Why the Outlook for Molycorp Remains Bearish

I have been maintaining a bearish outlook on rare earth miner Molycorp (NYSE: MCP  ) for quite some time. Lower prices of rare earths and production bottlenecks at Molycorp's Mountain Pass facility have hit the company hard in recent times.

But in a previous article on rare earths, I had observed that prices of rare minerals could spike after reports that Beijing could impose higher taxes on rare earth producers and enact tougher environmental laws from the second half of 2014 to curb illegal rare earth mining activities. Indeed, higher prices would be good news for Molycorp.

Still, the company's shares are still down sharply for the year as investors remain concerned about its weak financials, delays, and production bottlenecks. Apart from these, China's posturing on rare earth mining could also have negative implications for the company in the long term.

Rare earth market and China
China, which accounts for about nine tenths of the world's rare earth supplies, imposed export quotas on rare earth minerals. This led to significant shortage and higher prices in 2010. It also created an urgent need for alternative sources of supplies for rare earths, which are used in a range of products including smartphones and tablets.

Miners such as Molycorp and Australia's Lynas emerged as a result of China's policy of restricting rare earth exports. But just as Molycorp and other miners began production, prices of rare earths plummeted as supply exceeded demand.

As I have noted before, the rare earth market has lot of similarities to the iron ore market. For years, demand exceeded supply in the iron ore market, pushing prices higher and prompting miners such as BHP Billiton (NYSE: BHP  ) and Rio Tinto (NYSE: RIO  ) to increase production. But just as new production has begun hitting the market, demand for iron ore has weakened and there is likely to be a supply glut. Not surprisingly, iron ore prices have fallen sharply this year.

The rare earth market's cause was not helped by the World Trade Organization's (WTO) ruling against China's export restrictions. The WTO back in March had held that China's trade barriers on rare earth exports, which were created in 2010, went against the spirit of free and fair trade. While China initially opposed the WTO's ruling, earlier this month Reuters, citing sources familiar with the matter, reported that China is about to end its controversial quota restrictions and tariffs on rare earth exports.

Prices could rise
The ruling from WTO is not positive for the rare earth market as the removal of restrictions would mean that the market would be flooded with additional supplies. But as I noted in an article here, Chinese authorities may levy higher taxes on rare earth producers starting in the second half of this year.

According to a report in China Daily, the taxes would be levied on the value of rare earths produced rather than the volume. In addition, Chinese ministers are considering issuing environmental compliance certificates for rare earth exports in order to curb illegal and excessive mining. While the removal of export restrictions would have pushed rare earth prices lower, the measures being considered by Chinese authorities such as higher taxes and issuing environmental compliance certificates would actually send rare earth prices higher. This would be a positive for rare earth market and rare earth miners such as Molycorp. But this is not reflected in the performance of Molycorp shares, which are still down more than 50% this year.

The major worry investors have with Molycorp is the company's weak financials and production delays. Indeed, that is a major problem. But China's constantly changing rules on rare earth exports also have negative implications for the company in the long term.

China's changing stance
The introduction of new taxes and regulations for rare earths in the second half of the year by China are expected to drive prices higher. While the move would be positive for the rare earth market in the short term, it could have negative implications in the long term. It was higher prices that had encouraged producers such as Molycorp and Lynas to undertake rare earth projects four years ago. We could see something similar if prices were to rise again. 

Speaking to Bloomberg, Chen Huan, a rare earth analyst at Beijing Antaike Information Development Co., said that higher prices may spur the development of overseas rare earths mining projects. According to Bloomberg, at least 18 companies are looking to start production outside China by the end of the decade. Higher prices might encourage them to ramp up production, which would be negative for prices.

Another concern for rare earth miners is manufacturers switching to alternatives. China's changing stance on supplies has encouraged manufacturers to look for alternatives to rare earths. In fact, demand for rare earths has faded partly due to the fact that manufacturers have found alternatives. Samsung is investing millions of dollars into a research project. Part of the research will be focused on developing alternatives to rare earths. The ongoing development of alternatives could further hurt rare earth demand, which would further hurt prices given that several companies are looking to start production outside China.

For Molycorp, all these developments could mean more problems. I continue to remain bearish on the company and the rare earth market.

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