Is It Finally Time to Buy Molycorp?

Douglas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

With the nearly 24% selloff in Molycorp (NYSE: MCP) since September 18, which kicked off with a nearly 11% rise during the Monday session a few weeks ago, many have been wondering if it is finally time to establish a position in the company. The rare earth sector has been a classic example of the interaction of supply and demand, with a healthy dose of Chinese unpredictability thrown in for good measure. Ultimately, the stock remains inappropriate as a core holding under current conditions, but for anyone looking for an unusual speculative play, each progressive fall makes Molycorp more interesting.

The Chinese Influence

In terms of supply and demand alone, the news coming out of China continues to put competing pressures on the sector. A little over a month ago, the Chinese government raised export quotas for the first time in nearly seven years. The move was seen as a potential release of additional supply from the country that has been responsible for over 95% of global rare earth production. China has been able to keep tight control over the market as a result of its disproportionate influence over supply.

Just a few weeks later, the same government slashed the number of mine permits it issued for rare earth mines by 41%. This later move had the potential to contract supply, although industry insiders viewed it as a further expansion of government control over miners. By targeting larger companies for mining permits, the government puts control into companies that have less incentive to challenge export quotas.

Ultimately, the Chinese element increases the uncertainty present in the market because the moves made by government have not followed a cohesive approach. The supply control that can be exerted over the bulk of supply is a significant source of risk that cannot be overlooked. Until the expanding supply (discussed below) stabilizes, the country risk involved in rare earths remains high.

Supply Increases

In addition to Molycorp, Rare Element Resources (NYSEMKT: REE), Avalon Rare Metals Inc. (NYSEMKT: AVL) and Lynas Corporation Ltd. are each important market participants. As the companies continue to expand, the very nature of the market is shifting. While Rare Elements and Avalon have not made significant strides on the supply side, Molycorp’s Colorado mine and Lynas’s Australian mine have already begun to disrupt the supply picture. Each of these developments is positive for each respective company, but as production increases, the supply advances are bearish for the sector.

Demand Increases

One of the factors that seems to be consistently overlooked when critics write about the sector is the increasing demand for products that require rare earth elements. These range from smartphones to the batteries in hybrid cars, and are almost exclusively in high-growth areas of technology. Perhaps the most significant area of demand, and one that is likely to continue to grow well into the future, is in defense applications.

The high tech military applications of rare earth materials are critical to the success of Molycorp specifically. Generally speaking, the U.S. prefers to avoid reliance on foreign production for critical defense goods. The fact that rare earths are under the primary control of not just any foreign government but of China ups the importance of Molycorp’s Mountain Pass project. Not only do military applications give the company a built-in long-term customer, it means that the federal government is more likely to aid the company in smoothing out any regulatory issues that may arise.

The Trade

While the long-term outlook for Molycorp remains strong, the risk factors involved in the stock are extensive. At current levels, even after the selloff, the stock remains a speculative play. It has very strong long-term potential, but the road there may be a bumpy one. The stock’s 52-week low of $9.40 is likely an aggressive entry point, but targeting prices below $10 is reasonable. Molycorp will become an important core holding in the future, but at present, it is only appropriate if your risk tolerance is high.

Mr. Ehrman has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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