The Rare Earths Industry Is Only Just Beginning: Jon Hykawy
Tue, May 15, 2012
Is the rare earths space an industry in decline, a bubble popped? Not so, according to Jon Hykawy, head of global research and a clean technologies analyst at Byron Capital Markets. Hykawy tells The Critical Metals Report in this exclusive interview that establishing a supply outside of China could breathe new life into this exiled market. While the winners in the industry may be as rare as the elements they mine, Hykawy believes that the financial community is going to have to revisit rare earths once companies start to produce meaningful cash flows.
The Critical Metals Report: Most analysts outside the rare earth elements (REE) space suggest steering clear of this industry. To some extent, even you are suggesting that—except for a handful of players. Can you elaborate?
Jon Hykawy: We’ve been fairly adamant from the moment that we initiated coverage that the space would have, at most, a few winners and a very large number of losers. We refined the number down to a select few because we’re right about that. If you have more than a few companies producing, especially in the light rare earth (LREE) space, they will absolutely crush the market and some will go out of business. Very few companies in the LREE space will succeed in coming to market.
TCMR: Why is the market punishing LREE equities?
JH: Just about every LREE junior ran up dramatically through 2011, whether they had anything resembling a winning hand in the space or not. Now, every company in the space is getting punished, even those with winning hands.
TCMR: What’s going to turn this sector around?
JH: Well, in spite of the sector’s grim general performance, our picks have performed well. We initiated coverage on Great Western Minerals Group Ltd. (GWG:TSX.V; GWMGF:OTCQX) at around $0.18/share and the stock is trading up around $0.50/share. We initiated coverage on Molycorp Inc. (MCP:NYSE) when its stock was down around $16/share; the stock is now near $24/share. Granted, neither has done well in the last six months, considering all resource stocks have been taking a bit of a hit and LREE prices are dropping off significantly.
In order for the sector to turn around, companies need to start making money. We need to see Lynas Corp. (LYC:ASX) come to market and show that it can actually produce meaningful cash flows out of an LREE business. We need to see Molycorp come to market, start producing alloys and magnets, and demonstrate that added downstream processing contributes dramatically to both revenue and profitability. We need to see Great Western complete the reopening of its mine, the construction of its hydrometallurgical and solvent extraction facilities, and demonstrate that moving those materials into Less Common Metals in Birkenhead allows it to dramatically improve its cash flows. If those things happen, investors will start to concentrate on the metrics and on the names that matter in the space.
TCMR: In other words, we’re now in the “don’t tell me, show me” stage.
JH: Yes. The names that are able to actually translate the capital that they have on hand into an operation that generates substantial cash flow can’t be ignored.
TCMR: Rare earth oxide (REO) prices shot up in 2010 after China curtailed exports, but you argue that those prices should be largely dismissed when determining valuations for equities. Why?
JH: China imposed a quota that spiked REE prices. But the pre-quota prices matter much more. If you assume a Western supply chain is going to be developed and supply sufficient material, then the prices will be based on a freely trading market. To say that we’re suddenly in a different world because of the quotas, that the quotas will never be taken away and the higher prices will last until the end of time, is a pretty facile and erroneous analysis.
A better approach would be to conduct a proper economic analysis, which almost no one has done. That involves actually looking at the individual REEs.
Currently, we only price the seven that we’re able to obtain sufficient data on. Heavy rare earths (HREEs) will drop down in price, but will still be well above historical levels because they’re rare and will remain rare no matter what we do.
The prices of lanthanum and cerium, which are fairly prevalent in all deposits and are the most commonly available REEs, are going to crater to prices below their historic, pre-quota levels.
The price of neodymium will stay above the historical range, because high-quality REE magnets are in demand for a number of industries, but prices are likely going to be nothing like where they are trading today. We forecast $80/kilogram (kg) for neodymium and praseodymium because that is the economic threshold for the wind turbine industry.
TCMR: If you’re building models based on that conservative price deck, don’t you risk missing a couple of players that might succeed if you were slightly more generous in your pricing?
JH: A number of metrics are important. A company might be the most economic player in the space, but if it comes to market three years after five other companies, it doesn’t matter. That is why we prefer less expensive, less complicated, relatively faster-developing companies to those that are going to spend very large quantities of money to develop what could be very large projects in the middle of nowhere.
For example, if Avalon Rare Metals Inc. (AVL:TSX; AVL:NYSE; AVARF:OTCQX) is going to need $1.3 billion (B) to bring a project to market and it really isn’t going to come into serious production until 2017, investors better be darn sure that there aren’t six or eight smaller projects entering the market before that.
It’s not just a matter of which company is going to produce when, or which is going to produce at exactly the right price point, or which is the cheapest stock. When a company actually comes to market is a major factor, along with how well they fit into the demand curve.
TCMR: You have a Sell rating on Avalon. Is Avalon’s biggest fault simply its timing, and not its deposit?
JH: The problem is definitely not the deposit itself, though the timing and the money required are a function of the metallurgy. In our estimation, with our admittedly conservative price deck, Avalon is a bad place for investors to put their money. There are a large number of potential HREE projects that have shorter development horizons and are much less expensive to bring to market that could fill the gap that Avalon wants to fill.
TCMR: The other company that you have a Sell rating on is Orbite Aluminae Inc. (ORT:TSX). It’s created quite a stir, as there were some questions raised around its preliminary economic assessment (PEA) and its ability to extract REEs from its alumina clays. You looked at it more closely and decided that the numbers didn’t add up.
JH: Every company has risk associated with it. The issue that we saw with Orbite is that the perception of risk within the broader market was far more optimistic than we believe the actual situation to be. The PEA noted that natural gas would be the primary source of energy for the project, yet even the PEA quite plainly stated that there is no natural gas available in the area. There is no development available to provide natural gas to that project site—and there may not be for a substantial period of time.
We believe that the pricing of alumina as well as the REEs and rare metals in the PEA were optimistic. Using higher-than-rational pricing for these materials inflates a company’s net present value. We felt that needed to be addressed.
There was also technical risk. The process is not a slam dunk. There is a substantial amount of work to be done. Even some of the developers of some of the technology that’s required to execute the plan in the PEA acknowledge that. Combining all of those things, we questioned whether a value of about $3/share was justified. A price of $0.90/share would make us more comfortable.
TCMR: Let’s move on to some of the companies you do like. One of your long-time favorites is Great Western Minerals, but its share price has continued to trend lower since July. What’s going to turn Great Western around?
JH: There are three things that will certainly help. One of the long-time criticisms of Great Western is that there hasn’t been an NI 43-101 available on the deposit. There haven’t been that many people who’ve actually visited the Steenkampskraal project. However, geologists who have visited Steenkampskraal tend to come away with far less concern about the abundance of monazite available there, primarily because of the way the deposit is structured and the visible extent of that structure.
We should see an NI 43-101 published relatively soon, however, likely before the end of May. Drilling has been largely completed. The company has indicated that it may be able to report higher grades on the historical material than what was earlier reported because the historical testing tended to underestimate the amount of REEs available. The company may also be able to report a superior elemental distribution. That will obviously be very positive for the story.
If the company completes the refurbishment of the mine and reopens, it would be a very positive step. The company has indicated mine operations will recommence within Steenkampskraal before the end of the year.
It also needs to commence construction of the hydrometallurgical and solvent extraction plants in South Africa. A finalized design from its partner, Ganzhou Qiandong Rare Earth Group Ltd., for the solvent extraction plant would be a very welcome step for the company. Ganzhou Qiandong is well known as a leader in the solvent extraction space.
TCMR: You wrote in a recent report, “Great Western Minerals will, we believe, be producing magnet alloy for customers from its own material near the beginning of H2/13.” Is that soon enough?
JH: I believe so. It’s probably going to be a bit of a horse race between Molycorp and Great Western Minerals in trying to get those home-produced magnet alloys into people’s hands. Lynas, assuming the political situation in Malaysia and its permitting situation is resolved, is going to be producing material for sale to companies like Hitachi Inc. (HIT:NYSE), Shin-Etsu Chemical Co. Ltd. (SHE:Fkft) and others.
One of the big issues causing the reduction in demand for REEs has been the insecurity of supply. If a global auto manufacturer is contemplating whether it’s going to use an REE motor or an induction motor in a new hybrid vehicle, the fact that it really can’t count on Chinese supply for those REEs has to weigh on its decision. It’s likely pushing a number of manufacturers into using induction motors because they can’t afford the possibility that they won’t be able to source material. Having producers outside of China would make a big difference in purchasing decisions.
TCMR: What are some of the other companies you favor in the REE space?
JH: Matamec Explorations Inc. (MAT:TSX.V; MRHEF:OTCQX) is an interesting name. We have a $0.50 target and a Speculative Buy recommendation. Its pending partnership with Toyota Tsusho Corp. (TYHOF:OTC; 8015:JP) is a solid indication that this is a fairly tractable project in a good jurisdiction. It’s not the absolute cheapest-per-ton of total REOs produced, but it’s fairly inexpensive in terms of its capital spending and should be relatively quick to come to market.
We have a Speculative Buy on Ucore Rare Metals Inc. (UCU:TSX.V; UURAF:OTCQX) and an $0.80 target. Ucore has exactly the right address. It has an HREE project located in the U.S. It’s of interest to a number of players like Molycorp that want to produce their own magnets and are going to require a reasonable amount of dysprosium to do so; automotive companies that want their own magnets for use in drives; and a number of other potential end markets in Western Europe. Its location near deep water in Alaska, with the backing of the Alaska state government and the U.S. federal government, speaks well of the company.
TCMR: Ucore had a 93% success rate using x-ray sorting technology (XRT) to recover REEs. Does that change the economics of that project?
JH: It definitely improves the economics. Generally speaking, the economics of an REE project are not defined by mining. A bigger factor is the cost of processing that material. The use of x-ray fluorescence as a method of determining which particular pieces of rock contain the minerals they’re interested in and which ones can be safely rejected without losing anything of value is a very positive development.
TCMR: Texas Rare Earth Resources Corp. (TRER:OTCQX) is about to put out a PEA later this month on the Round Top project in Texas. What are you expecting from that?
JH: I’m trying to temper my expectations. I’ve been very impressed by some things at Texas Rare Earths. A lot of us comment that the most important thing within any mining company is its management team. Marc LeVier, chief executive at Texas Rare Earth, is a guy who’s been recommended to me by a number of people whose opinions I trust. He has a pedigree to back that up. He knows what he needs to do to declare this an economic deposit. He is practiced enough to know it’s not a perfect deposit.
The PEA’s results are going to be pinned on the head grade, acid consumption and reagent consumptions going into the mill. This is a relatively low-grade deposit. If the company can separate out the minerals it needs, it may still have a very positive economic result. It’s a bit of a dice roll still.
TCMR: Is there another company that has your attention?
JH: I’m going to actually discuss one that I have a Sell rating on, although that rating causes me a few headaches. Quest Rare Minerals Ltd. (QRM:TSX; QRM:NYSE.A) is a name that has been problematic for us in the sense that we like the potential of the deposit and we’re positively disposed toward management. The biggest issue is that it’s a project that’s rather isolated and that will be fairly expensive to build. The company has also had issues with its plan and has taken some of the comments we’ve made to heart. It has started to move toward incorporating a solvent extraction plant and moving downstream. It is not just trying to produce concentrate anymore.
TCMR: Are there any companies with plans to just produce concentrates anymore?
JH: I don’t think there are any companies left that have plans to only produce concentrates, with the possible exception of some ionic clays outside of China. Everyone else has started to realize that it’s going to be expensive enough to develop the project and that nobody is interested in buying another problem. The companies have to provide a finished product—an end product—and that means separated and purified oxide at minimum.
TCMR: There was a recent article in The Globe and Mail about Quest in which you were quoted as saying, “I hope they realize they’re in a race.” Can you express your thoughts behind that statement?
JH: When I do the analysis with my admittedly conservative price deck, I end up with about a $1.75 target. We’re starting to bang on the door of that level here. There have been delays in the project, which is unfortunate because the faster it can get to market with something that’s tractable, the more likely it’s going to be in the market long term. By the same token, it’s a good deposit. It could be economic. For the most part, Molycorp, Lynas, Great Western Minerals, Quest, Avalon and so on produce positive cash flow even with my conservative estimates for future rare earth prices. It’s really a question of whether that cash flow justifies all the up-front expenditure. Quest, to me, is a borderline call. That $1.75 point is a very interesting one.
TCMR: Would a partner change that for you?
JH: It could certainly help. There is no shortage of interest within the broader industry and within the end-user markets for at least obtaining an off-take agreement for a meaningful amount of the REEs. But if a company can’t produce an economically viable, relatively simple flow sheet, it’s probably not going to convince a partner that it has something that’s worth its money and time. Quest is on the bubble for me. If it gets down toward $1.75 or we see anything that indicates that it has the potential to come to market sooner, it’s something we’ll have to revisit.
TCMR: Some precious metals companies, such as South American Silver Corp. (SAC:TSX; SOHAF:OTCBB), have found their way into your coverage universe. Does this have more to do with the Street’s lack of interest in REEs at the moment or are these companies being considered legitimate electric metals plays?
JH: It’s not a case of running off after a “borderline” electric metal like silver because we’re not getting any love on REEs. This company is filled with projects that are going to produce what are definitively electric metals. It produces not just silver from its Malku Khota project in Bolivia, but indium and gallium. It also has copper in its Escalones project in Chile. That company is replete with electric metals. Even silver, whether most people realize it or not, has an extremely large industrial component of demand, made up primarily of conductive pastes that are used in things like the solar photovoltaic industry and solder used in electronics worldwide.
TCMR: Do you have any parting thoughts?
JH: We’ve said from day one that we’re not subscribers to the beliefs that REEs are essential, irreplaceable or anything of the sort. I’ve always told people that REEs are very nice to have at the right price. It looks like there may be a viable supply chain for REEs developed outside of China. That is going to improve the security of supply, reduce reliance on Chinese manufacturing and production and allow companies to reliably get materials without worrying about what next year’s quota is going to look like. It could have the positive effect of bringing the prices down to the point where many manufacturers and end users are going to be willing to look at using REEs again. The industry is just beginning to develop, whereas a lot of the financial community is looking at it as a popped bubble. That’s not the case. The financial community is going to have to revisit REEs down the line, when some of the companies start to produce really meaningful cash flows from their operations.
Jon Hykawy is currently with the research team at Byron Capital Markets, with a specialized focus in the lithium and clean technology/alternative energy industries. Jon holds both a Ph.D. in physics and an MBA from Queen’s University and has been working in capital markets as a clean technologies/alternative energy analyst for the last four years. He began his career in the investment industry in 2000, originally working as a technology analyst. His current area of focus is the electric metals sector, ranging from availability and production of various metals to lithium battery technology. He has extensive experience in the solar, wind and battery industries, conducting significant research in the areas of rechargeable batteries—ranging from rechargeable alkaline to lithium-ion to flow batteries.
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1) Brian Sylvester of The Critical Metals Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Critical Metals Report: Matamec Explorations Inc., Quest Rare Minerals Ltd., South American Silver Corp., Texas Rare Earth Resources Corp. and Ucore Rare Metals Inc. Streetwise Reports does not accept stock in exchange for services.
3) Jon Hykawy: I personally and/or my family own share(s) of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports to do this interview.
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