A rare cautionary tale

Fears of Chinese export cuts has sent the price of many rare earth metals up sharply in recent weeks and the share price of miners digging for the metals soaring. Its worth remembering that we have been here before. Back in 2010 China cut exports following a spat with Japan. What follows is an extract from my book, Crude Forecasts: Predictions, Pundits & Profits in the Commodity Casino

In 2010, Molycorp sensed an opportunity to capitalise on the high prices for REMs that had resulted from the cut in Chinese exports. The company’s Mountain Pass mine was expected to be America’s flagship source for REMs. The economics of Mountain Pass were built on extraordinarily rosy expectations of future prices. The Molycorp share prospectus included an assessment of current and future demand and supply for REMs and the implication for prices. Even accounting for the Mountain Pass facility starting production, prices for many of the metals were forecast to rise by 20–50% between 2010 and 2014, with prices forecast to double through to 2030. Nowhere in the prospectus was there any mention of the downside risks to prices, except this one line caveat in the footnote to the price forecast table, “that there will be no major changes to China’s rare earth strategy and no new application(s) that will have a material impact on demand.”

What concerns me looking at the prospectus, and should also have concerned any prospective investor at the time, is that there was no attempt to quantify the risks that the REMs market presented. No thought into whether substitute sources of REMs would be developed and no thought into whether the high prices would encourage manufacturers to substitute REMs with some other much cheaper product or at least reduce the amount they required.

Were investors emboldened by the stratospheric and parabolic price of REMs and the story that the demand for REMs would continue to grow sharply due to growth in demand from defence and the tech industry? Maybe. Did they think that China would continue to restrict supply indefinitely? Maybe. However, a cursory look at the history of other commodity markets should have given enough evidence to suggest that what goes up, inevitably goes down, eventually.

After REMs prices fell sharply post-2011, and due to the high level of investment required, Molycorp was eventually forced into bankruptcy. Investors in Molycorp were by no means the only suckers to fall for parabolic price increases as a trend. According to Chris Berry, many other REM mining companies were using three year trailing averages to justify their expectations of future prices. These price expectations then enabled what should have been a marginal project to get a valuation of over a billion dollars, and enabled many funds to be raised.

To an extent, it’s all about incentives, especially when it comes to early stage mining or exploration companies. In the early stages, running one of these companies is often more about salesmanship – convincing others to invest in your ideas – than geology. Executives spend all their time looking for financial resources, rather than those in the ground. And here there is the incentive to present the best possible story of how the future – prices, in particular – may pan out.

One final word from Chris Berry on the dangers to investors: “Beware narratives of limitless demand and limited supply which is nonsense junior mining companies excel in propagating. Any supply shocks will usually be met by some combination of recycling, thrifting, or technological advancement which displaces these unique materials.”

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