It is no secret that China has a  stranglehold on rare earths. For those who are uninitiated, rare earth elements (REE) comprise 17 metallic elements with a variety of modern industrial and commercial applications ranging from petroleum refining to laptop computers to green energy applications to radar. It has been reported that China produces 95% of the world?s REE.

As a result of China?s monopoly in supplying the world?s REE, the recent alleged unofficial REE embargo against Japan had caused alarm among REE importer nations, of which Japan is the largest.

However, as investors, we have to understand clearly what China?s ?monopoly? on REE is and isn?t. Although it?s true that China has a commercial monopoly on rare earths, it does not mean that it is a real monopoly. To understand what we mean, consider this recent news article,

China has 30 percent of the world?s reserve of rare earths, but mines it cheaply and effectively. More than 90 percent of the world?s available supply is currently mined in China.

Basically, China has less than one-third of the world?s REE reserves but produces 95% of the world?s REE. Hence, do you see a problem?

REE are not as rare as their name suggests. There are plenty of REE scattered around the world. Before 1979, the US was the largest producer of REE. So, what happened? A recent report from Stratfor wrote,

The story of REE is not the story of cheap Chinese labor driving the global textile industry into the ground. Instead, it is a much more familiar story of the Chinese financial system having a global impact.

Unlike Western financial systems, where banks grant loans based on the likelihood that the loans will be repaid, the primary goal of loans in China is promoting social stability through full employment. As such, the REE industry ? like many other heavy or extractive industries ? was targeted with massive levels of subsidized loans in the mid-1980s. At the same time, local governments obtained more flexibility in encouraging growth. The result was a proliferation of small mining concerns specializing in REE. Production rates increased by an annual average of 40 percent in the 1980s. They doubled in the first half of the 1990s, and then doubled again with a big increase in output just as the world tipped into recession in 2000. Prices predictably plunged, by an average of 95 percent compared to their pre-China averages.

Most of these Chinese firms rarely turned a profit. Some industry analysts maintain that for a good portion of the 2000s, most of them never even recovered their operating costs. At the same time, an illegal REE mining industry ran rampant, earning meagre profits by disregarding worker safety and the environment and ruthlessly undercutting competing prices. With an endless supply of below-market loans, it did not matter if the legitimate mining concerns were financially viable. It was in the environment of continued Chinese production despite massive losses that nearly every other REE producer in the world closed down ? and that the information technology revolution took root.

In fact, if not for China?s massive overproduction, the technological revolution of the past 15 years would not have looked the same. In all likelihood, it would have been slowed considerably.

This is a classic predatory pricing. As we wrote in Chinese strategic plans: control of the supply of rare earth metals,

Predatory pricing is an anti-competitive practice by monopolies to bankrupt their competitors by slashing price so much that everyone makes a loss. Since the loss-making monopoly will eventually outlast their loss-making competitors, it is only a matter of time competition is eliminated and the monopoly can increase prices.

So, what this means is that China will only maintain its commercial monopoly on REE as long as prices remain uneconomically low.

Now, do you see a long term problem that China faces?

As we wrote earlier, China has less than one-third of the world?s REE reserves but produces 95% of the world?s REE. That means that they are supplying REE to the world by running down their REE reserves first before anyone else. Obviously, that will be problematic for them in the future because one day, the tables will turn against them as they start to run out of REE. From that perspective, it makes sense for them to curb REE exports to feed their own domestic needs first.

Of course, if China halt all exports of REE tomorrow, it will cause immediate big problems to the rest of the world because there are not many functioning REE mines (and expertise) outside of China. But in the long run (say more than 5 years later), as new production come online, the world?s dependence on China for REE will decline.

Our long time readers will know that we keep a watchful eye on big picture secular trends. One of the big-picture secular trend is the rise of China. As we wrote before in Example of a secular trend- commodities and the upcoming rise of a potential superpower,

It has been said that today?s 21st century will see the secular rise of China. During the 20th century, China endured non-stop revolutions, civil wars, invasions, social upheavals, ideological experiments (e.g. Cultural Revolution, Great Leap Forward). It was the last couple of decades of the 20th century that China began to slowly emerge from her self-imposed shackles to catch up with the West.

As we observe China, it becomes clear that the Chinese government has a deliberate and long-term plan for the nation. Unlike its democratic Western counter-part, it does not have to worry about winning elections every few years. Since winning elections involves some level of populism, the short-term interests of the ballot vote can clash with the strategic long-term goals of the nation. By the way, please don’t get us wrong- we are not praising China here and political ideology is not our cup of tea. Our goal is to observe in the context of becoming a better investor.

So, for today’s article we will look at one aspect of China’s long-term strategic plan- the monopolisation of the rare earth supply.

First, what are rare earths? As this article explains,

Rare earths are the 15 elements within the lanthanide series of the periodic table, plus the elements yttrium and scandium. The best known are lanthanum, cerium, neodymium, praseodymium, gadolinium, europium and samarium.

Rare earths have a lot of vital industrial and electronic applications. Without them, many of the modern way of life that we enjoy today will not exist. The fact is, there are no substitutes for rare earths in some of these applications. Here are some examples:

1. Petroleum refining- large amounts of lanthanum and cerium have been used here, “with the result of increasing yields from each barrel of oil by about 10% while extending the life of other expensive catalysts like platinum.”
2. Aerospace super-alloys
3. Rechargeable batteries (NiMH).
4. Powerful permanent magnets in information technology products (e.g. hard disks, DVD, DVR, iPods, smart phones, computers), giant windmill assemblies, hybrid vehicles (a typical one consumes 50 pounds of rare earths).

Rare earths are particularly vital in the clean energy applications. Without them, there can be no clean energy industry. Also,

It?s also important to keep in mind that almost none of the rare earths used in large power systems (like windmills) or electric vehicles (such as with NiMH batteries) are currently being recycled. The long lifetimes of the magnets and batteries, coupled with the lack of recycling technologies and dedicated facilities, means that any increase in supply can only come from new mining.

Now, here comes the focus on China. China is the largest producer of rare earths. In fact, it is said that China is the Saudi Arabia of rare earths. This graphs shows the rare earth production over the past half-century:

The Chinese are in the process of cornering the supply of rare earths,

Another factor is that there appears to be an official Chinese policy to slow down export of rare earths. Chinese exports have decreased by 8% or so each of the past three years. Chinese suppliers have placed foreign customers on allocation, at reduced quantities from years past. The Chinese explain that they have closed mines for environmental reasons. Yet the Chinese also promise adequate supplies of rare earths if foreign users will move their industrial facilities into China.

By encouraging foreigners to move their industrial facilities, high teach factories and research centres to China in order to gain access to rare earths, there will be technology transfer to China.

Furthermore,

While about 42% of worldwide rare earths resources are outside China, there are NO non-Chinese sites with any significant processing or refining capacity.

…

Mr. Sato has stated, ?Many people are looking at establishing alternative refineries and sources outside China, but the investment is not necessarily a sound one because of the threat of price revenge by China. If new projects emerge, as they have recently in Malaysia and Australia, China could just drop its prices and force rivals out of business.?

In other words, the Chinese are engaging in predatory pricing. Predatory pricing is an anti-competitive practice by monopolies to bankrupt their competitors by slashing price so much that everyone makes a loss. Since the loss-making monopoly will eventually outlast their loss-making competitors, it is only a matter of time competition is eliminated and the monopoly can increase prices. Anti-competitive practices are illegal under the anti-trust laws. Though this law can be enforced on individual corporations, it is not possible to do so against a nation.

As for investors, this is a tricky investment theme. The rare earth mining company that you are investing in can be a victim of predatory pricing!