China Circles The Rare Earth Wagons

According to Reuters,  China yesterday made a couple of official announcements that will directly affect the global rare earths supply issue. It was announced that China will create a price discovery mechanism for the rare earths metals and

will [in order to accomplish these goals] establish a unified transportation and sales system and [is] are expected to consolidate production into 3-5 conglomerates in the long term.

It was also announced that

China’s Ministry of Commerce issued a second batch of 2010 export quotas for rare earths on Thursday, allowing 32 [trading] companies to export up to 7,976 t.

which is less than half of the allowed quota for the first half of 2010 thus bringing the total for the year down to 26,000 t even though…

in the first five months of the year, China exported 18,786 t, three times as much as in the same period of 2009.

The Reuters article also pointed out that

China has already this year put limits on rare earth production and stopped issuing new exploration licences until June 30, 2011. It also launched a crackdown on illegal rare earth mining last month to stamp out unauthorised supplies […] [I]ts leading producer has also been given permission to set up a strategic reserve in the northern region of Inner Mongolia.

So what is significant about each of these announcements and what is the overall significance of the announcements and their timimg?

China has circumvented the attempts by specialized reporting services and in particular by funds and ETFs recently started in the West to create a price discovery mechanism, so that, whatever share of their ‘value’ these funds and ETFs attributed to their price discovery mechanisms, has been reset, in all probability, to zero.

Not emphasized by Reuters but noted by others, has been the fact that the export allocation quota reductions will fall more on ‘foreign-run producers’ of rare earth metals, rather than on all producers. The meaning of this is ominous for those rare earth metal producers situated in China, so as to have access to rare earth concentrates for their export product manufacturing.

Stamping out unauthorized supplies probably translates as stamping out smuggled goods that do not pay taxes, from producers who also  do not follow environmental and work safety regulations, thus lowering their real costs dramatically. These ‘gentlemen’ are known worldwide, euphemistically, as ‘artisanal miners.’ It is commonly believed that at least one major Japanese car maker buys smuggled goods heavily as a ‘strategic reserve’ of its own. Of course this will now be policed and stopped.

Chinese miners and trading companies, have for some time believed that once rare earth metals leave China, their prices increase dramatically. There is little evidence of this actually happening on a large scale, but the belief in it has clearly influenced China’s moves to bring global pricing under its control, by literally setting the market price openly and officially.

It must be kept in mind that the fact that a price is set by a mandate, does not of itself  create an exchange. For that there must be physical supplies of the metals, and they must be deliverable at the date chosen by the buyer. If they are future deliveries then a hedging mechanism can be created, if China will allow contracts for the future delivery of rare earth metals for a price fixed before the delivery guarantee date. Finally, I think there are two reasons that “its leading producer has also been given permission to set up a strategic reserve in the northern region of Inner Mongolia.” – either:

1. The leading producer is setting up a strategic reserve to guarantee supplies to Chinese government-designated  domestic consumers, during a protracted shutdown of the national industry for environmental remediation and restructuring and rebuilding, or
2. The leading producer is establishing the physical reserves for a global rare earth metal exchange, to be based in China and which would offer not only price discovery, but also futures contracts (hedges) and inventory maintenance for customers, or
3. Both of the above

China has done the non-Western junior (not yet-producing or pure exploration) companies a huge favor and at the same time has exposed their greatest weakness. The value of the rare earth metals produced only after ore concentration, separation, purification, and reduction will now be known. Clearly the output of a mine, if, as is normal, it is just a concentrated ore, will be worth much less due to its lower position in the value chain. But at least now we will be able to put an upper bound on the value of the mine’s output at its shipping dock. If the cost of the mine’s ‘product’ exceeds its selling price, then for a stand alone mining operation, the only product of which is an ore concentrate, the total value will be less than nothing, since it will take an excess of capital, over any possible return at its shipping dock, to build and maintain it.

Chinese miners say they have been making a profit on a standalone basis. Any foreign rare earth mining operation that can say the same, is today, with the reduction in Chinese exports and China’s clear need in the near term, at least, for additional material, in the driver’s seat. The only alternative for non-Chinese miners who are not profitable as standalone operations, is to become part of the consolidated balance sheet of a large end user, so the mine’s losses can be balanced by value added processing and fabrication of end user parts and assemblies. General Electric, I’m talking to you, as a prime example of a large enough end user. Its time to cherry pick juniors. You can only remain viable within China as a foreign-controlled company in the long run by importing to China, the raw materials that you went to China to have access to in the first place.

China has learned to operate in the world of capitalism, and what goes around, comes around. Ain’t payback a bitch?  Of course, dear readers, I told you so, didn’t I…?