Lynas – the Make or Break Year
If there is one thing you need to know about Lynas, even more important than its bottom line or its debt levels, it is that Japan needs Lynas. After Japan’s atrocious treatment at the hands of the Chinese during the Islands Dispute several years ago, the terms of the Japanese deal with Lynas are to receive the allocation of a minimum of 8,500 tonnes (±500 tonnes) per annum of Rare Earths products for Japan, which currently represents 30% of the Japanese market, over a period of ten years. Without Lynas the Japanese industry would be thrown back at the mercy of the Chinese.
For that reason, and that reason alone, Lynas is a key chess piece for the Japanese.
The Japanese Nexus
The most important part of the Japanese relationship is the JARE facility. JARE stands for Japan Australia Rare Earths B.V. and is made up of Japan Oil, Gas and Metals National Corporation (JOGMEC) and Sojitz.
Back in March 2011, Sojitz and JOGMEC announced that they have entered into definitive agreements with Lynas to provide a total of US$250 million through loan and equity and to receive the allocation of a minimum of 8,500 tonnes (±500 tonnes) per annum of Rare Earths products for Japan, which currently represents 30% of the Japanese market, over a period of ten years. In addition, Sojitz signed a distribution & agency agreement with Lynas that Sojitz would be appointed as a sole distributor and sole agent of Lynas in Japan.
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In an interesting twist, the parties agreed an interest rate regime which gave Lynas with the ability to reduce the effective interest rate on the JARE facility from an initial 7% per annum to a floor of 2.8% per annum over time. The new framework set specific targets that, if met, would trigger a cascading decrease in the interest rate payable on the facility.
While it’s been five years in coming, Lynas finally exceeded the minimum supply qualification in the December quarter of 2015 and therefore, the interest rate under the JARE debt facility reduced from 7% per annum to 6.5% per annum with effect from 1 January 2016. Hopefully this is the first of many such reductions.
The Japanese clearly drove a pretty hard bargain because even back in 2011, 7% was a rather ritzy interest rate. To compare, at that time, the interest coupon with the Mt Kellett- led bond holder group, is maintained at the low level of 2.75% per annum.
The positive cashflow effects of a declining interest rate are obvious.
Now Prices Need to “Come to the Party”
The key thing lacking from the Lynas equation is good (or at least, better) REE prices. Chinese domestic NdPr prices did not recover as much as expected. Whilst increasing by US$3 from the previous quarter to US$34.40 at the end of December, they remained US$10-$11/kg lower than average levels experienced in 2014 and early 2015. Otherwise on the production front things seem to be going well. In the December quarter, 949 tonnes of NdPr was produced. Production of NdPr for the 6 months to 31st December was 1,916 tonnes which exceeded the JARE debt facility target of 1,860 tonnes (thus triggering the interest rate fall). If anything capacity constraints were holding Lynas back.
Despite continued very low rare earths prices, operating cashflow (sales receipts less production and administration costs) remained positive at AUD$2.97m. On a free cash flow basis (operating cashflow less capital expenditure) the business was within a breakeven range at negative AUD$0.5m. Crucially, the closing total cash balance was AUD$53.6m.
Capex demands are tapering off as the construction of the Tailings Facility Storage 2 at Mt Weld was completed in December, on budget and on schedule. In the current quarter, Lynas will start-up the fourth and final separation train in SX5. This will bring NdPr production capacity to 100% of design.
Sales are running at nearly AU$50 per quarter and might even top AUD$200mn for the full fiscal year. This would be a dramatic surge from the AU$148.6mn in FY14 when prices were higher.
An article last week in the Sydney Morning Herald extensively quoted Professor Dudley Kingsnorth, one of the Two Wise Monkeys still extant in the Rare Earth space (the third wise monkey unfortunately placed all his chips on Eudialyte and is now in a sort of permanent penalty box). Professor Kingsnorth’s view was that, “the problem is the amount of illegal mining, primarily in China, which continues”. He said these producers paid no tax and complied with no environmental controls.
Illegal mining of rare earths in China has undermined anticipated benefits from the forced rationalisation of China’s sector into a handful of large groups that are seeking to reduce accumulated stocks of rare earths, which are estimated at 150,000-200,000 tonnes of material.
He went on, “That [stockpile] needs to be reduced. China’s large operators are producing at around 50 per cent of capacity and by the third or fourth quarter of the year stocks will reduce to 50,000-100,000 tonnes. So I don’t see any movement in the current low price until the third or fourth quarter of the year due to the overhang of stock.”
I must confess to be the last conspiracist standing on China and REEs (and pretty much all else in the metals space). Just because China botched the FANYA exchange and screwed up prices of some associated metals does not mean they are as clueless as many would have us believe. I prefer to think that the prolonged low prices in the REE space have been an attempt to drive juniors and wannabes out of the space. In this they have had a brilliant success. They have brought Molycorp to its knees and made the going very tough for Lynas. To claim that this is solely the result of over-production and disorganization by the Chinese is to give them a free pass in a space where they have shown themselves to be brutally Machiavellian and manipulative in the past.
If one takes our point of view then the process of attrition is virtually over. There remains Lynas on its feet (with its Japanese fairy godmother, JARE) and a smattering of juniors (e.g. Peak). These do not represent anything vaguely like the threat that the 100 plus juniors, all airing grand ambitions back in 2010, did. Can the Chinese live with this level of competition? Yes… particularly if the JARE group makes clear that they will support a non-Chinese producer (i.e. Lynas) come hell or high water. The Chinese must still be holding off to ensure that Molycorp is a corpse well cold in its grave (and thus beyond reanimation) before they return to a bullish tack.
Once the Chinese feel comfortable that the REE universe is well circumscribed to one non-Chinese major and a small clique of specialized players then they can hike prices and the survivors of this attrition can make hay while the sun shines.
When the Rare Earth boom upsurged in the last year of the previous decade, no-one gave the Japanese end-users a course or guidebook in the ways of mining sector entrepreneurs. Little did they know that when a promoter said “this will be a big mine…” he actually omitted to add “…but not if I have anything to do with it”. And that old chestnut “shovel-ready” which meant “I would not know a shovel if I feel over it, but we expect you to do the digging”…. And the other gem “we are working towards a production date… which with any luck will be many years after we are all dead”.
The Japanese then threw their reputation and some money towards a number of projects only to find out that the opaque promotional soundbites would not put REE in their industrial processes. Of all the bets they made the one that has played out best (yes, best) has been Lynas because it is providing the product they need. Will they be prepared to let this go? We severely doubt it. It is not as if there are any other projects (for the next three years at least) even vaguely in prospect and the downfall of Molycorp has accentuated this grim supply outlook.
Calendar year 2016 will be a key one for Lynas. Survive this period and its future will no longer be a subject of discussion and the stock price will react accordingly.
Christopher Ecclestone is a Principal and mining strategist at Hallgarten & Company in London. Prior to founding Hallgarten & Company in New York in 2003 ... <Read more about Christopher Ecclestone>