Rare Earth Roundup

October 18, 2010

Matthew B. Smith

The past few months have been frantic in the rare earth sector with many companies seeing their share prices double or triple.  Investors are beginning to pile into the premier names and even venturing into the more speculative plays which has forced some of the more leveraged plays to move forcefully higher.  We continue to believe that investors finding the near-term producers will make the most money in the coming years, while others will return solid returns for investors until the markets realize that they will not beat the competition to market.

From what we can tell, there will be a few players entering the market over the next year or two, however their mines will produce in great quantities the light rare earths (LREEs).  Lynas should be first followed by Molycorp and Arafura.  Of the three we are intrigued by Lynas and Molycorp the most due to their core competencies, if you will. 

We see Lynas as a safe bet for a near-term supplier of the LREEs in this current LREE bull market, where producers have tremendous pricing power, thus tremendous profit potential early on.    Most new mines coming online in the early years will have heavy concentrations of LREEs, so first to market will be able to secure supply contracts and even lock in pricing for some contracts.  Once the HREE mines come online, and we believe that this is a real possibility starting in 2015 and thereafter, LREE mines will experience some stiff competition. 

Some of our clients and readers have debated us on this point, so please let us explain.  As a major HREE supplier with a deposit that is hypothetically on a 50:50 ratio of HREEs to LREEs, I have very valuable product constituting half of my production.  By 2015 we see quite a few LREE mines online and thus pricing power eroding, especially with the LREEs from HREE production, thus a supply overhang.  Japan, South Korea and many of the other Asian countries have conglomerates which will be buying the REEs for various entities, so it makes sense for them to have a few suppliers with access to a wide range of required materials for their production needs.  Would those buyers buy cheap cerium from an LREE producer and try to get the best price for HREEs from any HREE supplier with available production? The answer is obviously yes.  Would that same buyer drop the LREE supplier with the cheapest cerium for an HREE producer willing to guarantee a constant flow of HREEs in exchange for purchasing their cerium?  Once again the answer is a resounding yes.  We believe that the HREEs are the key to success as it allows a bargaining chip when negotiating supply contracts, everyone needs them and we believe that Lynas and Molycorp will venture into the HREE realm in the not too distant future to stake their claim.

Molycorp, as we have said before, should be one of the most tech savy rare earth companies out there with their numerous patents and the new water filter technology they have developed.  Initial reports out of the company suggest that the new technology could not only use up all of Molycorp’s Mountain Pass cerium production, but put a nice dent in the world’s other cerium production as well.  It is too early to tell, but this technology enables Molycorp to do two things the competition cannot do.  First it allows them the freedom to consume, rather than sell, their cerium production for a much higher return on their money.  Secondly, Molycorp is able to compete with the Chinese on price regarding the rest of their rare earths due to the value of their cerium production for their personal use.  The value added services they are able to perform from the manufacturing side, plus the issue of security of supply, ensures that once Mountain Pass is up and running that it will continue so.

We have stated in previous articles that we think that Stans Energy has a solid shot at becoming a near-term HREE play as their deposit historically ran at a 50:50 ratio of HREEs to LREEs.  Exploration should prove up some further mineralized zones for the company thus giving investors both a near-term producer and excellent HREE exploration play.  Some have expressed concerns about the country where the Kutessay project is located, Kyrgyzstan, however we feel that it is a safe operating environment.  The country borders, among others China and Kazakhstan, and the US Armed Forces use the country’s air bases as staging grounds for various missions in Afghanistan and Pakistan.  The country is important strategically to the world’s three superpowers (the above mentioned US and China as well as Russia), so we expect that the current status-quo shall continue (In our last article we pointed out that the recent elections went smoothly and without incident).  China could not afford to allow radical fundamentalists from the Middle East to take control for fear of those ideals and extreme fundamentalists infiltrating its western border and stirring up further troubles in its western provinces.  Russia is counting on rare earths from this country in the future as well as potentially developing other resources such as uranium and could not afford to have unrest either for fear of penetrating the borders of Kazakhstan where Russia has heavily invested in the uranium sector there via state controlled ARMZ and soon-to-be majority owned UraniumOne.

On Wednesday we will be posting to the site an interview we did with Stans Energy’s CEO, Mr. Robert Mackay, in which we feel there are a few jewels buried within that investors can walk away with and make money.  Most important is the fact that the company has been contacted regarding their Kutessay project in Kyrgyzstan and future production.  Now we do not know the depth of the conversation or the specifics, we simply received a ‘yes’ to the question we posed, but the fact that there are companies out there extending ‘feelers’ in regards to any future production from this project, in our opinion, speaks volumes as to the HREE consumers’ view on security of supply from Kyrgyzstan.

Other HREE producers we are keen on include Quest Rare Earths and Tasman Metals.  Tasman of course is run by the same guys who have run Mawson Resources so successfully (and shareholder friendly) over the years.  We were told by Mark Saxon, CEO of Tasman recently that it was the Board’s intention on building shareholder value by developing their projects to see exactly what they have on each and developing the best projects first with the potential to JV out projects they feel are not priorities in order to maximize shareholder value.  Also, the company intends to keep the share float low and not dilute shareholders through constant equity financings.  We are familiar with this management team and believe that lightning is going to strike twice for them and shareholders.

Regarding Quest we believe that the stock is one that is heavily played by momentum traders.  On pullbacks, for which it seems the company is becoming famous for (they seem to take 2 steps forward and 1 back constantly in regards to their share price), we would be accumulators.  This stock is widely followed by the investment community, will become one of the world’s strategic producers of HREEs at some point in the future and has an excellent management team and capital structure in place.  The company continues to move forward on the Strange Lake deposit, however like Stans Energy, they also possess excellent exploration property which could increase the company’s profile and footprint. 

Quest recently announced a financing, and it seems they were able to raise capital at fair prices this time.  The warrants issued with this financing will trade on the Toronto Stock Exchange, and we are very interested to see how these begin trading.  For investors hoping to get some leverage on pullbacks, the warrants could offer some extreme profits on minimal capital risk.  We have no opinion on these until we see them begin to trade and the volume, however it is something to nevertheless be aware of.

For some of our American clients we were able to re-recommend Rare Element Resources once it was announced they would list on the AMEX.  REE rose to about US$9/share before consolidating and we believe that pullbacks to around the $7/share range are opportunities for entry points.  We do note however the we believe the company will do a financing in the near future which, and this is assuming they do it correctly, should take them to production.  Their PEA stated they needed US$87 million to reach production, so our guess is that the company issues units (shares with warrants attached) in the amount of US$90 million (indicating an issue of say approximately 11.25 million shares at US$8/share).  The logic behind this is REE would only have to come to market once and the initial US$90 million would cover the initial estimate with US$3 million left over to pay their bills.  It is our opinion that they will want to do further drilling on both the gold sections of the property and further drilling on their various rare earth prospects (both on the property and less developed exploration properties).  The warrants, assuming each unit consisted of a share plus a ½ warrant, might be priced at say $15/share for two years.  If the company had all of these warrants exercised, it would result in a further 5.625 million shares issued and a further US$84.4 million for development and any cost overruns which may occur (for investors not familiar with mining projects, it seems there are always cost overruns).  We feel this would be the conservative path to take, but if another financing crisis hit, this would be almost the only way the company could bring the project to production.  It would also put the company in rare company as they would be one of the few entities having all of the required capital to place their project into production.

Hudson Resources has been steadily moving higher since we highlighted it in an article (Rare Earth Stock Poised to Make a Run) on September 13, 2010.  The stock is approaching C$1/share which we thought was where it deserved to be based on valuation comparisons with its peers.  Investors could see a further 25-30% rise in the shares as the company is poised to release their next batch of drilling results and a NI 43-101 resource estimate for their first target.  This project will be less like Strange Lake and more like Kutessay in that it will have multiple mineralized areas on the property rather than one large ore body.  Further drilling could change this, but at this time this is what our models are indicating.

We continue to believe that rare earths continue to offer a compelling investment opportunity to investors in the present and over the next few years.  We are in the early stages of a bull market here that should resemble the path previously taken by the uranium miners, and this rising tide should continue to lift all boats for the time being however investors should place some capital into those companies who are beginning to set themselves apart from the pack.