Rare Earths Could Be Pawn in Island Spat... Again

By: Heiko Ihle, CFA, Senior Research Analyst 

Heiko Ihle is a Senior Research Analyst with Euro Pacific Capital. 

 

We've written before about rare earth elements (REEs): the futuristic sounding group of 17 minerals with unpronounceable names that play a critical role in everything from hybrid cars to flat screen TVs. Of course, "rare" is something of a misnomer, as the minerals that make up the group are not all that rare. They are, however, difficult to mine in profitable concentrations.

As of now, China controls over 90 percent of the world's rare earth mining concerns. In the past, this near monopoly has allowed them to exert a significant influence over both price and supply. In 2010 and 2011, China used its position to send prices on a roller coaster ride, causing some individual minerals to quadruple in price. In 2011, prices for some elements doubled again, hitting record highs.

 

The catalyst that caused China's use (or misuse) of its near-monopoly power in 2010 was a dispute over some seemingly meaningless rocks in the South China Sea. Though currently uninhabited, many believe that the islands sit on top of valuable oil and gas reserves. Beyond that, both countries view the territory as an issue of sovereignty in the East China Sea. Until very recently, the islands, while officially controlled by Japan, were privately held. In September of that year, Japan arrested a Chinese fishing crew whose boat had collided with two Japanese Coast Guard vessels near the contested Diaoyu Islands (called the Senkaku Islands by Japan). The islands have been claimed by China but are under official Japanese control. The boat captain's 16-day incarceration ignited long simmering tensions between the two Asian powers.

 

Over the course of the dispute, China took the gloves off and hit Japan where it hurts: It halted shipments of rare earth elements to Japan, the world's largest importer. Japan had traditionally bought 60% of China's rare mineral supply for its high tech manufacturing industries. Predictably, prices spiked around the world.

 

The embargo even spread briefly to the United States and Europe after US officials announced plans to investigate China for possible WTO violations. Through it all, China stuck with its official stance, stating that no countries were being targeted but, rather, the shipment slowdowns were a result of increased regulation in the rare earths industry. But as many experts have suggested, China's unofficial embargo served as an effective ploy to manipulate prices (and punish international rivals) without implementing a policy change that would have exposed her to withering World Trade Organization (WTO) complaints from rival nations. Even without an overt policy change, the  US, EU, and Japan did ultimately file such a complaint.

 

After simmering down for a year or so tensions over the islands have flared up again. This time around, things could get worse. In mid-August, Japan arrested 14 Chinese activists for planting a flag on the disputed islands. While the protesters were quickly sent home, their arrest reignited tensions.  To make matters even more volatile the Japanese government just announced plans to buy the islands (which had been privately held even while they have been under Japanese political control).  

 

The announcement has produced a stronger reaction from China than the arrest of its citizens. According to the FT, China's news organization, Xinhua, reacted to the decision by saying, "that Tokyo had thrown bilateral relations into the scalding pot" and by warning that Japan's actions would have "serious consequences." It is unclear what, exactly, Beijing will do in response to the move, but the official government position views it as a violation of China's sovereignty and a breaking of long-held-if essentially unspoken-agreements between the two countries. What's more, a new crop of Chinese leaders is currently taking the helm in Beijing, and taking a tough line with Japan may be seen as a rite of passage.

 

Since tensions first broke out in August, it has been almost impossible to read media coverage of these events that didn't hark back to the 2010 embargo. Price spikes in 2010 and 2011 caused many companies to stock up on the resources, leading to price drops and lower Chinese exports. At this point, some analysts are unsure whether rare earth prices have hit a floor yet. Still, it is impossible to tell what China will do. With such power and unpredictability concentrated in a few hands, many understandably view REE investing as gambling at best. That may be true, but the best gamblers always look for an edge.

 

One major result of dicey diplomacy in the South China Sea and the rare earth price spikes over the past few years has been the desire to diversify away from the current near-monopoly held by Chinese producers. In 2012, Chinese exports dropped significantly, and even fell below the country's quota. At the same time, various rare earth consumers scrambled to set up new mining operations in places like Australia, the US, and Malaysia. In August of this year, Japanese technology concern Toshiba announced that it would replace a Chinese-sourced rare earth with one found in Australia and the US in a new motor.

 

The dispute between Japan and China should only speed up this process. The fight over a few small islands stands as more bad news for Chinese rare earths producers, but it may be great news for companies producing rare earths elsewhere.