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Anthony Young: China, Molycorp and the Future of Rare Earths
Source: Brian Sylvester of The Critical Metals Report (11/28/11)
Despite the name, rare earth elements are actually quite plentiful in the earth's crust—it's the companies that are close to producing these critical metals outside of China that are truly rare. In this exclusive Critical Metals Report interview, Analyst Anthony Young of investment bank Dahlman Rose & Co. discusses how two of the most developed rare earth mining companies are affecting environmental standards, offtake agreements and acquisitions within the industry.
Anthony Young: For the time being, China will continue to dominate the industry, but it may become a net importer of rare earths after 2015. As it cuts back on supply, prices are likely to remain elevated for an extended period of time.
TCMR: Do you think we'll see the day that China stops producing rare earths altogether?
AY: No, that is an unlikely outcome. China likes the manufacturing and jobs associated with rare earths: high-tech applications, cars, windmills and electric bicycles. Its goal is to keep rare earths affordable within the borders of China in order to incentivize manufacturers to move within its borders. China will never completely shut down the rare earths industry, but it will look to control supply as much as possible.
TCMR: The great irony of this sector is that while mining these elements has been far from environmentally friendly, rare earths are used for "green" technology like electric cars, hybrid cars and wind turbines. Can rare earths be mined in an environmentally responsible manner?
AY: Yes, they can. Molycorp Inc.'s (MCP:NYSE) asset in Mountain Pass met all of California's requirements, which are some of the strictest environmental standards across the globe. Maintaining high environmental safety standards is more costly for companies, but they have the opportunity to make attractive long-term returns after a large initial investment given the current pricing environment.
TCMR: Why are rare earths not being mined in environmentally sustainable ways in some jurisdictions?
AY: It's a matter of making the investment. China is getting there. Rare earths can be produced through brute force, which has been China's solution in the past, but the technologies that newer companies like Molycorp and Lynas Corp. (LYC:ASX) are employing can greatly reduce the environmental impact.
TCMR: In some cases, these deposits contain radioactive elements like thorium and uranium. Can rare earth deposits with those two elements be responsibly mined?
AY: Yes. Once those elements are extracted, they don't contain the radioactive materials that are present in the waste rock. If companies deposit waste rock in the region where it is mined, it doesn't impact the radioactive footprint of the area.
For example, there is a certain amount of radioactivity at Mountain Pass. Material has been mined from Mountain Pass with no impact to the broader California-Nevada population with respect to radioactivity. As long as companies mine, mill and separate rare earths in one location, they can extract rare earths without disturbing the radioactivity.
TCMR: As the environmental concerns associated with rare earth mines become more widely known, will they become more important than financing and metallurgy?
AY: I don't believe so. Regulators are extremely aware of the issues that have occurred in China and they understand there is a radioactive element to many deposits. Companies know that they have to address these concerns up front. In this environment, a company employing environmentally detrimental practices would not fly under the radar.
TCMR: The Financial Times of London recently reported that the development of a U.S.-based stockpile of rare earths was more likely after China's Baotou Steel stopped production earlier this year. What's your take?
AY: The U.S. government is closely analyzing the feasibility and relative benefits of establishing its own stockpile. However, I expect the elements that figure in military applications would be the top priority; I don't think that it would contain a broad basket of metals.
TCMR: Will other countries follow suit?
AY: It's likely. The U.S. government is being extremely deliberate, but not extremely aggressive about this—otherwise it would have started stockpiling in 2006, when China started implementing quotas. In all likelihood, the rare earth market will loosen up a little bit as Molycorp and Lynas commence production.
It takes the U.S. government an extremely long time to put procedures in place and determine exactly what's needed, how materials will be stored, what sort of databases will be required and so on. The process has already taken so long, the tightness of these markets may have been alleviated by the time it is ready. Nevertheless, given the critical nature of these metals in defense applications, the U.S. may still want some sidelined for inventory.
TCMR: Dacha Strategic Metals Inc. (DSM:TSX.V; DCHAF:OTCQX) is a small company that stockpiles rare earths mainly for Asian manufacturers. Could Dacha's business model be negatively impacted if more countries start stockpiling rare earths?
AY: It could certainly have an impact on its business, but not necessarily a cataclysmic impact.
TCMR: In an interview with Bloomberg, you said Molycorp was the best stock in the rare earths space based on commercial production at its Mountain Pass mine slated for next year. However, most of the production will consist of the light rare earths (LREEs), which are fetching much lower prices than the heavy rare earths (HREEs).
AY: It comes down to margins and cash flow for companies. Even if rare earth prices were to come down another 50–60%, Molycorp would still have tremendous margins. It would be generating great amounts of cash flow compared to exploration companies that are developing HREE assets with no cash flow until 2016. Investors are taking on a substantial amount of risk by investing in development-stage companies compared to a company like Molycorp, which will have significant production in 2012 and be fully ramped-up in 2013. There is a certainty in its earnings power that companies developing HREEs don't have. Any number of risks could sideline a development-stage project or result in its cancellation.
TCMR: In early October, Dahlman Rose slashed its 12-month target price on Molycorp from $120 to $70 a share. Why did you revise your target?
AY: The reason for the target cut wasn't Molycorp-specific. It was an acknowledgement of what had occurred in the broader markets. There was a sharp selloff in all of the commodity stocks in August as valuations and multiples contracted. Investors essentially weren't willing to pay the same multiples for commodity stocks as they had three months earlier. From a macro-perspective, we remain extremely positive on rare earths. But given what had happened in the broader commodities sector—and across the markets in general—we adjusted that price target to something that was more realistic in the current environment.
TCMR: Molycorp, which is currently trading around $34, recently lowered its production guidance for 2011. What are your thoughts on its guidance?
AY: The reduced guidance is related to the fact that Molycorp is in the middle of an almost $900 million (M) construction project that it's building in a little over a year. It started in December 2010 and will finish in March. Given all the development underfoot, with some trucks pouring cement and others moving REEs for processing, the company downshifted and said, "Let's determine guidance we can achieve without putting our workers, who are building and processing two complete flow charts at the same time, at any risk. How can we balance production and expansion most efficiently?" In our view, this was the reason for the decreased guidance.
TCMR: There is increasing chatter about more offtake agreements forming with junior REE development companies. Are you expecting more offtake deals?
AY: Molycorp and Lynas need to sell out first. The willingness of manufacturers to enter into offtake agreements with smaller companies further from production is an indication of how tight the REE market is. If there is material from Lynas or Molycorp available, why would manufacturers wait five years for a junior producer to deliver?
TCMR: But Lynas already has an offtake agreement.
AY: Molycorp and Lynas both have offtake agreements, but they're not completely sold out. They still have some material available for sale.
There's a fear among manufacturers prompting them to lock up through offtake agreements now, especially if the market continues to tighten. It is a trend that will continue to drive development of these projects. Mining companies need to take offtake agreements to the bank when they are seeking a loan to fund construction. These small-cap companies have $200M–300M in market cap, but their projects are sometimes two to three times that amount. There's a disconnect on how those will be financed. Offtake agreements will help close that gap.
TCMR: One of the companies that is expected to sign an offtake agreement soon is Matamec Explorations Inc. (MAT:TSX.V; MRHEF:OTCQX), a junior operating in central Quebec.
AY: Matamec has an interesting deposit. It's likely that they are in conversations because big manufacturers like to have supply from several sources. At points in time, they will leverage these companies against each other and say, "Mining company X-Y-Z is offering me these terms; can you match those?"
TCMR: You have buy ratings on Avalon Rare Metals Inc. (AVL:TSX; AVL:NYSE; AVARF:OTCQX), Hudson Resources Inc. (HUD:TSX.V) and Rare Element Resources Ltd. (RES:TSX; REE:NYSE.A), in addition to Molycorp. Can you talk about those names?
AY: Avalon will be a producer of HREEs dysprosium and terbium once it finishes its project in the Northwest Territories of Canada. Avalon has been doing exploration and development a little bit longer than some of the other companies out there. However, the project is a little more remote and the metallurgy is a little more difficult. Nevertheless, I still think this is a name that, if it's able to get the financing and construction going in the time frame it envisions, will have pretty tremendous cash flows.
TCMR: How does Avalon compare to Quest Rare Minerals Ltd. (QRM:TSX.V; QRM:NYSE.A), which is cheaper to develop, has a very similar grade and is closer to seafaring ports?
AY: Quest is an interesting name. When I initially started looking at REE companies a year and a half ago, Quest wasn't as far along as Avalon, so I rated it a Hold. Its chief executive, Peter Cashin, has been very aggressive in his development of Quest's project and there is recognition in the industry that it has made good progress. People like to play Quest against Avalon as if it's some sort of competition. It isn't. If you're looking for exposure to HREEs, Avalon and Quest would be the go-to names. Investors don't have to buy one or the other. They can buy both and have good odds of one or the other succeeding and making some outsize returns, possibly in both equities.
TCMR: Rare Element Resources in Wyoming has capital costs that are substantially lower than most because of its close proximity to infrastructure.
AY: Rare Earth Element's location is going to prove to be a real advantage—that and its simple metallurgy. It's a metallurgy that's been processed into REEs before, so there is off-the-shelf technology that it can obtain to make its processes work, while some of the other rare earth companies will have to do some work on the chemistry side of things to ultimately crack their ore into the various components.
TCMR: Could Hudson's location in Greenland be a setback?
AY: Investors get very nervous about any sort of deposit in Greenland. What's really attractive about Hudson is that it's right on the coast in a fairly temperate area. I visited this asset in May. It is actually relatively close to infrastructure and not too far from a former military base. We also like the fact that it has a lot of leverage to neodymium, a key magnet-making material.
TCMR: Lynas had a number of delays at its plant in Malaysia. Have you heard any updates?
AY: No. I don't have a Buy rating on Lynas because its outcome is dependent on the Malaysian government's decision. The valuation of its shares is relatively attractive, but it's uncertain when the Malaysian government will allow it to enter production.
TCMR: In an interview with CNBC, you said that you expect a rollup in the sector within a few years. Can you talk about that?
AY: As Molycorp and Lynas begin to experience cash flow from their two deposits, they will begin to pick off the attractive ore bodies with equity or cash flows from operations. Lynas has Mount Weld and another project in Africa, which it is attempting to develop despite some regulatory problems. Molycorp has the Mountain Pass project. Neither company has a clear second project to work on after its flagship project. They could very well pursue mergers and acquisitions in order to develop additional projects.
TCMR: Molycorp is not hurting for cash and juniors across the board are at some of their lowest prices of the year. Why wouldn't they just do it now?
AY: Molycorp and Lynas are both turning on a significant amount of production. Molycorp has 20,000 tons (Kt) next year and an additional 20 Kt in 2013. Lynas is bringing on 10 Kt and possibly 20 Kt in the future. The prudent step is to see how this additional supply impacts prices. If prices come down sharply, it's going to make sense to have waited because they may be able to purchase other equities at even lower prices. If the market is well supplied, equities will stay in their current range. Molycorp hasn't lost anything by waiting.
TCMR: Do you have any final thoughts?
AY: I remain extremely bullish on the rare earths sector over the next three to five years. With prices lowering for these materials, demand is going to remain extremely strong. There will be a global need for more rare earth mines beyond the two that are currently under development.
TCMR: Thanks, Anthony.
Anthony Young joined Dahlman Rose in February, 2008 as a member of the metals and mining team. He started his career in finance at Natexis Bleichroeder, before joining the metals and mining team at Bear Stearns. Prior to working in finance, he was an engineer for Hughes Electronics and AT&T. Mr. Young received his Bachelor of Science in electrical engineering from the University of California, Los Angeles. Mr. Young also has advanced degrees in electrical engineering from the University of Southern California, and in business administration from the University of Texas, Austin.
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1) Brian Sylvester of The Critical Metals Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Critical Metals Report: Dacha Strategic Metals Inc., Matamec Explorations Inc., Quest Rare Minerals Ltd. and Rare Element Resources Ltd.
3) Anthony Young: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None.
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