China’s Clever Little Trick Won't Save Molycorp

Molycorp (NYSE: MCP  ) has been on the receiving end of increasing criticism from bearish reviewers, most of which has been warranted given its performance over the year. The rare earth miner is not only deep in the red, a trend that has held for an extended period now, but it is also trading at around $2, an infinitesimal fraction of the $70-plus highs it touched in 2011, when prices of rare earth were significantly higher.

Molycorp, which posted a net loss of $86 million in the first quarter of 2014 compared with $38.2 million a year earlier, is largely underperforming because of increased rare earth supply in the broader industry—a development that has put downward pressure on pricing. Molycorp's average selling price for its product during the first quarter dropped to $33.69/kg from $44.71/kg the same quarter a year earlier, signaling the downward effect that increased rare earth supply in the industry has had on pricing.

There is however growing speculation that the rare earth pricing situation could improve in favor of Molycorp going forward. Moreover, the arguments to support these conjectures are compelling.

China's clever little trick
A report originated from Reuters, which cites persons with direct knowledge, says that China may soon end rare earth quotas and export tariffs following a ruling from a World Trade Organization panel that found the rules discriminatory. If China, which has close to 90% of all deposits, ends its quotas and tariffs on rare earths, the general consensus is that prices throughout the industry will decline further, which is a negative for rare earth miners.

China, however, has a trick up its sleeve that will maintain high prices for its product while inadvertently placing upward pressure on global rare earth prices. If China loses its appeal against WTO to maintain tariffs and quotas, it may consider imposing new taxes on producers, according to a report on China Daily. Higher taxes, which will be passed down to buyers in the form of higher prices, will offset any downward effect on prices that eliminating tariffs and taxes will have, allowing China to leave the pricing landscape unchanged, or perhaps even pushing prices higher.

Furthermore, the growing dislike for China's tariffs, quotas and now, possible taxes, which are all aimed at maintaining high rare earth prices, underlines the key problem that other producers in areas with less rare earth deposits are facing—China's outrageous rare earth monopoly. In response, a slew of companies are beginning to explore alternatives to rare earth. As fellow Fool Rich Duprey asserted in a previous article, start-ups such as Infinium, which has previously been featured in the MIT Technology Review, is creating rare earth minerals in labs cheaply and cleanly, though at a small scale level.

Back to reality
The reality is that despite the hope that these arguments present, rare earth prices are likely to continue tumbling for the foreseeable future. First, the news of new taxes being imposed in China is still largely unofficial. Despite gaining momentum on mainstream media, reports merely cite persons familiar with the matter, but do not indicate any official communication from the Asian country. The fact remains that China's official bodies have not yet commented on the matter. And even if official communication from China ratifies the prevailing reports, implementation could still be far off, meaning that the downward effect on rare earth prices brought about by possible lifting of quotas and tariffs will prevail for some time before taxes are introduced to rectify the situation.

In addition, the development of new rare earth alternatives, though still in its infancy, is a mixed bag—it bodes both misfortune and great possibilities. It is meaningful to remember that rare earth economics derive largely from production costs. The cost of developing these rare earth alternatives, due to their novelty, is still largely unknown and could turn out to be costly in the long run. This means that despite the new alternatives being touted as cheaper, they may actually attract unseen costs, exacerbating the low-margin situation that increased industry supply has placed on rare earth producers.

It may take a considerable amount of time for rare earth prices to improve, plausibly explaining why Molycorp decided to halt further expansion. This suggests that Molycorp's margins will persist in their discouraging trend going forward, limiting gains in Molycorp's share price. Moreover, the greater impediment to Molycorp's share price appreciation going forward is the fact that concerns are rife that the miner's troubling cash flows could prompt a dilutive equity raise later in 2014. As of February 2012, Molycorp had around 83 million shares outstanding. Today, that number has increased to around 250 million shares following the miner's successive and successful attempts to raise cash to stay afloat. All this has happened against the backdrop of slowed profitability. If Molycorp raises more equity, its shares will be further diluted, and its earnings per share, given its widening losses, will look even worse, making its shares more unattractive than they already are.

Even with all the speculation of impending rare earth price increases, things will get worse for Molycorp before they get better and China's clever little trick is unlikely to save it. For now, it may be best to sell and snap up other more rewarding plays.

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