Rare-earth stocks have gone from market darlings to market dogs. But if you can live with the risks, there are some good reasons to take another look.

Remember rare earths? And how prices of these metals, which are required raw materials for technologies such as wind turbines, hybrid cars, and flat-screen displays, had soared?

Technology manufacturers scrambled to find reliable sources of supply as China used its position as owner of 95% of global production of rare earths to restrict supplies to foreign manufacturers. And investors scurried to find a rare-earth stock or two to add to their portfolios.

And now?

Shares of Molycorp (MCP), the highest-profile US rare-earth miner, were down 33% in just one week (September 16 through 23) recently. Lynas (LYSDY, LYC.AU in Australia) dropped 17% in Sydney and 12% in New York on September 26.

After falling an additional 3.5% on September 30, to $32.87, Molycorp is 58% off its 52-week high. Lynas, at $1.07 in New York on September 30, is 64% off its 52-week high.

Why the Drop?
The plunge in the price of rare-earth stocks is, of course, partly a result of macroeconomic fears—of a slowdown in the Chinese economy, of a slide by the US economy back into recession, of a chaotic default by the Greek government that will return the global financial system to the brink it faced in 2008.

Because rare-earth stocks like Molycorp and Lynas are highly speculative issues—Molycorp has just begun full-scale mining, and Lynas is still waiting on approval from the Malaysian government to open a processing plant to turn rare-earth ores into useful forms of rare-earth minerals—their share prices are even more volatile than the highly volatile global financial markets.

The rare earth story isn’t all macroeconomics. The drop in the price of rare-earth stocks—and the odds that these shares might not only recover but also move up to new highs—is a result of changes in the rare-earth market that have nothing to do with global macroeconomics. And the trajectory of any individual stock in any rally will be strongly influenced by company-specific news.

In other words, if you want to figure out whether to invest in what are currently very depressed stocks, you need to understand what’s been happening in this once-hot sector since it dropped out of the headlines.

A Short History of Rare-Earth Stocks
Let me take you back to days of yesteryear—2009 or so, for most of us—when rare-earth stocks burst upon the investment scene.

China, which controls about 95% of the global supply of rare-earth elements, got the ball rolling with the threat of an export boycott. Because rare-earth elements are a key ingredient in many of the world’s emerging technologies, the threat was a big deal.

Adding a bit of one of the 17 rare-earth elements to a magnet in the engine of an electric or hybrid car increases the power and efficiency of the engine, because rare-earth magnets are the strongest type of permanent magnets now made.

Rare earths improve the color in TV screens and in lasers. You’ll also find rare-earth elements in tunable microwave resonators, and terbium, one of the rare-earth elements, is a key ingredient in low-energy light bulbs.

We’re not talking about trace amounts of these elements, either. The electric motor in a Toyota Prius uses about 2 pounds of neodymium in its permanent magnets. Each Prius battery also uses 20 to 30 pounds of another rare earth, lanthanum. And it takes about a ton of neodymium to make the big magnets used in each megawatt of wind-turbine capacity.

Fortunately, despite their name, rare-earth elements aren’t especially rare. They’re found in relatively high concentrations in the Earth’s crust, with one, cerium, coming in at the 25th most abundant element in the crust. Global production came to about 140,000 metric tons of refined rare earths in 2008.

But supplies of the rare earths that can be profitably mined aren’t distributed evenly across the globe. Partly that’s the luck of the geologic draw. But mostly it’s a function of the huge environmental costs of mining these rare earths.

The traditional method has been to bore holes into promising rock formations, pump acid down the holes to dissolve some of the rare earths, and then pump the slurry into holding ponds for extraction. That extraction leaves behind a lake of water mixed with acid and various and sundry dissolved minerals.

NEXT: A Mining Challange

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A Mining Challenge
It’s much, much cheaper if a company can get away with spending just about nothing on controlling the resulting water and sludge.

The world’s low-cost producers of rare-earth elements are not huge and efficient open-pit mines, but small, completely unregulated mom-and-pop mining companies in China. (The Chinese government is now trying to force many of these companies out of business. The motive is some combination of a desire to limit environmental damage in China and to exercise greater control over exports. I’d say that the latter dominates.)

Over the past 20 years, the accidents of geology and the realities of unequal regulation gradually led to the closure of most of the rare-earth mines outside of China. The Mountain Pass, Calif., mine, the world’s richest proven reserve of rare earths, stopped production in 2002, for example.

Rising demand started to change that picture. Companies such as Lynas and Molycorp crept back onto the stage with plans to start new mines or resume production from old mines.

It took the Chinese overplaying their hand, however, to turn that modest trend into a speculator’s dream. The Chinese started to reduce the amount of rare-earth metals that could be exported. Companies outside China began to worry about the very real possibilities of paying higher prices and of not being able to buy needed raw materials.

This seems to be a key goal in China’s strategy. By restricting exports, China would force high-technology companies that need these rare earths to relocate production to China, accelerating the transfer of intellectual property to Chinese companies. It’s no secret that China wants to create major wind, solar and hybrid-car industries.

The restrictions on production have increased in 2011. Beijing just about closed down its industry in early August to assess pollution problems (at least that’s the official story).

China is also creating a government-controlled monopoly, Bao Gang Rare Earth, that would consolidate the 35 companies that now mine rare earths in northern China. Three similar government-controlled companies will consolidate production in the south of the country.

The growing demand for rare earths from new technologies, plus China’s moves, had two immediate effects.

  • First, prices for rare-earth minerals, especially those of the heavy rare-earth elements, soared. Prices for some rare-earth elements climbed ten times from 2009 into 2011.
  • Second, the scramble was on for alternative sources of supply. Suddenly, there was plenty of capital available to restart mines that had closed because of low prices and stricter environmental regulation outside of China.

Then, a Twist
Like true love, the course of a mining startup is never smooth. And in 2011, two predictable, but certainly not widely predicted, consequences of soaring prices rose up to bite rare-earth mining companies on their bottom lines.

First, faced with a potential Chinese stranglehold on rare-earth production (in the short term, at least), some manufacturers started designing products to reduce their use of rare earths. For example, Toyota Motor (TM) and General Motors (GM) have both re-engineered some models to reduce or eliminate their need for rare-earth magnets.

General Electric (GE) has also announced that it is working on a new generation of wind turbines that will use less rare-earth material. And WR Grace (GRA) has begun selling a catalyst for oil refiners that uses less of the rare earth lanthanum.

That has helped push the price for lanthanum, one of the most abundant rare-earth elements, to $92 per kilogram from $135 in the second quarter. (That still leaves the price for lanthanum about 18 times higher than it was in 2009.)

Second, the fear of rising prices and a possible shutdown in Chinese exports produced an opaque market in which nobody knew exactly how much of any rare-earth mineral is available for purchase, where stockpiles are, or how large they might be. It’s unclear what actual demand is, as opposed to demand from investors purchasing rare earths for speculation and stockpiling.

With little visibility into the market, prices are extremely volatile and projections are all over the map. Lynas projects that a basket of the rare earths mined from its Mount Weld deposit had tumbled to $157.37 on September 23 from $173 a kilo in the second quarter of 2011.

According to Goldman Sachs, a basket of Lynas rare earths will fall to $83 a kilo in 2015—when rare-earth mines outside China come into production—but will climb to $240 a kilo in 2012.

NEXT: Lots of Uncertainy

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Lots of Uncertainty
Reducing the uncertainty in these projections would be hard enough if investors were working with an established industry, such as copper mining, with a long history of production and good sources of data from companies and analysts on how projected production growth is lagging or exceeding actual production growth.

Even then, projections in the mining sector aren’t easy. Right now, for example, it looks like copper’s gap between announced increases in annual production and actual increases is moving from about 2% a year to something more like 8%.

That direction of that trend doesn’t come with an ironclad guarantee—hence some of the supply-side uncertainty in the copper sector now—but a figure like this is still light years ahead of anything investors can draw on in the rare-earth sector.

Until the very end of 2010, for example, the rare earths that Molycorp was selling came from stockpiles left when the Mountain Pass mine closed.

Mining began in the fourth quarter of 2010 for the first time since 2002. The company has just closed funding for what it dubs Project Phoenix, which, among other goals, is projected to increase production more than tenfold in Phase 1.

It would be reassuring to look at other rare-earth companies that have completed something like this level of expansion in production and processing, but you know what? There aren’t any.

The figures from Lynas on its Mount Weld mine probably aren’t comparable at all. Lynas raised the cost of its rare-earth mine—and hence of production from that mine—in December 2010 to $7 a kilogram from $5.64 in March 2010. The Australian company raised that cost figure again in March 2011, to $10.11.

Molycorp, whose September 27 presentation at a Credit Suisse conference is the source of these numbers, touts its contrasting position as the low-cost global producer—lower by 50% even than the Chinese.

If you read the fine print in Molycorp’s presentation, however, you’ll note that its $2.77 cost per kilogram dates back to production costs as of April 2010—before Molycorp resumed mining at Mountain Pass. In other words it’s very hard to tell how much of Molycorp’s cost advantage comes from not actually mining rare-earth oxides, an “advantage” that will disappear in 2011.

It is important to point out at this point that the current price of the basket of rare earths produced at Mount Weld was $157 per kilogram on September 23 Not that Lynas is in full production at Mount Weld. The first crushed ore went into the ball mill at Mount Weld on May 14, 2011.

And, just in case this isn’t indefinite and uncertain enough, the mining and processing of rare earths into concentrate is only the first step in getting usable rare-earth products into the hands of corporate customers.

The ultimate profitability of any rare-earth company will depend on how much of this downstream processing it can do—and how much of the profit of turning rare earths into products it can capture.

Both of these companies, for example, are building out their advanced-processing capacity, Molycorp through the purchase of an existing processing company and Lynas through the construction of a greenfield processing plant in Malaysia.

The Australian company’s strategy is higher risk/higher reward because of local protests against siting a plant that produces a mildly radioactive waste. But a Malaysian site would give Lynas a significant edge in securing business from Asian technology customers.

Right now it looks like the yay/nay on Lynas’s Malaysian plant will arrive in December. I think the plant will get government approval—the government did, after all, invite Lynas to pick this site.

However, opponents have scored points, especially by noting that local Australian governments raised big doubts about the project even though in Australia it would have been sited farther from any substantial population and in extremely dry terrain.

A plant like Lynas’ Malaysian project doesn’t end the potential profit stream for a rare-earth company. Both Molycorp and Lynas are setting up joint ventures or partnerships to produce rare-earth magnets. Lynas’ joint venture with Siemens (SI) would give the miner a heavyweight partner.

NEXT: Should You Invest?

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Should You Invest?
OK, so how do you decide if you want to put a penny into either of these stocks, knowing what we know and don’t know about them?

First, I’d note that if you’re a long-term investor, the current macroeconomic turmoil is largely irrelevant. Rare-earth demand will climb in the long run with the development of technologies for wind turbines, electric cars, flat-screen displays, advance lighting systems, and more.

Second, saying only the long run counts isn’t code for “I’d buy at any price.” But thanks to what amounts to a bear market in rare-earth minerals and stocks, these two companies seem very reasonably priced—much more so than when everybody wanted to buy in 2009 and 2010.

Lynas sells for a market cap of just $1.7 billion currently, and Molycorp is not much more expensive at a market cap of $2.6 billion. I’d seriously think about a strategy of averaging down with monthly buys of equal dollar amounts over the next six months.

And third, I think that even though I can’t predict the price of lanthanum in a year, I can predict that investors will see a steady stream of milestones from these two companies that will increase the visibility of results. We’ve got increased production, more information on the size and composition of rare-earth deposits, and finally, news on downstream processing.

The latter entails significant risk for Lynas—the stock will drop if the Malaysian plant doesn’t get the go-ahead—but that very risk means more reward if the decision goes in the company’s favor, which I believe it will.

Both those stocks are speculative and risky. Don’t put money into them that you need to pay the mortgage or college tuition. There is real downside risk here. But I think the risk/reward ratio at current prices is tilted strongly toward reward for the truly patient investor.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of June, see the fund’s portfolio here.