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I Feel the (Rare) Earth Move Under My Feet

Sara E. Wright
April 20, 2012

This month China announced the formation of a rare-earth industry association. After a series of other moves aimed at protecting its scarce and essential rare-earth resources, this should alarm investors, but it could lead to some potential opportunities. Investors' ability to profit will depend on their tolerance for the seismic activity in this space.

Rare earth: uncommon dirt?
Let's pause here to define what we're talking about. Rare-earth elements are prized for their magnetism, luminescence, and strength. Manufacturers use them in a stunning array of products, from smartphones to wind turbines to hybrid cars. No rare earths, no Angry Birds. For something so scarce and inaccessible, rare earths are ubiquitous in our everyday lives.

In the 80s the U.S. was the dominant source of rare earths. Since then it has lost nearly all of its capacity, and become almost completely dependent on imports for this precious resource.

The Manchurian element
China produces 97% of these elements and enjoys 99% of global separation capacity -- whereby the elements are separated from one another into useful form -- even though the country is home to only 50% of global reserves.

China has been tightening supply on rare earths for some time now. Many investors remember 2009, when the country set serious export quotas on these elements, much to the concern of foreign companies dependent on the flow of raw materials. This latest move to create an industry association was reportedly designed to consolidate a sprawling industry and manage the environmental risks of ore extraction. Cynics see an attempt to shore up production for domestic use.

Rare-earth specialists expect Chinese domestic demand to catch up with supply around 2015. That would leave a huge shortfall of a vital raw material for countries like the U.S. People should be a lot more concerned about this than they seem to be. Did I mention that rare earths are critical to many essential military applications?

Dig it up and sell it, right?
Let's consider the rare-earth value chain. Making money in this space is not as simple as digging stuff out of the ground and selling it. If you were grabbing your prospecting tools and heading for the hills, please reconsider. Mining is just the first stage of the value chain. Once the ores are extracted, they need to be separated into their valuable components, which sometimes exist in very small concentrations. After separation, the resulting oxides are refined into metal. Still not finished. Those metals are fabricated into alloys, and only then can magnets and other components be manufactured for use in finished products.

This is important, because experts believe that unless the U.S. has domestic or friendly capacity at every level of this value chain, the country will be vulnerable. Remember how I mentioned projections that Chinese domestic supply and demand would converge? That doesn't leave much for the rest of us.

Replace, reduce, or recycle
Some end users have responded by pursuing a "replace, reduce, or recycle" approach to their rare-earth inputs. Toyota's (NYSE: TM  ) Prius probably incorporates more rare earths than any other product. In January, Toyota announced that it had developed a new techn