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Rare Earth Elements (REE) Discussion
The misguided notion about rare metals is that, it is referred to as if is just one type of metal. This couldn’t be further from the truth. REE is actually comprised of 17 different metals. They each have different properties, different supply and demand and differ in cost.
You can then divide the group of 17 metals into two categories; light and heavy.
If you own a mobile phone, LCD/LED TV or Toyota Prius, have taken a flight or even pointed a laser at somebody, then you’ve used a product containing rare metals. These are just some of the products that need rare metals in order to function. Most of these items you probably can’t live without nowadays.
But it doesn’t end here. REE has an enormous range of uses from basic products to defense applications and the increasingly growing new energy segment. Without such metals, you’ll be using a phone the size of a brick, a laptop you need to haul around in a luggage case and a wide screen TV that takes up half your living room.
Just take a look at the table below and for now, note the green underlines.
Supply and Demand
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Contrary to the world “rare”, all of the 17 metals are very common on the earths crust. Dig a little into the ground and you may possibly come across some rare metals.
The problem however, is that these metals are rarely concentrated into a single region for easy or economical mining. It is scattered throughout the world and the deposits that do exist are either financially impossible to mine and/or unsafe as rare earth mineral deposits contain thorium which is radioactive.
The US now imports 100% of its rare metals and it is likely to stay that way for several more years until Molycorp (NYSE:MCP) brings into production the reopened Mountain Pass property.
For any country in terms of politics, China producing 97% of the supply is a horrifying number, but since I’m talking about an investment here, this 97% figure could actually be a blessing.
China is playing its monopoly on REE extremely well. They have continually cut export quota driving up prices and profiting enormously. As long as China keeps its stranglehold on REE, don’t expect prices to fall. Remember that these are metals that cannot be replaced so companies must buy it.
Along with Molycorp, Lynas (ASX:LYC) is an Australian miner working to produce rare metals of its own. Both companies expect to be online within the next year or so, but there is a saying in mining that if there is something that can go wrong, then it will. Plus it gets even worse for rare earth miners because you can’t just dig up lumps of metal. These metals may be in the form of dust and grains when mined, and if there are 17 metals all mixed together in a heap, each metal must then be separated.
This means a whole lot of chemical processing and strong magnets are required for separation which only adds to the cost and complexity. That’s why investing in the rare earth miners is a big no no at the moment.
The current demand for REE is around 134,ooo tons per year with global production around 124,000 tons per year. The difference is covered by inventory as you can see in the above table, but as the world gets smarter, quicker, more efficient and more advanced, the demand will definitely rise. Demand is already projected to 180,000 tons by 2012 and by 2014, it’s expected that demand could exceed 200,000 tons a year.
However, the quotas do not differentiate between each of the REE’s and even China is finding it difficult to find heavy REE’s.
Source: Dacha Aug 2011 corporate presentation
In an effort by the Chinese government to crack down on mines exceeding the production permits, many mines have now stopped operations. There are reports that the 2011 quota of 93,800 tons has been reached and rare earth separation plants have already suspended production at the majority of its smelters in a bid to meet new environmental standards.
“The majority of rare earth separation plants have suspended production for around one month, and are upgrading their facilities and technology to meet the government’s higher standards,” a spokesman for the Jiangsu Rare Earth Association, surnamed Cai, told Reuters.” – Reuters
The Chinese government agency, the Ministry of Land and Resources, invoked a seldom-used mining law to take direct control of 11 rare earth mining districts in southern China. This has resulted in 30% of the mines in southern China ceasing operations. However, I still expect output to exceed the quota which is usually the case, but the demand is still going to be there with limited supply.
Most of the heavy rare earths come from an unusual geological formation that straddles the hilly, sometimes lawless southern border area of Jiangxi Province with Guangdong Province. According to geologists, it is the only known commercial deposit of rare earths in the world that has virtually no contamination from thorium, which is radioactive.
Many companies in the West indirectly depend on illegal mining and smuggling. Industry experts estimate that illegal production accounts for about a seventh of the supply of light rare earths in the world and as much as half of heavy rare earths. – Midas Letter
The end of the year is approaching which is when manufacturers start to increase production for Christmas as well as the new year, which will continue the demand for REE.
Light vs Heavy Rare Earth Elements
Getting back to those green underlines from the first table, let’s see what Molycorp and Lynas will produce in the REE group.
- Mines in China produces both light and heavy metals.
- Molycorp will produce light metals. In fact 99% of total production will be light metals.
- Lynas will produce light metals. 98% of total production will be light metals.
Notice something?
That’s right. Molycorp and Lynas will not produce any heavy metals. Unlike the light metal market that is likely going to get flooded by Molycorp and Lynas, heavy REE supply will continue to be dominated by China and companies like Samsung, Sony, Toshiba and Toyota will want alternative sellers.
Just as an example, Dysprosium (Dy) is a heavy REE that goes into the Toyota Prius. The Prius requires merely 100g of it which costs about $160 in a $24k+ car, but without it, there is no Prius.
Heavy REE applications are virtually impossible to replace.
Even if you’re not into mining and commodities, I hope you’ve grasped the potential of the Rare Metals industry, because this is where Dacha Strategic Metals (OTC:DCHAF)comes in.
Dacha: The Pure Play to REE
Dacha is an extremely easy to understand business. It strategically buys/accumulates heavy REE from the Chinese market and stores the physical oxide (powder form) and metal in its warehouses in China and South Korea. Dacha is able to trade REE with China due to a small Chinese trading company it bought in fiscal 2011.
That’s about as easy a business model as it gets. Dacha does not explore, mine, or produce any of its metals. The risk of the whole exploration and producing phases are non existent.
Another point that adds to Dacha’s undervaluation is that just until 2010, Dacha was mostly an investment holding company. The company lost money on its investments, decided that it wasn’t the next Berkshire Hathaway and proceeded to change the direction of the company. If you take time to go through the SEDAR (Canadian equivalent to the US Edgar), you will notice large losses which makes it seem like this is a deadbeat company.
You can read what they do in more detail from their corporate profile.
Who are the Insiders and are they Trustworthy?
When it comes to any commodity company, I’ve come to understand that management is crucial.
I have to admit that I am not the best judge of character when I’ve never met the people or spoke with them, but there is one person you need to be aware of, and that is Stan Bharti, the executive chairman.
Stan Bharti is the founder of a private merchant bank called Forbes and Manhattan (F&M) which invests in exploration companies and junior. What’s impressive is that F&M performs all of their analysis on potential companies in house. They have their own geologists, analysts, investment lawyers, M&A specialists, stock analysts and anyone else you would need to run a successful investment company, and by performing their own in depth analysis and field visits, F&M is able to decide which company has potential. Dacha just so happens to be one of those companies in their portfolio.
Stan Bharti and the current CEO Scott Moore came on the board after F&M’s private placement in Dacha. These two men decided there was more potential changing Dacha from an investment holding company to a REE holding company. Look at all the warrants and options they have, both these men are in it to win it.
Here’s a profile article on Stan (broken link). Like most articles, it’s all positive stuff, but it’s something to keep in mind.
One thing to be concerned about is that because Stan is on the board of so many companies and has a strong position in the company, there are related party transactions to know about. Dacha provided a loan back to F&M but from the wording in the filings, it looks as if Dacha doesn’t mind not being repaid.
During the year ended March 31, 2011, the Company extended the maturity date on the loan outstanding to FAMCo to April 30, 2011 and advanced an additional $118,625 under the facility. At March 31, 2011, the principal outstanding was $3,056,118. Subsequent to March 31, 2011 the loan was extend an additional six months, to October 31, 2011. FAMCo currently does not have sufficient current net assets to repay the secured debenture and has no operating cash flow to service the interest payments. The payment of interest on the secured debenture and the repayment of the principal are dependent on FAMCo’s successful implementation of its business plan or the sale of its assets.
Dacha has the option, exercisable at any time, to convert the principal amount outstanding into 33% of the outstanding security of FAMCo as at the time of conversion. As at March 31, 2011, accrued interest of $440,203 (2010 – $77,090) related to the loan was included in amounts receivable. As at March 31, 2011, the Company has reviewed the recoverability of the FAMCo loan and has determined that no impairment is required.
Risk – What’s the Catch?
As good as Dacha sounds, it isn’t without risk. Dacha certainly isn’t for everyone.
- Valuation is dependent on REE pricing. The price of REE has gone parabolic and you could believe that prices are inflated. If REE prices come down, so too does the value of Dacha.
- Exchange rate risk. Dacha is a Canadian company and so the reporting figures are all in Canadian dollars.
- Foreign operations in China could come under further regulation making it difficult for Dacha to stock pile the needed metals.
- Although the company made $0.33 EPS profit, this could be a one time thing with the price of REE being so high.
- Big concentration in metal portfolio. Terbium oxide: 30-40%, Dysprosium metal: 35-45%, Yttrium oxide: 5-10%, Gdolimium & Lutetium: 5-10%, and Europium: 10-15%.
- Stan Bharti’s influence over the company.
- Dacha could continue to be recognized more like an ETF of REE as opposed to a heavy REE metal buyer/seller.
Valuation
Like all commodities, valuation is dependent on the pricing of the metals. REE prices are quoted on Metal Pages and is one of two sources where Dacha and many of the companies in the industry get their pricing.
Here is the last quoted inventory value on Dacha’s website. (An updated price quote was released the day after I wrote this with the asset value being very similar.)
Based on this information and the numbers from the latest reports, I come up with the following valuation which shows Dacha to be 40% undervalued to its Net Asset Value on a fully diluted basis.
August is a typically a quiet month for REE’s and let’s say that the entire inventory value dropped 20%. Even still, Dacha is at a 26% discount to Net Asset Value.
Additional Opinions
Matt Gowing, Mackie Research (8/22/11) “Dacha Strategic Metals Inc. remains significantly undervalued. . .and the company has been successful in timing its rare earth purchases. As a result, Dacha has seen significant gains in its rare earth inventory (current inventory value of $150M versus $30M in December 2010); in addition, the company only has to pay a corporate tax of 2.5% due to its offices in Barbados. Hence, Dacha’s corporate structure will allow it to realize higher after-tax profits from its transactions.”
The Critical Metals Report Interview with Jon Hykawy (8/2/11) “Dacha is dealing with materials that are generally bought and sold in smaller quantities; a few tons at a time rather than hundreds of tons. They sell to a group of customers who typically buy their material on a regular schedule. It’s not the sort of material and not the group of manufacturers that are likely to sign a big-name offtake agreement. Dacha likely has a place in the market moving forward for a long time yet. . .So far, company management has done very well. . .Inside or outside of China, we’re likely to see continued price appreciation in the materials that Dacha holds through most of 2012.” More >
Dacha Capital: A Discussion With Patrick Wong by Gareth Hatch (7/22/11) “Well it’s not that our model includes or assumes some sort of price discovery. Our model tries to identify situations where risk is limited and upside price appreciation is much higher. Part of this is finding these ‘pinch points’, and the belief that the process of price discovery will create more efficient markets, and therefore a better recognition of value. We believe people may be getting price transparency and price discovery confused. Dacha views price transparency as a means of pricing data to be a true representation of the market at that time, while price discovery is the process of markets identifying or recognizing fair value for assets.” More >
Closing Thoughts…
China is in complete control of REE which has in turn become a political issue. At the moment, even the quickest production schedule isn’t expected until 2014, but even still, it doesn’t address supply for heavy REE’s, only light REE’s.
The world will continue to become more sophisticated. Smartphones are beginning to enter the 3rd world countries, LCD TV’s used to cost $10k but is now a commodity, and the demand for defense and green energy is high on the list.
The world needs REE’s and I’m betting that Dacha will be able to capitalize on this demand.
Disclosure
I hold shares of DCHAF at the time of this writing.
