There was quite a meeting in Washington, D.C., last week. Some of the key players in government and the metals industry came together in the same room to discuss the looming shortages of critical elements that are coming down the road.

The idea is that supply chains are only as strong as their weakest link. The fact is that many thousands of technologies — electronics, aerospace, military, automotive, clean-tech and renewable energy, to name just a handful — rely on a small number of specialty metals, or what some call “technology metals.” These metals have obscure names, but in many cases, there are simply no substitutes.

United States of Windmills

Some so-called “technologies of the future” are destined to fail due to lack of critical metals with which to effect buildout. Take the rare earth, neodymium, for example. It’s a component of strong permanent magnets — which are made out of a mixture of neodymium, iron and boron.

Strong permanent magnets are critical to gaining efficiency in rotating power-generation units like, say, windmills. Y’know… we’re going to replace burning fossil fuels with windmills, right? Isn’t that the idea? We’re going to live in the United States of Windmills, right?

Except one fact of physics is that without strong permanent magnets, you can’t generate nearly as much power with each turn of the large blades. So neodymium — in the magnets — is critical to our windmill future. There’s NO substitute for neodymium, and believe me, people have tried to figure a way around it.

But with neodymium, as with a host of other relatively obscure substances from the periodic table, the global supply is precarious. In some cases, the supply chain is at great risk because there are but a few sources. For some of those sources, we see things like a major mine playing out due to depletion (Baotou, China, for rare earths) or shut down due to environmental issues (Mountain Pass, Calif., again for rare earths). With other metals, many mines are effectively off-limits due to political problems (in the Congo, for instance).

Looking Ahead with Critical Metals

Most of the strategic and critical metals are just plain “different” than other major industrial metals, like copper, aluminum, lead and even gold and silver.

From the standpoint of nuclear physics, for example, rare earths are not like the other elements. They are brilliant, stubborn and complex, and at the same chemically similar and uniquely individual. You take each rare earth atom the way it was formed in a nuclear reaction within some long-gone, exploded sun, billions of years past.

Another more mundane aspect of the critical metals is that few are exchange traded. For the most part, there’s no futures market, other public market or well-defined transparent price discovery mechanism. There has never been sufficient volume to build up a worldwide market for futures in these obscure elements. So most of the critical metals that get used in world commerce are sold under one-on-one, long-term contracts.

Lacking a forward market, industrial users can’t lock in future prices or deliveries through traditional hedging. They have to sign a contract and agree to pay for future product. It sounds straightforward, but the reality is different. The firms that use many specialty metals live in the worst of both worlds. There’s no futures market, but they are still vulnerable to supply interruptions, spot shortages and price squeezes in the market.

Dealing with Risk, and Virtual Hedging

One technique for users — as well as strategic-minded governments — is simply to pay upfront and stockpile material. This leads to issues with the costs of storage, ensuring physical security, the cost of money and the usual problems with inventory accounting and taxes. Also, with some metals, there are insurmountable storage problems with the rapid deterioration of product due to oxidation or other chemical deterioration.

In other words, in a world where supplies of critical metals are spotty, the traditional tools of costing and forecasting are unreliable. There’s just more risk in the critical metals biz, in some cases rising to “bet the company” levels.

The newest trend in the industry is what’s called “virtual hedging.” This is a term to describe a menu of techniques for developing forward prices and assured deliveries of critical raw materials. Firms use virtual hedging where a futures market does not traditionally exist.

One tool of virtual hedging is to make a direct investment in a mine and get payback via guaranteed metal deliveries (also called off-take agreements). Other kinds of virtual hedging are wide ranging, from stockpiling (for oneself or others), synthetic and/or over-the-counter hedges, material leasing, strategic reserves (i.e., get the government to do it for you) and closed-loop recycling.

Meanwhile, users are hard at work trying to work around issues of physical supply. There are aggressive efforts going on with traditional programs like critical material “thrifting” (use less and see what happens), material substitution, pricing index selection (gear the amount of input to the cost), flexible transfer pricing (charge the customer a surcharge for the extra costs of critical inputs) and in-house waste stream recoveries. The idea is to develop an overall strategy and methodology to mitigate price and supply risk of critical raw materials.

Similarly, producers and industrial processors may also employ these tools as a way to assure adequate income streams for debt retirement, more assured profitability and funding for future expansion and production. Virtual hedging truly has the ability to be the elusive win-win formula that most Western businessmen publicly promote, but are rarely able to employ.

Living Off Past Stockpiles

With one particular element — which I’ll decline to name just now — there’s already a severe supply crunch. This is an element that’s used in a wide variety of electronic products. The supply chain could run dry soon.

Thus, the industry that uses this item is “living off past stockpiles,” according to one inside player. Last year, the general estimate was that there’s enough product in the supply chain to last for two years. So the pipeline will be dry by 2012.

What happened? The problems originated with an unprecedented spike in the spot market price in 2000. In this thinly traded resource, supply fears caused many nervous dealers to sign long-term contracts and lock themselves into high market prices. Then when prices crashed for product off contract, across the user community, there were significant inventory write-downs, both current and future.

By 2006 and 2007, the industry returned to some semblance of normality. But with the crash of 2008, everything fell off a cliff as the economic meltdown jammed the brakes on consumer demand.

Meanwhile, the few companies that mine the substance suspended production. So now there’s a situation in which primary production of ore is all but shut down. There are stockpiles, and just a very limited amount of material coming out of a very small number of mines in faraway jurisdictions.

Thus, with this product, as with most other of the critical technology metals, the question to ask is what does is the downstream industry fear more? High prices for an essential, irreplaceable input? Or lack of physical supply from the mine and mill and widespread unavailability of any product at any price?

It’s a problem within the industry. And it’s just this kind of situation that gives us an entree into an opportunity for profit.

Until we meet again,
Byron King

October 30, 2009

Byron King

Prior to joining Penny Sleuth, 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 has made frequent appearances in mainstream media such as The Washington Post, MSN Money, Marketwatch.com, Fox Business News, CNBC's Squawk Box, Larry Kudlow, Glenn Beck and PBS Newshour. He also had a feature article written in the Financial Times, and has appeared on both CNN and Marketplace radio broadcasts. Byron has also been quoted in various international publications such as The Guardian and De Volkskrant, and has been a guest on Canada's CBC television broadcast.

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