Rare Earth Juniors Have a Five-Year Window: John Kaiser
Interview

The Critical Metals Report: John, a recent Brookings Institution report suggested that greater collaboration between U.S. and Chinese companies would alleviate tensions over tightening rare earth markets. Is the proposed merger between the Canadian company Neo Material Technologies (NEM:TSX), which operates primarily in China, and Molycorp Inc. (MCP:NYSE), which is developing a resource in the U.S., what the doctor ordered?

John Kaiser: The merger between NEO Material and Molycorp combines NEO's knowledge about producing and fabricating downstream products from rare earths (REEs) and other specialized metals with Molycorp's emergence as a major U.S.-based REE supplier, especially light rare earths (LREEs). Within two years, Molycorp's Mountain Pass project will deliver a substantial portion of global supply. The output from Mountain Pass and Lynas Corp.'s (LYC:ASX) Mt. Weld project will boost global output to 170,000 tons, knocking China off its perch as the 95% dominant supplier to a less overwhelming position of 65%. That will alleviate some of the anxiety underlying what the Brookings Institution calls "mutual strategic distrust" between China and the U.S.

The Brookings paper emphasizes the need for the government to become more accommodating about Chinese ownership of American assets, especially if it involves capital investment. Right now we have a one-way street where western capital invests itself in China, ships back cheap goods to Europe and the United States, and waits for access to the Chinese consumer to open up. Not only would Chinese investment in America put their strategic goals more in harmony, but it might prod American companies to invest some of the trillion dollars they are hoarding because of the uncertainty over how the seemingly opposed destinies of China and America will play out.

TCMR: Toyota has a pending REE deal with Matamec Explorations Inc. (MAT:TSX.V; MRHEF:OTCQX) in Canada. German manufacturers are talking to Tasman Metals Ltd. (TSM:TSX.V; TAS:NYSE.A; TASXF:OTCPK; T61:FSE) in Sweden. Will deals like this end China's monopoly on REEs, lower their price and encourage more manufacturers to use these elements?

JK: Historically, REE prices have been very low due to China's abundant resources and its ability to produce them very cheaply. China is aware that it could become the world's biggest polluter when its economy eclipses that of the U.S. China is very concerned about making sure it has the raw materials on hand to assure its clean-energy future. The supply restrictions China introduced a couple of years ago were part of a campaign to clean up and consolidate its high-pollution industries. Those restrictions resulted in spectacularly high REE prices for export and substantially higher prices within China. Since July 2011, the drop in demand and China's inability to control smuggling resulted in a pullback in REE prices. To some degree, I think China wants its monopoly to end. China's ambitions go far beyond squeezing a few profits out of a market it controls.

All of this was a wakeup call. Companies all over the world realized that their new technologies can no longer rely on cheap REEs from China. Toyota's deal with Matamec, which is essentially a 100% offtake agreement, is critical to Toyota's plans to continue manufacturing hybrid and electric cars over the coming decades.

What distinguishes projects such as Tasman's Norra Karr, Matamec's Kipawa, Avalon's Nechalacho and Quest Rare Minerals Ltd.'s (QRM:TSX; QRM:NYSE.A) Strange Lake is that these deposits offer the full spectrum of rare earths from lights to heavies. China's natural rare earth abundance is skewed toward LREEs of the sort Molycorp and Lynas are bringing onstream. China's bounty of HREEs are restricted to a group of rapidly depleting low grade clay deposits in southern China. While it is questionable that the world needs any more major light rare earth mines beyond Mountain Pass and Mt. Weld in the near term, bringing on stream heavy rare earth supply is in the interest of everybody, including China.

TCMR: What are China's goals? Is the endgame to have companies move to China?

JK: China's primary goals are to make sure the country does not run out of these critical materials. A secondary goal is to clean up the pollution. As China becomes more of a middle-class society, quality of life becomes a pressing issue. If the Chinese public rallies against pollution, it could become a destabilizing nightmare for the government.

Introducing supply quotas created a situation where end-users outside of China had to consider moving their production capacity there to get materials at a reasonable price. Technology companies have moved to China, creating a serious bone of contention related to the theft of intellectual property.

For the next two to four years, China will be in a position to force the transfer of technology production into China, where it can be co-opted by domestic companies and companies owned in part by the state. These companies would in turn compete with western companies. This is a convenient byproduct of China's long-term strategy.

TCMR: If manufacturers will be able to source materials outside China, will they move out or stay in Asia, where the market is growing?

JK: Companies know that it is wise to have a foothold in Asia, the world's biggest long-term growth market. Companies already there are likely to stay. In the case of NEO Material, I would be very surprised if Molycorp ends up shipping REEs to China to be processed at its facilities, as [Molycorp CEO] Mark Smith suggested in the post-merger conference call. Molycorp's output will first flow to facilities Neo has outside of China, such as those in Thaliand and Germany. Neo currently holds export quotas that are still in the "provisional" category awaiting environmental clearance even though NEO claims to have been exemplary in complying with new regulations. I believe the true value of the NEO/Molycorp merger lies in the possibility that NEO will be able to transfer its know-how outside of China, possibly back into the United States itself. It is interesting that of the 472,000 manufacturing jobs created since 2010 in the United States, 120,600 have come in the sub-sector called "fabricated metal products." I do believe that once the merger has closed, Molycorp will look at acquiring a major deposit outside of China that will give it control over a full spectrum of rare earths. Because NEO is also involved with the fabrication of zirconium metal products, I would expect Molycorp to be interested in Avalon, Quest or Tasman, whose heavy rare earth deposits will also include a zirconium credit.

Allowing Chinese capital to invest in the U.S. would also address the trillions of U.S. dollar reserve assets China holds. We could see a migration of capital into the U.S., tapping into American automation technology and rebuilding the domestic manufacturing base. This evolving trend could put the American economy back on an uptrend.

TCMR: Will the price of oil influence where manufacturing facilities are located?

JK: The cost of moving goods across the Pacific and Atlantic oceans is likely to stay high. However, we may see different pricing for oil in the immediate vicinity of North America. We already see a significant difference between Brent oil and West Texas Intermediate oil. One must also keep in mind the fixed cost of multiple port handling and cargo transfer charges, which become more important as the production cost of Chinese goods destined for export markets rises.

In competitive terms, making your goods in the U.S. in a highly automated manner and shipping it to distribution centers cuts both the cost and the risk of shipping them across the ocean. Chinese companies are already looking at importing automation technology to deal with their rising labor costs, which strikes me as a recipe for domestic trouble. It would make more sense to make this sort of investment in America where three decades of manufacturing job losses have choked off labor opposition to automation.

TCMR: You mentioned Matamec and Tasman. Are those two companies ahead of the pack when it comes to development? What hurdles do they still face?

JK: Molycorp and Lynas Corp. are the two companies in the lead with high-grade LREE projects. Molycorp is marching along very nicely. Lynas is hung up in Malaysia due to political opposition to how the company wants to deal with the radioactive thorium waste from processing REE concentrates. If these two companies come fully onstream, they will glut the market with LREEs, primarily lanthanum and cerium, as well as a fair amount of neodymium, the key REE used in magnets. This will bring free-on-board prices down and may even lower the current domestic spot price in China.

Next come companies with a mix of REEs, which I call full-spectrum deposits. In this group, Avalon Rare Metals Inc. (AVL:TSX; AVL:NYSE; AVARF:OTCQX) is the most advanced. It hopes to have a feasibility report on its Nechalacho project done by the end of 2012 with permits in place by the middle of 2013 to initiate construction.

The other companies with large projects are Quest Rare Minerals, Tasman and Matamec, which have all done preliminary economic assessments (PEAs). Quest has been working on a prefeasibility study for more than a year and expects to have it done in H2 of 2012; Tasman and Matamec are just starting prefeasibility work. However, if Matamec's deal with Toyota goes to the next step, Toyota will define feasibility, which need not be as rigorous as an independent "bankable" feasibility study. If Toyota is satisfied the metallurgy works and the costs are in line with what it would want to pay for rare earth oxides in the market, it could make a production decision for Kipawa much sooner than would be the case for an independent company.

TCMR: Matamec's PEA targets production for Q216. Do you think that is plausible?

JK: I think it is plausible, assuming Toyota is satisfied with the flow sheet. Toyota wants to mine the Kipawa deposit very aggressively. Matamec is confident that over time, it will find additional mineralization and will be able to stretch production beyond the current 11-year forecast.

Remember, Toyota wants a 100% offtake deal. That would make all the REES from Kipawa available to one major manufacturer. The rest of the world will have to look to to Avalon, Quest and Tasman.

TCMR: It looks like Avalon is scheduled to go into production in late 2015. What about Tasman and Quest?

JK: At best, I would expect them to break ground in mid-2016, followed by commercial production in 2017, assuming everything goes smoothly. Although Tasman is a year behind Quest, the location of Norra Karr in southern Sweden close to infrastructure will shorten the development timeline.

TCMR: You mentioned that a lot of REE companies may not survive the next five years. How many will be left when the dust settles?

JK: In 1992 in the junior mining sector, nobody was paying attention to diamonds. Then Lac de Gras was discovered. Within four years, there were 200 diamond exploration companies. Twenty years later, there are six junior companies still in the game. The REE junior space will be similar, but in a shorter timeframe.

The period from 2015 to 2020 is critical for REE production coming onstream, which means if a company's project is not at an advanced stage right now and does not have a full spectrum of REEs—heavy and light—that company is not in the game anymore. It is too late for grassroots exploration for REEs. I regard half a dozen companies as serious contenders. End users must make decisions during the next 12-18 months about which projects they will back financially in order to secure their needs in 2015-2020. This does not mean exploration juniors should give up trying to make new rare earth discoveries. But they must accept that their discoveries will not be considered for production earlier than 2020. Meanwhile, they will have to endure market uncertainty about future rare earth demand. Some observers believe that the current shortages are causing permanent demand destruction that will result in a supply glut in 2015-2020 that renders the current crop of advanced projects future economic failures. Others believe the demand destruction is temporary. Demand will rebound and achieve new heights once it becomes clear that non-Chinese supply is coming on stream.

I belong in the second camp. Toyota's new Prius C line is a hybrid priced below $20,000 whose sales pitch is not its "green status" but rather its fuel efficiency of 46-53 mpg. It is the hottest selling small car in decades. During the next decade, the streets will be ruled by conventional hybrids that use rare earth-based permanent magnets and the nickel-metal-hydride batteries that use the rare earth lanthanum.

So even if many of the rare earth projects do not make it into the 2015-2020 production round, the current REE boom is creating a future inventory for the world to draw on if these various clean technologies do take off and continue to require significant amounts of REEs.

TCMR: Graphite seems to be the newest "it" mineral. What are the most positive projects out there?

JK: China is the dominant producer, with about 65% of the graphite supply. But its best deposits are heading toward depletion. Because of the boom in the price of large-flake graphite prices, a lot of deposits, in Canada for example, are being revisited. Of these projects, you need a large enough flake with minimal impurities. Northern Graphite Corporation (NGC:TSX; NGPHF:OTCQX) has resurrected the Bissett Creek deposit in Ontario. Flinders Resources Ltd. (FDR:TSX.V) has resurrected a project in Sweden. Northern Graphite and Flinders are the most advanced public projects, though a number of advanced and operating private graphite projects are being readied to go public by IPO or reverse takeover.

The rest are grassroots projects or ones where graphite was intersected by past drilling campaigns seeking base metal discoveries. They were never delineated because they were failures. Early-stage graphite projects have better potential for attracting market attention than early-stage rare earth projects because they are simpler to develop and the big market demand is still down the road.

Unlike the REE sector, where each project requires a custom chemical plant, we will probably see a boom in mergers and acquisitions in the graphite space. Graphite projects do not command billion-dollar valuations; their small size and the comparatively low unit cost of graphite limit individual projects to net present value-based valuations below $200 million (M). The long-term supply will have to come from multiple operations, not a handful of world-class mines. Once companies drill their targets and demonstrate deposits of 20–30 million tons of 5–10% of the right sort of graphite, bigger companies will buy them up.

TCMR: When would Northern Graphite reach production?

JK: Northern Graphite hopes to publish a feasibility study in Q212. The permitting process is not complicated, so it could be in production by the end of 2013.

Flinders was in production at one point; this is really a case of refurbishing the mill and putting it back into production.

TCMR: What are the prospects for non-Chinese companies developing tungsten?

JK: A number of smaller operations are attracting attention. Sojitz Tungsten Resources Inc. (2768:JSX) bought out Primary Metals' Panasqueira deposit in Portugal in 2007 and now uses it as a supply for tool-making.

Woulfe Mining (WOF:TSX.V) acquired Sangdong, the historic Korean tungsten deposit. Woulfe just did a deal with International Metalworking, which is controlled by Warren Buffett's empire. International Metalworking invested directly in the mine and will develop a processing plant to upgrade the concentrates to ammonium paratungstate (APT), which is the primary form of tungsten used by manufacturers.

This is another example of end-users not waiting for the market to solve their problem. Instead, they are tracking down the juniors and putting up the capital directly.

North American Tungsten Corporation Ltd. (NTC:TSX) has the Cantung Project in Canada. Its production is on and off and really needs the current tungsten price to be profitable.

I am also watching EMC Metals Corp. (EMC:TSX). Its Springer deposit in Nevada is a mill that needs $30M more to come fully onstream. Ironically, Springer was created in the late 70s by General Electric when China jerked the tungsten price higher. Once the Chinese realized GE could produce its own tungsten, they let the price come down and GE mothballed the mine. Now, EMC would like to bring it back into production as an American tungsten source.

TCMR: Is that viable?

JK: It is if the tungsten price stays above $300/MTU. If the price sinks below $300/MTU, the mine would start to lose money.

For the past year, the price has been parked in the range of $400–450/million tons per unit (MTU) for ammonium paratungstate (APT) tungsten. Over the previous 15–20 years, the high had been $300/MTU, which is looking more like a base price these days. That is the level above which non-Chinese projects are economic to mine.

Incidentally, in 2011 total world tungsten production was valued at $3.7 billion (B), compared to $1B for graphite and roughly the same amount for lithium production.

TCMR: Is developing alternative sources to Chinese critical metal resources a better solution to the supply problem than the World Trade Organization's (WTO) lawsuits? Or should both go forward on parallel tracks?

JK: When dealing with raw materials, it is always wise to have production coming from a variety of geographically distinct locations. Anytime you depend on a single-source supplier, you are setting yourself up for a malicious or accidental supply disruption. The latter could be a catastrophe that shuts down a key mine or a civil insurrection that makes the country incapable of producing anything.

If the WTO were massively successful—in other words, if China were to turn the taps back on—it would still be counterproductive, because China retains the ability to shut down its mines at any point. The WTO's action is more a pressure tactic and is largely irrelevant to reducing supply dependency.

TCMR: If the U.S. economy continues to improve, how will that affect U.S./Chinese relations?

JK: It would help, because part of the tension is due to the trade imbalance. China knows it cannot rely on an export-based economy forever. It needs to develop a domestic economy.

After the crash, China bit the bullet and invested more than $600B in infrastructure development. It was counting on the U.S. to have emerged from the recession by now. Ongoing weakness in the U.S. economy increases the opposition to the import of low-priced Chinese goods.

None of this would be important if the American economy—in particular manufacturing—were growing again. Just as we need to rebalance global sources of raw materials, we need to rebalance manufacturing. Chinese capital investment in U.S. manufacturing capacity expansion would go a long way toward reducing the tension between the two countries.

TCMR: John thanks for talking with us.

John Kaiser, a mining analyst with 25-plus years of experience, produces Kaiser Research Online. After graduating from the University of British Columbia in 1982, he joined Continental Carlisle Douglas as a research assistant. Six years later, he moved to Pacific International Securities as research director, and also became a registered investment adviser. He moved to the U.S. with his family in 1994.

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DISCLOSURE:
1) JT Long of The Critical Metals Report conducted this interview. She personally and/or her 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: Matamec Explorations Inc., Tasman Metals Ltd., Quest Rare Minerals Ltd. and Northern Graphite Corporation.
3) John Kaiser: I personally and/or my family own shares of the following companies mentioned in this interview: Matamec Explorations Inc., Quest Rare Minerals Ltd., Tasman Metals Ltd., Flinders Resources Ltd., EMC Metals Corp. I personally and/or my family am paid by the following companies mentioned in this interview: None.