Strategy Metals Bulletin (60)

Aims to update investors on developments in the world of strategy metals – crucial inputs to industry, defense and technology innovation

Terence van der Hout                    
Mar 25 – 31, 2012 Gold&Discovery Fund

This week’s bulletin discusses the consequences of President Obama’s appeal to the WTO to settle the perceived unfair Chinese trade practices on the topic of rare earths.

WhaT Of rare earths?
Last Tuesday, President Obama in a short speech announced his intention to present a case at the WTO accusing China of unfair trade practices relating to the export controls on rare earth elements (REE). The case was supported by the EU and Japan, and seeks redress for China´s blocking access to the ingredients deemed vital for economic growth and innovation.

China gains dominance
Recapping the last two decades of developments in the REE sector, we first saw China’s successful attempt to capture REE technology from the US of metals for which Deng Xiaoping had the vision to say they would be to China what oil was to the Middle East. This statement was made in 1987, and led to the transfer of expertise from Molycorp’s predecessor to China, at the beginning of the millennium. Since then, China has gone full force into producing rare earth oxide (REO) ore from numerous intensely competitive operations that had little regard for labour conditions or the environment. The result was a very large volume of very low priced REO supply, which ousted Australian and American production from the market.

A decade of Chinese REE monopoly ensued, a dependency no one really cared about until green technology came to the forefront of political attention. Suddenly, the world woke up to the importance of REE and their dependence on them for their lifestyles and economic growth. The quota system that China had applied for years without opposition became an issue and REE supplies to Japan temporarily caused a diplomatic row in November 2010.

China fuelled the fire by laying out a detailed set of policies that intended to clean up the upstream part of the industry, curbing REO production by a licensing system, production caps and by setting out to concentrate production through regional centres. China literally said these measures were needed not only for environmental purposes, but also to control price and production of an industry it saw as of critical importance. This went against the grain of a powerful weste high-end industry that saw itself threatened in its existence, and which was capable of mobilizing politics to the highest of levels, resulting in Obama’s speech.

Pros & cons
So now that we have an official REE case at the WTO, what are the chances of the US, the EU and Japan? Well, on the one hand, China may be perceived as having the right to clean up its industry, and to incorporate environmental costs into its cost of production. Also, with specific reference to the imposition of export quotas, this system has been in place for a long while, and despite this the outside world has always had full access to all the REE that were needed. Only in 2010, at the height of the scramble for REE, were the quotas fully filled, probably by companies willing to stock up before supplies became shut off.

On the other hand, the Chinese policies are causing prices between REE on the Chinese domestic markets to be significantly lower than those for the export markets, negatively affecting the competitiveness of secondary processors outside of China. In fact, virtually no facilities for the separation of concentrates outside of China exist as a consequence (Molycorp, Rhodia and possibly a number of Japanese car makers are probably the only exceptions). This has led to the downstream monopolization that reaches almost all the way to the end product. In this sense, China’s monopoly position prevents a strong case at the WTO.

From another perspective, the WTO case may influence relations between China and the three other largest economic powers. China is a country that holds a huge portion of the reserves in currencies of both the US and the EU. China is also a supporter of the EU bailouts, and is one of the only places left the US can tu to for placing new debt. This new, powerful and assertive China will not enjoy being stung by bees that depend on it for their survival.

Banana precedent
How will the WTO case play out? Well for one, don’t expect a quick resolution. Detailed files will now be built by eager bureaucrats, which may lead to a WTO decision in a year or so. Should China lose, it will have the opportunity to appeal the decision, extending the case further. A case handed to the GATT (the WTO’s predecessor) for arbitration in January 1996 conceing unfair European trade practices in import duties on bananas, was set for final settlement only in January 1999 (final resolution actually took place in 2009, as the case was changed a number of times). So save a little time before expecting actual results.

Scenarios
In the unlikely event that China wins the case, it will further its path of providing REO to the world. But earlier this year, China started to distinguish between heavy REO (HREO) and light REO (LREO) in the export quotas. Also, it has previously stated that it will need to import HREO by around 2014 – 2015 because of depleting domestic supply. Adding the two together leads me to believe the export of HREO will gradually be pinched out, in favour of the more abundant LREO, of which both Lynas and Molycorp will provide large volumes to the rest of the world once they get to full production.

Even if China were to lose the case, it is unlikely to lead to corrective measures in the rare earths. China has repeatedly signalled that the REE supply chain is far too important to relinquish to the outside world. In previous cases that were settled by the WTO, the distortions remained in place and retaliating sanctions were instituted in completely unrelated sectors. In this way, a European WTO case ruling unfair trade practices by the US in support of their ailing steel industry, led to sanctions on the import of oranges from Florida. China may therefore keep the REO trade system in place, whilst being forced to undergo sanctions in other exported goods. Alteatively, China can agree to abolish the quotas whilst inteally setting up mechanisms that ensure no HREO become available for export. Or finally, Chinese repercussions might be to briefly reopen the REO gates, flooding the markets with low priced REO no weste company can compete with. This will kill off the rejuvenated non-Chinese REE industry for another ten years, giving China ample time to cherry-pick those projects abroad that will supply them with the much needed heavies.

In all scenarios, I see China closing the door on the export of HREO, eventually.

Twitter: @GoldDiscFund
www.gdfund.com

 
Disclaimer: The author is a researcher for the Gold&Discovery Fund, and neither he nor the Gold&Discovery Fund has commercial ties to, or shares in, the companies reviewed, unless explicitly stated in the text. The information in this bulletin is the author’s independent opinion of developments in markets and at companies, and hence may contain factual errors, and may not reflect the opinions of the Gold&Discovery Fund. The content of this bulletin is not intended as an investment recommendation.

Copyright: The information in this bulletin can be forwarded, cited or used otherwise, but only within the context as intended by the author, and with complete reference to the source.

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