Index Member Comment - February 3, 2011: Molycorp leading contender to deliver meaningful ROW rare earth supply
Molycorp Inc has emerged as the proxy for rare earth sentiment since trading started on the NYSE on July 29, 2010 after the company completed an IPO consisting of 28,125,000 shares at $14 to raise $367 million. Molycorp is not the usual NYSE company with years of revenues and earnings; it is a Canadian style resource sector junior whose primary goal is to put a rare earth deposit into production. As such it has baffled the Wall Street media which has little experience with how to value a mine development story. Despite the small size of the rare earth sector in production value terms, namely less than $2 billion in 2009 when the market woke up to the rare earth story, the couple dozen or so juniors with advanced rare earth projects have attracted a stunning amount of vitriol from "bubble experts", many of whom expressed no such reservations when they piled into resource juniors during the last decade which owned uranium or molybdenum deposits. Remarkably, the annual production value of uranium and molybdenum had motored along below $2 billion for a couple decades before their prices underwent a breakout in 2004 which pushed the inferred annual value into the $10-$15 billion range before the 2008 Crash knocked back prices. Today uranium and molybdenum, both incremental but critical inputs for considerably more valuable downstream products, are generating annual upstream production revenues in the $5-$10 billion range and nobody talks about a uranium or molybdenum bubble. Uranium and molybdenum are simple metals compared to rare earths which consist of 15 elements with a broad range of unique properties which bestow functionality on an even bigger range of applications. Uranium and molybdenum demand is tied to the business cycle and long term energy infrastructure plans which makes analysis of future supply-demand imbalances straightforward. For the EBITDA schooled who know how to use a pocket calculator uranium and molybdenum are easy; but when they apply their high school skills to rare earths, they bump up against wild demand drivers called innovation and policy which offer no comfort in the form of rationally constrained numbers. Those who recoil at the challenge of deploying intellect and imagination to understand the rare earth story become bears, while those with the will and capacity to rise to the challenge become bulls. There is thus no lack of irony in the fact that Denver based Resource Capital Funds (RCF), famous for its patient and risk-averse approach to the resource sector, is about to collect a massive payday through a secondary offering that will net Molycorp's founders $500 million by selling a small portion of their original investment. The rare earth sector has entered the big leagues, with the inferred value of annual production now hovering in the $5-$10 billion range where it is starting to attract the curiosity of major mining companies which had hitherto ignored rare earths on grounds that their market value was too small and their production processes too complicated to be worth the bother.
The Kaiser Rare Earth Stock Index finished 2010 with a strong uptrend that climaxed during the final week with news that China this time was serious about cracking down on illegal and polluting rare earth production in order to achieve its goal of 90,000 tonnes of annual rare earth production under the auspices of a small group of large state owned mining companies for whom the rare earth production was a fraction of their overall business. Although China provided the gloomy news that its export quota for the first half of 2011 would be just under 15,000 tonnes, suggesting that a similar quota for the second half would leave the 2011 export quota roughly in line with the overall 2010 quota, and some FOB spot prices as well as domestic spot prices ticked higher, the juniors with advanced rare earth projects which comprise the Rare Earth Stock Index hit the wall during January. However, on January 21 during the Cambridge Critical Metals Conference which ran in Vancouver on January 21-22, the oracle of Chinese rare earth policy, Dr Chen Zhanheng, presented a paper through Jay Roberge (Dr Chen and his associate were unable to obtain travel visas in time to make the trip) which had stunning implications for the rare earth sector.
Dr Chen offered several key messages. One was that China was serious about curtailing illegal and polluting rare earth production which by inference suggested that 30,000 tonnes of production, much of it smuggled offshore, would vanish during 2011, bringing China's production down to 90,000 tonnes. This message clashes with the perception that similar past efforts by Beijing have all failed. The second message was that China intended to boost rare earth production to only 100,000 tonnes by 2015. This message clashes with the perception that China has a super-abundance of rare earth resources that it will soon enough deploy to glut the market and sink any rare earth mines in the "rest of the world" that have been brought on stream in the belief that cheap Chinese rare earth prices are history. The third message was that he envisioned 2016 demand ("target supply") to be 278,000 tonnes, which clashes with the 185,000-200,000 tonne demand range IMCOA's Dudley Kingsnorth has been projecting for 2015. Dr Chen's declaration was significant because while Kingsnorth's projections are based on extrapolations of empirically observed demand growth trends, Dr Chen is plugged into China's central command which presides over the innovations with commercialization potential China's heavy R&D investment may have generated during the past decade, and which dictates policy goals such as the electrification of China's transportation sector and the development of wind and solar as major components of China's energy infrastructure. In other words, Dr Chen has looked at demand driver "cards" which are hidden from Dudley Kingsnorth. Dr Chen projects western demand as growing 15% annually, and while he does not present China's demand growth, it would be odd to see its growth rate not match that of the rest of the world. Applying 15% compounded growth to Dr Chen's 2010 Chinese and ROW demand figures we get pretty close to his "target supply" of 278,000 tonnes beyond 2015. The fourth message was that China was counting on the rest of the world to supply the extra 178,000 tonnes by 2015, and that China would be a net importer of rare earths. This clashes with the perception that China's rare earth policy is designed to maintain a supply monopoly it can use to manipulate its economic and military competitors. Instead Dr Chen was suggesting that diversity of rare earth supply from many locations in the world would be good for everybody, including China. The fifth message was an arithmetic boondoggle arising from Dr Chen's claim that China's current rare earth demand was about 74,000 tonnes and its export quotas for 2011-2015 would run between 32,000-35,000 tonnes. This clashes with simple math: if China's production is restricted to 90,000 tonnes, and domestic demand is 74,000 tonnes, and likely growing as more end-users transfer component production to China in order to secure access to critical rare earth inputs, then China will have only 16,000 tonnes available for export, and most of that has already been allotted to the first half of 2011. In other words, if China's priority is to supply domestic rare earth demand without boosting domestic production beyond 90,000 tonnes, then there will be little material available for export markets. This is bad news for all manufacturers outside of China, and anybody who is counting on a decline in FOB spot prices while the world awaits the arrival of non-Chinese rare earth supply.
Dr Chen's 178,000 tonne supply gap is the prize to which the non-Chinese rare earth juniors aspire, and Molycorp is a leading contender for a 40,000 tonne chunk of the prize. Molycorp is spending $781 million in two stages of $531 million and $250 million to bring its 100% owned Mountain Pass rare earth project back into production at a rate which is expected to produce about 40,000 tonnes of separated rare earth oxides annually starting in 2014. This capital cost applies only to infrastructure required to produce separated rare earth oxides. Phase 1 is expected to be complete at the end of 2012 and allow production of 20,000 tonnes annually starting in 2013. The Mountain Pass operation is currently producing about 3,000 tonnes of rare earth oxides annually from stockpiled ore. All approvals to begin construction of a new mill to produce a concentrate were received in December 2010. The mine site has a mining permit with a maximum rate of 2,400 tons per day. At full capacity Molycorp would deplete its current resource in 16 years. Molycorp has a "mine to market" development plan which envisions the company open pit mining the Mountain Pass deposit, milling and flotation of the ore to produce a bastnaesite concentrate grading 68% TREO, cracking the concentrate with a "secret" process to extract a mixed oxide, separating the mixed rare earth oxides through solvent extraction, selling some rare earth oxides directly to end-users (ie 75% of lanthanum oxide will be sold to WR Grace as an input for its fluid cracking catalyst product), converting some oxides into magnet powders and refining some into high purity metal, producing value added downstream products such as alloys and magnets, and using some of the rare earth oxides such as cerium as an input for wholly owned advanced technologies such as XSORBX, Molycorp's water filter.
The complexity of Molycorp's business plan makes it impossible to conduct a discounted cash flow model based valuation of the company, but the technical report provides enough operating cost information to construct a cash flow model for the production of separated rare earth oxides. In an effort to facilitate net present value based valuations for comparison among other juniors developing rare earth projects, we have constructed a simple model which envisions a mining rate of 1,100 tpd during the first year, and 2,200 tpd thereafter (converted from tons to tonnes), recovering 60% of the TREO head grade with uniform recovery of the rare earth elements in the target bastnaesite ore, and selling separated rare earth oxides at "market" prices. We have accepted the company's most recent disclosures with regard to capital and operating costs as well as recoveries. Molycorp along with a number of Australian companies presents operating costs in terms of TREO units produced rather than cost per tonne of ore processed. We have converted these numbers into $/t figures before running the model using the various price sets in the table below to generate revenues based on separated rare earth oxides, and graphed the DCF (10% discount rate) results as net present value per share against the value per kg TREO produced.
Rare Earth Oxide Prices US $/kg as of February 3, 2011
|Rare Earth Oxide||FOB 3 Year|
|FOB Spot||Domestic 3|
|1) FOB and Domestic average and spot prices as of January 27, 2011 - Metal-Pages|
|2) JP Morgan prices used in Sept 29, 2010 research report as basis for DCF valuation that set A $1.71 price target for Lynas, where no REO given, 3 year FOB averages were used|
While all rare earth projects have substantial uncertainty with regard to recovery rates at commercial scale and the associated cost structure, the greatest uncertainty lies with the revenue side of the equation, namely the prices for separated rare earth oxides. The rare earth oxide price table above shows dramatic differences between trailing three year average and spot prices, as well as between Chinese domestic and FOB spot prices. The REO Composite Price chart shows the historical trend for the four key price sets. The chart below shows the value breakdown of Molycorp's 40,000 tpa projected production in terms of FOB and domestic spot prices prevailing at the end of January 2011 and applied to the recoverable distribution inherent to the deposit. The chart makes it clear that Mountain Pass will make very little contribution to the world's heavy rare earth needs, and that there is a substantial difference between the revenue potential at FOB and domestic spot prices.
The after tax NPV chart below for Molycorp's Mountain Pass project depicts the valuation's sensitivity to rare earth prices. The yellow line shows the price Molycorp would command if the $/kg price set became the reality for the life of the mine. It should be noted that because innovation and policy are significant drivers of future rare earth demand, the future relative prices of rare earth oxides may vary drastically from historical trends. Innovation can boost demand as when large scale commercialization of new technology happens, or it can reduce demand for a rare earth by achieving better functionality through another rare earth, as happened when neodymium magnets displaced samarium magnets, or a substitute is developed which achievers a similar or superior functionality with a cheaper and more readily available critical input. Policy can affect demand in a variety of forms, such as the car industry adopting more efficient combustion engines in response to fuel efficiency standards rather than seeking a shift away from gasoline in favor of electricity as a transportation fuel (this would chill rather than boost rare earth demand). Another example of policy driven demand would be China's decision to combat the 2008 Crash through fiscal stimulus programs such as the construction of huge wind farms which utilize rare earth magnets. Who can predict what policy will be floated and implemented? In other words, the appropriate prices to use in valuing a rare earth project are anybody's guess, which is why in the battle between the bulls and the bears the winner cannot be predicted.
Cash Flow Metal Price Sensitivity Analysis
|Molycorp Inc||Mountain Pass||California, USA|
|Parameter Source:||Molycorp Technical Report||Scenario Author:||JK||Primary Metal:||REO|
|Breakeven||Domestic Spot||Domestic 3 Year Avg||FOB 3 Year Avg||JP Morgan||FOB Spot|
|TREO Price $/kg :||$5.56||$12.42||$6.69||$16.23||$30.68||$72.18|
|Recoverable Rock Value $/t:||$313.48||$699.00||$376.51||$913.42||$1,726.67||$4,062.29|
|Average Annual Revenue:||$211,821,911||$473,170,639||$254,872,107||$618,322,018||$1,168,830,531||$2,749,875,740|
|Average Annual Pre-Tax Cash Flow:||$113,453,253||$374,801,931||$156,503,400||$519,953,311||$1,070,461,877||$2,651,507,033|
|Pre Tax NPV:||$86,932,774||$1,919,057,396||$388,556,723||$2,936,720,147||$6,796,359,715||$17,881,137,713|
|After Tax NPV:||($267,293)||$1,349,382,007||$227,919,922||$2,086,887,665||$4,873,277,810||$12,856,184,498|
|After Tax Price/Share:||$0.00||$15.62||$2.64||$24.16||$56.43||$148.86|
|Internal Rate of Return:||8.5%||37.6%||14.3%||50.8%||96.4%||207.6%|
|Mine Parameters||Cost Parameters||Other Parameters|
|Tonnage||12,326,762||Capital Cost||$781,000,000||Fully Diluted||86,366,385|
|Grade||8.242% TREO||Annual Sustaining Cost||$9,200,000||Net Interest||100.0%|
|Primary Metal||REO||Net Smelter Royalty||0.00%||CAPEX Funding||100% Equity|
|Primary Recovery||60%||Marketing Cost||0.0%||Years to Startup||1|
|Primary Production||39,507 tonnes
||Mining Cost $/t||$9.19||Mine Life||16|
|Mining Method||Open-Pit||Processing Cost $/t||$0.00||USD:USD Exchange Rate||1.00|
|Processing Method||Cracking/Separation||Transportation Cost $/t||$0.00||Discount Rate||10%|
|Milling/Mining Rate tpd||2,200||Cracking/Separation Cost $/t||$106.55||Tax Rate||28%|
|Operating Days||365||G&A Cost $/t||$31.00||Payback Tax Holiday||Yes|
|Ore Mined Annually (tonnes)||803,000||Reclamation Cost $/t||$0.00||Cost Inflator||0%|
|Waste to ore Ratio||0.00||Miscellaneous Cost $/t||$0.00|
|Concentrate||0.0%||Total Operating Cost $/t||$146.74||Currency||USD|
|1) High grade proven reserve is mined in year one, scaling up to lower grade ore in year 2|
|2) Recovery based on 65% ore to concentrate, 95% extraction of mixed oxides from concentrate, 99% solvent extraction, 98% separation|
|3) Molycorp reports mining rate in short tons, we have converted to metric tonnes to reflect international standards|
|4) Mining cost incoporates 7.7:1 waste to ore stripping rate|
|5) Mountain Pass has zero transportation cost because mining through separation is done at mine site|
|6) Capital costs are spent in year one prior to commencement of production|
|7) Corporate tax is applied after payback of capex and allows straightline depreciation of capex over mine life|
Analysis: In the best case scenario where current FOB spot prices become the long term reality Molycorp would have an NPV of $140 per share. On the other hand, if current domestic China prices prevailed as the long term reality, the NPV would drop to $15.62 per share, slightly higher than the $14 IPO price. In terms of execution risk we tend to believe Molycorp's projected timeline because in light of the urgency that the REO supply situation has achieved in American government circles we do not believe the project will get bogged down in American "nimbyism". Molycorp does like to spout the GAO Report conclusion that it can take 7-15 years to bring a rare earth mine into production, but we interpret this as little more than a cynical ploy to undermine optimism that competing rare earth projects could be rushed into production in considerably less time. We do note that Molycorp's engineers have gone to considerable effort to design a closed loop system which reduces dependency on outside power sources and minimizes reliance on waste storage strategies. With regard to Molycorp's recovery projections, the company does claim to have doubled the recovery efficiency of the past mining operation, which we are inclined to believe while noting the risk that this improvement may not scale to full production capacity. In terms of mineral control risk, namely that that ore mill-feed will not mesh with the cracking design, we do note that Molycorp's technical report conveys a detailed awareness of mineralogical variation within the deposit which suggests that the company will avoid mining ore that will "gum up the works" or "suck up acid like there is no tomorrow". We believe it is plausible that Molycorp will achieve its rare earth oxide production goals within its projected timeline of 20,000 tonnes during 2013 and 40,000 tonnes during 2014. In terms of valuation based on our simplified cash flow model, we think the current stock price reflects a reasonable long term REO price. However, in terms of Molycorp's actual "mine to market" business plan which positions the company as a manufacturer of clean energy related technologies and products, which its in-house security of supply from Mountain Pass will facilitate, we believe Molycorp has the potential to grow into a clean energy industrial with a stock price in the $100-$200 range. Although we note that Molycorp claims to have sufficient potential to discover and develop lower grade monazite zones on its Mountain Pass property which could boost its production of heavy rare earths and extend the mine life, we are skeptical that these brownfields efforts will be successful. We also note that Molycorp has publicly stated it is open to acquisitions, but that it is still looking, which we interpret to mean that Molycorp is aware of the other advanced juniors and has found them lacking. We suspect that once JP Morgan has found a new home for $500 million worth of paper owned by the current insiders, and the catastrophe risk posed by Molycorp's dependency on a single rare earth mine sinks in, the company will evolve a mandate to boost its own security of supply by acquiring and developing other major rare earth projects.