Molycorp, Inc. (MCP) – There's a New Scarce Resource On The Rise

The below bullish call on Molycorp MCP was originally published exclusively to premium readers of The Thematic Investor yesterday at 9:30am. Since that time, the stock has risen over 11%. This is another big win for subscribers of the The Thematic Investor.

The Thematic Investor Call - Molycorp, Inc. (MCP- 31.69) I recommend taking an initial position in Molycorp, Inc. MCP at the current price of $31.69. While there is modest risk associated with the pullback in commodity pricing levels for rare earth elements given the vapid increase over the last 12 months, I see favorable underlying fundamentals that are fueled by the Scarce Resources aspect of rare earth elements, both on its own given the nature of the elements but also the near monopoly that China has in these elements - at least today.

Given the growing nature of the high tech, green tech, military tech and other markets that drive demand for rare earth elements, long term demand patterns look bright. In addition, given the commodity price nature of these rare earth elements, they and therefore MCP shares offer protection should inflation come on stronger than expected. As such, I would use any pronounced pull back in MCP shares to increase your position - all things being equal, I would get more aggressive in the shares the closer they approached $28.

Background

This week fast food stalwart McDonald's Corporation MCD delivered impressive quarterly earnings amid rising food costs. As I have mentioned previously, increasing commodity costs are one of the several things I have my eyes on. Normally when investors think of commodities, things like corn, wheat, soybeans, hogs, cocoa, lumber, gold, silver, and coffee enter the mind. While those are key ones to watch, there are a number of others and a certain subset are getting all the attention. What I'm talking about is rare earth elements.

Never heard of them? Well you are not in the minority, unless you happen to be in a high school or college chemistry class. That or you happen to look at the periodic table for fun! So let's get some background on these rare earth elements.

As defined by The International Union of Pure and Applied Chemistry (IUPAC), rare earth elements or rare earth metals are a collection of seventeen chemical elements in the periodic table – scandium, yttrium, lanthanum, cerium, praseodymium, neodymium, samarium, europium, gadolinium, terbium, dysprosium, holmium, erbium, thulium, ytterbium, and lutetium. Despite their name, rare earth elements are found in relatively high concentrations in the Earth's crust, but because of their geochemical properties, they rarely concentrate into economically exploitable deposits. It's from the rareness of the minerals in which these elements are concentrated and from which they are isolated that they have been named rare earth elements. Until 1948, most of the world's rare earths were sourced from India and Brazil but this shifted in the 1950s to South Africa. Through the 1960s until the 1980s, the Mountain Pass rare earth mine in California was the leading producer. Today, the Indian and South African deposits still produce some rare earth concentrates, but they are dwarfed by the amount sourced in China. China represents more than 97% of the world's rare earth supply.

These 17 rare earth elements are becoming an increasingly important part of our daily lives as their use in modern technology has increased dramatically over the years. Rare earth elements are now incorporated into many technological devices, including computers, superconductors, select types of magnets, electronic polishers, refining catalysts and hybrid car components. For example, there are nearly ten pounds of the rare earth element, lanthanum, in every Toyota Prius engine. Other uses include luminescent materials used in optoelectronics applications, optical-fiber communication systems, cathode ray tube technology, tunable microwave resonators, and military technologies.

The increased usage over the last few years amid strained supply has raised concern over potential shortages of these key ingredients. In each of the last 3 years, China has reduced the amount of local rare earth production to be exported. For example, the total export quota for 2010 is 30,258 tons, down 40% from the 50,145 tons exported in 2009 and there has been some talk in the headlines that China may reduce export levels again in 2011. In addition, China has made moves to buy other rare earth resources around the world - in 2008, Chinese government-owned mining companies acquired 52% of Lynas Corporation and 25% of Arafura Resources, which plan to open mines in the next few years that would have a combined production equal to 25% of the global rare earth output. In September, China made political waves by blocking all rare earth exports to Japan, as the two nations were caught up in a spat after a Chinese fishing boat collided with a Japanese coast guard vessel.

Given the nature of these elements, the markets and products they serve as well as concern over China's near monopoly position, the US government is taking steps to help increase production of these elements. Earlier this month, the US House of Representatives passed the Rare Earths and Critical Materials Revitalization Act of 2010, which supports the discovery and development of rare earth sites inside of the United States. According to Kathy Dahlkemper, the author of the Rare Earth bill, "We need to act now to begin the process of creating our own supply of rare earth materials so the United States is never dependent on China for crucial components for our national security."

This brings me to one of my investing themes – Scarce Resources. Normally when people think of scarce resources, it tends to be oil, water or some other type. Based on the above, I would argue rare earth elements fall into that category as well. Luckily there are more than a few ways to play this from an investing perspective, some of which are easy and perhaps more transparent than others.

There are two companies listed on domestic stock exchanges – Molycorp, Inc., which trades on the NYSE under symbol MCP, and Rare Element Resources REE, which is an AMEX listed stock under the symbol REE. Both are relatively new companies in terms of being publicly traded – Rare Elements since late 2008 while Molycorp came public earlier this year. As such, there is limited history and operating performance that we can examine but what is available is not only filed with the SEC but must conform with generally accepted accounting principles or GAAP accounting. The same cannot always be said for other companies with rare earth element exposure that are listed on other exchanges throughout the world. Other companies with exposure to these elements include Avalon Rare Metals and Neo Material Technologies as well as Great Western Materials, all of which are located in Canada. China based companies include Baotou Steel Rare Earth Hi-Tech, China Rare Earth Holdings and Jiangxi Copper.

From my perch, I prefer the domestically traded plays and while that may equate to missed opportunities, the ability to track the companies and rely on the financials is more than appealing. This means choosing between Molycorp and Rare Earth Elements.

Of the two, Molycorp is a far more liquid company in terms of trading volume and boasts equity research coverage from four top investment banks compared to none for Rare Earth Elements. Normally, I would not give the lack of research coverage a second thought but again these are newly public companies and more information in my mind is better than not. Notice I didn't say better information. Moreover, while Rare Earth trades on the AMEX, it is based in Canada. Now there are a lot of good Canadian companies, but given the comments from Kathy Dahlkemper, the author of the Rare Earth bill, I'd favor a domestic rare earth element company.

Aside from these factors, what attracts me to Molycorp is its owning the largest non-Chinese rare earth deposit in the world. The Mountain Pass facility is located in San Bernardino County, California and is the only significant developed rare earth resource in the western world. Operations at the Mountain Pass facility began in 1952 under Molybdenum Corporation of America, which was purchased by Union Oil of California in 1977. In 2005, Chevron Corporation purchased Union Oil of California and the until early 2010 only a pilot line was up and running.

Moreover, its management team has inked a letter of intent for a technology transfer agreement between the companies pursuant to which Neo would provide Molycorp with technical assistance and know-how with respect to production of rare earth metals, alloys and magnets. The same letter of intent contemplates potential supply agreements pursuant to which Neo would purchase mixed rare earth carbonates, as well as neodymium and praseodymium oxides or metals from Molycorp.

Perhaps the biggest drawback in Molycorp is the lack of earnings, for it's not expected to generate positive earnings per share until 2012 as the company works to restart and expand its rare earth mining operations in Mountain Pass. As such has to contend with less than optimal capacity utilization levels but it has ample resources given the $379 million in net proceeds from the recent IPO. Another thing about the IPO, just after that event several insiders bought around 4 million MCP shares.

But when you boil it down, this is a mining stock and that means that there are other ways to value the shares - namely the value of the underlying asset, which hinges on commodity prices for the mine. According to Metal Pages, from October 2009 to mid-August 2010, prices for rare earths have risen by approximately 400% on average. Furthermore, over the same period, prices for some of the most common rare earths (cerium oxide, lanthanum oxide, neodymium oxide, didymium oxide and rare earth carbonate) have risen by more than 700% on average.

To be fair, arguably the greatest risk associated with MCP shares is a popping of what some are calling the rare earth element bubble. I on the other hand look at the situation this way - these are scarce resources serving a growing number of global markets and the US government is going to get behind domestic suppliers of these elements in a defensive posture. While the short term ride may get bumpy, the long term fundamentals are in place.

With regard to REE shares, based on several technical indicators they appear overbought, which I attribute to takeover speculation that has been rampant in the press. Should such an event not come to pass and the shares cool off, I would look to re-examine them below the $10 level.