Stealth Symbolism, and a Rare Earths Update

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When US Defense Secretary Robert Gates visited China last week, his hosts chose that particular time to test-fly their new “stealth” aircraft, dubbed the J-20.

There appears to be symbolism at work here. The most direct interpretation is that the timing of the first flight of this new Chinese airplane was meant to insult Sec. Gates, the man who last year canceled the – far more advanced – US F-22 program.

Then again, perhaps we should all calm down and believe what a Chinese military spokesperson said. He helpfully explained that the weather at the test site, Chengdu, finally lifted and it was a nice day for a flight. Yes, of course.

What to believe? Hey, we may never know. Which leads to the next item.

Rare Earths Crackdown

This week, Chinese President Hu Jintao is visiting Washington, DC, to discuss US-China issues with President Obama and other dignitaries. One would think that the diplomats from each nation would pass the word for everyone to keep a lid on developments that could somehow cast a shadow over a high profile state visit.

So what are we to make of the announcement, out of Beijing, that the Chinese Ministry of Land and Resources has brought 11 rare earth mines under state control? The Ministry announced that the 11 mines, covering an area of 978 square miles, were the first batch of “state planned mining zones” for rare earths.

According to news accounts, Chinese authorities stated that the government’s goal is to strengthen “protection and reasonable development” of the rare earths sector. Really? Why not just say that the weather was good, and it was a nice time to nationalize some more rare earths mines?

Consolidation and Higher Prices

This news about rare earths may not exactly be thunder out of China. But under the circumstances, it sure touches a nerve because China already controls about 97% of world’s rare earth resources. Indeed, as you probably know, in recent months China has tightened control over rare earths by slashing quotas for overseas shipments, halting unauthorized exports, hiking export taxes and cracking down on heavily polluting mines.

The overall picture is that China is consolidating a formerly fragmented industry. The result is – and will continue to be – industrial consolidation, stronger state control and generally higher prices in the future.

China is already enjoying greater returns from its diminishing rare earths exports. Earlier this week, China’s Ministry of Commerce reported that China’s rare earths exports totaled 35,000 tonnes (metric tons) in the first 11 months of 2010, exceeding the posted annual quota of 30,300 tonnes. With soaring international prices, the value of China’s rare earths exports jumped by 171% from 2009.

Looking ahead, the Commerce Ministry announced last month that it’s slashing rare earths export quotas by about 35% for the first six months of this year.

According to an account in The New York Times, with very solid reporting by Keith Bradsher, mining in the “southern end of Jiangxi Province, ha[s] been placed under [China’s] national planning authority. That step removes administrative oversight of mining from provincial and municipal control.”

The Chinese View

Let me make a few points here, based on my observations over time, as well as what I heard Chinese representatives say during a recent trip to Hong Kong:

1. China’s leadership truly views rare earths as a current and future, strategic center of gravity for national economic development, future tech of many forms, and of course military power. In other words, they “get it.” They will manage this rare earths issue from the top-down, making policy and directing assets and capital as appropriate.

2. Past mining practices have caused immense and immeasurable environmental damage within China. Meanwhile, much of the past practice used poor techniques that did not maximize output or return on investment. This is entirely unacceptable anymore, and the strategic nature of the rare earths issue makes now as good a time as any to clean up this mess – figuratively and literally.

3. The unlicensed, black market for Chinese rare earths materials has amounted to as much as 40% (maybe more) of total output, up until recently – the past two years or so. This is entirely unacceptable in a Communist state with a nominally “planned” economy. In other words, they’re busting the rare earths Mafia in China.

4. Looking forward, China will “cooperate” with the international community on future RE exports – but ONLY to the extent that the overall process benefits China. Otherwise, the Chinese will always have an excuse for what they’re doing or not doing.

5. I anticipate that, primarily, China will focus and prioritize its export of rare earths materials that go into value-added articles that then must come back to China to use in other manufacturing. One hand will wash the other. In other words, don’t expect China to open the gates for rare earths exports, just to permit Western (non-Chinese) companies to manufacture stuff that doesn’t somehow benefit China.

6. The Chinese are smart enough to identify potential markets for rare earths that COMPETE against China. They’ll do everything they can – active and passive measures – to divert exports away from these kinds of markets.

Here’s the bottom line. There’s a great future for the rare earths industry in the West… but you have to be careful about chasing momentum. You need to invest wisely, with a focus on companies that can actually deliver an end product after managing years of capital expenditure, and forming-up many systems of systems.

Regards,

Byron King,
For Daily Reckoning Australia

Editor’s Notes:
Byron received his Juris Doctor from the University of Pittsburgh School of Law, was a cum laude graduate of Harvard University, served on the staff of the Chief of Naval Operations and as a field historian with the Navy. Our resident energy and oil expert, Byron is the editor of Outstanding Investments and Energy and Scarcity Investor.

Byron King
Byron King currently serves as an attorney in Pittsburgh, Pennsylvania. He received his Juris Doctor from the University of Pittsburgh School of Law in 1981 and is a cum laude graduate of Harvard University. Byron is also co-editor of Outstanding Investments.
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