Jon Hykawy is the head of Global Research with Toronto-based Byron Capital Markets. Few people in the rare earth elements space know more about it than he does. In this exclusive interview with SmallCapPower.com, Jon provides his perspective on China’s new export quotas and reveals Byron Capital’s top picks, plus another name with an intriguing type of deposit.
SmallCapPower.com: Jon, a recent post on RareMetalBlog.com said that despite reports to the contrary, China’s export quotas of rare earth elements (REE) will increase in 2012, if one can believe an announcement made by China’s Ministry of Commerce. Do you believe that report? And, if so, what impact could an increase have on the sector?
Jon Hykawy: First, I absolutely believe the announcements out of the Ministry of Commerce. Over the last few years the Chinese have ably demonstrated that what they say they are going to do with respect to rare earths is what they do.
We had some suspicions that the initial, more stringent quotas that came in 2010 were there for window dressing and were going to be relaxed relatively quickly. But when I attended talks in China about the rare earths industry, they made it plain that these quotas were serious and that they were going to remain in place. That is entirely what has happened since.
What the Chinese are doing right now is what they should do from a marketing perspective. We’ve seen prices of rare earths dropping since about June 2011 largely because buyers are uncertain about supply. Buyers did not know whether the quotas would be going down, going down drastically, or if they would be able to get the material they need to build certain products. As a result, as much as possible, buyers were either using technology substitutions or material substitutions, to lower their need for rare earths.
The knee-jerk reaction that you get if prices start to fall – and it was highlighted in some reports out of China – is, “we should further limit the quotas because that’ll drive prices back up.” But that’s like saying, “ridership on Toronto’s transit system is down, therefore we should raise prices!” That’s not going to have more people riding the subway. That’s likely actually going to drive down subway ridership even more. Similarly, dropping the quotas and raising the prices would likely drive REE demand down even further.
What the Chinese have done is entirely correct. They’ve emphasized stability. They’ve emphasized reliability of supply. As a result, the prices of rare earths should stabilize and the people who can afford to use them are going to be able to use them. I think that’s a very good thing for the sector.
SmallCapPower.com: In essence, they’ve strengthened their position by making things clearer.
Jon Hykawy: Yes. One of the basic principles of marketing is that you want people to understand your position. And you want people to be able to rely on that position. If you say that you’re going to supply a certain amount of material, then you supply that amount of material. Chinese officials have said that these quotas are something that you can rely on.
SmallCapPower.com: We’ve seen some recent reports about the environmental degradation involved with the mining of rare earths, especially in China. But Chinese officials say that the country is committed to cleaning up its rare earths sector, and as part of that strategy a 2012 export license has not been issued to Inner Mongolia Baotou Steel Rare-Earth Co., which operates the Baiyunebo rare earths mine in Inner Mongolia – one of the most prolific mines of its kind. Do you believe that China is serious about cleaning up its rare earths sector? Or is this window dressing?
Jon Hykawy: You have to differentiate between different portions of the Chinese rare earths industry. First, there is the supply of heavy rare earths coming from the ionic clays in Southern China. As far as I know, I’m one of the very few people in the west that has actually visited working ionic clay mines. Because the ionic clays are the strange deposits that they are, the Chinese are using in-situ recovery to extract those rare earths. In effect they’re doing the mining and the hydrometallurgy in one step, which is why these mines are such inexpensive producers of heavy rare earths. They’re using in-situ recovery chemicals that are essentially benign. They’re effectively using fertilizers and other things that are going to cause as little environmental damage as possible.
In the north, where you’ve got Baotou Steel Rare Earth Co. and other companies operating, the rare earths are produced as a byproduct of iron mining. And there is a lot of chemical processing involved. Frankly, when these companies started, there wasn’t a lot of effort being put into environmental stabilization and clean up. And those businesses are quite environmentally damaging.
In a lot of areas of the economy, the Chinese are putting their money where their mouth is. They’re requiring people to do things that are more expensive now but that have a long-term benefit. They’ve emphasized high-efficiency lighting in government offices and are spreading that through the entire commercial sector. They’ve emphasized alternative energy, with the emphasis on solar and wind power. They’re looking to do just about anything they can do to drive down the use of coal because they want to clean things up. I think this is real. And if Baotou doesn’t pass its environmental survey by July, the ministry has said is that any quota that was going to be extended to Baotou Steel will be reallocated to other companies in the rare earths space that have passed their environmental audits.
SmallCapPower.com: A report published recently said that the IPOs now done in China are outnumbering the IPOs done in the United States. Are we going to see more rare earths companies doing IPOs and financings in China versus North America?
Jon Hykawy: It’s entirely possible. We know of many private companies with very good technology in very good deposits in China. We’ve seen some very lofty valuations given to Chinese companies in the “green metal” space when compared with what they could possibly receive in North American markets. I think it’s safe to say you’ve got a bit of a bubble in China’s resource sector, and especially in the “green metals” or “electric metals” area. That’s something that we’re going to continue to see evolve through 2012 and 2013.
SmallCapPower.com: When it comes to rare earths we often hear about the exploding demand for heavy rare earths for their use in rare earth magnets and military technologies. But in a recent Byron Capital Markets report, you argue that cerium and lanthanum, both of which are light rare earths, will be key drivers of the prices for the other rare earths. Can you explain that?
Jon Hykawy: Sure. When you look at a company like Molycorp Inc. (NYSE:MCP) or Lynas Corp. (ASX:LYC), a goodly fraction of the rare earths oxides that they’re going to produce are cerium and lanthanum. That’s just a function of the way the universe works. Cerium and lanthanum are far more common than the other rare earths. In the case of Molycorp, you’ll have 83 or 84% of its rare earths being cerium and lanthanum oxides. If you can’t sell those or if you can’t sell them at a decent price, then basically what you’re doing is you’re transferring the economic onus to all the other rare earths. So, in effect you’re asking 15 or 16% of your rare earths to pay for everything. In doing so, the prices asked for materials such as neodymium or dysprosium are probably going to rise.
One of the key concerns that we have about the sector moving forward is a likely long-term glut of cerium and lanthanum oxide in the space, both from China as well as from however many companies are producing in the West. That will dramatically drive down the price for cerium and lanthanum oxide below their historical trading ranges, which is between US$5.00 to US$6.00 per kilogram (kg). It’s certainly not the US$150/kg that we saw at the peak of the market not that long ago.
Given that, we believe you’ve got to make sure that any company that you’re going to invest in can, in effect, carry the economic ball with the amount of magnet materials, like neodymium and praseodymium, and the amount of heavy rare earths, like dysprosium, terbium and europium, that the company is going to produce. Companies are not going to be able to pay their way with cerium and lanthanum.
SmallCapPower.com: One unsettling trend in the REE space, at least if you’re an investor, is the substitution of other technologies for rare earth-based magnets. One example is Toyota Motor Corp., (NYSE:TM), which chose to use an induction motor using no magnets in Toyota’s new Rav4 Electric. Why are companies finding alternatives to REE and is that trend likely to continue?
Jon Hykawy: There are basic reasons why anyone would look for a substitute. The main ones are either economic or manufacturing related. If the prices go too high for the raw materials or for the components required, then you’re going to substitute them out, either using a material substitution or a technology substitution. And if the supply risk is too high from a manufacturability point of view, then you simply won’t use that design. Toyota obviously used permanent magnets in the electric motors used in the Prius and continues to use them for the new Prius Plug-in Hybrid. The reasons why manufacturers are moving these materials out depend on the particular industry.
For example, we’ve seen good evidence that lanthanum oxide demand has dropped dramatically in the fluid cracking catalyst (FCC) space. FCCs are used to process heavy oils into gasoline, diesel and other products. The reason is based largely on price. At US$150/kg at the peak, compared to their historical price of US$5/kg or US$6/kg, there was no reason for companies to continue to try to use lanthanum. Lanthanum is an OK catalyst, but what the petroleum industry liked most was that it was cheap and available. If it’s no longer cheap or reliably available, you’re going to use other catalytic metals.
In the case of the Rav4 Electric, I think that decision was primarily based on the future supply risk regarding rare earth elements like neodymium. Even at the peak cost of US$300/kg or so, neodymium was a good choice to use in the magnets of the motors for electric vehicles. But if you suddenly can’t get that neodymium, the result is going to be an idle plant and a whole lot of losses.
As we move through 2012 that trend is probably not going to continue. We will see a number of companies bringing rare earths to market outside of China as well as the stabilization in the quotas from China, which we’ve already seen evidence of.
SmallCapPower.com: Which projects will likely reach commercial production in 2012?
Jon Hykawy: There’s good reason to expect that Lynas will see its pre-operating licenses approved in Malaysia and be able to start some level of production in 2012. We cover Lynas, but we have a “sell” rating on it because we just don’t see how the company is going to return sufficient cash flow to investors given where we think rare earths pricing is going. And Lynas is only going to produce separated and purified oxides versus any downstream products.
We also expect Great Western Minerals Group Ltd. (TSX.V:GWG) to begin mining at Steenkampskraal in South Africa by the end of the first half of 2012 and likely have a solvent-extraction plant built with their Chinese partners between Q3 and early Q4 2012.
Molycorp should certainly be able to reach production in 2012 as well. So, by 2013, there should be at least three western companies, perhaps even four counting one private company operating in Turkey, in production of some meaningful quantity of rare earths. And that’s going to do nothing but increase buyers’ willingness to rely on rare earths as the supply starts to pick up outside of China.
SmallCapPower.com: What are Byron Capital’s top three picks in the REE space?
Jon Hykawy: Our absolute top pick in the space would be Saskatoon-based Great Western Minerals Group. This is a company that is still overlooked by a large portion of the investors interested in the rare earths space. It is a downstream manufacturer of advanced rare earth alloys, rather than a simple miner. The only reason that the company is reopening a mine in South Africa is because of uncertainty with respect to getting the supply of materials that they need to make magnet alloys. Without being able to reliably get neodymium and dysprosium from the Chinese – an issue that they saw years ago – the least expensive way for GWG to reliably get those materials was to reopen a mine.
But what people don’t really appreciate is the leverage that’s given to anybody participating in this downstream space. A company making good magnet alloys, which are necessary to make really high-quality rare earth magnets, can expect to sell those alloys for up to US$300/kg. This is an alloy that only contains about 30% neodymium. The rest of the material is relatively cheap iron and boron. So, even at the peak of neodymium pricing, these magnets contained about US$100 of neodymium. That means you’re selling US$100 of neodymium for US$300. That’s not bad leverage. But when Steenkampskraal reaches production, my estimates for Great Western would suggest that this sort of US$300/kg alloy could be produced by GWG for probably less than US$15/kg or US$20/kg.
And in no circumstance do we see the price for high-quality magnet alloys dropping below US$100/kg. So, if you’re looking at an $80 or $85 margin on one kilogram of magnet alloy, you’re not doing too badly. The cash flow that a company like GWG can generate is fairly robust.
SmallCapPower.com: What’s your 12-month target on GWG?
Jon Hykawy: Currently it’s $3.40, which looks a little extravagant compared to the trading range that it’s in but, frankly, it still only represents a $1 billion to $1.5 billion market cap, and this is a company that we believe, when it’s in full production, will generate cash flow of $300 - $400 million a year.
SmallCapPower.com: And your second pick?
Jon Hykawy: Our second pick actually is one that we’ve had a “sell” on for a long time, but the market has chosen to drive the stock down to the point where we actually believe there’s considerable value in it, and that’s Molycorp.
Molycorp, too, is a downstream producer. And, again, we think that is very important because if you follow the pricing through, what we see is that magnet-making is a very good multiplier for revenue. Molycorp just recently signed a joint-venture agreement with two Japanese companies that will see the partners take the lanthanum and cerium output from Molycorp’s Mountain Pass mine in California and sell that to partners interested in taking that material and putting it into the catalyst space.
But once Molycorp starts producing neodymium, it will then take that through its supply chain all the way to building magnets, adding value at each level. We could see Molycorp cash flowing at US$500 million a year once it’s in Phase Two of production. And that easily supports the target that we have on them, which is $40 at this point.
SmallCapPower.com: And your third pick?
Jon Hykawy: The third name we like is Matamec Explorations Inc. (TSX.V:MAT). It has been criticized lately for the deal that it did with Toyota Tsusho. But it is a very interesting name to us because of the very simple metallurgy that’s associated with their deposits. The deposits that comprise Matamec’s Kipawa project are relatively low-grade but have a high percentage of heavy rare earths. Once Matamec is in production, it will produce a larger volume of heavy rare earths than either Great Western Minerals Group or Molycorp. But Matamec likely won’t be in full production of finished concentrates until sometime in 2015.
But this pick is really about the metallurgy, which is very straightforward. All Matamec is doing is using a magnetic separation technique to upgrade their milled ore. They then take the rare earth concentrate and put it in sulphuric acid at room temperature for a couple of hours. The acid consumption is very low, and there’s no heat involved. That means the cost of their hydrometallurgy is very low. And so Matamec should eventually reap the advantages of selling valuable heavy rare earths with very low processing costs.
SmallCapPower.com: Do you believe that Matamec President Andre Gauthier secured enough in return for what he gave up to Toyota Tsusho?
Jon Hykawy: I’ve had discussions with him about that. I think it’s fair to say we believe that they could have received more. On the other hand, the argument that we’ve been given and one that we have to agree with is that the rare earths space includes about 400 names that are all trying to come to market and the rare earths industry can’t support 400 new projects. To reach production, a rare earths mine has to have four things: a tractable deposit; an economic deposit; a customer for its end-product, and the financing to build it. Without all of those, you don’t have a mine. What Matamec gained in signing its agreement with Toyota Tsusho – and doing the best deal that they believed they could do at the time – is access to financing and access to the customer. And that means that Kipawa is fully on track to become a mine. Not too many other companies in this space can say that. And you can’t quibble with the fact that you’ve still got a good investment return for shareholders. Our target on the company is $0.95 and carry a “buy” recommendation on it because, frankly, that’s what their portion of this project is worth.
SmallCapPower.com: Is there another name in the space that people probably have not heard about?
Jon Hykawy: There is a private company out of Turkey called AMR. This is a company that is processing a clay deposit in Turkey. That clay deposit contains a high proportion of what’s called micronized magnetite. It’s effectively iron oxide that’s very finely ground. And it’s that way naturally. That material is used in the cleaning of thermal coal. The choice for the coal manufacturers is either you take iron ore and you mill it down yourself, or you buy this material from a company like AMR. AMR secures a decent return just doing that. But they found that the heavy mineral concentrates within the clay also contain niobium, scandium, rare earths and a number of other valuable metals. And they’ve discovered that they can extract those different metals very economically. AMR is already in production of small quantities of some of these materials and it will be ramping up that production pretty dramatically through 2012. We believe AMR could be another supplier of light rare earths as early as 2013.
SmallCapPower.com: Is AMR likely to do an IPO?
Jon Hykawy: It’s possible. There’s enough interest from strategic investors and other involved parties that any public listing could be pushed off for a long period of time. A lot of people are just interested in securing supply; they’re not interested in public listings.
SmallCapPower.com: Is there another below-the-radar name that is publicly listed?
Jon Hykawy: Sure, Tantalus Rare Earths AG, which trades on the Frankfurt exchange. Again, we have no recommendation or target on it, but it’s indicative of a very interesting development in this space. Tantalus has a clay deposit well located in Madagascar. What’s most interesting about this clay deposit, though, is that it’s shown signs that indicate that it’s analogous to the ionic clays in Southern China. So, it’s a deposit that tends toward the heavy rare earths. But it’s a deposit that you can use chemicals like fertilizers on, and recover the rare earths directly from the clays. So there’s no need to mine a hard rock, crush and grind it, apply heat, apply concentrated acids and a bunch of other expensive techniques, to try and break the rare earths out. You simply take this clay, pour something like citric acid on it, and rare earths run out the bottom. And that’s what happens with the Chinese clays, and that’s why they’re as inexpensive a source of heavy rare earths as they are. This really looks to be one of the very first ionic clays identified outside of China.
SmallCapPower.com: Sounds fascinating, Jon. Perhaps we’ll learn more about Tantalus the next time we talk with you. Thank you for talking with us today.
Interview Disclosure: This interview was conducted by Brian Sylvester on behalf of SmallCapPower.com. Mr. Sylvester and/or his family may own shares of the companies mentioned in this interview.
Jon Hykawy may/may not own shares in all of the companies mentioned in this interview.
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