earth oxide prices, but warned that speculators should not trust the company's cost structure figures and pointed out that Arafura has not been forthright about its recoveries. The sudden departure of key people who not long ago were gushing optimism suggests that Arafura is an unfolding train wreck and I continue to recommend that Arafura be avoided. Bad news for Arafura, however, is good news for Frontier, whose detailed PEA news release makes it much easier to evaluate the plausibility of the net present value figures generated by the discounted cash flow model, which will be further facilitated when the company files its technical report on SEDAR.

I have added Zandkopsdrift to my rare earth supply evolution chart using management's timeline, though I should warn that Frontier's cost structure assumptions are based on a flowsheet so far tested only on a bench scale. In my December 3, 2010 Index Member Comment on Frontier I pointed out that the big challenge facing Zandkopsdrift is an irregular weathering profile that intersperses unaltered acid sucking lower grade mineralization with the higher grade supergene mineralization that is the focus of the flowsheet. Mineralogical control during mining will be critical to cost control at the cracking stage. However, in terms of relying on a major long term supply of light rare earths I would much rather bet on Frontier's Zandkopsdrift project than Arafura's Nolans Bore.

I have constructed a discounted cash flow model of Zandkopsdrift relying on the parameters disclosed in the PEA news release which is subject to revision after I have reviewed the details in the technical report. My model assumes all capital cost expenditure in year one and full production at life of mine averages starting in year two and operating for 20 years. At the $58.23/kg base case basket price my model generates an after-tax net present value of $4.8 billion at a 10% discount rate which is higher than the $3.65 billion the PEA generates at 11%. Assuming an 85% economic interest and 102.1 million shares fully diluted, and USD:CAD parity, this works out to a value of $39.81 per Frontier share. The internal rate of return is 73% and payback occurs within one year. Breakeven where the net present value is zero and all capital is paid back is a basket price of $21.07/kg. I have also run the model using a 5% discount rate so that readers can estimate what the NPV might be at a rate below 10%. I do not think it is appropriate to use a discount rate less than 10% for a rare earth project. I would also urge a further 50% reduction of the NPV to reflect the high error margin at the PEA level and the years still required to achieve production. I think the use of a $58.23/kg basket price which is well above the $46/kg basket price at domestic spot is inappropriate. At this stage the use of 3 year trailing average FOB prices is also foolhardy, sort of like using 3 year trailing nickel prices during the past couple years after nickel's 2007 run to $25/lb. My recommendation is to look at how Zandkopsdrift fares in the $30-$40/kg basket price range, with emphasis on the $33/kg basket defined by my so-called "Toyota 2016 Price Deck". What this suggests is that Frontier has considerable upside from the current $1.22 price level even in this more conservative future price scenario, with $12.79 per share as the NPV at the Toyota basket price, or about $6 after applying the 50% uncertainty and time delay discount. The after tax NPV at the $33/kg basket price using a 10% discount rate is about $1.5 billion, the internal rate of return is 31%, and the payback period 2 years.

While the cost of producing a basket of rare earth oxides can be quantified by a PEA with an error margin of 35%-40%, the big unknown in the rare earth sector lies on the revenue side of the equation. As the Zandkopsdrift basket price chart below demonstrates, three year average domestic and FOB prices are still rising while spot domestic and FOB prices are plunging with no bottom in sight other than the theoretical one of equilibrium being about 200%-300% above the levels that prevailed in 2009 before China started to rethink its environmental and long term supply management policies in 2010. This would be in line with what we have seen in almost all mineral commodities during the past decade such as nickel, copper, uranium, potash, molybdenum and iron where there has been a scaling up of demand thanks to the emergence of China and its BRIC cousins as the new engines of global economic growth back-stopped by a much larger population base than that of the mature Anglo-American-European-Japanese economies.

Rare earths, however, are different from these other metals in that they have a supply-demand dynamic with an incomparable complexity. Rare earth demand is controlled by the unpredictable forces of innovation, policy, and price sensitive substitution strategies, while potential supply coming from non-Chinese sources gets hammered by ideological agenda of the Casey Research sort which cannot be explained by the lack of cheap paper in good rare earth projects run by explorer club heroes. The war that has been waged against the junior rare earth sector goes beyond the desire of hedge funds to profit from shorting what is a drop in the overall bucket. The rare earth sector has become a punching bag for the fossil fuel lobby and China bashers, which efforts, ironically, serve to undermine the ability of the capital markets to deliver a solution to the rare earth supply problem.

A further layer of complexity is created by the fact that once a rare earth deposit is brought into production, it will supply the intrinsic mix of rare earths regardless of the price of the individual rare earth oxides, each one of which has a demand linked to its unique properties. Furthermore, all the rare earths qualify as "critical" in the sense that without them certain applications simply do not work, though none of these applications are so important that they can handle any price for their critical inputs, and all of these applications require multi-year lead times for commercialization, as a result of which potential demand swirls within a vortex of uncertainty. The circular, second guessing nature of the rare earth sector creates only one certainty, namely that anybody who proposes a "rare earth price deck" for 2015 and beyond with a straight face is either an idiot or an aspiring market manipulator.

An economic analysis of a potential mining project does, of course, require a future "price deck", and Frontier has chosen one which is a blend of the 3 year trailing FOB average and the mid-point of the ranges Roskill forecast for 2015 that works out to a basket price of $58.23/kg for Zandkopsdrift's output (excluding the minor heavy rare earths mentioned earlier: Er, Ho, Tm, Yb, Lu) which compares to the $52.10/kg basket price forecast by Roskill for 2015 (substituting the 3 year trailing averages for gadolinium and samarium which Roskill does not forecast) and $64.36/kg for the 3 year FOB trailing average as of December 1, 2011. Compare that to my basket prices which include the prices used by Avalon in 2009 for Nechalacho for the excluded minor heavy rare earths and which use Metal-Pages based prices as of February 21, 2012: $99/kg for FOB spot, $73/kg for 3 year average FOB, $46/kg for domestic spot, and $31/kg for 3 year average domestic. Above all, consider that the Zandkopsdrift basket price is $33/kg using the price deck applied by Matamec to its recent Kipawa PEA which I discussed in my January 30, 2012 Index Member Comment for Matamec.

I call the Kipawa price deck the "Toyota 2016" price deck because of its peculiar nature. As the chart above depicting the differential between domestic spot and the Kipawa/Toyota price deck shows, it is too unusual and conservative to be something that Matamec's CEO Andre Gauthier invented just to discourage his shareholders; it was, according to Matamec management, the price deck recommended by Toyota for the PEA which will be the basis for its own pending decision to acquire a 49% stake in Kipawa and 100% offtake rights to a fairly pure mixed rare earth oxide concentrate it will buy at a 30% discount to their separated value. I do not think Toyota is a foolish company, so I am inclined to view Toyota's 2016 price deck not as the outcome of its attempt to solve the non-linear future rare earth supply-demand equation, but rather as a "line in the sand" declaration as to the sort of rare earth oxide prices that will work with its commercialization plans for future products and technologies that require rare earths as critical inputs. If Matamec's Kipawa DFS meets with Toyota's approval, it will finance Kipawa's development and purchase the output for internal consumption. What Toyota is putting in place is a price cap linked to production costs for what it perceives to be its future rare earth needs as critical inputs for vastly more valuable downstream products. By investing in Kipawa Toyota would secure the strategic advantage of being in a position to commercialize products that require rare earths without worrying about their source, which is the predicament all non-China based end users have ended up in since 2010. I believe other end-users are beginning to understand this, and I regard the involvement of KORES, a Korean state owned entity whose mandate it is to secure the raw material inputs for Korean end users, as motivated more by "security of supply" goals than profit maximization goals. I am now of the opinion that if a rare earth project has a significant net present value using the Toyota 2016 price deck, it has a very good chance of making it across the finish line as a future solution to the world's rare earth supply problem.

The chart above showing how the Frontier PEA price deck compares to the Toyota-Kipawa 2016 price deck reveals that the Frontier PEA is considerably more optimistic. In any case, the market is disinclined to take seriously the sort of valuations which can be cranked out using current domestic spot, FOB spot and 3 year trailing FOB based basket prices, so we might as well ignore those price decks and focus on the $30-$40/kg range where it is conceivable that demand destruction will cease and enough profit remains to ensure significant supply growth from non-Chinese sources that will in turn encourage end-users to resume developing rare earth based commercialization plans that will provide an offsetting demand for a spurt in global rare earth output into the 200,000-300,000 tonnes per year range during 2015-2020.

While the China domestic spot versus Toyota 2016 price deck chart shows that in Toyota's imagination most rare earth oxide prices are heading lower than current domestic spot prices, with FOB spot prices set to fall steeply when "rest-of-world" production comes on stream, the FOB versus Domestic Spot chart shows that despite falling FOB spot prices, the differential is now nearly 100% higher or more for all the key rare earth oxides. This premium for FOB over domestic spot is more than the 25% represented by export duties for rare earth oxides, and reflects China's strategic policy to protect domestic end-users from high rare earth input prices while encouraging foreign end-users to shift their rare earth dependent production into China and thereby facilitate the transfer into Chinese hands of sophisticated downstream technology.

If you look at those rare earth charts in my Rare Earth Resource Center which include the FOB premium over time - the yellow line - you will note that the price differential has collapsed for the light rare earths and the abundant heavy rare earth yttrium after a major spike starting in mid 2010, but not for the other heavy rare earths. The cerium oxide chart above and the dysprosium oxide chart below are representative of these trends where the FOB premium is shrinking for the lights and growing for the heavies. This is partly due to the expectation that during the next two years 40,000-60,000 tonnes of light rare earths will start coming on stream from Lynas and Molycorp.

But this recent trend is also an outcome of China's decision at the end of 2011 to split export quotas to about 85% light and 15% heavy rare earths, which closely resembles the existing Chinese production structure. This shift in policy reverses the undesired effect of the 2010 decision to slash the annual rare earth export quota without distinguishing between light and heavy rare earths. The result was a rush by Chinese quota holders to export the higher value heavy rare earths and in doing so create an artificial FOB shortage of light rare earths. The environmentally framed crackdown in 2011 on domestic rare earth production and processing induced a bout of speculative hoarding by the Chinese which hurt domestic end-users as a result of the spike in domestic spot prices, and undermined Beijing's strategic goal of using relatively cheaper domestic rare earth prices to steer rare earth dependent production to China and thereby facilitate intellectual property transfer. Instead it unleashed demand destruction as the Germans and Japanese scrambled to figure out ways to do without rare earth inputs. It also stimulated creative ways to smuggle rare earths out of China, which would explain why somehow non-China based end-users managed to buy less than half the official 2011 export quota of 30,184 tonnes. The loss of the 15%-25% export duties on half the allowable exports probably did not please Beijing.

Although domestic prices in general continue to sink, followed to a lesser degree by FOB prices, the 2012 Chinese export quota policy, which ostensibly matches the overall 2011 quota despite less than 50% utilization, is designed to spring a major surprise on foreign end-users in mid 2012. On December 27, 2011 the Chinese Ministry of Commerce unveiled the first round of export quota allocations (see Gareth Hatch's excellent TMR Report - December 28, 2011 for details). China has used environmental "inspections" to classify export quota holders as "confirmed" or "provisional". Very interestingly, China's two major foreign downstream rare earth processors and fabricators, Rhodia and Neo Materials, have been put on the provisional list. The people running Rhodia and Neo Materials are no dummies, and, being naturally sensitive to Chinese rules, would do everything within their power to be beyond reproach, at least in comparison to their domestic peers. So one has to wonder how they managed to be put on the provisional list. China has stated that if any of the provisional quota holders do not pass environmental muster by June 30, 2012, their provisional export quotas will be transferred to producers and processors who have passed the "environmental inspections". Unfortunately, even though these provisional export quotas may get transferred to China's "responsible corporate citizens", these may not have the means to secure and export the oxides allowed by their quotas.

China officially allotted 24,904 tonnes which it indicated would be 80% of the total for 2012, making the unofficial 2012 export quota 31,130 tonnes. The 24,904 tomnes official quota has been split 21,700 tonnes for light rare earths and 3,204 tonnes for what China calls mid to heavy rare earths and which we generally call heavy rare earths. The lights and heavies have been allocated to quota holders on a roughly 85% and 15% basis regardless whether they specialize in one or the other. Of the 24,904 tonnes, allocations for 10,546 tonnes (9,095 t light 1,451 t heavy) are confirmed while 14,538 tonnes (12,605 t light 1,753 t heavy) are provisional, namely subject to the processors or producers passing inspections. An updated list was rumored for February but is now rumored for mid March. Meanwhile export demand has been weak as end users wait for prices to slide lower. Because China has a reputation for corruption when it comes to enforcement of environmental regulations, and because Beijing seems to have lost control of local officials, one would assume that that it is only a matter of time before the provisional quota holders get confirmed. However, the list of quota holders is small, and the topic is geopolitically sensitive, so it is reasonable to believe that absolute control over who passes inspections resides in the hands of Beijing. Furthermore, because compliance with environmental regulations is ultimately a matter of degree, confirmation can happen the instant the local official gets the nod from Beijing.

China has very cleverly set up a system whereby it can monitor export demand and accommodate it by moving quotas from provisional to confirmed on a real time basis. WTO complaints about export quotas being used to curtail supply to non-Chinese end users lost their sting when reported exports tallied 14,508 tonnes, less than half the 30,246 tonne 2011 quota. Given a 2012 policy which links the right to export to meeting locally enforced environmental standards, even though failure on this account does not seem to imply a prohibition against selling to domestic end-users at domestic spot prices, how can anybody outside China complain if by the end of 2012 confirmed export quotas grow only modestly beyond the current 10,546 confirmed tonnes?

The downtrends in both domestic and FOB spot prices imply that there should eventually be a surge of demand for FOB rare earth oxides as they become cheaper, even though some end users such as Nidec Motor Corp are reportedly investing $3.6 billion in the development of rare earth free motors by 2015. China has effectively closed the door on rare earth exports and positioned itself to open that door on an as needed basis. The elephant in the room is that the reason the rest-of-the-world was able to cope with less than half of the 2011 export quota being exported is because it was able to secure its needs through smuggling channels at prices that were painful but considerably less painful than implied by the official export prices. China failed to collect its 25% export duty on these smuggled rare earths, attracted a lot of abuse in WTO related quarters, and did not really execute on its technology transfer agenda while its domestic end-users found themselves shafted by rare earth speculators. China has consolidated control over its rare earth industry and made rare earth "alloys" subject to export quotas, so it is now in a much better position to manage its rare earth policy for its own benefit. It is wrong to think China is super-smart when it designs its policies, but even more wrong to think China is slow to learn from its mistakes.

The general view is that the rare earth media bubble is finished, but conditions for a revival later this year are place, though next time around it will center only on major advanced projects whose achievement of commercial production would make a difference to the supply problem. Despite the high level political visits there is considerable tension brewing between China and the United States. The Obama administration is keen to reverse the trade imbalance by pushing China to further boost the value of its currency which has been rising steadily after spending 2008-2010 pegged to the US dollar. This is hurting the export capability of Chinese manufacturers and creating a source of domestic tension which has pushed Beijing into a hyper-vigilant mode of suppressing dissent. If war mongering leads to a Middle East conflict centered on Iran, China will have to look elsewhere for its oil such as the sources whose crude normally flows to the United States, some of whom such as Venezuela have pro-China-anti-America sympathies. Sharply higher gasoline prices and evidence that China is muscling into America's closer to home sources will boost American anti-China sentiment, especially during an election year where the latest Republican tactic is to blame Obama for rising gasoline prices.

Then there is the touchy topic of the shift in US military focus to southeast Asia where the United States seems to be pursuing a strategy of encirclement that controls China's shipping lanes. Even Myanmar, which offered China access to the Indian Ocean and its oil resources, appears to be turning its back on China with the recent Irrawaddy River dam decision and a newfound embrace of America. 2012 appears ripe for an escalation of tensions between China and the United States as a result of which rare earths could become very topical again. The United States could easily stop China dead in its tracks if it adopted a hardball strategy of using its current military supremacy to shut down the shipping channels that service China, while accepting a consequence in the form of sudden product shortages accompanied by sharp price increases for goods normally imported from Asia at a "China Price" subsidized by dumping costs on powerless Asian locals in a manner not allowed by business stifling regulations in America. Such a development would threaten Obama's re-election chances, so he would have to pre-empt the Republicans by playing the national security card, which messing with Iran would in any case entail. But such bravado would collide with the reality that China is a dominant exporter of many materials relevant to national security (scan my Global Metal Production Overview to discover that China is not just dominant in rare earths, but also other materials such as graphite, the budding security of supply flavor of the day story, and tungsten, the much ignored key to going to war with bullet resistant armor as well as a key to liberating the shale oil now viewed as America's road to freedom from foreign fossil fuel serfdom). But one doesn't even have to entertain such nefarious conspiracy theories; what if the "China is a Mirage" crowd is correct that China is trapped in an inexorably unfolding train wreck that will render it a dysfunctional supplier of nothing to the rest of the world?

I don't think the future will plot this extreme fork, but it will end up at its crossroads where there will be a much bigger second wave of anxiety about "security of supply" issues whose resolution will be much more tangible than the outcome of a tussle between stock market longs and shorts. The extreme fork would be a disaster for the global economy, but an arrival at the crossroads would be the sort of media nexus that translates itself into a lot of interest in realistic solutions to security of supply problems. But we do not have to harbor a macabre interest in such a conflict to be opimistic that positions in key rare earth juniors will prove profitable in 2012. China merely needs to behave in a self-serving manner of the sort praised by free market ideologues. China does have a legitimate reason to preserve its heavy rare earth production potential because most of it resides within the ion adsorption clay deposits which have been wastefully and destructively exploited, with estimates now pegging their supply potential at only 10-15 years. China understands that its citizens, not the relatively smaller population residing in the United States, will determine the future health of the planet, and because its leadership is still a de facto dictatorship and thus capable of designing and implementing industrial policy that serves the entire constituency rather than that of a narrow group capable of financing the latest free market propaganda machine otherwise known as a "Super-Pac", it will hardwire strategies that give it the means to preserve the planet for its citizens. And those means include rare earths which serve as complex critical inputs for renewable energy technologies, efficiency enhancements, and miniaturization strategies.

As far as the light rare earths are concerned, China is secure, but where heavy rare earths become critical, in the long run China will be at the mercy of external sources just as it is for nickel, copper, potash, chromium, niobium, platinum group metals, and uranium. For now China has allotted export quotas on a uniform 85:15 basis to quota holders, even though this does not make sense in practical terms. There is no reason China cannot recognize this problem and make adjustments to the light-heavy quota allocations. It has a mechanism in place to allow the export of light rare earths to grow as western supply from Mt Weld and Mountain Pass comes on stream. China also has the ability and strategic incentive to curtail the export supply of heavy rare earths, many of which critically partner with the more abundant light rare earths in certain applications such as magnets. Yes, Nidec Motor Corp of Japan is investing $3.6 billlion to invent totally rare earth free motors, Toyota continues to talk about the same thing despite investing capital in rare earth supply projects, and Molycorp's Mark Smith enthuses about the investment in Boulder Wind Power which supposedly has a way to produce rare earth based magnets for wind power generators that do not require the heavy rare earths of which the Mountain Pass operation will produce very little. But one can counter that Nidec is merely intending to spend all that dough and would in a heartbeat allocate that capital to establishing a secure long term, meaningful supply of rare earths at a reasonably fixed cost if such a project demonstrated feasibility, that Toyota's investments in India's Orissa project, Vietnam's Dong Pao project, and possibly Quebec's Kipawa project already rflects a conclusion that rare earth based applications are supeior to complicated workarounds, and that Molycorp is merely using the Boulder investment as a tool to pave the way for its goal of making opportunistic upstream acquisitions (as emphasized during the February 23, 2012 conference call) which will target anything but light rare earth dominated projects. The focus on commercializing its cerium dependent XSORBX water cleaning technology tells us that Molycorp agrees that the world does not need much more light rare earths than Mt Weld and Mountain Pass will add to the Chinese supply in coming years unless there is a dramatic surge in demand from sources not evident in the rearview mirrors Dudley Kingsnorth and Roskill use to project future demand.

Look at the Mt Weld and Mountain Pass 2016 production distribution potential charts. They promise much relief for light rare earth users, but offer little hope for heavy rare earth users. There is a fair bit of wisdom in Toyota's 2016 price deck which envisions considerably lower light rare earth prices but resilience at current domestic spot levels for the heavy rare earths. Companies such as Frontier with better heavy distributions will benefit from an intensification of the rare earth discourse even as rare earth oxide prices stabilize at levels resembling the Toyota-Kipawa 2016 price deck. Just as with gold and silver, money is to be made when the market decides that prices are not returning to the cheap levels of yesteryear. If Toyota's 2016 price deck is correct, particularly with regard to heavy rare earth prices, it is reasonable to expect that development capital will shun rare earth projects with less than 10% heavy rare earths, and will in fact favor projects that qualify as "full spectrum" which ideally means at least 20% heavy rare earths. That would seem to disqualify Zandkopsdrift, but as pointed out earlier, it has a heavy rare earth trump card called europium which the the main full spectrum contenders cannot match.


 
 

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