Rare Earth Metals growth drivers: Siddharth Rajeev

With so many moving variables in the rare earth space, how can investors evaluate investment opportunities? Siddharth Rajeev of Fundamental Research Corp. finds his top prospects by zeroing in on a specific material and tracking its growth drivers. Rajeev argues that critical materials used in viable new technologies will see increasing demand. In this exclusive interview with The Critical Metals Report, he explains how lithium-ion battery development and the forthcoming WTO ruling effect his outlook for graphite and niobium.

The Critical Metals Report: China recently announced it is maintaining its rare earth export quotas of 31,130 metric tons (t), but the U.S., the EU and Japan filed a claim at the World Trade Organization (WTO), saying that the restrictions are illegal. What will this controversy mean for rare earth prices?

Siddharth Rajeev: One of the main reasons for the run-up in rare earth prices is the export quotas set by China, which controls 97–98% of the supply. End users started looking for alternatives to rare earths, which is resulting in lower demand. As for the WTO case regarding China’s export quotas, Chinese officials think they are in line with WTO regulations. The WTO had previously ruled against China for restricting exports of bauxite, magnesium, zinc, etc., so it is possible the WTO might go against China here as well, which would negatively impact rare earth prices. In addition, companies outside China now nearing production, including Molycorp Inc. (MCP:NYSE), Great Western Minerals Group Ltd. (GWG:TSX.V; GWMGF:OTCQX) in South Africa and Australia’s Lynas Corp. (LYC:ASX), may alleviate supply constraints, thus driving prices down. Still more projects are expected to come online in the next two years, which would further add to supply.

TCMR: When do you expect the WTO to decide on a ruling?

SR: It’s going to be a long process, but it’s something that could potentially affect long-term rather than short-term prices.

TCMR: Because rare earth materials are so varied, you use a fair-value metric instead of target prices when you evaluate these stocks. But how do you determine the intrinsic value of a critical metal stock when there is all of this uncertainty?

SR: Every commodity is priced based on expected long-term demand and supply. To forecast commodity prices, we project long-term demand based on the potential growth of the major demand drivers. Supply is projected based on the projects that may come onstream over the next 10 years. But as you mentioned, the forecast demand for critical elements is harder than, say, forecasting demand for copper or zinc. Demand for critical elements can be a moving target. We mitigate this problem by constantly updating our models to capture this variable. For example, major lithium demand drivers are expected to be lithium-ion batteries. Precisely forecasting demand for lithium-ion batteries depends on other growth drivers, such as electric vehicle proliferation. So we constantly update our models as to reflect projected demand in related sectors. That’s how we calculate price forecasts for all the commodities in the rare earth and critical metals space.

TCMR: You recently released a report on graphite and its uses for everything from brake linings to batteries and nuclear power. Graphite prices have jumped as much as $500/t in the last year for certain grades. How high could that price go, and what’s driving that?

SR: Over the long term, we are bullish on graphite. The main reasons are the following: First, we think the main demand growth drivers of graphite could be new applications, such as lithium-ion batteries, fuel cells and nuclear power. Natural graphite might take away a significant market share from the synthetic graphite market, because high-purity, high-grade graphite is required for these technological developments. Synthetic graphite currently trades at four to six times the price of natural graphite.

Second, on the supply side, China accounts for more than 70% of production. The U.S. imports its entire graphite consumption. So, again, we are seeing a highly concentrated supply in one area. Another thing, the blue-sky potential for graphite involves a product called graphene, which is made by chemically processing graphite. Graphene is very unique because it’s highly flexible, like rubber, yet stronger than steel, and it’s a very good conductor of heat, 10 times more effective than copper. It’s a recent technology and there is a lot of research going on in the sector. All things considered, we have a bullish outlook on graphite.

TCMR: What companies outside of China are you watching in this space?

SR: We’ll be initiating coverage on Focus Metals Inc. (FMS:TSX.V) in the next month or so. Its project, which it acquired from IAMGOLD Corp. (IMG:TSX; IAG:NYSE) in 2010, is located in Quebec. I have not seen any other project with such high grades of graphite in the deposit. Focus Metals has a grade of 16%, whereas most of the graphite deposits out there are less than 3%. It has large-flake material, which is highly in demand for applications such as lithium-ion batteries. Focus Metals recently completed a resource estimate. It’s working on a scoping study now. It’s a low-capital expenditure project, less than $75 million (M). The company has an extremely strong cash position, $16M. Market cap is just over $80M.

Another story we like is Flinders Resources Ltd. (FDR:TSX.V), a brand-new company. It started trading on the Toronto Stock Exchange Venture a few weeks ago. Its project is the Kringel project. A lot of historic work has been done on the project. It has a historical resource of 7 million tons (Mt) at 9% graphite, which is a high-grade material. It has a lot of catalysts coming up over the next 12 months, one of the biggest being its plans to convert the historic resource to an NI 43-101-compliant resource. It has a fully permitted mine that can be put into production in the next 18–24 months. It has a strong cash position of $5M, and its market cap is $60M.

Another company is Lomiko Metals Inc. (LMR:TSX.V). It’s a very early-stage project. It just acquired a project in Quebec. Some historic work has been done on the property. As for near-term catalysts, it is working on an NI 43-101 technical report [released 3/27/12], and it is going to commence an exploration program on the property.

TCMR: Lomiko is historically a gold company that just diversified into the graphite space. Is that common? Are a lot of companies following suit?

SR: Because of graphite’s highly attractive fundamentals and growing investor interest, we have been seeing a lot of new companies pop up or switch their focus to graphite, which is normal in the commodities sector. We saw the same pattern a few years ago when the rare earth boom started. The same has been the case with lithium. This is common, but bear in mind that a lot of companies might not survive the boom period.

TCMR: Do you see Lomiko’s stock going up because of the diversification?

SR: Our last report on Lomiko’s graphite came out a few months ago. The stock had doubled since the initial report. It’s dropped since then. As long as the graphite market stays in its current space, where I expect it to stay for a while, and if Lomiko’s exploration program produces positive results, that should reflect in the stock price. In other words, it’s too early to tell.

TCMR: You also focus on niobium, which is used in the technology, aviation and steel industries to make metals lighter and stronger. The price for ferro-niobium has come down from more than $46/kilogram (kg) to about $43. Is that a function of more supply or less demand?

SR: Niobium demand is highly correlated with steel demand, and steel demand is highly correlated with global gross domestic product (GDP) growth. The recent slowdown in global GDP growth, especially from China, has resulted in a softening of prices for commodities that service the steel industry.

TCMR: How does that price action affect your outlook for niobium suppliers, particularly in North America?

SR: The U.S. produces very little niobium. That’s been the case for a long time. Brazil is the number-one producer of niobium, accounting for about 92% of global production. Canada comes in a far second. We cover two North American companies in the space. The first is Quantum Rare Earth Developments Corp. (QRE:TSX.V; BR3:FSE; QREDF:OTCBB). It has the Elk Creek project in Nebraska, of which it owns 100%. In March 2011, it came up with an Inferred resource of 80 Mt at 0.62% niobium oxide, which is a significant deposit. This company has quite a few catalysts expected this year. In Q112, it expects a new NI 43-101 resource report, and in Q212 it expects some results of its metallurgical testing. These two numbers should give it enough information to commence a preliminary economic assessment (PEA) later this year.

TCMR: If those reports come out positive, could that override any niobium price challenges?

SR: Definitely.

TCMR: What other companies do you follow in that space?

SR: Another company is Commerce Resources Corp. (CCE:TSX.V; D7H:FSE; CMRZF:OTCQX). It has the Tantalum niobium project in British Columbia. It recently completed a PEA of the property, but its main asset now is its rare earth project in Quebec, which has produced a lot of positive news for the last 6 to 12 months. It recently came out with a huge increase in its resource estimate, and its initial estimate was one of the largest outside of China. The newer resource has doubled the figures, so that’s a significant development. It identified middle rare earths (MREEs) and heavy rare earths (HREEs), which are more valuable than light rare earths (LREEs),close to the surface of the property.

TCMR: Are the price dynamics different for HREEs and LREEs due to respective export quotas?

SR: Yes, exactly. Prices of light and abundant rare earths dropped much more than other rare earths that are more scarcely available. So there’s been a wide fluctuation, and different commodities in the rare earth sector have reacted differently. But overall, the rare earth market has been hit significantly in the last 6 to 12 months.

TCMR: Commerce has, as you mentioned, both MREEs and HREEs. Do you expect those prices to remain high or perhaps escalate?

SR: Overall, we saw significant price increases in the rare earth market, increasing as much as five- or tenfold in some cases over the last few years. We’ve since seen sort of a correction. But even at these relatively lower prices, a lot of projects are economic. So we wouldn’t need to see an increase in prices to make these companies look favorable.

TCMR: What other factors might impact this sector, particularly in an election year, that investors should take into consideration when considering critical metals companies?

SR: Global economic growth and price levels of critical metals are not directly linked. Critical metals are more influenced by new technologies. Any commodity that can be used for viable and efficient new technologies is going to see good growth and demand. This would include commodities like lithium and graphite, which are used in lithium-ion batteries. We have a strong outlook on lithium-ion batteries for electric cars. Those are the kinds of technologies that can be viable in the long run, and all the associated technologies are likewise going to see a significant increase in demand. Critical materials that figure into these developments will be less affected by shorter-term developments like the U.S. presidential election or a slowdown in the Chinese economy because many of these new technologies have a lot of room for upside, even before demand stabilizes.

TCMR: Thank you for speaking with us today.

SR: My pleasure.

Siddharth Rajeev is vice president and head of research at Fundamental Research Corp., the largest independent equity research firm in Canada. He holds a bachelor of technology in electronics engineering from the Cochin University of Science & Technology and a Masters of Business Administration in finance from the University of British Columbia. He is also a CFA charter holder. He is ranked as a four-star analyst in the energy and mining sectors by Deutsche Asset Manage