Profit from rare earth 'dragon' metals

Rare earth, or 'dragon', metals are increasingly essential, yet increasingly hard to get hold of. That spells opportunity, says Kevin Kerr.

It began as a diplomatic spat over some obscure, uninhabited rocks in the East China Sea. Japan and China both lay claim to the Senkaku Islands, and last month, the Japanese coast guard arrested a Chinese fisherman after his trawler collided with Japanese patrol boats near the islands. The Chinese reaction was far more aggressive than the Japanese had expected, with cultural exchanges scrapped, tourist trips ditched, and strong language by diplomatic standards employed.

But what really hurt Japan and the factor that many believe was key in persuading the Japanese to release the fisherman was the fact that all exports of rare earth metals "mysteriously ceased", as Sean Daly notes on Seeking Alpha. Although China says there was no explicit export ban, many Japanese businesses claim they are still having difficulties getting shipments of the metals, despite the dispute being resolved.

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So what's so important about rare earths and how can you profit from them?

What are rare earth elements?

The rare earth metals, or rare earth elements, as they are also known, are a collection of 17 elements in the periodic table. The term 'rare earths' comes from the fact that the minerals that contain these unusual elements were quite rare when first discovered in Ytterby, Sweden (for more on the individual elements, see below).

Rare earths are vital components for modern electronic goods and also in many environmentally friendly technologies. But prior to the digital revolution and the green movement, most investors had never heard of rare earth elements. After all, for many years the rare earths were hardly a vital part of modern industry. In the 1980s, for example, the rare earths sector was worth less than $100m and was thus very unattractive to institutional investors, let alone individual traders. Any glimmering of a bull market in rare earths was continually stalled as cheaper alternatives were used instead any time prices rose. Virtually all countries that have sources of rare earths not to mention those who were net importers of these now ultra-precious metals ignored the potential for future supply shortages.

All, that is, except for one country: China. China has a long history of being one step ahead in the resources arena, and in this case, they are yet again. As other investors and most nations shunned the rare earth elements sector, China actually ramped up its efforts to control the industry. Indeed, in 1992, Deng Xiaoping compared China's rare earths to the Middle East's oil reserves, and he was right. Indeed, rare earths are sometimes referred to as the 'dragon metals', because China has such quantities of them. Nowadays, the country supplies around 96% of global demand for rare earths. Yet most of the rest of the world remained unconcerned. At least, until last year, when prices really started to soar.

Now, particularly after Japan's spat with China, the chatter about rare earths is heating up and there are opportunities for resource investors, right now.

Why do rare earths matter?

The global market for rare earths has grown at an annual rate of about 8%-11% over the last decade, according to the World Trade Organisation, but this pace has spiked in the past 12-18 months or so. One of the main reasons is because consumers around the globe, particularly in China and the rest of emerging Asia, are buying electronics goods, such as cameras, new Apple i-Pads, Samsung flat-screens, and many other products, hand-over-fist. Simply put, trillions of dollars of modern devices wouldn't be possible without the existence of these metals.

And for around the past five years, China has been quietly implementing quotas, cutting exports of rare earths by 5%-10% each year, and pushing up prices. In 2009 an index holding shares of 12 rare-earth miners rose by more than 600%. Countries such as Japan, which rely heavily on rare-earth imports to produce electronics, have been the hardest hit. This trend is likely to continue for a very long time indeed.

Now governments around the world that depend on rare earths are panicking.

In light of inconsistent statements coming out of China about its rare-earth quotas, the European Commission issued a report back in June, saying it was imperative that a complete supply chain be developed outside of China. Soon after, in July, China announced it was cutting exports by another 40%, and rumours swirled that it had nearly filled its export quotas by the end of August.

Japan is clearly the country most vulnerable to such a sharp drop in supplies. So Japan and Mongolia have now agreed to explore Mongolian rare-earth reserves together. But the question is: how long will it take and how much will it cost? Japan is certainly pulling out all the stops to recycle rare earths from used electronics. And Japanese car companies, including Honda, Toyota, and Nissan, have long been trying to switch to lithium-ion batteries, which don't require rare earths, in electric cars. But all of this cannot stem the need for the rare earths vital to so many of Japan's top exports.

The elements are used for much more than simply electronic gadgets or cars. The most common use is in missile technology and wind turbines. And in these cases in particular it won't be easy to find substitutes for rare earths. The challenge for the industry is whether they'll be able to supply enough of these elements and do so as quickly as needed. The answer is almost certainly not.

The grim reality is that building a new rare-earth supply chain outside of China will probably take at least a decade, maybe even much longer than that. The reasons are simple. The infrastructure for rare-earths exploration and mining takes years to build many experts reckon between seven and 15 years not to mention billions of dollars. So prices should remain high for some time, along with demand for miners who can get the metals out of the ground. We look at some of the best bets below.

Are commodities the new currencies?

Irrational exuberance or intelligent diversification? That's the question on a lot of traders' minds lately when they look at the resource markets. Commodities have been rising across the board, in some cases exponentially. In many ways the rally is reminiscent of the surge we saw in 2008 in gold, oil, agricultural commodities and so forth, before it all came crashing down.

So is the current move into resources just another knee-jerk reaction by funds and individual investors? Or is this long-term bull market for real?

I have been quite vocal about the fact that I believe in the coming years we will see commodities become a form of de-facto reserve currency. Many analysts and traders out there balk at my ideas, saying the notion that a period of higher inflation will make commodities the new reserve currency and displace the US dollar is absurd.

Yet, it can't be denied that emerging markets are growing rapidly. And so far this has created a long-term bull market in oil, commodities and raw materials. I believe that continued demand from emerging economies means that these markets are likely to outperform both inflation and typical selected investment classes.

However, I also believe that with the Federal Reserve hell-bent on encouraging inflation, the dollar will continue to shed value in the long term. That will encourage already shaky investors to diversify out of paper currencies and into assets with real tangible value. So far markets such as the precious metals and oil have been the biggest benefactors. But there are opportunities in plenty of other areas too and rare earths are just one of them.

How the metals are used

The rare earth elements are found in slots 21, 39 and 57-71 on the periodic table. Here are a few of the most commonly used rare earths. You'll probably be surprised at just how many of the products you own, or services that you use, require rare earths to function.

Cerium

The most abundant of the rare earths. It's found in catalytic converters in vehicles, and other

forms of pollution control equipment. It helps to reduce sulphur oxide emissions, and is also added to diesel fuel to help it burn better.

Neodymium

This is used in magnets to boost their magnetic field. Cell phones, computers and audio speakers wouldn't exist without neodymium magnets. And miniature motors wouldn't be possible at all without it.

Holmium

This rare earth has the greatest magnetic strength of any element, and is used in medical and dental lasers and nuclear control rods. It's also a colourant for glass.

Dysprosium

This metal's magnetic strength properties make it a useful material for certain lasers, in fuel injectors for diesel engines, and in compact discs and other data-storage applications.

Thulium

One of the rarest and most expensive rare earths. Its unique properties make it ideal for laser-based surgical tools.

Yttrium

This rare earth is mainly used to make red phosphors for use in red light emitting diodes (LEDs) and superconductors.

Erbium

A silvery white metal created for use in photographic filters and as a colouring agent in cheap sunglasses and jewellery. It's also a key element in the optical amplifiers widely used in fibre-optic communications systems.

The best plays on rare earth metals

Kevin Kerr picks the best ways to profit from the scramble for 'rare earth' metals.

One company, Australia's Lynas Corp. (ASX: LYC; NYSE: LYSDY), stands out above the rest. Lynas has been developing a rare-earths business line since 2001, and seems to be one of the more advanced companies in rare earth elements (REE) production. It owns one of the world's richest rare earth deposits at Mt Weld, Western Australia. It is currently mining and it's well along the path to establishing a large processing facility in Malaysia, which it aims to open in late 2011. Supposedly it already has a few customers lined up, and it signed a new contract with a Japanese company last week. Lynas struggled during the global economic meltdown, but is now reaping the benefits of betting on a rare-earth demand explosion. The share price has more than doubled recently, but it's still very attractive in my view.

Another rising star in the REE area is US firm Molycorp (NYSE: MCP). The miner had its initial public offering in July, raising nearly $400m to re-open a mine it closed in California in 2002. The mine was originally shut due both to competition from low Chinese labour costs and because of challenges from environmentalists. Rare-earth mining can be dangerous and environmentally hazardous. That means it's expensive. Molycorp and its investors believe the mine will produce 20,000 tons of rare earths a year by 2012. This may be delayed due to environmental concerns, among other challenges, but the company remains confident. One very bullish sign for the sector, and particularly these two stocks, is that since 2002 state-owned Chinese firms have tried to buy both of them. China is likely to do what it takes to head off the competition and maintain its position in the rare-earth market. It may even attempt to flood the market in order to push down prices and put rivals, such as Lynas and Molycorp, out of business. But I don't think it will succeed. So REE producers should be an excellent addition to almost any portfolio.

Of course, these two stocks are also very much on the radar screens of traders in the sector, and are priced accordingly. There are lesser-known opportunities that may have even more upside. Toronto-based Avalon Rare Metals Inc (TSE: AVL) is developing a number of rare metals projects throughout Canada, and is best known for its Thor Lake project in Canada's Northwest Outer Territories. Thor Lake hosts the Nechalacho deposit. It's the second-largest rare earth element deposit in the world, but its real value lies in the fact that it is also high grade, which should mean high operating margins. The downside is that the project is fairly inaccessible. It's located 100km south west of the city of Yellowknife. Access is currently by air, but there will be summer access by barge across the Great Slave Lake to a railhead, and ice road access in winter. This means costs will be higher than average but the opportunity to tap into this high-grade deposit seems worth it, as the long-term feasibility of its deposits and production seem very solid. Also, the company has no debt and $8m in the treasury.

Rare Element Resources (TSX.V: RES) is best known for its property Bear Lodge, in Wyoming. This vast 2,000+ acre property is estimated to have one of the largest rare-earth deposits in North America. On top of that it also boasts extensive gold mineralisation. And unlike Avalon's property, local infrastructure is very good, with paved roads and power within two miles and a railhead only 35 miles away. These elements are vital to good value when looking in the REE space more remote locations or projects that are long distances from rail or roads add major costs to production. According to the firm, initial estimates suggest that the most prevalent elements are cerium, lanthanum and neodymium. The company is now looking to expand, and plans further drilling to clarify reserves and expand the deposits.

Rounding out our list of suggested REE plays is lesser known Medallion Resources (TSE.V: MDL). With a market cap of just around C$9m, it's certainly among our more speculative suggestions. However, we like what we see. Medallion is working to grow through acquisitions and the application of advanced exploration techniques on the cutting edge of the REE exploration industry in North America. The goal is to find opportunities that are more weighted towards the heavy rare earths, and for which large-tonnage open-pit production is feasible. Medallion is now involved in at least two such projects.

These strategic partnerships can be very beneficial to cash flow. For example, MDL has an option with Rare Earth Resources and will "earn up to 65% on the Eden REE project in Manitoba through payments of $1.45m cash and 1.8 million shares, and expenditures of $2.25m over five years", according to reports. Medallion's interest in this project is clear. After all, as noted above, it believes that it could be one of the most promising REE projects in North America. More good news for Medallion is that the property isn't expected to present significant permitting, environmental, or social challenges. Often these are also problems in the REE space.

Medallion also has a second project, the Red Wine Heavy REE Project located in southern Labrador, Canada, where Medallion has an option to earn 100% through a series of payments in cash, shares and exploration commitments. This property is more speculative but has great potential, based on the fact there has been no detailed REE exploration in the area since concentrations were discovered during the search for uranium about 50 years ago. Over the years the area has been lightly prospected for elements like niobium, tantalum, beryllium and zircon. The REEs were always noted but more or less discarded at least, until now.

Kevin Kerr is a commodities trader who started on the floor of the NY Cotton Exchange in 1989. Kerr has worked, or owned seats on, almost every trading floor in North America.

This article was originally published in MoneyWeek magazine issue number 508 on 15 October 2010, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.