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John Kaiser: The Race to Rare Earths

-- Posted Tuesday, 2 June 2009 | | Source:

China's export-based economy, once dependent on American greed, is now but a fading memory. While the U.S. was busy printing and preening, the Chinese were long-range planning. But America wasn't the only country caught off guard by China's strategic, if surreptitious, supply procurement. In this exclusive interview with The Gold Report, John Kaiser, mining analyst for more than 25 years, explains how the East-West economic tables got turned and why he remains steadfast in the belief that "we are not at the mercy of places like China."


The Gold Report: John, you have indicated that base metal prices will be stronger than one would expect given the gloomy global economic outlook, but more importantly, that the valuations of companies with "pounds in the ground" will surprise us on the upside. You believe that security-of-supply concerns will replace what you call short-term "economic logic" with a long-term "strategic logic" as a driving force behind valuations—particularly for the group of metals you call "infrastructure support metals." Can you give us an overview of those metals and why you think there's such a strong upside possibility?


John Kaiser: These days I'm not only concerned that the United States is losing its relative clout on the global stage, but also that countries like China are going to have to go it on their own. They're sitting on these enormous foreign reserves—$2 trillion—two-thirds of which are U.S. denominated instruments—and all of this was built up when they were very dependent on an export economy. They were making things, selling them to the United States, and then shipping the dollars back for IOUs in the future.


But this game is now over. They know it and they are developing infrastructure internally to develop their own domestic economy. They're looking around and saying, "Where are we going to get all the raw materials that will allow us to keep building our own infrastructure and economy, and what are we going to do with all these IOUs?" So they're taking these IOUs and solving this security-of-supply problem by acquiring deposits and assets around the world to ensure that they will have control of the key raw materials that are needed for their long-range plan.


Now long-range planning is not something that we in the West are accustomed to. We're always just thinking of the economics of profitability in the short term. So the rest of the world is being caught off guard as China sneaks around the world and buys up these assets. And the critical ones are not nickel and zinc and copper, the traditional base metals. There are a lot of those deposits around the world, and if the price is high enough, they can be put into production and everybody will have whatever copper they need. It's the more obscure metals—what I call infrastructure support metals—like molybdenum, the rare earth oxides, lithium, tungsten and tantalum. They represent just an incremental cost of the total end product.


Uranium is a classic example. The uranium fuel represents just 3% of the cost of producing nuclear energy. These things are essential. You cannot have the larger product without them. In the case of rare earth oxides, we're looking at a situation where the Obama Administration would like to see clean energy replace gasoline-based energy in transportation fuel. The Chinese are thinking along similar lines because they don't want to be dependent on foreign oil supplies any more than the United States does. Rare earth oxides go into these super magnets that are a key part of these hybrid and electric cars. The Japanese, the Europeans, and North American carmakers would like to commercialize the production of hybrid cars, but they are afraid to do so because all the rare earths right now come out of China. And China has said "we would like all the manufacturing to be done in China and we'll sell it to the rest of the world." Well, that puts everybody at the mercy of China. So now there's a scramble afoot to look for these deposits outside of China and never mind that China could flood the market with their rare earth oxides. The end users are thinking we need to have security of supply for these rare earth oxides so we're not at the mercy of political machinations by a country like China.


Tantalum is another metal where it's a key input in cell phone capacitors. The supply has come only from a few mines, all of which are now shut down as part of the strategy to get the processors to allow a price increase.


For the juniors, the opportunity right now is to source these projects. They get title to them, and when these end users want to develop them, they're going to have to pay a premium to have these projects developed. So it will not be economic logic that results in these companies getting bought out and having their deposits developed. It'll be a strategic logic linked to long-term security-of-supply and redundancy concerns. And we're seeing that sort of psychology at work in this market. It's a bit of a niche in this market. Not as big as gold, but it is an interesting one because of the long-term real economy link implications that it has.


TGR: If this becomes a strategic logic play as opposed to economic, are the potential acquirers government or large companies?


JK: In the case of most of the Chinese mining companies, they are all at least partly if not wholly owned by the State. And we just saw an example where a distressed Australian company, which had several hundred million dollars lined up from Western sources to put its rare deposit into production, had the plug pulled on them. The stock was at 10 cents, they were dead in the water, and then the Chinese came in and ponied up $360 million in a combination debt equity financing that will give them majority control of this company and, of course, they've got all the boilerplate in the news release saying we will honor all the offtake agreements. All these offtake agreements are just good for five years and they only represent a small fraction of the total resource that will now be under the control, indirectly, of the Chinese government. So, in a sense, they've tied up what could have been one of the independent sources of raw materials in the world for the non-Chinese manufacturers.


And the governments in the Western world still aren't waking up to this problem. For example, we have Mountain Pass here in California, which Molycorp owns and which a group of private investors has now bought from Chevron; and they want to get back into production. They want the government to recognize that we need these things to happen for our military and space programs and even our domestic consumer economies, so we are not at the mercy of places like China.


TGR: And is the government doing that?


JK: At the government level, nobody seems conscious of the need to nail down security of supply of some of these raw materials within friendly jurisdictions. They are very aware of it with regard to oil because you look at what countries have the big long-term reserves and they aren't exactly the "friends of America" club. Part of this move towards clean energy isn't just concern about global warming and carbon dioxide emissions. It is a strategic desire to reduce the dependency on oil coming from these unstable or unfriendly parts of the world.


But they haven't really thought about that in terms of these more obscure metals. Everybody assumes that in this globalized economy, price will determine supply. Anybody who has the dollars to pay for this stuff will get all the moly they need. Except what I'm seeing is we're starting to see a destruction of the fungibility of these commodity markets. These supply contracts are not in the open market; they're private supply contracts.


In fact, the uranium market is like that. Utilities nail down long-term contracts with suppliers so they are assured the uranium. And it's interesting that the spot price, which was as high as $140 a year and a half ago, collapsed to $40; but the lowest the long-term contracts went was about $65. So you're seeing prices being paid for commodities in this hidden market that are not reflected in the so-called public reviewable spot markets.


So with regard to these more obscure metals, you do not have the transparent global markets that we have for the more traditional metals such as gold, platinum, nickel and copper. When you simply assume that when the need arises, the price will go up and the supply will materialize, one finds that all the supply has already been privately contracted at fixed prices and there is nothing to really put into the market. Then you would probably see the spot price go crazy as the parties that absolutely need that incremental demand rush into the market to tie it up so that they can, in the case of uranium, keep their reactor going.


TGR: So are we chasing our tail? It sounds like we have technology that needs to be developed that will use these rare earths, but it won't be developed if we don't have a commercially guaranteed supply of it.


JK: Yes, exactly. It's a classic chicken-and-egg problem and what's interesting now is when you have these sorts of big picture strategic needs like clean energy or reducing dependency on a certain type of energy, suddenly there's the impetus to solve this chicken-and-egg problem. And with these commodities, it's not so much an issue of 'can we get a significantly higher price for them?' It's more 'can we expand the market for them?' Three years ago, the rare earth market was worth a piddling $1 billion.


TGR: The entire market?


JK: Yes. So that's not very interesting and the prices had already gone up a fair bit at that stage. What becomes interesting is that this market could become $5 to $10 billion due to demand growth arising precisely because end-users are guaranteed an unending supply at these prices.


There are deposits out there where they could be profitable. They have rock values of $300 to $1,000 a ton, but nobody had dreamed of developing them during the last 30 years because the size of the market wasn't large enough to absorb the supply of this raw material.


In fact, eight years ago, the Chinese did glut the market with rare earth oxides before all this hybrid stuff really started taking off. And it's only recently that they realized they were depleting their own internal resources and decided to put export quotas in place. And now that we have these application scenarios where you can scale the demand 10, 100, 1,000 times bigger and you suddenly say, "uh-oh, where are we going to get this raw material?" Well, this is where, again, I see the strategic logic come into play—where the end users, who can make a lot of money selling hybrid cars if they have these raw materials in place, will actually pay a premium to control these pounds in the ground and see them developed (even if it is at a break-even basis after it's in production).


TGR: This has been very educational. Are there any other parting thoughts you'd like to give our readers who are investing in mining stocks?


JK: Yes, I would say when you're looking at these juniors, you've always got to figure out what is it that's going to change with regard to the company. Is it going to be a discovery? Is it going to be some breakthrough in metallurgy or on the cost side of the project? Or is it going to be a change in the price of the commodity that suddenly completely changes the value potential of the company's project and results in it being re-priced upwards?


You have to assume that the market is reasonably efficient in pricing these companies at the current price and you need to identify what it is that needs to change to justify a significantly higher price. And, also, on the downside, what is your downside risk? What negative potential changes are there associated with this company and its projects that could make your investment go down significantly? The lesson learned in the last 10 years is if you want significant upside potential, it only comes with significant downside potential. So you have to understand that risk-reward balance. At least with these companies, you have your 1,000% upside balancing your 90% downside, as opposed to owning a bank stock with 10% upside delivering you 90% downside.


TGR: This has been great. John, we appreciate your time.


John Kaiser, a mining analyst with over 25 years experience, is editor of the Kaiser Bottom-Fishing Report. He specializes in high risk speculative Canadian securities and the resource sector is the primary focus for an investment approach he developed that combines his "bottom-fishing strategy" with his "rational speculation model." Kaiser began work in January 1983 as a research assistant with Continental Carlisle Douglas, a Vancouver brokerage firm that specialized in Vancouver Stock Exchange listed securities. In 1989 he moved to Pacific International Securities Inc where he was research director until April 1994 when he moved to the United States with his family. From 1989 until 1994 he was also a registered investment advisor. He worked six months as a researcher for Bob Bishop's Gold Mining Stock Report before branching out on his own with the publication of the first issue of the Kaiser Bottom-Fishing Report in October 1994. He has written extensively about speculative Canadian issues, is frequently quoted by the media, and is a regular speaker at investment conferences.



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