Aims to update investors on developments in the world of strategy metals – crucial inputs to industry, defense and technology innovation

Terence van der Hout                    

Oct 16 – 22, 2011 Gold&Discovery Fund

This week’s bulletin is an all- rare earth affair, as we try to find Baotou Steel’s real motivation for suspension of REE production, and we look at progress at Lynas and Molycorp.

Why is Baotou suspending production of REE?
Topping the rare earth headlines this week is word that Chinese Baotou Steel is halting the processing of REE ore for a month. The report follows the suspension of activities at three smaller Chinese mining operations, a month earlier. Baotou Steel is a steel producer with huge iron mining operations. It also extracts 60% of the world supply of rare earths as a by-product, implying that the impact of its suspension decision is significant.

The official reason is that the measure will “stabilize the market and balance supply and demand.” This statement implies there is such a thing as a relationship between the price of REE, and its supply and demand fundamentals. Recent price falls of REE caused by lagging demands as a consequence of global economic downtu are cited as triggers, and the move is aimed at preventing a further plunge in prices by forcing a draw down on the inventory of traders. As a second measure, Baotou also plans to buy rare earths, which is another way of saying they will commence with the officially announced policy of stockpiling.

I am a little bit curious as to the timing of this measure. The chart above shows the price development of the separate rare earth elements, as they are sold in China, indexed per January (prices from metal-pages.com). These are the so-called China domestic prices, and the ones Baotou Steel will be monitoring very closely. As you can see, these prices peaked last July, declined for 2 months, but flattened as of the beginning of September. Some have even risen during the last month. Clearly, if prices within China are set by supply and demand (something we may legitimately question), demand isn’t crashing to any sort of bottom, and appears to be picking up. So why is Baotou seeking to correct a market not in need of further correcting? Is price stability really a true motivator for China, or is something else going on?

Well, Baotou’s actions should certainly be expected to influence the Chinese domestic rare earths prices. Holding back one month’s production by the world’s largest rare earth producer adds up to over 4% of global annual supply, which isn’t particularly large, but does send a very strong message the markets cannot ignore.

Is it in China’s interest to maintain higher domestic prices? Absolutely not. Local manufacturers of low-end magnets are ceasing production as a consequence of sharply risen costs. High domestic prices are unsustainable to production lines where manufacturers are having to charge consumers a doubling or tripling in prices to consumers.

However, pegging domestic prices does something else. There is a level of correlation between domestic prices and FOB prices. At the moment, LREE in China are roughly four times cheaper than they are on the export market, and HREE twice. Stopping the free-fall of the domestic prices is bound to halt the fall of FOB prices, albeit with a time lag, as there is somewhat of a disconnect between the rise and fall of the two sets of prices. And continued higher FOB prices keeps the manufacturing of high-end products containing REE unsustainably high for a longer period. I believe it is sustained high FOB prices that China is seeking.

If China can maintain high FOB prices (and therefore choke demand) for the time it takes for more manufacturers like Hitachi to move their sophisticated and proprietary (and sensitive) magnet making expertise to China, it may just raise enough of a barrier to prevent serious REE supply chains in the west to ever get established. China will have a lasting edge on the rest of the world for the application of technologies at the innovative frontier. Baotou’s action falls in line with other Chinese policies of export quota tightening and the crack-down on smuggling, all of which sends a powerful message that the only place you need to be if you are serious about manufacturing high-end goods containing REE is China. Now that is in China’s interest.

White knights
And what of the weste white knights? The two most serious non-Chinese contenders are following their separate paths. Lynas is experiencing increasing head winds in the form of Malaysian community protests against the import and processing of ore containing elevated levels of radiation. The latest set-back has been a rumour that Malaysian authorities were intent on refusing Lynas permission to import the ore from Australian for processing in Malaysia, a statement Lynas furiously denied, citing permission is not due for a couple of weeks. Lynas’ road to REE production has been as tough as it gets, and these latest developments may further prevent them from achieving their production timelines.
On the other end of the spectrum, Molycorp has announced they seek to accelerate the initial start-up of their processing facility. The pulling forward of production by three months will add 3,500 tons to Molycorp’s 2012 production. This is worth $114 million, clearly a drop in the pool of Molycorp’s vast financial resources. The additional 3,500 tons thus amount to roughly $31 per kg, which is a good reflection of the cost price Molycorp is prepared to pay to become the white knight saving the day.

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Disclaimer: The author is a researcher for the Gold&Discovery Fund, and neither he nor the Gold&Discovery Fund has commercial ties to, or shares in, the companies reviewed, unless explicitly stated in the text. The information in this bulletin is the author’s independent opinion of developments in markets and at companies, and hence may contain factual errors, and may not reflect the opinions of the Gold&Discovery Fund. The content of this bulletin is not intended as an investment recommendation.

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