The Critical Metals Report: Let's start with the basics. In general terms, what exactly are "specialty" metals?
Richard Karn: We use the term "specialty metals" to refer to metals and elements that are neither base metals (iron, copper, nickel, lead and zinc)—which oxidize, tarnish or corrode easily, nor energy metals (uranium and thorium). We find the nomenclature the market uses to refer to these metals not only confusing but also conflicting and misleading: Precious, industrial, clean, rare, military, green, critical, minor, technology and strategic.
Most of these metals have a wide range of applications that resist such simple categorization. For instance, so-called minor or industrial metals, such as antimony, manganese, tungsten, molybdenum, vanadium or magnesium are largely leveraged to the base metals they are commonly alloyed with and are clearly critical or strategic in that you cannot make steel or myriad alloys without them, yet all of them are increasingly finding use in so-called "clean" or "green" applications. Precious metals—gold, silver and the platinum group metals (PGMs)—also are in widespread use in technology, green, military and industrial applications. We're also discovering that rare earth elements (REEs) are in a surprisingly wide variety of applications and devices that make modern life possible.
In essence, what we are trying to do with the term "specialty metals" is simplify the language in hopes of making a lucrative but demanding investment trend more accessible to the broad market.
TCMR: In broad strokes, please outline the investment case for specialty metals.
RK: Essentially, the West, which we loosely label "free marketeers," allowed the East, which we label "neomercantilists," to gradually take market share in the production of the vast majority of specialty metals.
Free marketeers were so focused on short-term profits, and often the executive compensation attendant, to making the number each quarter, that they lost control of the long-term supply of the specialty metals critical to their businesses. Novel business models like just-in-time supply chains are starting to break down as a result. Today, free marketeers are in denial about what they have wrought; so, they are clinging to slogans like, "Market Forces Will Prevail," while they scramble to secure supplies of these metals.
On the other hand, the neomercantilists have arrived at the happy situation wherein they have near-monopolistic control of a whole range of metals—not just REEs—and they are openly pressing their advantage. We were somewhat surprised last year by the market's reaction to China's announcement that it would severely curtail the availability of REEs. The country had been incrementally reducing production, making regular cuts to export volumes and increasing export taxes for years. But in the whimsical ways of the market, none of that mattered at all until it suddenly became paramount. We actually had been expecting such an announcement pertaining to antimony, tungsten, graphite, indium or germanium rather than REEs—all of which are, incidentally, also largely controlled by China and ended up being included in its strategic reserve.
That's the Reader's Digest, condensed version of how we arrived at our current situation.
What we consider the largest single demand driver of the trend in specialty metals today is simply our endless pursuit of higher-quality, ever-more efficient devices at ever-lower prices. It's difficult for many people to grasp the extent to which the combination of advances in computer-processing power, analytical and modeling software and data storage—all of which were attended by plunging prices—has enabled an explosion in material science and metallurgical R&D.
Literally, the more these scientists look, the more new and exciting uses they find for these specialty metals. The unique performance characteristics of these metals limit substitution and such trace amounts are used, that the metals are price inelastic. Many of these metals, such as tellurium, which is actually scarcer than platinum, are sourced only as a byproduct of other metal production, which render them supply inelastic. Add in the fact that many experience dissipative uses, but lack recycling protocols, and the enormity of the supply problems begin to come into focus. Add sovereign risk and resource protectionism to the mix, and it becomes equally apparent that these supply problems are entrenched, structural and without quick remedy—regardless of how fervently the free marketeers chant, "Market Forces Will Prevail."
Keep in mind that rapid technological advance shrinks a device's operational lifespan (everyone wants the latest, greatest version) and that, to a large degree, the specialty metal demand trajectory is discovery-driven rather than correlated directly with GDP, as is the case with oil, base metals, lumber, etc. An example of this can be seen with the mobile phone market—while the global financial crisis (GFC) crimped demand for high-end phones, unit sales of low-end models actually increased as demand from so-called "emerging markets" continued unabated.
TCMR: There are some commonly held misconceptions about the specialty metals market. Could you please clear those up or dispel those myths for our readers?
RK: The biggest myth is the aforementioned, "Market Forces Will Prevail." You simply cannot fix structural problems that took decades to develop quickly by throwing money at the problem. Specialty metal projects are difficult to find, and financing more difficult to arrange, because the majority of these metals are unhedgeable—that is, they trade off exchange—which makes banks nervous.
The market is just starting to become aware of the difficulty involved with processing these metals, which, in many cases, more closely resemble sophisticated industrial chemistry than traditional onsite brute processing. Putting flow sheets together that process these metals and elements economically is no mean feat. And the neomercantilists are increasingly acting like cartels, in that they are actively taking steps to protect their controlling positions.
Another myth is the extent to which substitutions for these metals can be found. It's true that often you can substitute certain metals or elements with those in the same group, such as with PGMs or REEs, but that frequently results in the price of the substitute increasing, as well. Finding substitutes outside the group tends to require more of the substituted material and usually results in a bulkier device with poorer performance characteristics. Researchers worldwide are scrambling to find alternatives, but I wouldn't use that as a rationale upon which to base an investment decision.
The same applies to recycling. We are huge fans of recycling, especially of specialty metals, because we live in an increasingly resource-constrained world and metals are effectively infinitely recyclable, which makes them a truly sustainable resource. But only a small percentage of the specialty metals found in computers, mobile phones and consumer electronics are recycled. All too often, the same people protesting new mine development, or clamoring for a bigger piece of the resource pie, think nothing of discarding the devices containing these precious resources. We can't have it both ways. If we had the political wherewithal to mandate recycling, perhaps by adding a metal-value surcharge to the price of a device that could be redeemed at recycling centers, we could significantly increase our resource base and preserve it for future generations.
As it stands, recycling is a for-profit business. Until the prices of these metals get high enough to warrant the time and energy to develop recycling technologies, many of which resemble sophisticated chemistry rather than crushing and baling, recyclers will focus primarily on the easily recoverable, high-value metals. I read recently that more than 90% of the contained value in computers is found in just four metals: Gold, silver, palladium and copper—in mobile phones, it was 95%. That means literally dozens of other specialty metals are simply being thrown away.
Even Japan, which is very good at such things, is having problems recycling the REEs used in a variety of devices. This does not bode well for prices. Think about it—a number of these electronics manufacturers are recycling their own products, which means they have access to the exact metallurgy involved in their products' alloys, yet they are having problems recovering them.
One last myth that keeps popping up is that these metals represent but a few billion dollars of value in a $50 trillion global economy; so, why do they really matter? As China is making abundantly clear—it's what these metals mean, in terms of value-added products that count. And that certainly runs to the trillions of dollars.
TCMR: One problem with investing in specialty metals is the lack of transparency. Most base metals are traded on the London Metals Exchange (LME), which means just about anyone can visit the LME website, see the prices for and inventory of those metals. Do you expect to see a similar bourse develop for specialty metals? If not, how will transparency find its way into this rapidly growing sector?
RK: China just announced plans for a rare earth element exchange—not a futures exchange, but rather a vehicle to determine (some would say dictate) the spot price. We are leery of China's motivations these days. In fact, a groundswell is gathering momentum that could result in China being brought before the WTO for a number of its practices. We wouldn't be surprised if the country's response is, shall we say, unsettling.
Some metals are legitimate candidates for exchanges, others are far more problematic because they are byproducts sold forward at a discount to meet financing demands or are produced in such small quantities that it would not be practical. Others are sold on a highly confidential basis between producer and user, with the latter developing and maintaining a competitive advantage over its rivals via these negotiations.
So, no, we don't see most of these metals ever trading on exchanges and, judging from some of the questionable practices being allowed on the gold and silver futures exchanges, that might not be a bad thing.
TCMR: Richard, you say the price of critical metals is "discovery driven" and not tied to GDP growth, as is the case with commodities like oil and base metals. What are some examples of discoveries that really drove up the prices of specialty metals?
RK: One example is ruthenium, the minor PGM that was instrumental in facilitating the jump from longitudinal-bit stacking to perpendicular-bit stacking and the higher magnetism used in our multiterabyte hard disk drives today. Others include the use of gallium and tellurium in competing types of solar panels, rhenium in the superalloys used in jet turbines, indium in flat panel displays, graphite in lithium-ion batteries, carbon nanotubes, graphene, and grafoil, or antimony in flame retardants in everything from the plastics used in consumer electronics to children's clothing and upholstery.
Once you start looking at these metals and their uses, it's actually quite fascinating. The advances we have seen especially in consumer electronics over the last decade and a half have not been driven by lone inventors or college kids tinkering in their parents' garages, but rather by very large, well-equipped and -staffed research arms of powerful corporations. The stakes are high and if a certain metal is critical in an application, they will buy it regardless of the price.
TCMR: Going back to your discovery-driven investment thesis, wouldn't an economic slowdown result in less money flowing into R&D budgets, ultimately leading to fewer new discoveries and, thus, lower demand for critical metals?
RK: More than half the world's population is doing its damnedest to secure the standard of living that we take for granted. They were largely unaffected by the global credit crisis because they live in a largely cash-and-carry world. So, barring an abject collapse, I doubt we will see a significant demand decrease.
TCMR: In your research, you say the price of rare earth elements is up 1,700% over the previous 10 years. Likewise, the price of antimony is up 1,600%; zirconium and magnesium—both up 950%; tungsten up 750%; and manganese up 700%. Are there four or five metals that you expect similar rises for over the next decade?
RK: We can easily see the majority of the 50 metals (including gold) we cover experiencing similar price increases, though we would caution readers to be careful what they wish for. We have long maintained that the monetary inflation being visited upon the world by a plague of bureaucrats—and it is a global phenomenon not limited to the U.S.—eventually will produce elevated commodity prices. You can only use perpetually devaluing paper currency to purchase real hard assets for so long before commodity producers' start demanding significantly more paper for their products, or their projects become uneconomic and fold up entirely.
We would also add that, at some point, the U.S. and the EU are going to wake up to the fact that they have neglected their infrastructure for the better part of 30 years and simply can no longer afford to continue the neglect if they wish to maintain any pretense of being globally competitive. In the case of the U.S., whether it is QE3 or QE3, at some point, the administration will stumble across the idea that putting people to work repairing, replacing and expanding our infrastructure is what is needed to put America back on track.
So, we expect specialty metal prices to remain volatile but with a decided upward bias, because we simply do not believe there are sufficient specialty metal projects coming onstream to meet demand. Once the U.S. and EU start their infrastructure-refurbishment program, things will get very interesting indeed.
TCMR: You claim that no less than 50 specialty metals (including gold) are subject to supply threats. Moreover, you report that 40 of those metals can be found in Australia and will be mined there inside three years. In fact, you're a big proponent of investing down under. Why are you so bullish on Australia?
RK: Allow me to give you a little background on the 50 specialty metals we consider to be under supply threat. First, we consider there to be essentially five forms of supply threat: 1.) Sovereign risk; 2.) Scarcity; 3.) No substitute for the metal in a primary use; 4.) Byproduct sourcing; and 5.) Dissipative use in a primary application. In order to qualify, for our list, a metal must experience at least two forms of threat—the average is three.
Of these five threats, only two are really under any semblance of investor control: 1.) Sovereign risk; and 2.) Dissipative use—assuming that at some point we wake up and mandate recycling.
We have been concerned, and writing, about sovereign risk since early 2007, at which point we began limiting our investment universe to North America and Australia. In the aftermath of the GFC, resource protectionism, nationalization and corruption are on the rise—as is consistent with more than 150 years of economic history. We see no reason to tolerate any sovereign risk.
Successive Prime Ministers Rudd and Gillard notwithstanding, we consider Australia about as politically secure as can be found today. Australians honor their agreements, contractual or otherwise.
Australian geology is also unique. As the most tectonically stable continent on the planet, its considerable mineral endowment has benefited from eons of exposure to water, wind and sun concentrating what it has. And Australia has at least 40 of the 50 metals we track; for example, though slightly off topic, BHP Billiton Ltd. (NYSE:BHP; OTCPK:BHPLF) and Rio Tinto (NYSE:RIO; ASX:RIO) are mining ore in the hell-and-gone of the Pilbara region, which is nearly 60% iron and requires no processing whatsoever before being loaded on trains and shipped to the coast for export. In fact, were it not for this natural processing, or concentrating, a case can be made that a number of their projects would not be economic.
I can talk about this all day long because, for me, it is a perpetually unfurling tableau of wonder; but to put things in perspective, think about this—you can go down in Karijini Gorge in Western Australia and put your hands on rocks that are at least 2.5 billion years old�literally from the basement of time.
TCMR: You note that the clash between free marketeers and neomercantilists has created investing opportunities in Australia. Tell us about that ongoing battle and what it could mean to investors.
RK: When the neomercantilists were taking market share by undercutting the world's for-profit mines on price, a significant number of those closed were located in Australia—not least due to the high wages Australia pays and the fact that it's a difficult, arid geography in which to operate. A lot of Australian mines were closed not for lack of ore but because they were undercut on price. Today, metal prices have rebounded and many are reaching new highs, which certainly renders these mines economic again. Many still have functional infrastructure and a few of the operators of such mines have had the foresight to keep their mining licenses current.
The same applies to a number of very promising specialty metal deposits that cannot arrange financing in the aftermath of the GFC because the metals in question are not hedgeable. This is presenting a range of opportunities for private equity money, and we believe many of these projects will do quite well following their eventual IPOs.
Further, over the last year or 18 months, the large caps and the micro caps in Australia have outperformed the mid caps significantly. This usually results in significant M&A activity as the large caps use their richly valued shares to pick up comparatively undervalued mid caps. This process has just begun, and we expect it to accelerate from here.
TCMR: Some of those 40 metals that will be mined in Australia will be REEs. Are there some companies operating in Australia that you believe have exciting opportunities for growth in the coming years?
RK: We wrote up Alkane Resources Ltd. (ASX:ALK) as our first investment report in early April 2010. We not only liked its suite of REEs but also that it would be producing a variety of zirconium compounds, as well as niobium and tantalum concentrates. In other words, this was a company flying under the world's radar, for the most part, that was set to produce 19 of our 50 metals in one go. It had been working in conjunction with the Australian government in a public-private initiative to develop and demonstrate its flow sheet, which put it well ahead of the majority of REE projects. Throw in what I consider stellar management, a very long-life asset and a clear plan to throw off dividends for a long time once in production, and we thought it made a brilliant inaugural report.
Then, when China made its REE announcement last June, we issued a bulletin to our sponsors to buy more ALK, as well as Arafura Resources Ltd. (ASX:ARU), Lynas Corporation (ASX:LYC) and Molycorp Inc. (NYSE:MCP), for which the IPO was slated in August, but which went off in late July. All have performed well, and we expect this to continue to be the case.
A related specialty metal we are particularly taken with is scandium—a fascinating metal that stands to significantly improve the performance and economics of both the aviation and fuel cell industries. It is literally a case of significant demand awaiting reliable supply to give birth to a new metal market. As is the case with REEs, with which scandium is usually grouped, economic deposits are very rare and processing is difficult.
We actually were onsite in Greenvale in northern Queensland with the geologist who found the bonanza grades when Metallica Resources Inc. made its announcement about the scope of the scandium deposits on its Lucknow and Kokomo tenements. To the best of our knowledge, there are currently only three deposits in the world that are deemed economic�all three are in Australia, and MLM controls two. The third is a joint venture (JV) at Nyngan, New South Wales that EMC Metals Corp. (TSX:EMC) is farming into; so, we issued a Buy on both companies. One way or the other, we wanted a piece of those deposits because the metal is too important not to have economic deposits get developed.
By way of disclosure, not only do we own shares in both companies, but also, subsequent to the release of that report, I have personally become involved with a private equity group that is in discussions with MLM to form a JV company to put part of the Lucknow tenement into production.
TCMR: And how have your recommendations performed?
RK: On June 1, 2011, our sponsors were up 137% since April of 2010, and our annual subscribers were up 94%.
TCMR: What are some rules of thumb that investors should adhere to when investing in specialty metals?
RK: Do your homework—this is not the market for the lazy or uninformed. But by the same token, you really do not need to be a specialist either. We're generalists, but developments over the five years we've been following the specialty metal sector have provided us with insights borne of experience. Heck, I'm not a geologist, metallurgist or process engineer—I'm a retired university professor—of American Literature.
TCMR: This has been very informative, Richard. Thank you so much for speaking with us today.
Richard Karn, managing editor of The Emerging Trends Report, has a broad, multidisciplinary background, industry contacts and a working knowledge of precious and specialty metals, as well as considerable research, analytical and writing experience. He has written for publications ranging from Barron's, Kitco and Fullermoney to Financial Sense online.
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DISCLOSURE:
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 Gold Report: None.
3) Richard Karn: I personally and/or my family own shares of the following companies mentioned in this interview: Alkane, BHP Billiton, Arafura, Lynas, Molycorp, Metallica Minerals and EMC Metals. I personally and/or my family am paid by the following companies mentioned in this interview: None.
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