Rare Element is a Canada-based company that owns the Bear Lodge mine located in the northeastern corner of Wyoming. The stock price is up more than 500% since early July and more than 65% in the past three days. With the euphoria of the strong move in RE element stocks, speculators have bought first and asked questions later. We believe Rare Element investors will wish they had conducted more diligence before piling into a company with a potentially worthless plot of land. We believe Rare Element is a heavily promoted stock with questionable management and massive risks to a business plan that, under the rosiest scenario, will not be at full production until 2015 or 2016. By that time, we expect the world could suffer from a glut of RE supplies. As a result, we believe current investors face at least 70% downside from current levels.
Rare Earths - Not That Rare
"Rare earth elements" are 17 minerals on the periodic table. The elements are used in various applications, typically in miniscule quantities. There is a reason many investors have not heard of the RE elements since middle-school science class. Simply, RE elements represent a very small market. According to the United States Geological Survey, a mere 124,000 tons of RE were consumed worldwide, representing a market size of less than $2 billion.
More than a year ago, stories began to appear about China's dominance in RE mining, with 97% of the world's production and exploration efforts in South Africa, Brazil, Canada and the United States. As with most hyped spaces, this story has been recycled on a daily basis by news agencies, Internet chat rooms and even company investor relations firms. Following the initial public offering of MolyCorp (NYSE: MCP) in July and recent Chinese export quotas, RE element prices and stocks have skyrocketed. China is now using its market clout in RE as a political statement, increasing export quotas and withholding exports to Japan. The result has been a further spike in RE element prices.
We believe elevated RE prices are a temporary phenomenon for two reasons. First, we believe China will likely concede and begin exporting RE elements again as political pressures mount. The Chinese have a history of flooding markets with a massive supply of raw materials or end products, and could resume exporting and crush RE prices at any time.
Second, the term "rare earth" is a misnomer. The USGS states: "Despite their name, most rare earths are not particularly rare." The USGS estimates that the total worldwide reserves of RE equals 99 million tons, or 800 years of supply at current consumption rates.
In addition, most RE consumption takes place in China, which consumed 65% of supply, according to the USGS. Most of the goods produced in China with RE element inputs actually end up as exports to the rest of the world (and these products are not subject to any quotas). Japan consumes another 26% of supply, meaning these two countries consume more than 90% of worldwide supply. According to the USGS, the U.S. imported less than 7,000 tons of RE in 2009 and actually exported a greater quantity than it imported.
When MolyCorp's Mountain Pass mine is running in 2012, management has stated that it expects the company to produce 20,000 tons of RE. This represents THREE TIMES the amount of RE imported to the U.S. in 2009. The USGS estimates that China's Bayan Obo mine has more than 40 million tons of RE elements, which is enough to supply the world for the next three centuries.
Congress and the U.S. military have also expressed concern for RE element needs for certain weapons. We estimate that the demand by the U.S. military is likely less than 1,000 tons a year, however, and will easily be addressed by Mountain Pass.
We expect the world to be awash in RE supply if and when Rare Element's Bear Lodge is producing in 2015 or 2016. Currently, the worldwide demand for RE outside of China is a meager 44,000 tons, and only 12,000 tons excluding Japan. While we view RE elements as a growth market, we believe RE recycling and RE alternatives could mute market growth.
We reviewed plans for six public companies in the RE space, and combined, they plan more than 82,000 tons of production of RE per year. Those companies include: Lynas (OTC: LYSCF.PK), 22,000 tons; MolyCorp, 20,000 tons; Arafura, 20,000 tons; Rare Elements, 10,000 tons; Avalon (OTC: AVARF.PK), 5,000 tons; and Quest Rate, 5,000 tons. That total represents almost two times the current demand outside of China and excludes massive private projects in India, Brazil, South Africa, Australia and the U.S.
One estimate suggests that, more than a year ago, there were 120 RE element mining projects globally at various stages. And this was BEFORE the recent spike in prices. Given the massive expansion of worldwide RE mining, we expect the world to experience a glut of RE elements by the time Rare Element's mine is up and running. As a result, we believe it is a faulty assumption to extrapolate "bubble" pricing into future projections.
Red Flags at Bear Lodge
Rare Element currently has a market cap of more than $400 million. The company’s latest financials show only $10 million in assets, however, and zero revenues. It had just $5 million in cash on its balance sheet at the time of its last filing.
According to its latest 20-F, Rare Element has just two full-time employees and five part-time employees. This "exploration and development" company has also spent less than $7,000 over the course of the past three years. While management has issued a steady stream of press releases, we expect that news to prove irrelevant for the company until we move much closer to the middle of this decade.
As previously noted, Rare Element is conducting its RE element testing at Bear Lodge in the northeast corner of Wyoming. Spartacus Capital, the predecessor company to Rare Elements, acquired the Bear Lodge mine in 2002 for less than $1 million. The company expects production of the plant to begin in 2015.
According to its own documents, however, three highly sophisticated mining companies -- Hecla Mining (NYSE: HL), MolyCorp and Duval – have already owned and explored Bear Lodge for RE elements over the course of the past 38 years. After 44 drill holes, none these sophisticated miners continued to drill, all choosing to abandon their efforts and eat the sunk costs.
We believe one of the reasons for past failures stems from the low ore grade of Bear Lodge. According to Rare Element's investor presentation, Bear Lodge has an ore grade of 3.5%, less that half of MolyCorp's Mountain Pass (8.2%) and a third of Lynas' Mount Weld (13.6%). Based on our research, this makes Bear Lodge's prospects for successful operation extremely dependent on RE element prices staying at existing levels.
If our earlier assumption is correct (along with the apparent conclusions of three highly sophisticated miners), and prices of RE elements normalize, it will prove uneconomical to mine Bear Lodge (assuming the asset even possesses enough to participate in the future of this oversupplied market). So while many RE stocks have increased significantly on higher RE prices, most -- including Rare Elements -- will never be in a position to take advantage of today's prices.
Given the abundance of RE elements worldwide, access to RE may not be that problematic. However, processing RE elements into usable raw materials is expensive, difficult and environmentally destructive. In fact, Mountain Pass was originally shut down not only due to a flood of cheap RE elements from China, but also for environmental concerns.
To justify Rare Element's lofty market cap, we believe prices of RE not only need to stay extremely high, but the company must also build processing capability. A Bryon Securities report estimates this project would cost Rare Elements $350 million. In addition, Rare Elements would have to overcome significant permitting and environmental concerns, along with significant start-up expenses. With two full-time employees, a tiny balance sheet and prospects for significant dilutive equity deals, common sense suggests something does not pass the smell test.
We put little value on Rare Element's other projects: gold mining at Eden Lake and Bear Lodge. Eden Lake is a property Rare Element acquired recently for less than $1 million. Rare Element management also claims potential for gold mining at Bear Lodge.
Earlier this year, Newmont (NYSE: NEM) walked away from a joint venture it had with Rare Elements on this property. Newmont will receive a net smelter royalty should anything be found there, but chose to go ahead and cut its losses on development and exploration. (The company spent almost $3 million on development and refused to spend more). Given the sophistication of Newmont, we believe this gold project offers little value.
Red Flags Around Management
The quality of a management team is extremely important for any small-cap company. But when your management bench is as small as Rare Element's, assessment of management is vital.
We found it curious that Rare Elements shares its listed address (325 Howe St., #410, Vancouver, British Columbia, Canada V6C 1Z7) with at least six other businesses: Pacific Opportunity Capital, run by Chairman and CEO Donald Ranta, CFO Mark T. Brown and Secretary Winnie Wong; Animas Resources (ANI.V); Tenant Payment Systems; Avrupa Minerals (AVU.V), formerly known as Everclear Capital; Cordova Industries; and Sutter Gold Mining (SGM.V).
Our concern was already elevated, given the commingled nature of the office address, but nothing could have prepared us for the shock of seeing management's bios and history. Most management teams we talk to are consumed with running one company. We believe it is a significant red flag that critical members of Rare Element's management team are engaged with more than five companies currently.
It is our understanding that Rare Element Secretary Winnie Wong and CFO Mark T. Brown are principals of something called Pacific Opportunity Capital, which shares office space with the company. Brown's bio in the 20-F lists 18 companies where he is the current or former CFO or director. Almost all of these companies are Canadian-traded penny stocks. A simple Google news search reveals that Mark T. Brown has issued press releases for at least three other companies in the past two weeks, including Pitchstone Exploration, Avrupa Minerals and Tarsis.
Chairman and CEO Donald E. Ranta was previously with Greenstone Resources, a mining play that is currently trading in penny territory. Ranta is also on the board of Avrupa Minerals, along with Brown and Wong.
Wong was (until recently) also the secretary of Portal Resources (PDO.V), an oil and gas penny stock. She is also the CFO of Avrupa Minerals, currently trading in the 40-cent range in Canada. In addition, she is the corporate secretary of Apoquindo Minerals and the CFO of Animus Resources (ANI.V), another penny stock trading in the 40-cent range. She has served as the president of Deal Capital and the CFO of Fox Resources and Mediterranean Minerals as well.
Constantine Karayannopoulos, the CEO of Neo Materials (TSX: NEM), stands out as one rational voice in the RE elements space. As the head of a company with 85% market share in processing neo powders, Karayannopoulos is heavily incentivized to promote RE elements. However, in several recent presentations, he has expressed concerns about the bubble in RE elements.
By way of background, Neo Materials has exclusive access to mine heavy RE elements at the Pitinga mine in Brazil -- a fact investors have seemed to overlook when comparing NEM's stock to other RE names. Notably, on Sept. 15, Karayannopoulos stated: “It's very, very dangerous for people to be committing hundreds of millions of dollars to projects that will take another five years or more to see the light of day.”
As if alluding specifically to Rare Elements, Karayannopoulos then went on to caution: “At the end of the day, rare earths are not that rare. Bubble economics aside, there just isn't enough value in the ground to justify digging the stuff up and processing it.”
While it is refreshing to hear a CEO talk candidly about the market, we believe Karayannopoulos’ warning to investors has gone unnoticed.
We have recently begun our research on Rare Element Resources and are disturbed by the red flags we have found. We believe momentum investors face significant risk by speculating in shares at unjustifiable price levels. We view Rare Element's stock as the definition of “the greater fool's” theory.
When the stock breaks, no reasonable investor will provide liquidity to sellers on the way down. If RE element prices remain high in five years, Bear Lodge could have some value. If we are correct and RE prices drop given a glut in supply, however, the Bear Lodge mine could be worthless.
We expect to report back after conducting further due diligence.
* Disclosure: The author of this report has a short position in REE stock.