The Rising Influence of Rising Affluence

[DewDiligence]

MCP—Playing Rare-Earth Roulette With Beijing

http://online.wsj.com/article/SB10001424052748704631504575531650484852086.html

›OCTOBER 5, 2010
By DAVID FICKLING

The bull case for investing in miners of rare earth is simple: China accounts for 95% of the world's production. The bear case is oddly similar.

China has long dominated the market for these metals, which are critical to cutting-edge technology such as hybrid cars and low-energy light bulbs. Only recently, though, has this dominance moved markets.

In July, Beijing cut its annual export quota for the minerals by 40%, sending the price of rare earth soaring and animating shares of the two companies with the best prospects of producing the elements in the next few years. Shares in Australia's Lynas have more than doubled in three months, while U.S. rival Molycorp has also more than doubled since its late July initial public offering.

Both companies are hoping to serve as a lifeline to rare-earth buyers by breaking China's near-monopoly. Between them, they expect to produce about 40,000 tons of rare earth a year from 2012, equivalent to 35% of China's current production.

To some extent, the surge in share prices makes sense. Thanks to China's export squeeze, Lynas estimates that the basket price of the rare earth it has in the ground has quadrupled to more than $50 per kilogram of refined material. That gives the company an impressive margin above cash costs, which J.P. Morgan estimates to be $10.60 per kilogram.

But this is a rally that's entirely dependent on Beijing's whims. China is looking to increase its pricing power by consolidating its fragmented domestic industry and building up a stockpile of the goods, but the emergence of foreign production on the scale Lynas and Molycorp are planning will undermine China's dominance of the global market.

The risk, of course, is that just as Beijing's moves have resulted in a price spike, a change in direction could bring about a slump. China's foreign rivals will struggle if prices fall back to their pre-squeeze levels; indeed, on J.P. Morgan's cash costs analysis, Lynas would have been unprofitable in 2009.

This wouldn't be the first time China has crippled overseas rivals. In the early 1990s, it flooded the market for tungsten, a scarce element used in high-temperature alloys. Rival producers have yet to recover.

After all, investors with burnt fingers rarely return in a hurry.‹