Is Our Reliance on This Chinese Import a Threat to National Security?

A recent Department of Defense report on rare earth elements (REE) has raised the question of importing an essential commodity from China and the impact on national security. Almost 95% of REEs consumed by U.S. industry come from China. This poses two concerns for investors if the supply is interrupted: First, how will U.S. manufacturing be affected? And second, how will national security be affected?

The U.S. tech industry relies heavily on REEs for everything from touch screens to missile guidance systems built by Raytheon (NYSE: RTN  ) . There is a greater domestic civilian demand for REEs than DoD demand, primarily due to budget cuts. The recent two-year budget will give the DoD a bump in 2014 but will see further cuts in 2015. The U.S. also doesn't have a growing need for missiles since there is a lack of engagement in any conflicts that require armaments and assets that rely on the use of REEs. Currently, the DoD only uses 5% of REEs, which can easily be found in domestic production supply chains.

Chinese monopoly
In addition to exporting 95% of REEs to U.S. markets, approximately 80% of world demand for REEs is met by Chinese sources; this is critical to strategic industries. With the market position that Beijing has, it has begun to regulate the industry. The Wall Street Journal has noted that roughly 80% of Chinese mining operations from extraction to processing are unlicensed, and are therefore unmonitored. The REE economy within China is about to become a command economy, with the state becoming a majority stakeholder. State-owned Inner Mongolia Baotou Steel Rare-Earth Group Hi-Tech Co. has recently acquired nine mining companies with the purpose of controlling output.

Impact on U.S. strategic industries
In a recent analysis of REEs, the Congressional Research Service (CRS) noted that "the United States was once self-reliant in domestically produced REEs, but over the past 15 years has become 100% reliant on imports, primarily from China, because of lower-cost operations."

A strategy to ensure that the U.S. has options for REE supplies within its strategic industries will be driven by the market and legislation.

Opportunities for domestic extraction and production of REEs will prove lucrative for investors. Unfortunately, the REE supply chain in the U.S. is not as sophisticated as that which is found in China. With time and investments, however, the supply chain will be able to handle any projected demand.

Molycorp (NYSE: MCP  ) is the primary company in the continental U.S. that mines REEs. It has recently expanded its operations in California by opening a cracking plant. This is a significant move for the REE industry, as cracking plants are an essential component in the chemical refining process of various REEs to make them useable in industrial applications. This plant is part of a greater effort located in the Mountain Pass facility by Molycorp to create more affordable unit costs.

Unlike other companies around the world that deal in REEs, Molycorp is the only one that "controls a world-class REE resource and can produce high-purity, custom engineered REE products to meet increasingly demanding customer specifications." This places Molycorp in a unique position among its peers that will provide potentially lucrative opportunities for investors over the long term.

The Mountain Pass facility is expected to become fully operational in 2014, producing 19,050 metric tons per year. This will more than satisfy the current demand in the U.S. for REEs.

Partnerships with (or acquisitions of) REE suppliers in Canada and Australia are part of the ability of the U.S. to remain independent of the growing Chinese state-owned industries. The recent acquisition of Neo Materials Technology, which was renamed Moly Canada and ironically has facilities in China, could prove problematic if Beijing continues its plans of nationalizing the Chinese REE industry.

Legislative controls
The U.S. has put forth two significant legal controls to ensure the supply of REEs. In 2012, the Obama administration filed a case with the World Trade Organization (WTO) against China, citing unfair trade practices. This case is ongoing and has the potential to isolate the U.S. from its primary supplier of REEs.

In September, the House of Representatives passed the bill H.R. 716, The National Strategic and Critical Minerals Production Act of 2013. This bill was designed to protect critical REEs. The USGS will also need to have a funded survey to further understand the limits and opportunities of REEs.

The cost of demand
Demand has decreased in the U.S. in recent years. In 2006, China exported 24,239 metric tons of REEs. Just four years later, demand fell to 13,907 metric tons. Even though the demand has decreased, the cost has risen from $42 million to $129 million.

Recent tensions with China
When China asserted itself over maritime claims, it positioned Japan to seek REE from other sources -- preferably non-Chinese sources. There is a growing fear that Japan will put in place a trade embargo against Chinese goods, which would create opportunities for other suppliers such as the Australia-based Lynas (NASDAQOTH: LYSDY  ) and Molycorp.

Investors take note
It will take time to rebuild the REE supply chain in the United States. With growing dissatisfaction regarding the Chinese monopoly on REEs, a need has been identified and an opportunity has been created. Many former regional buyers that have been longtime consumers of Chinese REEs are rethinking their strategies and looking elsewhere. The opportunity for investors to get in on the ground floor of a growing industry is seen in the revitalization of a long-dormant industry. It will take time to see any significant ROI, but as the momentum grows so will the potential for a positive ROI.

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