April 07, 2011 - 10:59pm EST by
2011 2012
Price: 68.45 EPS $0.00 $0.00
Shares Out. (in M): 82 P/E 0.0x 0.0x
Market Cap (in $M): 5,634 P/FCF 0.0x 0.0x
Net Debt (in $M): -313 EBIT 0 0
TEV ($): 5,321 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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"I think our opinion on that right now is basically that regardless of what production is brought on right now by Molycorp or others, that the gap between supply and demand is going to continue to exist." Mark Smith, Molycorp CEO, 4Q10 conference call

Molycorp (MCP) will be a great short because contrary to what Mr. Smith says the laws of supply and demand also apply to rare earths. The stock is up more than 300% from the July IPO as investors have focused on 1.) skyrocketing prices outside of China due to an artificial supply squeeze caused by a dramatic cut to Chinese export quotas (who produce more than 90% of worldwide supply) and 2.) skyrocketing prices inside of China due to rampant speculation by non-economic actors. Looking forward, massive amounts of new supply are coming online which will push prices to marginal cost and allow MCP to earn a normalized return on capital instead of the 100%+ ROIC implied by sell side estimates. Assuming an $800mm - $1,000mm reproduction cost and a 10% - 12% ROIC, MCP should earn around $100mm on a sustainable basis giving it a market cap of around $1B (down from the current $5.6B).


Supply / Demand: In 2010 demand outside of China was 55,000 tons while supply was roughly 40,000 tons (30,000 from Chinese exports and 8,000 from other ROW players). In 2013, demand is unlikely to grow significantly (see below) from current levels while supply will be close to 100,000 tons (40,000 tons from MCP by end of the year, 20,000 tons from Lynas, 15,000 - 20,000 tons from other ROW sources and 20,000 from exports). Even if China stopped exporting rare earths the market will still be oversupplied.


So why has the stock done so well? Here are some common misconceptions about rare earth:


Myth #1 - Rare earths are rare

  • Some rare earths are more common than tin or gold in the earth's crust. There is close to a millennia of worldwide rare earth reserves at current production rates.
  • There is an over capacity of rare earths production worldwide. China could produce 200,000 tons a year, compared to 2010 worldwide demand of 135,000, if it wanted to.
  • Many countries, including Japan and China, already have strategic reserves and no customers have reported issues getting supply if they are willing to pay current prices.


Myth #2 - Demand for rare earth outside of China is accelerating

  • Demand for rare earth outside of China has been constant at 55,000 tons annually since 2005.
  • Demand is increasing in China but only at high single digits.
  • The highest potential growth area, hybrid batteries, are going from lithium-Ion cobalt (have rare earths) to lithium iron phosphate (do not have rare earths). Wind turbine manufacturers, another area supposed to produce significant demand, are all working on reducing or replacing rare earths.  
  • There are numerous other stories of high prices are impacting demand through recycling (Japan recycling hard drives), substitution (Toyota possibly moving to induction motor) and reduction (Japan has supposedly created new magnet technology that dramatically reduces the amount of rare earth in magnets).


Myth #3 - Rare earths only mines are a good idea

  • The majority of rare earths in the world are produced as a byproduct of iron ore mining giving it a zero cost basis putting rare earth only mines in a terrible economic situation.
  • The small size of the market (one of the world's largest drybulk ships can carry three years worth of worldwide demand) makes it impossible to bring on meaningful new supply without dramatically affecting prices


Other interesting points:

Extreme price difference between Chinese and ROW pricing

  • The 2H10 quota cut caused exporters to stop selling lower value rare earth which caused La and Ce prices to increase by over 1,000%
    • The rare earths most likely to be oversupplied (La and Ce), which make up 80% of MCP's deposit, are sold for 8% and 9% inside of China compared to what they are sold for outside of China
    • The traditional relationship before the large export cut around 15% (caused by the impact of export taxes)
    • It is highly likely that ROW prices revert to China prices once the market is in oversupply

 Rare earths are not in structural undersupply, they are just not being exported out of China.

  • Outside of China there is supply equal to at least 125% of demand coming online by 2013.
  • Rare earths have low barriers to entry as they are not difficult to mine or refine, there are huge amounts of reserves and hundreds of projects underway to mine them.

Some analysts have pointed to increases in domestic China prices as a reason for optimism on MCP. We believe it is nothing more than a speculative phenomenon which is unlikely to last, especially as export prices collapse as MCP and LYC AU come online. This story does a good job of explaining what is happening:

If you don't believe my supply / demand numbers, check out the governments. Even using their generous demand numbers, La, Ce and most likely Nd (which collectively make up >95% of MCP's deposit) will be oversupplied once MCP is online. Also, keep in mind that they are using a 20,000 ton supply figure for MCP instead of 40,000:


You can also look at MCP's numbers which imply that the market will be in oversupply. Check out slide 15 from the link below which does not include MCP Phase 2 and only includes the Lynas supply in a dotted line. Even without Phase 2 the market will be dramatically oversupplied:


Summary: Spot prices achieved during a supply squeeze become irrelevant once a market is oversupplied. As the market tips into oversupply, prices will revert to marginal cost of around $10 kg (Lynas cost) compared to the current $100+ per kg. At that price level, MCP will earn a decent return on capital similar to other commodity businesses as opposed to the current market cap which implies MCP earns high returns on capital into perpetuity in an oversupplied commodity market.



Lynas Corp and MCP ramping production in late 2011 and 2012 tipping the market from deficit to surplus.
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