On September 7, a Chinese fishing boat collided with a Japanese Coast Guard vessel near a group of disputed islands in the East China Sea. The collision sparked a chain of events that led to an apparent cutoff of China's shipments to Japan of rare earth elements (REEs), vital ingredients in many high-tech products. Suddenly the world became aware that China, home to some 95% of global REE production, held an alarming strategic monopoly.
The episode raises several economic questions. What factors allowed China to become the world's leading producer of REEs? Does China's current 95% market share represent a true natural monopoly? What factors could undermine China's current REE dominance? Application of a few basic economic concepts can go a long way toward providing answers.
We can begin by revealing what everyone already seems to know: Rare earths are not really rare. All 17 rare earth elements are more abundant in the earth's crust than gold, and some of them are as abundant as lead. The thing that makes them hard to mine is the fact that they are not found in highly concentrated deposits like gold and lead are. Even the best REE ores have very low concentrations. On the other hand, such ores are found widely throughout the world. Until the 1960s, India, Brazil, and South Africa were the leading producers. From the 1960s to the 1990s, the Mountain Pass Mine in California was the biggest source. China's dominance of REE production dates only from the late 1990s.
So, what explains China's big market share? Good ore deposits, but not uniquely good, are one factor. Second, low labor costs help China's REE mines just as they help its toy factories. A third consideration may have been most important of all. Mining of REEs can produce very nasty waste products. Up until recently, Chinese authorities were willing to turn a blind eye to environmental devastation caused by primitive, often illegal, but low-cost small-scale mines. Meanwhile, environmental problems were a major factor leading to the shutdown of the Mountain Pass Mine. Following a big spill of radioactive waste, US authorities demanded new environmental safeguards. Already facing low-cost Chinese competition, the mine closed rather than undertake the needed investments.
The abundance of REE ores suggests that China's 95% market share does not represent a true natural monopoly, that is, one based on ownership of unique resources. However, that does not mean it lacks short-run monopoly power. In the short run, supply of REEs is much less elastic than in the long run. Any short run increase in supply can only come from mines that are already open or, to a very limited extent, from "urban mining"--recycling of REEs from scrapped computers and the like.
Short-run demand is also inelastic. High-tech production lines are set up to produce hybrid cars and computer hard drives using well-tested but REE-dependent technologies. You can't just substitute nickel for the neodymium in a magnet and expect the product still to do its job.
Given highly inelastic short-term supply and demand, it is not surprising that China's cutback in supplies this year sent market prices soaring. Bloomberg reports that prices of Neodymium jumped from $41 per kilogram in April to $92 in October, and Cerium oxide from $4.70 to $36 per kilo over the same period.
In the long run, all evidence points to much greater elasticity of both supply and demand. The press is full of news about old mines reopening or new ones under development. California's Mountain Pass Mine is expected to come back on line in 2011. Canadian companies are moving rapidly forward with projects in Wyoming and Tanzania, among other places. Australia, a supplier of nearly every other mineral, may also become a player.
On the demand side, it is not quite true to say that REEs are irreplaceable ingredients of today's high-tech products. At least in many cases, current REE-dependent technologies were chosen not because they are the only way to do something, but because they are a good way to do it given reasonable prices and reliable availability of the raw materials. Finding alternative technologies can take time, but the clock is now ticking. Japanese researchers are reporting success with REE-free technologies for electric car motors. Several new technologies are competing to replace conventional hard drives for computers, until now another big REE user. The Korean government is encouraging research into REE substitutes, as well.
The bottom line: China has a big market share, but no natural monopoly. Any efforts it makes to exploit its advantage based on low short-run elasticities only accelerates the development of alternative sources and new technologies.
Instead of trying to keep prices at the current high levels, once the ripples from the fishing-boat episode die down, China is likely to practice "limit pricing." Limit pricing is a classic monopoly tactic that involves holding prices high enough to give moderate but steady profits, while still low enough to discourage the growth of competition. At the same time, expect China's own rapidly expanding high-tech industries to absorb more of its REE output. In fact, encouraging them to do so seems to be an element of Chinese policy. Preferential access to low-cost REE supplies could give those industries a competitive advantage on world markets over a longer time horizon than that over which China could hope to maintain its near monopoly as a supplier of raw REEs.
Meanwhile, China's competitors in Asia, North America, and Europe should get serious with incentives to develop alternative sources and REE-free technologies. Targeting research funds would be helpful. Military research dollars should be included, since REEs have key applications in helicopter blades, laser gun sites, radars, and other military hardware.
The issue of environmental harm from REE mining also needs to be addressed. Relaxing environmental regulations in the United States and other new source countries is not the way to go. We do not want the Mountain Pass Mine to go back to spilling radioactive waste water in the California desert. China is showing signs of cleaning up its own worst REE polluters, and if it follows through, this may become a non-issue. If it does not, one option for consideration would be countervailing environmental tariffs, to the extent these are allowed by WTO rules.
With or without major government action, however, market forces appear unfavorable to China's continued dominance of REE production. After the East China Sea incident, concerns over reliability of supply, as much as concerns over price, are triggering research and investment to an extent that suggests that the long run--as in "long-run elasticity"--is fast approaching.
Follow this link to download a slide show with charts and additional analysis related to China's fragile rare earth monopoly.
Thank you Ed, this blog is great.ReplyDelete
Very interesting post! Sometimes it seems that that rare earth mineral bulls are like gold bugs on steroids, so it's nice to read a level headed analysis of the issue.ReplyDelete
A good and very fair piece on rare earth elements (REEs).
I agree with your overall assessment that China does not have any natural or long run monopoly on REEs. Nonetheless, they do have very much have a short term one.
The FOB spot price is now some 3 to 4 times what a Chinese-based end user would pay for access to these minerals.
As such, China is using the promise of 'access" to REEs to “encourage” non-Chinese manufacturers who want to produce goods which require rare earth inputs to set up shop in China. This ensures jobs for the Chinese. More importantly in the long term, those foreign companies that do move are essentially forfeiting their technologies to Chinese.
So increasingly these companies have a choice. They can substitute REEs out of their product, which begs the question of how competitive their products will be against those manufacturers who still have access to REEs—and don’t have to substitute.
And while I don't disagree that substitution will come into some effect—the latest iteration of Apple’s MacBook Air eliminates the traditional hard disk for a flash drive—there are too many advantages and too many uses of REEs in myriad applications for this to have any real effect.
Neodymium magnets are just one example. They're the most powerful of all permanent magnets and can lift more than any other type of magnet of the same size. They invention made the original walkman possible in the early 1980s, hence many applications are very much embedded into our everyday usage. Today, they’re even used for alleviating symptoms and relieving pain caused by health issues like arthritis.
There are more current uses for rare earths Ed, than are dreamt of in your philiosophy.
The question then becomes one of the opportunity cost suffered by end-users who lose the ability to commercialize and market products, which require rare earths as critical inputs.
Thus we may see “strategic logic” rather than pure economic logic would drive the development and eventual the future of REEs.
The game is also about controlling the downstream products, capturing the value added by converting rare earth oxides into metals and into products. Given that REEs are typically used in relatively small amounts vis a vis the total amount of product inputs, their cost is a relatively small part of total product cost and thus should have a muted effected on product demand.
Manufacturers that do have access to REEs will have a competitive advantage and may gain market share vis a vis those that have limited or no access to crucial REEs.
So the question becomes how will some large manufacturers—Toyota's making of Prius for one example—risk losing the high "end value" captured from selling the entire car because they can't access enough REEs for a critical components? Will they risk losing the cost reduction benefits from a more scaled up production?
Or will they "capture their REE supply" buy investing in/buying up proven deposits? Thus ensuring they remain competitive at what they do?
Kevin, I don't disagree with any of this. I admit that when economists see that one state of the world is not sustainable (the 95%--or is it 97% now?) Chinese REE market share, and see that another state of the world is coming (more research into REE substitutes and more investment in supply outside China), they (we, that is) tend not to focus so much on the fact that the transition from one state of the world to the other is time consuming and costly. Another way to put this is to say that economists are always looking for a "tendency for something to happen" and neglecting to emphasize that even when there is a tendency for something to happen, it does not have to happen right away, and that the transition to the new state of affairs may sometimes be incomplete even in the long run.ReplyDelete
Putting on my hat as an adviser to China, the strategy of controlling downstream products to extract the value added by REEs is probably a sound one, and makes more sense than just holding the rest of the world up for high prices on the REEs themselves. But even that strategy will only slow down the gradual erosion of their strategic position.
I see recent moves by China to assure the US of their reliability as a supplier as part of this strategy. It reminds me of Russia's attempt to assure Western Europe of its reliability as a gas supplier after each episode in which they cut gas off for a while. I just hope no one believes their assurances.
Great article Ed, thanks for sharing your opinion.ReplyDelete
Here is some update - China is considering establishing an industry association and a government unit for the rare earths industry http://www.chinadaily.com.cn/china/2010-12/29/content_11767880.htm