Why You Should Think Twice Before Investing in Rare Earths

The slowdown in China has hit prices of raw materials hard in 2014. Copper and iron ore prices have slumped in recent weeks, hitting shares of miners such as Rio Tinto Plc (NYSE: RIO  ) and Freeport-McMoRan Copper & Gold (NYSE: FCX  ) . In the past month, shares of Rio Tinto have fallen nearly 12%, while Freeport-McMoRan shares have fallen nearly 7%. More importantly, the outlook for copper and iron ore is weak in the wake of a supply glut and weak demand, which could keep prices under pressure this year. Will rare earth minerals, which have application in industries ranging from clean tech energies, consumer electronics, and defense, meet the same fate?

Outlook for rare earth minerals
Recently, North American rare earth producer Molycorp (NYSE: MCP  ) posted a bigger-than-expected loss per share in its fourth quarter. The company's revenue also came in short of Street expectations. Lower average selling prices for its products coupled with higher costs, put pressure on margins. Not surprisingly, the stock is down more than 5% this year. In the past year, Molycorp shares have fallen more than 12%, even as the S&P 500 has posted gains of more than 21%.

While Molycorp's quarterly results disappointed investors, the company said in its conference call that it expects to perform better in fiscal 2014, citing pick-up in demand and less volatility in prices.

Certainly the U.S. economic environment has been improving, which is underpinned by the ongoing tapering of the bond purchase program by the Federal Reserve. But can we expect rare earths demand to improve in 2014? I am not very convinced. While the macroeconomic condition has certainly improved, there are still a few headwinds that can negatively impact the rare earths markets.

Cautious outlook on rare earths and Molycorp in near term
Recent economic data from the U.S. has been mixed. Much of the disappointing data has been blamed on the severe weather conditions in January and February. That has also been the Fed's assessment as the central bank continued its tapering in the most recent FOMC. Notwithstanding the weak data in the past two months, the economic environment has certainly been improving. But, the recovery in consumer spending, which is the biggest contributor to the U.S. GDP growth, still remains fragile. This is not encouraging news for Molycorp, whose products have applications in many consumer electronic products such as mobile phones, iPods, LCDs, plasma screens, and several other items.

The preliminary reading on the widely followed Thomson Reuters/University of Michigan consumer sentiment index for the month of March fell to 79.9, the lowest level since November. The falling confidence level stems from the fact that U.S. consumers are still nervous after last year's government shutdown, economic derailment caused by severe weather conditions, and rising interest rates. Additionally, the U.S. consumer is still highly indebted and hence the spending will be cautious, which in turn would weaken the demand for consumer electronic goods.

Another reason why I have a cautious outlook on rare earths is China, which is also the world's largest producer of rare earth minerals. Lately, China's economic economic indicators have shown a sharp slowdown in business investments and consumer spending. As I have noted in previous articles, the Chinese economy is rebalancing from investment and exports to consumption. Therefore, in the long-term, this would be a positive for rare earths demand as much of China's rare earth production could be consumed domestically.

But, the rebalancing will have a negative impact on economic growth in the near-term, which is bad news for the rare earths market as it could create a supply glut, thus putting pressure on prices. China's closely watched indicators such as industrial production, factory orders and retail sales have all fallen to multi-year lows during the first two months of the year. The trend is likely to continue for the year as the country looks to bring some structural reforms.

In Japan, Shinzo Abe and the Bank of Japan's unprecedented efforts to shore up the stalling economy by pumping in more money has succeeded in improving consumer spending. But, rare earth metal producers will be disheartened after February's trade figure, which showed that the exports rose by 9.2% year over year in February, missing analysts' estimate of an increase of 12.4%. Japan is one of the leading exporters of electronic items, and a slowdown in exports will hurt demand for rare earths. Molycorp anticipates demand in Japan remaining soft.

Rare earths also have wide applications in the defense industry. A Bloomberg report back in December quoted the Pentagon as saying that the U.S. defense industry will now be less dependent on China for rare earths as home-grown Molycorp starts mining at its Mountain Pass plant in California. This development certainly augurs well for U.S. defense supplies contractors as it will reduce supply disruptions and price volatility.

However, we must remember that following the bipartisan deal, the sequester has come into effect from March 2013, and the Pentagon is expected to slash defense spending by $31 billion in 2014 itself. In 2015, the Pentagon is expected to slash defense spending by another $45 billion. In this backdrop, the Pentagon will not only be forced to cut its military strength but also scrap or scale down many projects involving the manufacture of defense equipment. This again would hurt demand for rare earths.

Bottom line
The outlook for rare earths in the longer-term is definitely positive, given the improvement in the U.S. economy, and China's shift to consumption. But, in the near term there are many issues, which is why I am cautious in my outlook for rare earths and producers Molycorp in the near-term.

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