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Zombies in Rare Earth Elements

2010's speculative top in REEs left behind a pile of undead juniors...
RICHARD KARN is managing editor of The Emerging Trends Report, and has a broad, multi-disciplinary background, writing for publications ranging from Barron's, Kitco and Fullermoney to Financial Sense Online.
Here he tells The Gold Report's sister title, The Mining Report, how the 2010 top in rare earth and specialty metals – when the froth saw speculators throwing money at a sector they didn't understand – has left behind so-called zombies, walking dead companies lurking on the TSX and ASX exchanges with all talk and no product...
The Mining Report: On the TSX Venture Exchange, there are hundreds of mining companies called "zombies", that is, their market caps and cash balances are so low as to be companies in name only. How many zombie companies are there on the ASX?
Richard Karn: Unfortunately, Australia finds itself in much the same condition.
There are 707 mining and resource companies on the ASX. Of these, more than 400 have a market cap of less than $10 million Australian. Furthermore, more than 200 have market caps of less than AU$2m and cash balances of less than AU$850,000. With the cost of maintaining an ASX listing conservatively estimated to be in the range of AU$650,000 per year, and the end of the financial year looming (June 30, 2014), a number of companies are verging on insolvency.
TMR: How many of these ASX-listed zombies will disappear before the end of the current fiscal year?
Richard Karn: I have no way of knowing that, but I am aware of a number of companies that have cut their payrolls to the bone and are essentially in hibernation mode – barely surviving, with the remaining employees on significantly reduced salaries.
For Australian juniors, for all intents and purposes the commercial finance markets are closed and the fund-raising environment is simply hostile. Too many retail shareholders are trapped in unprofitable positions and are now largely unwilling to participate in capital raisings, not the least because there is little reason to think the situation will improve anytime soon.
Asset sales in this market are similarly brutal: It's a buyer's market and many of these small companies are loathe to let go of assets they have developed for the merest fraction of what they have spent.
TMR: Will this culling of moribund companies be a good thing?
Richard Karn: Yes. Whether the commodity boom of the last decade is over or simply correcting, there is little question a considerable amount of froth developed in the specialty metal sector and excesses that were accumulated need to be worked off. 
And that is a process, not an event, meaning it takes time.
We attribute the spark for the specialty metal boom that peaked in early to mid-2012 to China's June 2010 announcement that it was curtailing rare earth element (REE) exports and increasing the taxes to do so. That China had done exactly the same thing for the previous two years had not mattered to the market, but suddenly, inexplicably, it mattered to everyone. 
Potential supply disruptions for a whole range of specialty metals critical to a wide range of electronic, green and military applications became the topic de jour, spawning Congressional hearings, Department of Defense white papers and World Trade Organization (WTO) actions.
Suddenly, specialty metal projects were on the receiving end of a flood of hot money, and hot money flowing without regard to reality always and everywhere leads to excesses. And the REEs were the poster children, though by no means the only specialty metal projects to attract these speculative capital flows.
At one point, we were aware of more than 720 listed companies globally that were promoting REE projects. We estimated that it would be miraculous if 18 of those projects were in production by 2020 because most of those companies had no idea of what was involved with putting a REE project into production, but that did not stop some opportunistic behavior on the part of both speculators and junior resource company managements.
One example of this suffices to demonstrate the madness of the crowds in this regard. We know of a junior resource company, which shall remain nameless, that was sitting on a tenement they'd acquired a few years before during the uranium boom that, as is often the case, had attendant relatively minor concentrations of REEs. Management flew a geologist out into "the back of beyond" in Western Australia, plunked him down by an outcrop, and took some photos of the geologist hammering a few samples from the rock of its "newest REE discovery." The geologist was so embarrassed by the sham that he kept tilting his head to make sure his face was not identifiable in the photographs – but the share price damn near doubled in the following few days.
This is the type of behavior that is spawned by a speculative boom and must be worked through before the good companies can rise to the top.
Another aspect is simply that people tend to extrapolate good times into perpetuity, and junior resource companies' managements are not immune to this temptation.
It is very common for a small cap, even a micro cap, Australian resource company to have a number of very good projects; the problem is they lack the funds or expertise to develop any of them.
Australia boasts a very rich geology, and Australians exploration companies are very good at finding and conducting early-stage development of projects, typically through the JORC-compliant stage, at which point they try to spin out the asset or try to sell it to a larger company with the financial wherewithal and expertise to develop it.
But if there are no buyers, the costs of maintaining the asset can become fairly onerous – and the more projects a company has, the higher the cost of maintaining them. That is a very real cash drain today.
In the final shakeout we are anticipating, a number of mismanaged companies will deservedly go under – as, unfortunately, will some quite good companies – and some very good projects will be picked up very cheaply. 
And being able to pick up outstanding assets for very little money always marks the bottom of the cycle, because it increases the odds of success as the cycle turns up.
TMR: What are "specialty metals," and why are specialty metal projects so difficult to put into production?
Richard Karn: Specialty metals can be generally thought of as metals with extraordinary properties that are produced in small amounts for relatively specific applications. 
Many, such as graphite, tungsten, vanadium and molybdenum, are of a more industrial nature and are primarily alloying agents for base metals. As such, their prices are effectively leveraged to those base metals. 
Others, such as germanium, tellurium, ruthenium, antimony or REEs, find wide use (albeit in trace amounts) in consumer electronics, green and military applications, but the complex metallurgy and highly specialized, technical uses are often difficult to understand – sometimes even by end-users. The prices of these metals tend to be discovery-driven rather than GDP-correlated in that it takes very little new marginal demand to create price shocks.
We contend, however, that the biggest impediment to putting a specialty metal project into production is not the metallurgy but the lack of commercial finance. Because production of many specialty metals is so small, literally only tens or hundreds of tons per year, they often do not trade on a futures exchange, so a commercial bank cannot hedge its risk by selling a certain percentage of production forward into the market. Unless there is sufficient hedgeable byproduct, the average specialty metals project constitutes an unacceptable risk. 
Taken together, we can certainly make the case that many specialty metal projects would profit from staying private – as simply being a smallish JV between the producer and the end-user, with the end-user providing the capital to put the project into production in return for guaranteed long-term supply and a share of the profits. 
TMR: Why are specialty metals so important to emerging technologies, and given that they are so difficult and costly to mine, what prevents technology companies from using substitutes or workarounds?
Richard Karn: Each specialty metal has unique properties that render it better in a given application than another metal. Certainly there can be a degree of substitution across metal groups, such as is the case with palladium for platinum in catalytic converters, but that is the exception rather than the rule; by and large the substitute of one specialty metal for another produces an inferior result, for example the end product may be heavier or less efficient in terms of energy use, etc.
When a number of these specialty metals are combined in alloys that produce unique performance characteristics, such as the super alloys used in jet engine turbine blades, it is usually not possible to substitute one specialty metal for another because the balance trying to be struck in the design specifications is so fine, so precise, that there is no room for half measures or workarounds. In these types of applications, such trace amounts are used that availability, not price, is the primary concern.
And as can be the case with many specialty metals, the metals may be byproducts of other primary mine production, such as tellurium from copper production or ruthenium from platinum group metals (PGM) production, so they are largely supply inelastic as well.
TMR: Finding end-users is critical to specialty metals companies. Is this a radically different skill set than what junior resource executives usually bring to the table?
Richard Karn: Putting aside the previously discussed opportunistic self-promotion, not really. The critical skill set revolves around actually producing specialty metals for end-users to evaluate, not talking about it.
End-users are sick of talk: they want to see product. All the salesmanship in the world does not compare with a managing director being able to walk into an end-user's office and dropping a kilogram product sample on his desk for the company to evaluate. That is the legitimate start of a dialogue that leads to off-take and funding agreements.
The companies we will discuss briefly in a moment can do that – are doing that; few others can.
As mentioned, we believe there will be a final washout in the specialty metal space – a point where especially retail investors just say they want out at any price rather than losing everything when the company goes into administration. 
We further believe this will result in money being funneled into those companies that are delivering on their promises – those companies that put their heads down, kept their mouths shut, and have done what they needed to do to put their projects into production. 
These companies have made a lot of sacrifices and may not be making a lot of money today, but they have succeeded to the extent that they have products to show end-users, which in the current environment in the specialty metal sector is more of an accomplishment than the market realizes – or currently values.
As more and more companies fall by the wayside, investors – not the speculators who have vacated the specialty metal space and are busy chasing the latest craze, like buying Greek debt – as well as specialty metal end-users, will start to focus on those companies that are delivering on their promises, and those companies will be the recipients of the resulting capital flows.
TMR: What are the ASX-listed companies you consider models for bringing specialty metals to market?
Richard Karn: We've spent most of the last five years looking at precious and specialty metal projects in Australia, and three companies that we wrote up early in our investigations continue to impress us because they are delivering on their promises to the market. We have owned and traded around positions in these companies for a long time.
In this regard they are models of innovation and perseverance because as anyone down under will tell you, the markets have been bloody hard for at least the last two years.
TMR: There seems to be a glut of graphite projects around the world. 
Richard Karn: I do not buy the submission that there is a glut of graphite projects globally. I believe there is a glut of graphite promoters who have made some pretty grandiose claims over the past few years because it helped their share price, but very few that have delivered on the promises they have made to the market.
In the case of both graphite and tungsten, the Chinese flooded the market with cheap supply, rendering many operations globally uneconomic. 
Fast forward 20 or 30 years, and Chinese control of various specialty metal markets, ranging from REEs to antimony to graphite and tungsten, is such that end-users of these metals have finally started to sober up from binging on New Age economic drivel like "just in time delivery", which simply cannot apply to the specialty metal supply and are seriously questioning the security of their supply chain.
We contend that at some point in the near future, non-Sino sources of specialty metals will actually command a premium to the quoted market price because ensured supply will trump price concerns. The arms race in Asia, which the western press has been studiously ignoring, is accelerating and will exacerbate this situation.
TMR: Richard, thank you for your detailed insights.
Richard Karn: My pleasure.

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