The World Trade Organization (WTO) on Wednesday ruled against China in a case related to its policy of imposing duties on rare earth exports as it was a violation of the WTO agreement. The ruling will have a major impact on the rare earth market by possibly increasing supplies. This will further push prices down given the weak demand environment. As a result, my outlook for North American rare earth producer Molycorp (NYSE: MCP) is now even more cautious in the near-term.

WTO ruling
The case, which was filed by the office of U.S. Trade Representative two years ago, argued that China's trade barrier was against the spirit of free-and-fair trade rules laid out by the Geneva-based trade organization. The ruling is a positive development for global technology and defense equipment manufacturers. Rare earths have widespread applications in hi-tech products, thus removing of trade barriers will ensure firms' supply chains are not affected.

China's restriction on exports
Until 2010, China had complete dominance over the rare-earths markets. The world's second largest economy accounted for more than 90% of the world's total rare earths output in 2010. Prices of rare earths skyrocketed in the first half of 2011 after China decided to restrict exports, citing environmental concerns. Back then, demand for rare earths was strong as the global economy was showing signs of recovery after the financial crisis of 2009. At the same time, China was the only major supplier. Thus, there was a significant demand/supply mismatch, which pushed prices significantly higher.

Need for geographic diversification
Trade barriers raised by China and threats of possible supply chain disruptions arising from over-dependence on one supplier led to a need for geographical diversification. Since then, Molycorp, aiming to boost its output, raised its capital expenditure for its mine at Mountain Pass, California.

Australia-based Lynas is another company which is slowly but surely turning into one of the major rare earths producers. Lynas said in a statement on Thursday that it will register a record output for the quarter ending March 2014.

Many other rare earth projects are also in the pipeline around the world. Russia, in order to reduce its reliance on imports, announced last year that it will invest $1 billion in rare earth mining projects through a joint venture. Also last year, Greenland announced its decision to remove a ban on rare earth and uranium mining. With all these developments during the last two years, China's share in global rare earth production has gone down to 80%, according to The Wall Street Journal.

But rising global supplies have dented rare earth prices even as demand is likely to be subdued.

Prices pushed lower
While economic slowdown and overcapacity forced Beijing to remove some export restrictions from 2011, rising production levels from miners such as Molycorp have also increased rare earth inventories. As a result, rare earth prices have remained under pressure over the last two and a half years. Prices are down more than 50% from the peaks reached during the summer of 2011 due to oversupply and weak demand.

The bottom line
The WTO ruling is good news for manufacturers; however, it has come at a time when prices were already under pressure due to an increase in supply. The rare earth market is in fact witnessing something very similar to the iron ore market. Strong demand from China over the years created a supply deficit in the iron ore market, which prompted miners such as BHP Billiton (BHP -0.91%) and Rio Tinto (RIO -0.61%) to increase their iron ore production. Now that the two companies are expected to increase their supplies this year, demand for iron ore has weakened due to a slowdown in China. As a result, iron ore prices have plummeted this year, along with shares of BHP and Rio.

Demand for rare earths peaked in the first half of 2011, prompting producers outside China to boost production. But, as supply sources have increased demand has stagnated, hurting prices. Now with China likely to remove restrictions on exports following the WTO ruling, there could be a significant increase in supplies. This could push prices down even more. I already had a cautious outlook on Molycorp. With the WTO ruling, I would be even more cautious on the rare earth producer.