There Is Oil in the Middle East; There Are Rare Earths in China
So far, we have discussed the demand for technology and the easily discernible accelerating demand for green technologies, ranging from hybrid vehicles, to wind turbines, to fluorescent bulbs. The world has a substantial appetite for the rare earth materials that are absolutely essential to the production of these products. The acknowledgment of this surging demand prompts the question, Who supplies rare earth?
The answer returns us to our opening mention of Deng Xiaoping, and a somewhat unsettling reality for technology companies around the world: One country ostensibly controls the entire world's current supply of rare earth—China.
For much of the first decade of the twenty-first century, China was often noted for its relative paucity of vital commodities needed for the construction of its growing economy, including copper, cement, and forest products. These supply-and-demand relationships have been real, but as it turns out, the country controls the supply of commodities that is the bedrock for all current and future innovation in technology. As obscure as his statement was in 1992, Deng had it right—China has rare earth. In fact, by most recent estimates, the country controls from 95% to 97% of the world's current supply of rare earth raw materials. iPods, cell phones, LCD TVs, hybrid vehicles, wind turbines, computers, and, yes, even fluorescent light bulbs are drawing on the production of rare earth materials that are supplied almost entirely by this one country. Concern is growing over this supply-and-demand dynamic, because some observers are worried that China will hold the world hostage. This outcome is very unlikely, barring any unprompted and totally ill-advised trade war coming from elsewhere. China's goal is to find the best way to monetize its asset. If China were to pursue this course of action, and prices rose too high, there would be a supply response in time from other countries such as Australia, Canada, Brazil, and the United States. All these countries possess these assets in some way, shape, or form, but in lower concentrations and at higher costs of production. Actually, rare earth materials are found all over the globe in the crust of the Earth. Conversely, finding a heavy concentration of these materials in one place, and extracting them in an economical way, is a totally different story. For this reason, China sits on the world's most abundant localized supply of rare earth. In a fit of irony, it is also an inconvenient truth that the key ingredients of all these important green technologies are extracted through a highly ungreen and polluting process. Most often, the crude form of the process has involved applying acid directly to the ore source in the ground that in turn leaches the ore from the other soil materials but leaves the acid behind. For that reason, the United States' own source of rare earth raw materials in Mountain Pass, Calif., which saw its production heyday during the initial boom in color TVs, was mothballed years ago. Not surprisingly, China—as always, stereotyped by its notoriety for exploiting natural resources for profit (just like the United States 100 years earlier)—was left as one of the few producers. Other governments killed the industry with regulation for its potentially contaminative processes. In the past few years, though, a consortium of private equity investors have backed a firm named Molycorp to begin production at Mountain Pass. Numerous other announcements in the past few years have come from mining companies in Canada and Australia. However, optimistically speaking, it will take years for these projects to come online, and then a few more years to reach full production, while technology demand continues to pace ahead. The announced projects to date represent only a fraction of the output from China, which still holds about 80% of the market. For that matter, these are optimistic scenarios for production responses from outside China. Mining rare earths is far from simple, and refining them into something useable is a whole other ball of wax. One good example comes from Lynas Corp. of Australia, which is working on rare earth extraction from the Mount Weld project in that country. After decades of commercial interest, the project has yet to produce the materials. The capital it needs to subsist has been choked off—at least intermittently thanks to the financial crisis. Here again, we find strong evidence of another headwind facing the production of rare earth from locations outside China. Ever since the financial crisis, capital has become much scarcer. More importantly, capital-seeking risky ventures such as getting in on the ground floor of a start-up mining project are becoming scarce, notwithstanding the attractiveness of the opportunity, thanks to good old-fashioned risk aversion. Taking these factors into consideration, it is reasonable to conclude that the supply response from outside China will be years in the making. With all that said, let's take a closer look at the supply-and-demand relationship for rare earth materials as it is currently understood. Figure 11.5 shows four relationships using data from the Industrial Minerals Company of Australia. To begin, we have rare-earth supply from China, rest of world (ROW) supply, global demand for rare earth on the top line, and finally Chinese demand on the bottom line. This figure points out two significant facts. The first is that the rate of change in global demand has been outpacing the rate of change in supply from China. The second is that the rate of change in Chinese demand has also been outpacing the growth in supply from China.
Figure 11.5 Rare-earth market supply and demand, both recent and projected
Source: Dudley Kingsnorth, IMCOA
These relationships, insofar as they persist, have important implications for the price of rare earth materials in the coming years. Global demand for rare earth materials has consistently ranged in the high single digits to low double digits since the early 2000s. Despite the approximate matching of Chinese supply to worldwide demand, with intermittent deficits and surpluses thus far, the industry will need to raise production levels in light of the increasing demand owed to the secular trend of consumption derived from green technology. As we look at expected demand levels over the next five years, meeting the world's production requirement will increasingly fall on producers from outside China. To bring these specific relationships into better focus, let us take a closer look at the expected growth dynamics in the coming years. In particular, the fastest demand growth is occurring in the metal alloys and magnets. Here consumption is expected to continue growing over the next several years in the range of 10% to 20% per year, depending on the specific product. So where does this leave potential supply and demand in the coming years? Based on what is known and available to outsiders, China's recent annual production of rare earth has been approximately 115,000 metric tons, and total global supply was 124,000 metric tons in 2008. Therefore, outside sources need to start bringing new supply onto the market to meet projected demand during the next several years or risk supply deficits. There are many potential, but unproven, sources, including a host of sites such as Mountain Pass, Calif.; Mount Weld, Australia; Dubbo, Australia; Nolans, Australia; Hoidas Lake, Canada; and India. In order for these projects and other outside sources to close the possible deficit that may appear in the coming years absent their supply, production will need to almost double from 2008 levels. This feat would meet the projected deficit and keep the market roughly balanced. Whether producers outside China can raise world production more than twofold over the coming years remains to be seen. Historically, miners often struggle bringing capacity on line as soon and as easily as expected. Even if they can, the market will still only balance out based on these projections from IMCOA. Finally, this discussion has not included the scenario of demand growth above the mid-single digit growth projections offered in the data which, based on historical levels, is closer to 8% per year in the several years leading up to 2008. If the market for rare earths entered a supply deficit in the coming years, this would not be without precedent. During 2007, as evidenced in Figure 11.5, global demand far outstripped all the combined supply sources. As the market tightened in the procession to this event, prices in key rare earths such as neodymium skyrocketed, as shown in Figure 11.6. Technology producers had to continue buying these materials either way to continue selling their product.
Figure 11.6 Neodymium prices in USD/KG
Source: Feller Magnets
The future always remains unknown. However, the supply-and-demand relationships we have discussed create a bullish scenario for rare earth prices, as well as for producers lying in the upstream to midstream portions of the value chain that can pass along price increases. Moreover, in accompaniment with the rising demand dynamic, China is progressing in ways that will limit the future amount of rare earth available on the world market for foreign technology companies. The United States eventually recoiled at the environmental consequences of the commercial production of rare earth. And now China is clamping down on the weaker operators in the industry and driving out the most polluting producers in an effort to better care for its environment. Indeed, the sign of a prospering country is its increasing attention to environmental matters at the expense of unchecked commercial interests. Also, as China continues to develop its economy, it is increasingly moving its own technology industry up the value chain and into higher, more sophisticated technology products. The easiest detectable by-products of this shift, and a direct manifestation of these developments, are China's export and production quotas that have continuously restricted the availability of rare earths for export to entities outside China. This paradigm has been misconstrued by outside observers as an aggressive move to limit availability. On the other hand, it is more likely that the quotas simply underscore the changing attitudes of a progressing nation that wants to develop a key natural resource in the most economic and efficient way possible. In the coming years, China will continue to consume more of these goods internally due to its own development, which may lead to a few side effects. First, this will prompt foreign companies to move their own production to China to gain secure access to rare earths. Second, it should help advance the technology industry within China, because the country has relatively unfettered, low-cost access to these critical raw materials. In both respects, this helps China monetize the natural resource in a more constructive manner. In the first case, when foreign manufacturers bring their operations into China, this will create much-needed employment in higher-wage, value-added segments. In the second case it will provide Chinese technology firms with a competitive advantage in the sourcing of raw materials. Both cases create an enterprise-based solution to China's constant need to gainfully employ its citizens, particularly in the absence of the long-ago discarded "iron bowl" of social safety nets. Finally, since these raw materials are at the epicenter of technology innovation, in the years and decades to come China can eventually position itself at the headwaters of innovation in technology. This represents a significant opportunity for progress in China's economy and standard of living. The bottom line is that in the twenty-first century, China has a deep competitive advantage in the race toward advanced technology. Careful observers have seen some evidence of the competitive advantage the Chinese possess thanks to their cheap access to rare earths and their relentless drive to compete and innovate. For instance, a battery producer called BYD (Build Your Dreams) used its expertise to build a sedan called the E6 that reportedly gets 249 miles per charge. The Chevy Volt reportedly travels only 40 miles on one charge. This says as much as anything about what China really wants to accomplish through its control of rare earths—creating products that can compete and win in the global marketplace.
In sum, the rare-earth industry presents a growing opportunity for investors to participate in the rapid growth of technology. For starters, investors can sidestep the most glaring pitfall and risk of technology investment—the constant threat of obsolescence. No investor wants to load up on shares of the manufacturer of the Betamax VCR when the VHS VCR will be introduced a year later. Likewise, the Walkman gave way to the CD player, which gave way to the iPod. Technology is about innovation, and innovation leads to upheaval. If an investor knows, however, that many key technologies spring from the application of a few raw materials, that investor can focus on these upstream products; therefore, risks are tied less to obsolescence as he or she seeks to capitalize on the constant demand in this industry. Finally, it is difficult to overlook the potential role the Chinese will play in technology in the years to come, blessed with these competitive advantages.