Prudence in the Rare Earths Market

“What is going on with rare earths?” reads the email from a slightly panicked reader. “They are just plunging to death, and I am afraid they are taking me with them.”

We don’t usually start with reader mail, but this is a timely issue, as evidenced by this chart. It’s of the sector’s darling stocks, Molycorp.

Molycorp's Performance Since Its July 2010 IPO

Molycorp is one of three rare earth stocks this reader says he owns…and is mighty worried about. “The fundamentals are there (or at least I thought so) to support a continued uptrend, but this bear market since they topped on Jan. 3 is killing me. What gives?”

It’s true, the fundamentals are there. Just today, as China’s president Hu meets with President Obama in Washington, Chinese statistics revealed a 9.3% drop in rare earth exports between 2009 and 2010.

That’s a big deal, since China produces 97% of world supply. And without rare earths, a lot of things we take for granted just wouldn’t exist – everything from your mobile phone…to your car’s catalytic converter…to the Pentagon’s precision-guided missiles.

“You could make a lot of money investing in rare earths,” says Byron King, editor of Energy and Scarcity Investor… And here comes the caveat… “if you can handle a lot of risk. And I mean a LOT of risk.”

Byron knows rare earths as well as anyone. He first alerted readers of The 5 Minute Forecast to their potential on March 31, 2008 – years before the Chinese made headlines by clamping down on rare earth exports. Last October, he spoke at a conference in Washington, DC, that gathered rare earth specialists from around the world.

He keenly follows the companies trying to bring mines into production outside of China. And the potential is immense. But just because “the fundamentals are there,” in our reader’s words, investing in the space is not a slam-dunk.

“Right now, there are about 200 distinct rare earths investment ‘ideas’ out there,” says Byron. “The promoters will all tell you about their great acreage, their drill program, the core results, the processing research they’re doing.

“But are there really 200 sets of great managers in a sector that’s been dead as a doornail in the West for two decades? How many of these guys can succeed in a short time, in a tight investment space, with immense capital requirements (many billions!) and with ultra-complex engineering challenges?”

There’s still no publicly traded Western company that has a mine or a refinery up and running, much less product to sell. “All of the publicly traded investment ideas – even the best of them, and some are quite good – are speculative ventures on future output.” Which gets us back to Molycorp.

“I recommended Molycorp in Energy & Scarcity Investor last September, when it was selling at $18.90 per share,” says Byron. “Molycorp has enjoyed a serious run-up and a huge gain. Indeed, that’s the problem. Too far, too fast, too much. It was a Molycorp melt-up.”

Byron told readers to sell a week ago today, for a gain of 178%. “I like the company. I like the ore deposit at Mountain Pass, California. I’ve met the CEO and the chairman of the board and I like them and respect them. I like the other members of management whom I’ve met. There’s nothing not to like about Molycorp, except its current share price.”

Getting to the core of our reader’s concern, “Molycorp shares have outrun the fundamentals of whatever it can accomplish,” Byron concludes, “even under the VERY best assumptions. The market is valuing Molycorp – just one company – at nearly the revenue for the entire rare earths industry.”

Thus, he sees MCP falling to $25-30 over the next two or three months.

So is this the end of the rare earths story? Hardly. But the reality is inescapable here in early 2011: The rare earth game has changed. Investors have to get smarter about rare earths…and choosier about where to put their money.

Dave Gonigam
for The Daily Reckoning

The Daily Reckoning