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Spec Value Hunter Comment - May 24, 2012: Quest's Strange Lake finishes bench scale met study needed for its PFS
 Quest Rare Minerals Ltd was recommended a Good Relative Spec Value Buy at $2.22 on December 30, 2011 based on my assessment that its Strange Lake rare earth project in northern Quebec is the most important full-spectrum rare earth deposit in the world, and on my expectation that the BZone will go into production to produce 10,000-20,000 tonnes of rare earth oxides annually for many decades. Although the junior published a preliminary economic assessment (PEA) in September 2010 for a 4,000 tpd mining scenario whose parameters implied multi-billion dollar target valuations in the context of the elevated rare earth prices the market has experienced during the past year both within and outside China, I did not make Quest a Good Absolute Speculative Buy because the company has changed the mining scenario and in doing so has put in question the PEA cost assumptions. Quest embarked on a prefeasibility study (PFS) in 2011 which will establish the capital and operating costs of the new scenario, but the market was led to expect the PFS by Q1 of 2012. Unfortunately, the bench scale metallurgical study by Hazen Research on BZone ore encountered a glitch that generated erratic results which could have been avoided if there were more vigilance about the application of prescribed protocols. The glitch required Hazen to restart a 3 month study cycle in January 2012, with the result that Quest did not provide a metallurgical update until May 15, 2012.
 The significance of this milestone is that all bench scale studies related to the flow-sheet from mining through precipitation of a mixed rare earth oxalate concentrate have been completed and the results have been submitted to the engineers responsible for producing the PFS. The engineering and cost estimation is expected to take 4 months, which puts the PFS delivery date some time during Q4 of 2012. A mini pilot plant study will begin in September 2012 and run until the end of the year. It will be operated by Ortech which has expertise in solvent extraction methods. The mini pilot plant study will simulate the pregnant leach solution that will be left over after Quest has stripped out the zirconium and niobium by-products as well as the contaminants uranium and thorium along with other waste products. The good news in the update is that the Hazen studies have demonstrated that the radioactive uranium (0.01% U3O8) and thorium (0.07% THO2) can be fully and selectively extracted from the solution so that none of the concentrates containing payable metals have any radioactive content. The plan is to turn the uranium and thorium into a slag that can be blended back into the tailings at a background grade level. Using "synthetic" inputs (purchased rare earth oxides because the work done so far has produced only a vial of rare earth oxides shown in the photo from the latest Quest presentation) to reproduce the pregnant solution, the mini pilot plant study will precipitate the rare earths as an oxalate using oxalic acid, and then re-dissolve the oxalate to allow tests for the optimal method to separate the individual rare earth oxides. The resulting information will be the basis of a PEA for a standalone separation plant dedicated to processing Strange Lake concentrate. The site has yet to be determined, but it will likely be in southern Quebec. The Strange Lake facility will only produce a mixed rare earth concentrate that will be transported to the separation plant. Quest is in negotiation with various end-users for the funding of the separation plant in conjunction with off-take arrangements. The separation plant PEA is expected shortly after the mine PFS is delivered. Assuming the PFS gives the goahead for a feasibility study, Quest will initiate a pilot plant study in early 2013 that will utilize the 30 tonnes of core and assay rejects to test the entire flow-sheet from crushing through oxalate precipitation. Assuming the scaling up from bench to a pilot plant does not generate any unpleasant surprises, Quest hopes to deliver a feasibility study by the end of 2013. That would put Strange Lake on schedule for production in 2017. The important news is that except for separation studies, the Strange Lake project has gone beyond bench scale studies.
I was at the Hard Assets conference in New York last week when Quest put out the news and held a conference call which I have since reviewed. My initial impression was negative, and so far this year I have closed out two Spec Value Hunter recommendations of rare earth juniors after they published bobbled and disappointing news releases. Both of those companies are now trading at lower prices due in part to the negative sentiment engulfing not just the rare earth sector, but the entire resource sector be it precious or base metals. The news release left many questions unanswered, and the conference call was plagued by management evasiveness as analysts probed for answers related to the cost implications of the changed mining scenario and the metallurgical study results. However, following direct discussions with management my alarm has subsided, and I am now confident that Quest has met a major metallurgy milestone and is on track to delivering its PFS sometime during Q4 of 2012. That, unfortunately, is not likely to help Spec Value Hunters see a profit in their Quest positions during the short term. There is little we will learn between now and publication of the PFS that would be positive for Quest's outlook, and, while I believe Quest is capable of outperforming other contenders in the race to deliver a solution to the world's rare earth supply problem, the downtrend for the rare earth sector has not yet turned around. Even the uptick in domestic rare earth oxide prices that started in April is now rolling over. As a result I am switching my Good Relative Spec Value Buy recommendation to a Fair Relative Spec Value Hold recommendation at $1.95. This means that the price of Quest will be a function of market forces unrelated to the company's fundamentals, which are shaping up very well. Spec Value Hunters who own Quest must decide whether or not they can stomach the market volatility that lies ahead.
The most important question facing Spec Value Hunters is how the revised mining scenario will affect capital and operating costs. The PEA envisioned a minimal footprint for the minesite in Quebec where the ore would be open-pit mined, crushed and transported via a 150 km slurry pipeline to a processing facility on the coast of Labrador. This scenario faced several problems. One was the risk that a pumping breakdown during the winter would allow the slurry to freeze until spring thaw unless it was loaded with anti-freeze chemicals whose impact on the local environment in the event of a spill would not be a happy development. Another was the fact that the Strange Lake ore does not lend itself to beneficiation, namely getting rid of gangue minerals through pre-concentration steps such as gravity and magnetic separation and flotation. The latest update confirms that no progress was been made on this front. The Strange Lake flow-sheet involves fine grinding of the whole rock ore, baking it in sulphuric acid to crack the key minerals, and water leaching the result to create a pregnant solution from which the target metals will be extracted through various methods. Minus the 3-4% extracted as payable metals, the Labrador facility would generate 35 million tonnes of waste material during its 25 year mine life. Not only did this scenario require environmental permitting of two "mine" sites in two different provincial jurisdictions, but it also opened a tax sharing can of worms. The PEA scenario had too many loose ends whose tie-up could cause considerable delays.
During 2011 Quest decided to base the entire process at Strange Lake on the Quebec side of the border, so that all mine permitting and taxation would take place under the jurisdiction of Quebec. Newfoundland would benefit because the port handling and transportation of consumables to the minesite would take place in Labrador, providing multi-decade job security that would serve as a platform for opening other inland Labrador business ventures. Rather than wait in the dark until the PFS is published, I have attempted a modification of the PEA parameters and plugged them into my discounted cash flow model.
The PEA assumed an operating cost of $103/tonne ore for a 4,000 tpd processing facility with a capital cost of $573 million that generated a mixed rare earth oxide concentrate. I have boosted the operating cost to $150/tonne, the capital cost to $800 million, and applied a 30% payability discount to the BZone basket price based on separated oxide prices. Using the updated resource estimate published in April 2011 which identified a near surface high grade "pegmatite spine" within the BZone, I have adjusted the mining plan to process the higher grade spine during the first seven years (10.2 million tonnes of 1.63% TREO), followed by a lower grade envelope of 26.3 million tonnes of 1.16% TREO. Quest hopes to boost the amount of higher grade ore it can process in the early years. During 2012 Quest plans a drilling program aimed at discovering high grade satellite deposits that might provide high grade ore from starter pits outside the high grade "pegmatite spine" of the BZone. Although I think the Strange Lake project is too advanced for drill results to make a market impact, if new zones started delivering longer intervals of the sort described below, it might stimulate buyers to leave the sidelines.
Slide 14 of the Webcast Presentation offers visuals of core that runs about 5% TREO, which is unusual in that this grade is represented 70%-80% by the heavy rare earths. I say this is unusual because whenever I have seen grade spikes well above the resource grade in the drill logs the high grade was always attributable to a spike in the light rare earths with a decline in the heavy percentage. Quest has not discussed this potential for material whose grade and heavy percentage spike well above the life of mine grade and percentage, so perhaps we did learn something unexpectedly new and positive about Strange Lake whose virtue is that the ore grade never drops below 0.7% TREO but rarely rises above 2% TREO. When I queried Peter Cashin about this development he confirmed that this positive double whammy does occur within the Pegmatite Spine, and the goal with the summer drilling is to fine similar hotspots within the Strange Lake complex that could supplement mill-feed from the BZone.
Conclusion: The revised mining plan coupled with Quest's improved metallurgical recoveries would produce 20,100 tonnes of rare earth oxides during the first 7 years while the higher grade Pegmatite Spine is mined, dropping to 14,400 tonnes annually in later years when the lower grade envelope is mined. Both run about 51% heavy rare earths by weight. Assuming that Quest's 67.4 million shares fully diluted remains unchanged, the after-tax net present value of the modified PEA mining plan is $2.1 billion or $31.53 per shares at a 10% discount rate using the 3 year trailing average for domestic rare earth oxides prices which works out to a basket price of $58/kg. The target price using the 2016 price deck Toyota recommended Matamec use for its Kipawa project, $70/kg, is $43.26 per share. The $75/kg domestic spot basket price as of May 24, 2012 generates a valuation of $48.14 per share. If we keep the domestic spot prices constant while reducing the three most abundant rare earth oxides - cerium, lanthanum and yttrium - to zero, the basket price is still $61/kg, suggesting that the Strange Lake project can well withstand a glut of the most common rare earths should all the non-Chinese supply contenders come on stream by 2017. On the premise that a resource junior at this stage of the development cycle which does not have project funding lined up should trade at 10% of its DCF based NPV, Quest should be trading in the $3-$4 range. In fact, it should be trading higher because in my cash flow model I have assigned zero value to the 31,400 tonnes of zirconium and 3,950 tonnes of niobium Strange Lake should generate each year. Furthermore, the Pegmatite Spine contains 0.19% beryllium oxide (BeO), 36% of which converts into beryllium metal. If Quest can recover 50% of the contained beryllium, it would produce 500 tonnes annually, double current global production, most of which comes from Materion's Spor Mountain project in Utah. If the cost to extract the BZone beryllium is incremental, Quest would have a profound impact on applications that benefit from a beryllium alloy. At the current China price of nearly $500/lb of 4N beryllium metal, this annual waste by-product would be worth over $500 million, though in reality we might see the price plunge to $100/lb. Depending on the value added to a downstream fabricated metal product that has a beryllium alloy as a critical input, this abundance of cheap beryllium could be of substantial strategic value to a downstream fabricator. Quest management has not had much to say about the beryllium content, but Canadian government officials have told the company to pay attention to it, and not because in airborne form it is deadly to people with a vulnerable genetic disposition. Spec Value Hunters may have to endure lower prices in the interim, but eventually they will receive a much better price, assuming the PFS costs come in along the lines I have assumed in my DCF analysis.
*JK owns shares in Quest Rare Minerals Ltd
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