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Express 2010-02
April 19, 2010
Rare Earth Crisis coming to a Head: say goodbye to cheap prices
Synopsis: April has been a big month for the rare earth sector due to the much anticipated publication of the U.S. Government's General Accounting Office's report on Rare Earth Metals in the Defense Supply Chain. The reality of the GAO Report is something of a letdown because it admits there is a problem, notes that nothing is being done about it, and worries that not much can be done about it in a timely manner because the United States has a hopelessly convoluted permitting process. The RESTART bill submitted in March sets as its goal the creation of a competitive rare earth industry but offers only government intervention measures seemingly designed to subsidize a restart of Mountain Pass and protect it from external competition. The world, however, is matching onwards, and recent developments leave RESTART and the GAO Report in the dust.
In early April a representative of the Chinese rare earth industry called Dr. Chen Zhanheng published a semi-official policy paper which signals that the rare earth game is changing. China is cracking down on inefficient, polluting and sometimes illegal rare earth operations in an effort to consolidate what had become a wild-west style industry. China has much more aggressive medium to long term demand growth expectations than non-Chinese rare earth experts, and is determined to manage the supply side so as to better serve its domestic agenda. The result will be a higher cost structure for Chinese production, and an interim curtailment of supply from small scale operations and a substantial smuggling business, which will translate into sharply higher rare earth prices China hopes will encourage the development of non-Chinese rare earth supply. The policy paper is designed to shift the American perspective from worrying about predatory pricing and price busting supply gluts to recognizing that rare earths face a future global supply shortage unless more deposits are developed.
Another development is the announcement on April 15 by Molycorp that it was preparing to file a registration statement for a near-term IPO, which reflects a shift away from lobbying Washington for support to tapping capital markets to get the job of restarting an American based rare earth industry done without government intervention. The next day Molycorp did indeed file an S-1 for a NYSE destined IPO by JP Morgan and Morgan Stanley that may raise up to $350 million of the $511 million Molycorp anticipates spending on a modernization program that could see Molycorp supplying a large part of America's demand by 2013. The S-1 also discloses that Molycorp has a letter of intent to acquire a US based refiner of rare earth metals, though details and terms are not provided. The S-1 does not spell out IPO pricing details though it does warn investors that the IPO price will be at a substantial premium to the net worth of the company which is about $74 million; based on the last documented share issuance price, the current market capitalization of Molycorp is $154 million reflecting an investment of $122 million put up mainly by Resource Capital Funds, Pegasus Capital Investors, and Traxys. Based on these numbers we can assume an IPO price which creates a market cap of $500 million to $1 billion for Molycorp.
Molycorp's S-1 statement also confirms the company's goal is to wander downstream and become heavily involved with the development and production of technologies that utilize rare earths as a critical input. Most surprising is the company's contention that its cerium-based XSORBX water filtration technology has a growth potential that can consume several times the cerium Mountain Pass can produce, which is half the 19,090 tonnes of projected annual rare earth oxide production. This innovation puts Molycorp squarely in the "clean tech" camp, and will give the stock the upside sizzle needed to make it a market darling. If there is anything the world needs more than rare earths, it is technology that cheaply strips arsenic and other heavy metals out of contaminated water, as well as organic contaminants.
Molycorp's S-1 statement also makes it clear that the heavy rare earths are a major hole in its business plan which its brownfields exploration efforts may not solve soon or on a meaningful scale. Should the XSORBX technology become a marketing success Molycorp will need to secure more non-Chinese cerium, which could lead it to acquire and develop other light rare earth deposits. However, this would not fulfill the heavy rare earth deficit, which is the foundation of the DOD's dependency on China. Molycorp would be much better served if it acquired and developed major Canadian rare earth projects such as Avalon's Nechalacho and Quest's Strange Lake which not only contain the heavy rare earths largely missing at Mountain Pass, but also have a decent endowment of cerium. Furthermore, these deposits are not sullied by past environmental abuse and are located in a jurisdiction which has among the most stringent environmental impact standards in the world without the "not in my backyard" mentality that keeps American resource projects on a permitting treadmill. While Mountain Pass can displace much of America's current rare earth import dependency on China, the broader solution involving the full spectrum of rare earths lies north of the border in Canada which has an advanced mine permitting system and a domestic commitment to mine development.
The RESTART bill and GAO Report have served a purpose in bringing attention to the undesirability of not just the United States, but the rest of the world, having a critical dependency on a raw material produced by a single country which has itself become concerned about its own long term security of supply. With China now signaling a desire for higher rare earth prices and development of non-Chinese rare earth deposits, the resistance toward the rare earth sector that we have witnessed in the capital markets is set to change in a way that will be very beneficial to companies with reasonably advanced rare earth projects and will foster a non-government solution to the looming rare earth supply problem. In what follows I first analyze the GAO Report and then move on to the much more important policy paper written by Dr. Chen ZhanHeng and published by the Chinese Society of Rare Earths, and finally I address details gleaned from Molycorp's registration statement.
GAO: Rare Earth Materials in the Defense Supply Chain
The rare earth sector has been the subject of considerable media coverage since August 2009 when a leaked Chinese draft policy suggested China was considering more restrictions of rare earth exports, a move interpreted to encourage manufacturers who rely on rare earth inputs for certain products to locate related production facilities in China. This caused alarm bells to ring in political corners of the United States which led to a National Defense Authorization Act requesting the US Government Accountability Office (GAO) to hold congressional hearings and prepare a report on Rare Earth Materials in the Defense Supply Chain by April 1, 2010. Separately, on March 16, 2010, the Investigations & Oversight Subcommittee of the US House Committee on Science and Technology held a hearing titled "Rare Earth Minerals and 21st Century Industry" in Washington DC which addressed the broader question of the rare earth industry's relationship to America's leadership in technology innovation and production.
GAO Report identifies vulnerability about which nothing is being done
The GAO report was made public on April 14, 2010. The report observed that although at one time all stages of the rare earth supply chain were performed in the United States, today the entire supply chain is dominated by China, and that it could take as much as 15 years to re-establish the supply chain on American soil. The GAO's mission is to identify the facts and does not include a mandate to make recommendations for solving any problems its work may have highlighted. As such a GAO Report does not dictate action, but can serve as a reference for parties seeking legislative action related to the report. The GAO report on American rare earth dependency is remarkable in that it manages to provide a deadpan description of an urgent vulnerability while quietly admitting that little is being done about this vulnerability and that little can be done during the short to medium term.
RESTART bill proposes government intervention to restart rare earth industry
On March 17, 2010 US House Representative Mike Coffman, a Republican from Colorado whose rhetoric generally rules out taxpayer funded interventions in free market processes, sponsored the HR 4866 "RESTART" bill known as the Rare Earths Supply-Chain Technology and Resources Transformation Act of 2010. The RESTART bill proposes to use taxpayer money to fund a rare earth national defense stockpile to prevent free market forces from determining a true equilibrium price for rare earths, to provide taxpayer backed loan guarantees for operations that free capital markets will not finance because such operations cannot profitably compete with similar Chinese operations, to provide a basis for trumping up charges which can be submitted to the World Trade Organization to justify trade protectionist measures against China, and to legitimize the use of Code 10 USC 2538 to expropriate in a time of war any rare earth related operation that received funds under the RESTART Act. Just in case any Republicans notice that the rather "socialistic" RESTART Act violates a fair number of party principles, the bill insists that the domestic rare earth production industry it proposes to reestablish be "competitive".
Molycorp announces intention to conduct initial public offering
In light of the pessimistic observations made by the GAO report with regard to how long it would take to reestablish a competitive rare earth industry in the United States, and in view of the fact that Mountain Pass is the only possible short term rare earth supply response to the problem highlighted by both the GAO Report and RESTART bill, the RESTART Act could be renamed the MolyCorp Support Act. Late in the day on April 15, nearly three weeks after Goldman Sachs sold its minority stake to the other shareholders, Molycorp quietly signaled its intent to conduct an IPO by announcing plans to file a registration statement. The S-1 was filed on April 16. It is unlikely that the Obama administration or the Republican opposition will support the RESTART bill in its present form, nor is it clear that Molycorp will need any taxpayer funded support to lead the restart of an American based rare earth industry. However, Molycorp does need government support to overcome the American NIMBY (Not in my Backyard) mentality which insists on having its cake baked elsewhere, and to ensure that China's rare earth policies do not marginalize the economics of a rare earth industry in the United States.
China weighs in with "unofficial" policy white paper
Significant government intervention to protect a nascent non-Chinese rare earth industry may not be necessary if the message about Chinese rare earth policy presented in a recently published white paper accurately reflects Chinese intentions. On April 7, 2010 the Chinese Society of Rare Earths published an Outline on the Development and Policies of China Rare Earth Industry written by its Deputy Director Dr. Chen Zhanheng who seeks to set the record straight about China's plans. Although Dr. Chen qualifies his comments as "unofficial", stating that the "official" version will be released during the August 2-6 China Rare Earth Summit in Beijing, the document has the look and feel of official Chinese policy. Dr. Chen's message is that China is serious about consolidating its own rare earth industry in order to reduce waste and pollution, intends to manage domestic supply to protect its long term interests, and has aggressive expectations about future rare earth demand growth.
Chinese policy suggests the days of cheap rare earth supply is ending
If China carries out these plans, and demand for rare earth related products continues to grow, possibly outstripping industry projections, the result will be sharply higher rare earth prices. Dr. Chen sees higher prices as necessary to allow the development of rare earth projects outside of China, which he regards as critical for an adequate supply response to medium to long term demand growth. Because China anticipates long term shortages it is encouraging Chinese mining companies to pursue investment in non-Chinese rare earth projects, as we have already seen in the cases of Arafura and Lynas, both of which have also received financial backing from JP Morgan and Morgan Stanley, the proposed underwriters for the Molycorp IPO. (JP Morgan and Morgan Stanley have been net sellers of Lynas since January on behalf of managed funds, and in March 2010 both declared that they were no longer insiders by virtue of having dropped below 5%.) In effect Dr. Chen is saying that the low cost structure that enabled Chinese rare earth production to marginalize non-Chinese production and dominate global supply is switching to a much higher cost structure that should help non-Chinese rare earth production become competitive. If Dr. Chen is correct, the rare earth dependency identified by the GAO report will only worsen America's strategic vulnerability if non-Chinese rare earth supply is not brought on stream during the next 5-10 years.
RESTART geared toward China as a price killing rare earth dumper
The measures proposed by the RESTART bill address a worst case scenario where a Chinese strategy of mixing export restrictions with the threat of price gutting product dumping discourages capital investment in a non-Chinese rare earth industry. The GAO report makes it clear that such a situation is problematic for American strategic interests, and that nothing has yet been done to mitigate this vulnerability. The GAO report does not attempt to analyze Chinese policy scenarios because that is not its mandate. The GAO concluded that the Department of Defense (DOD) has a widespread dependency on rare earth materials which is unlikely to change due to a lack of effective substitutes and a complete reliance on Chinese sources. In fact, the DOD has identified some systems whose production could be delayed due to lack of rare earth availability, and that some have already experienced delays in certain cases requiring lanthanum, cerium, europium and gadolinium as critical inputs. The GAO discovered that DOD defense systems rely widely on commercial "off-the-shelf" components, which is consistent with a "just-in-time" procurement strategy that leans heavily on the ability of free markets to provide whatever is needed when it is needed, with price being the only variable.
Does the DOD have a hidden rare earth dependency mediated by Japan and South Korea?
The GAO did not reveal the production origin of these "off-the-shelf" components, which one suspects come from Japan and South Korea in so far that the DOD requires high performance components with tight specifications that are not so exotic and classified they have to be manufactured by American defence contractors. Japan and South Korea have both adopted national stockpiling programs for rare earths, and are the likely destination for heavy rare earths smuggled out of China. Japanese companies such as Sumitomo, Toshiba, Mitsubishi and Toyota have been actively investigating potential non-Chinese sources for rare earths in countries like Kazakhstan, Brazil, Vietnam and Canada. JOGMEC, the government branch mandated with monitoring the security of Japanese supply chain inputs, has even done a deal with a Canadian junior on a grassroots rare earth project. So far the Japanese have steered clear of the more advanced projects, perhaps because of an unwillingness to reveal any short term supply urgency, and awareness that few of the projects with heavy rare earth potential have reached a stage where a distinct development timeline is identifiable.
DOD does not perceive Chinese rare earth dependency as a national security risk
The GAO noted that although defense contractors are worried about the Chinese rare earth monopoly, the DOD does not recognize any national security risk inherent in this dependency, nor has it taken any department wide steps to address this dependency. The DOD, however, is conducting a study on its vulnerability it expects to be complete by September 2010. In its summary the GAO report notes that some parts of the DOD and other federal agencies are taking steps to limit their reliance on rare earth materials or expand the existing supplier base. The GAO does not comment on the contradiction between these efforts and its own conclusions that there are no effective substitutes and that the supplier base exists entirely in China. To sum up very briefly, the GAO Report announces that "Houston, we have a problem", while admitting that Houston is "not so sure, but will check it out". Given the sensitivity of admitting a strategic military vulnerability at a time when there is considerable tension between the United States and China over China's currency peg and reluctance to support sanctions against Iran, what response other than a grudging shrug from the DOD would have been appropriate for the national interest?
The GAO report does address the prospect of rebuilding a US supply chain, but comes up with very pessimistic conclusions. It concedes that Molycorp's Mountain Pass deposit is the largest non-Chinese deposit in the world, but points out that Mountain Pass lacks in meaningful quantities the heavy rare earth elements such as dysprosium used in many industry and defense applications. If Molycorp is indeed the indirect sponsor of the GAO Report and the RESTART bill, it certainly did not get a wholehearted endorsement as the solution to the problem.
GAO identifies permitting as biggest obstacle to a Made in America solution to the problem of Chinese rare earth dependency
The GAO acknowledges that other rare earth deposits do exist in Idaho, Montana, Colorado, Missouri, Utah and Wyoming, but warns that these are at an early development stage which would still require 7-15 years from a production decision to achieve commercial production mainly due to multiple state and federal permitting regulations. These are not encouraging timelines, for it can easily take an early stage exploration junior 3-6 years to complete a feasibility study, and then on top of that have to spend an eternity navigating the approval gauntlet? The failure of the GAO to focus on the unusual amount of time needed to move a rare earth project from resource delineation to the stage where it has all its metallurgical recovery processes sorted out, suggests an overwhelming preoccupation with America's NIMBY problem ("not in my backyard") which will even pit a strident environmentalist against a proposal to establish a wind or solar farm in his or her backyard. Whether or not the US permitting system is indeed as bad as the GAO has been led to believe is unclear, but its conclusions to that effect have spawned speculation that Molycorp has used the permitting headache associated with its own polluted Mountain Pass site to shape a discourse where a simpler option for a government concerned about security of supply would be to cut the Gordian knot at Mountain Pass on Molycorp's behalf rather than tackle reform of a dysfunctional permitting system.
Mountain Pass only a partial solution to the dependency problem
In acknowledging the power of NIMBY to block development, the GAO is indirectly stating that Molycorp's Mountain Pass deposit offers the only near term hope for rare earth supply in the United States. This may have been the goal of the intensive lobbying Molycorp has done in Washington during the past year, but if Mountain Pass is only a partial solution to the problem as the GAO suggests, namely keeping America's gasoline refineries supplied with fluid cracking catalysts, should the United States not simply throw in the towel on rare earths and balance the equation by offering China something it cannot otherwise secure for itself in a globalized market, such as a willing export market? The problem with this option as outlined in Express 2010-01: Understanding why Rare Earths are such a Big Deal is that rebalancing the trade deficit with China and rebuilding production based employment is America's challenge.
Radioactive elements in rare earth systems an environmental hot button
Somewhat redundantly, and thus an obvious allusion to weak or absent environmental emission controls in Chinese rare earth mining and processing operations, the GAO report points out that rare earth minerals sometimes contain radioactive elements such as thorium whose handling requires compliance with environmental regulations. Zero emissions, however, is the new reality that any developer needs to price a mine on in the non-Chinese world, and the western mining industry has demonstrated itself as quite adept at meeting tough new standards. Furthermore, there are signs that the Chinese themselves are eager to dump their role as the world's sewer for unmitigated effluents.
Capital markets hung up on predatory pricing risk
Another obstacle highlighted by the GAO report is investor concern that predatory pricing by China will undercut the rare earth prices required for profitable operation of rare earth production facilities in the United States. Understandably, this concern arises from the experience of the past two decades during which China used a low cost structure subsidized by cheap labor and lax environmental emission controls to marginalize non-Chinese rare earth mines throughout the world, but treating this concern as still relevant requires one to dismiss the signals about domestic security of supply concern coming out of China as nothing more than a manipulative ruse to set up non-Chinese rare earth project investors and creditors for a shellacking.
Catch 22: No supply, no refinery, no refinery, no supply
The GAO report recognizes the chicken and the egg problem inherent in the fact that facilities which refine oxides into metals are typically owned and operated by companies distinct from the producers of rare earth concentrates, and that this refining capacity will not be developed unless a non-Chinese supply is secure. Although the GAO report does not explicitly say so, a non-Chinese rare earth mine cannot get production financing unless non-Chinese separation facilities exist to handle the resulting concentrates. However, this catch-22 trap is based on the traditional mining model where a producer limits its activities to the top of the supply chain where it extracts a raw material and sells it in its crudest form. It does not envision a scenario where a raw material producer wanders down the supply chain and takes on value-adding processing stages which enables it to sell a large variety of products to a broad range of end-users. Nor does it consider a scenario where a very large and diversified end-user or consortium thereof wanders upstream and operates this part of the supply chain as a secure "in-house" supply of its downstream needs. The economic justification for such activity would come from the profits derived from being able to produce and sell products whose marketability comes from non-substitutable functionality provided by minor but critical rare earth inputs.
Grasping at straws: maybe a materials science miracle will make the rare earth problem go away
In what appears to be the only flutter of optimism in the report, the GAO mentions as a supply chain development obstacle the concern that in 10-15 years alternatives to rare earth based materials may have emerged, though it does express skepticism that these alternatives will be fully functional substitutes. It is true that if the United States threw an enormous amount of capital at basic material science research, such as the Chinese have done for a number of years, but without the advanced intellectual base developed by the United States during the second half of the 20th century, remarkable innovations could emerge utilizing far more readily available materials than rare earths (for a glimpse of such a future, I recommend Andre Dierderen's presentation hosted by the OilDrum on Elements of Hope). But to count on such an outcome is to take a stance akin to not worrying about peak oil or climate change because maybe cold fusion will eventually deliver its promise of abundant and cheap energy to save us all. A wiser strategy is to throw resources at breakthrough oriented research, and implement measures that hedge against breakthrough failure, as suggested by the Breakthrough Institute.
China eager to dispel notion that it wishes to maintain its rare earth monopoly
The GAO Report limits its analysis to the current situation and does not touch the direction of Chinese rare earth policy, let alone speculate about Chinese intentions. Because China has been so adept at delivering the lowest manufacturing cost structure and at persuading western manufacturers to relocate their factories to China, there is a tendency to regard China as single-minded in its goal to replace the United States as the world's powerhouse. When a draft policy leaked in August 2009 seemed to indicate that China planned to prohibit the export of certain rare earths and impose further export restrictions on others, westerners jumped to the conclusion that China was using its near monopoly on rare earth supply to bully western companies into basing all their downstream manufacturing operations that require rare earths as inputs on Chinese soil. While there is considerable truth in the assertion that China is eager to achieve vertical integration of the entire supply chain for finished goods - what country in the world is not eager to be involved in the value-adding downstream portions of the supply chain - it is less plausible to assert that China is pursuing policies designed to maintain its near monopoly in rare earth supply. It is Dr. Chen Zhanzeng's goal to explain that this is not the case.
High export tax for valuable heavies encourages smuggling
According to Dr. Chen China has become very concerned about the disorderly evolution of its rare earth industry, particularly in southern China where the heavy rare earth bearing ion adsorption clay deposits are mined and processed through a multitude of small scale operations. These are often controlled by criminal networks which divert what may be the majority of production to export markets through smuggling, primarily to Japan and South Korea. China has created an export tax ranging from 15% to 25% in an effort to capture from foreign markets revenue it cannot collect from domestic producers. Because the heavy rare earths are subject to a 25% export tax as well as export quotas, and are minor but critical inputs for many of the high performance technology products still produced by Japan, the foreign end-user will be less concerned by price than availability. Smugglers thus do not have to sell their smuggled products at a "stolen goods" discount, and can easily pocket the 25% export "tax" for themselves. Furthermore, the high cost to weight ratio of the heavy rare earths makes it more profitable to smuggle the heavies while reducing the risk of detection.
China may be losing 75% of its heavy production through smuggling
If Dr. Chen's estimate that 30,000-40,000 tonnes are lost through smuggling is correct, and it is the case that the smuggled rare earths are mainly the heavy rare earths mined and processed in the southern provinces, China is losing to export markets 2-3 times the official heavy production reported in 2007. According to statistics compiled by Roskill, the heavies represented 14% of the 96,409 tonnes of official REO production reported by China or about 13,500 tonnes. Dr. Chen reports that the separation capacity in the region of the South China clays is 60,000 tonnes which is geared toward middle to heavy rare earths. (The Chinese define light REE as La, Ce, Pr and Nd, middle REE as Sm, Eu, Gd, Tb and Dy, and the heavy REE as Ho, Er, Tm, Yb, Lu and Y. In contrast, westerners, including Molycorp, define the light REE as La, Ce, Pr, Nd and Sm, and the heavy REE as Eu, Gd, Tb, Dy, Ho, Er, Tm, Yb, Lu and Y.) 60,000 tonnes seems like a rather large capacity relative to official production if these plants process clays dominated by what we call heavy rare earths as is the case with the Longnan operations in Jiangxi province.
Inefficient illegal production is rapidly depleting a finite resource
China's unhappiness about this smuggling activity does not stop at the lost revenue. Dr. Chen estimates that the clay deposits represent only 3% of the 67.8 million tonne contained REO resource China reported in 2005. China's natural endowment of heavy rare earths resides in this small percentage; the rest consists mainly of light rare earth dominated deposits. This resource exists as a "weathered crust" of clay-like material typically 8-10 metres thick though ranging up to 30 metres with a low grade of 0.1%-0.3% TREO that is easily mined and processed through acid leaching. At 4 year average REO prices this material has a "rock" value well below $100 per tonne, but production benefits from low mining and separation costs compared to that associated with the complex mineralogies of peralkaline intrusive complexes such as Nechalacho and Strange Lake. Small scale operators and criminal organizations process these deposits as cheaply as possible, which means they not only do horrendous damage to the local environment by simply dumping the contaminated tailings into local rivers and rice paddies, but they are content to recover only that portion of the contained rare earths which leaches out easily. Roskill recently reported that the remaining life of these deposits has shrunk to 15-20 years based on existing operating methods and projected demand. Because these heavy rare earth deposits have been enriched through weathering of granite and volcanic rocks, they only exist on the surface. Once they have been stripped away, there is nothing left to be found through further exploration such as drilling for "blind" deposits.
China seeks better supply management control over rare earth industry
According to Dr. Chen it is China's goal to eliminate the small and poorly organized operations whose production is difficult to monitor and control by either shutting them down or merging them into larger enterprises. The surviving entities will be members of the China Rare Earth Industry Association formed in 2009 whose function it will be to monitor production and impose quotas based on its assessment of supply and demand conditions. Currently there are 24 operations that produce rare earth concentrates and 100 operations that separate the concentrates into individual rare earth oxides, and smelt (refine) them into high purity metals and other compounds. The separation capacity is estimated at 170,000 tonnes per year, which is above the maximum production achieved in 2006 and well below that of 2008. Output dropped in 2007 because this was when authorities initiated a consolidation campaign whose goal is to reduce the number of "enterprises" to 20 by 2015.
Chinese rare earth policies signal a shift to higher rare earth prices
Dr. Chen outlines a number of policy initiatives which he describes as unofficial, with official policies to be described in the China Rare Earth Summit being held in Beijing on August 2-6, 2010.
1) All mining companies will require a rare earth mining permit from the government which is subject to a production quota the government has the discretion to change in accordance with market conditions. China is moving toward centralized supply management for domestic production similar to the OPEC cartel where its challenge is to prevent quota cheating by the numerous currently unregulated operations.
2) There is a freeze on approvals for new processing facilities or their expansion until 2015, and all existing operations must make investments to improve product quality and reduce emissions. China wants to avoid a "whack a mole" situation as it consolidates the industry, particularly in southern China where the "weathered crust elution-deposited" ion adsorption clay deposits occur as hundreds of isolated zones.
3) The export of rare earths in any form that is a precursor to separated rare earth oxides is prohibited, and the export of terbium and dysprosium in metal will be limited but not prohibited. If industry consolidation results in a domestic supply shortfall, China will not hesitate to manage export restrictions so as to fulfill domestic needs.
4) The import of radioactive rare earth bearing minerals or scrap is prohibited. This restriction normally applies to thorium rich monazite recovered from heavy mineral deposits in India, Malaysia and Brazil because China does not want to deal with the thorium waste byproduct. But because all rare earth deposits contain some degree of thorium, and those containing heavy rare earths tend to have more thorium in the related minerals than light rare earth dominated deposits, the Chinese could use a sliding threshold of maximum radioactivity to limit the import of concentrates for separation processing. This risk pretty much rules out a partial solution where a deposit is mined outside of China and the concentrates are shipped to China where the existing separation capacity can do the "dirty" work.
5) Rare earth products will be subject to an export tax of at least 10%. Dr. Chen does not mention that the export tax on the heavy rare earths already stands at 25%.
6) Foreign investment in mining activity is prohibited, but foreign joint ventures in processing facilities that bring capital, new materials and applications are encouraged. China is always keen to encourage technology transfer into China and any investment in downstream processing, but it is determined to maintain control of upstream mineral extraction.
7) Rare earth mining and processing operations are required to meet new stringent emission standards or be shut down. This is the killer policy that has its share of skeptics, because it was weak or poorly enforced emission standards which bestowed on Chinese rare earth production the low cost structure which allowed cheap product pricing to force rare earth operations outside of China out of business during the past decade, and which hindered the development of new rare earth projects. The concern about pollution started in 2007 and may very well be genuine in that damage inflicted by rare earth operations has become a hot button issue for local communities affected by the pollution. It does, however, provide an excuse for the government to crack down on illegal operations and smuggling which stand in the way of engineering sharply higher rare earth prices. Although Dr. Chen sincerely urges the rest of the world to develop their own deposits, Chinese authorities are no doubt laughing about the conclusion of the GAO that the permitting regime in the United States would delay new projects for 7-15 years. The gap between current Chinese and American emission standards is so big that China can instigate substantial reductions in its emissions without coming close to the cost structure imposed by American standards.
Is a major rare earth supply deficit around the corner?
Dr. Chen's group of policies justifies the alarm bells ringing outside of China because they signal that Chinese supply could contract during the next five years, or, at the very least, fail to keep up with demand growth. This was the experience in 2003 when China decided to crack down on wasteful molybdenum mining just as molybdenum demand shot up; molybdenum prices increased tenfold but fortunately Chile, the United States and Canada were major producers who were able to boost supply and profit handsomely from higher prices. China has now started to crackdown on its antimony mines which dominate global supply, is contemplating similar measures for tungsten which it also dominates, and may even tackle zinc for which it is now a net importer after decades of killing the price with surplus production. Rare earths pose a problem for the rest of the world because China totally dominates supply and these obscure metals are interwoven in many products we take for granted.
Is Dr. Chen warning us that heavy rare earth based technology demand is set to soar?
Dr. Chen estimates that by 2015 global demand will be 210,000 tonnes, of which China's share will be 138,000 tonnes or 66%. Given that no new or expanded processing capacity will be allowed until 2015, and that the 170,000 tonnes of current capacity will likely shrink when owners fail to upgrade the plants to comply with new emission standards the authorities are enforcing, it looks like a shortfall is looming unless non-Chinese supply kicks in. By 2020 Dr. Chen believes China's demand will be 190,000 tonnes or 68% of global demand, which implies that global demand in 2020 will be 279,000 tonnes. While Dr. Chen's demand growth projections do not go exponential after 2015, they do imply sustained growth over the next decade. Of particular interest is his suggestion that 130,000 tonnes of Chinese demand will be consumed by the "high-tech" sector, which certainly will include the heavy rare earths and probably neodymium in so far as it is used for miniaturized magnets rather than wind turbine or hybrid car magnets. Dr. Chen does not elaborate on his definition of "hi-tech", but if it indeed applies to heavy rare earth based applications, his eagerness to see non-Chinese rare earth deposits developed has a ring of authenticity. Although China's resource base has plenty of the light rare earths, its heavy rare earths are concentrated in clay deposits which do not have the enormous scale of the peralkaline intrusive complexes that resource juniors control in Canada, Greenland and Scandinavia.
Molycorp proposes to raise up to $350 million for its $511 million modernization plan
If Dr. Chen's unofficial version of China's rare earth strategy is in fact correct, it offers a green light for capital markets to bankroll non-Chinese rare earth projects such as Molycorp's modernization plan which would see Mountain Pass in full production by the end of 2012. The $350 million Molycorp hopes to raise through an IPO will cover only 68% of the projected $511 million cost through 2012 to bring the Mountain Pass operation into full production. Of this $397 million is earmarked for refurbishment and expansion of the extraction (flotation to produce concentrates)and separation facilities, $44 million is for a natural gas co-generation plant, $26 million for over-burden removal (pre-stripping to allow resumption of open-pit mining), and $33 million for acquisition and upgrading of a metal refinery. Somewhere in there must be the chlor-alkali plant Molycorp has to develop because it no longer has at its disposal the Ivanpah dry lake bed where the previous operator dumped waste salt water to let it evaporate. Because the chlor-alkaki plant recycles the waste stream to recover hydrochloric acid and sodium hydroxide it will reduce Molycorp's reliance on freshwater, whose availability has become a controversial issue in southern California.
Molycorp obfuscates Mountain Pass resource estimate
Molycorp may have one of the richest rare earth deposits in the world, but it is not a fix for dramatic medium term growth in heavy rare earth demand, which may explain the embarrassment implicit in the peculiar way Molycorp presents its Mountain Pass resource estimate. The format provided by SRK Consulting illustrates why the SEC is a backwater when it comes to reporting mineral resources. SRK reports the resource as recoverable lbs of rare earth oxides with a head grade of 9.38% for proven reserves and 8.2% for probable reserves for a combined grade of 8.24% TREO. Why Molycorp and SRK do not report the resource in terms of metric tonnes and contained grade, with recoveries stated separately is beyond comprehension. However, the S-1 does provide a clue through which we can reconstruct numbers in 43-101 and JORC terms. The key is a footnote which indicates that REO mill recovery is 63%. The glossary indicates that the "mill" produces concentrates, and elsewhere in the S-1 Molycorp indicates that it is achieving 98% recovery at the solvent extraction stage which separates individual rare earth oxides from the concentrates. So through deductive reasoning one should assume that the recovery is 61.7%, but because the S-1 is geared for American rather than the more mining industry attuned Canadian regulators, I shall assume that the recoverable resource quoted by SRK is based on "mill recovery" at 63% being a net recovery. Under these terms the recoverable 2,210,000,000 lbs of REO at 8.24% convert into a proven and probable resource of 19,307,000 tonnes of 8.24% TREO within which is a proven resource of 675,353 tonnes of 9.38% TREO, all at a 5% cutoff. These numbers are pretty much consistent with those quoted by the USGS in 2002, and the rare earth distributions reported by SRK are similar to published numbers for the Mountain Pass bastnaesite ore. Using the 4 year price average for rare earth oxides as of February 2009 the rock value of the proven and probable Mountain Pass resource is $509 per tonne on a 100% basis, and $837 per tonne using prices as of April 2010. Using the 4 year average the overall resource would have an in situ value of $9.8 billion, though with a 63% recovery that reduces to $6.2 billion. This assumes that the 63% recovery is constant for all contained rare earths.
$35 million production loss is explained as R&D leading to a "new cracking technology"
Molycorp claims that it will be able to produce 19,090 tonnes of rare earth oxides in various forms per year by mining only 1,000 tpd to 1,500 tpd compared to 2,000 tpd historically. Mountain Pass has a permit to mine 2,400 tpd, which allows Molycorp to state that it could double output if it made sense to do so. Assuming 365 days of operation, an 8.24% TREO head grade, and a 63% recovery for separated rare earth oxides, Mountain Pass could churn out 17,243 tonnes per year at 1,000 tpd and 25,864 tonnes per year at 1,500 tpd. This increase in productivity was achieved as a result of a "new cracking technology" Molycorp developed from June 12, 2008 through December 31, 2009 during which it processed stockpiled concentrates to generate $9,230,000 in lanthanum dominated sales at a direct cost of $34,812,000. Molycorp describes this money-losing activity as R&D which has led to a significant recovery boost at the solvent extraction stage where rare earths are separated into individual oxides. If we do the math backwards it appears that the historical recovery at Mountain Pass was a rather atrocious 30%-40%. That these numbers do seem quite right highlights the confusing nature of Molycorp's resource disclosures in its S-1. Hopefully the SEC has similar questions and forces Molycorp to make a more intelligible disclosure about its resource and net recoveries.
Founders have invested $122 million in Molycorp
Molycorp investors paid $82.1 million ($80 million cash) for the rare earth company in 2008, less $7.9 million in a one third joint venture with Sumitomo which it sold at cost, for a net investment of $72.4 million, of which $22,181,000 was represented by inventory of which 87% consisted of stockpiled concentrates. Losses from inception (June 12, 2008) to December 31, 2009 have been $42,661,000 of which $25,582,000 can be allocated to processing R&D while $15,664,000 relate to overhead and selling expenses. From inception to April 15, 2010 Molycorp's investors have contributed $122.2 million which has been converted into 1,339,937 combined class A & B shares which convert into a single class upon completion of the IPO. This implies an average price of $91 per share, with the last documented transaction priced at $115 per share when Traxys converted a $6.8 million loan into shares on November 15, 2009. This includes management incentive and profit interests converted to stock; the lowest stock price for which shares were issued for cash was $95 per share. Based on these numbers the implied value of Molycorp is $154.1 million, just over double the net equity of $74,615,000 as of December 31, 2009. An IPO at $115 per share raising $350 million would imply a value of $500 million for Molycorp's Mountain Pass asset. IPO's, however, are never done at anything near the price at which seed investors put up money, especially for a company such as Molycorp whose business strategy includes a range of unquantifiable growth potential linked to downstream product innovation. A markup of 100% to 200% is conceivable, which at 200% would imply a market capitalization of $800 million at the IPO price. We will have to wait and see what price JP Morgan and Morgan Stanley negotiated for the IPO. Incidentally, Molycorp will likely split its stock before completing an IPO so that the IPO price may be well below $100 per share.
Permitting delays for modernization plan Molycorp's biggest risk
Molycorp's biggest risk factor lies with its ability to secure the numerous permits required at federal, state and local levels for its Mountain Pass modernization plan. The GAO Report identified long timelines of 7-15 years related largely to the permitting cycle as the primary obstacle to any near term solution to American dependency on imported rare earths. The most likely function the RESTART bill can serve is to push for streamlining the permitting process which is largely linked to emission standards. Critical to Molycorp's modernization plan is the development of a natural gas co-generation power plant and a chlor-alkali plant which will address four issues affecting the economic viability of Mountain Pass: an inadequate electricity supply from the local grid, volatility in reagent prices, severe restrictions on the disposal of tailings, and water shortages. The chlor-alkali plant will produce sodium hydroxide (caustic soda) and hydrochloric acid used during the acid leaching and solvent extraction stages of the Mountain Pass recovery process. This will reduce Molycorp's exposure to reagent price volatility, eliminate the need to dump waste salt water into evaporation ponds, and reduce the need for freshwater supply. If Molycorp's modernization plan is implemented its most significant exposure to variable costs will be natural gas and labor.
Labor union agreement expires just ahead of commercial startup
Another risk factor is that Molycorp's collective bargaining agreement with the United Steelworkers of America regarding 60 workers expires in March 2012. Given the apparent urgency of restarting American rare earth production, this is a wonderful opportunity to extract concessions which a Canadian union would never neglect to exploit, but this may be less of an issue in the United States where unions are considerably less militant.
50 year mining history may have created unknown off site reclamation liability
The S-1 does mention one worrisome risk factor linked to the 50 year operating history of Mountain Pass during which it is possible that waste material was delivered to off-site locations waiting to be discovered as a reclamation liability. There is also the possibility that the reclamation liability left over from the 1998 spill of radioactive waste water may exceed unspecified limits to the indemnification Chevron granted the purchasers of Molycorp in 2008. And without question the Mountain Pass site itself is a huge reclamation liability whose postponement into the future would be a prudent reason to stretch out the mine life. Undeveloped sites such as Nechalacho and Strange Lake have the benefit of being developed according to contemporary emission control standards.
Molycorp hopes to restablish magnet production in the United States
Molycorp seems to be less concerned about predatory pricing by China with regard to rare earth oxides and metals than it is worried that China will dump rare earth magnets. Currently there is no magnet production in the United States, with all rare earth magnets imported. Molycorp's "mine to magnet" strategy involves developing a collaborative joint venture with a magnet distributor in the United States to establish a magnet production facility which would secure its raw material inputs from Mountain Pass. While Molycorp does intend to sell separated rare oxides and metals into the market, its business strategy is to wander downstream to develop and make products that utilize rare earths. In so far that China can do the same, Molycorp is worried that China could target any such downstream product Molycorp chooses to focus on. However, Molycorp does believe that China has embarked on a long term plan to invest $150 billion to develop 100 gigawatts of wind power, which may require diversion of NdFeB magnet production for domestic uses. Interestingly, Molycorp proposes to "build the largest, most advanced and efficient fully integrated REO processing facility in the world", which seems to be a way of saying that the Chinese rare earth capacity is inefficient, disorganized and comprised of many small scale operations. This does appear to be the case in China, which is why China has initiated a massive consolidation campaign in 2007.
Cerium based water purification system could be a clean-tech blockbuster
The most interesting new detail in Molycorp's S-1 filing involves the water filtration system Molycorp has developed. Its trademarked name is XSORBX and it appears to consist of a cerium based compound capable of stripping arsenic and other heavy metals out of waste water streams. Molycorp has 100 issued or pending patents related to XSORBX which represents a major technology innovation aimed at the "clean tech" industry. Molycorp suggests that this water treatment technology can be commercialized on a broad range of scales from industrial plants to foreign aid to the backpacker market. While acknowledging IMCOA's projection that cerium will be in surplus due to modest growth in the glass and catalyst demand segments, Molycorp makes the remarkable claim that XSORBX related demand "alone is expected to consume many times more cerium units than we can produce". This is a remarkable claim because 49% of the Mountain Pass production will consist of cerium, and a good portion of that could go to serve the fluid cracking catalyst needs of America's oil refineries. Given that potable water ranks among the most urgent issues facing the world, and that much water is unfit for human consumption due to heavy metal contamination, XSORBX could be an extraordinary revenue driver for Molycorp that may require Molycorp to acquire and develop other rare earth dominated deposits in order to secure more cerium. While China has an extraordinary amount of cerium in its Bayan Obo deposit, China also has a serious need to decontaminate its own waste water, and if it got hold of XSORBX style technology by license or otherwise, it would generate huge domestic demand for cerium. In fact, wouldn't it be something if China licensed Molycorp's XSORBX water treatment to use cerium to clean up the tailings mess surrounding its giant Bayan Obo rare earth mine? Given that the Achilles Heel of Mountain Pass is a very low grade for the heavy rare earth elements, and that both Avalon's Nechalacho and Strange Lake deposits contain a significant amount of cerium, taking out and developing one of these deposits would seem to be very strategic for Molycorp's business plan. Water purification systems are an old standby for pump and dump OTC Bulletin Board deals, so one has to take a breath and wonder, is this time different, has Molycorp indeed invented a blockbuster technology that inexpensively produces distilled water?
Conclusion: The publication of the GAO Report and the subsequent filing of a registration statement for a Molycorp IPO during the second week of April managed to depress rather than spark market interest in the rare earth juniors. However, this downturn coincided with a broader downturn in the resource sector, which in turn was linked to news that the SEC was taking on Goldman Sachs and thus the entire investment banking establishment. The ability of the bad boys to take away the ball if they are no longer allowed to play has spooked the market, and there is nothing one can do about it until it becomes apparent that the world's economy can carry on just fine without the banking establishment in the predatory, exploitive form into which it has mutated. More worrisome is the suggestion that the GAO Report has presented a message of futility for any solution to the rare earth supply problem other than one delivered by Molycorp and its Mountain Pass project. I believe that the GAO Report underlines the urgency of the rare earth security of supply problem but is misguided in its pessimism about development timelines. With regard to Molycorp, the solution it offers is only a partial solution to a problem which is growing larger, especially if Dr. Chen is right about China's determination to clean up its inefficient, polluting, unregulated and sometimes downright criminal rare earth production system, and his belief that technology innovation will drive rare earth demand growth for the next decade. And if Molycorp's enthusiasm for its cerium based XSORBX water treatment technology is based in fact, not fantasy, its upcoming IPO is going to be hot, the market will finally "get" how rare earth companies are different from gold or base metal companies, and Molycorp stock will become a market darling that unleashes a flood of capital into the other advanced rare earth juniors whose prospects will be enhanced, not marginalized by the public debut of Molycorp.
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