How To Invest In An ETF Based On Rare Metals

by Jack Lifton on July 20, 2010 · 7 comments

in Lithium, News Analysis, Rare Earths

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There is a threshold of investor awareness and confidence that the rare earths have not yet passed; I don’t know if the rare earth sector will ever even achieve that threshold much less pass through it, but I do know why it hasn’t so far. There are indeed many critical uses for the rare earths and they, the rare earths as functional components, are pervasive in our technological culture. Understanding those uses  requires specialist education and/or technical skills. Explaining why, exactly, the rare earths are important to the general public, involves teaching skills far beyond that of the typical disgruntled or adventurous scientists and engineers, who have become analysts and publicists for the  financial firms servicing the high-tech sector of the stock markets.

The lithium battery sector has been better served by the educational and analyst establishment than the rare earth sector. I think this is because everyone with even a general higher education, thinks they understand at least the use of batteries. Thus the technical language of the battery sector of energy storage economics, seems to them to be at least familiar enough for them to be comfortable, that they understand it generally.

Between 2008 and 2009, the global production of lithium declined by 30%, entirely for economic reasons.  In fact, I created a definition for rare metals in 2009, in which I defined a rare metal in 2009 as one produced at a global rate of 25,000 metric tonnes per year or less. Lithium was my threshold rare metal in 2009 by this definition. In 2008 it was in fact produced at a rate of 25,000 t a year. When updating my rare metals chart earlier this year, to produce my list of the rare metals for 2009, I fully expected that lithium’s production would have increased to the point where it was no longer a rare metal by my definition. Instead, to my surprise, lithium tracked the recession. Its 2009 production was in fact 30% less than it had been in 2008; it was, in 2009, only 18,000 t for the year.

Like every other commodity metal besides gold, silver, or platinum, the production and price of lithium is dependent on the demand for the element in the global industrial marketplace and has no intrinsic value component at all. This demand in its turn is a direct function of the end use of lithium, in all of its chemical forms in mass produced devices, chemical catalysis, and pharmaceuticals. Therefore, instead of just being based on lithium metal production, a lithium ETF for a small investor is much better based on being indexed to not only actual production and demand but also to the probability of future demand and supply increases, due to technological breakthroughs. An indexed ETF that includes investments in technological breakthroughs that can drive future high demand, is the best bet for a small investor, providing that the companies indexed by the ETF are chosen for their ability to increase existing production of lithium, or to economically bring new production on line when called for, and/or for their ability to innovate uses for lithium and to commercialize those innovations profitably.

I don’t know who is choosing companies of both types, either lithium producers or present and future lithium users , for the new fund mentioned in the Wall Street Journal article noted below, but that individual or group of individuals will make all of the difference, among this new lithium ETF and any other lithium ETF that will be created now or ever. Before you invest in such a natural resource-based rare metal ETF, look carefully at its board of advisors and at its founders.

When I first encountered Euclidean geometry in junior high school 56 years ago, my understanding blossomed when the teacher ridiculed my answer to the question, ‘What is the reason that side A of the figure equals side A of the same figure? My answer was “it is obvious.” The very good teacher said “No, it is because they are congruent, and that is what is obvious, Mr. Lifton.” I realized at that moment, that nothing is obvious unless we all agree on the subject matter, the meaning of terms, and the rules of  logic.

Without further ado then, I give you the Magic World of rare metals-themed investing (drumroll, please and a cloud of non-toxic, non-irritating smoke – this type of smoke is called steam by the way; it is the visible output from nuclear reactors, for example, and is often mistaken for pollution…)

Yesterday’s Wall Street Journal had on the first page of its regular section called “Money & Investing”, a story I have been waiting for that I thought would come sooner, entitled “Lithium ETF Aims to Rev Obscure Part of the Market”.

Who benefits from an ETF based on rare metals such as lithium?

An ETF places in the hands of a group of experts, the role of advisor to small investors, on a sector that the majority of individuals find either too arcane or too technical to comprehend. There are, however, questions to ask these advisors – the answers for which are understandable by almost anyone without a specialized knowledge of the rare metal or metals (such as lithium) or its uses.

I am going to use lithium below in all of the questions and answers, but you can substitute any rare metal or metals generally ,and still need to answer the same questions:

Q: Is there today a shortage of lithium – is the current demand for it, greater than the current supply?

A: Unequivocally NO.

Q: Are there today sufficient existing producers of lithium, to meet foreseeable increases in near term demand (at least five years), by increasing output from existing proven resources?

A: Unequivocally YES.

Q: Is it possible for a new industry, such as, in the case of lithium, an automotive /transportation themed lithium battery industry, to use enough lithium to create a shortage if current production rates hold constant?

A: It is possible ,but highly unlikely until the second half of this decade at the earliest.

Q: Can current lithium battery chemistries (the principal end use) be mass produced economically enough for transportation uses, so that new producers of lithium would be required in the next decade?

A: NO and this is not due to the price of lithium, whose price in 2010 accounts for little more than 1% of the manufacturing cost of a storage battery for transportation use, in any of the chemistries being developed or tried in use.

Q: If there were to be a breakthrough in lithium battery chemistry, and in the manufacturing technology needed to mass produce it (two entirely different categories of problems and solutions), then which  manufacturing scheme for that technology, and which competent management to carry it through would be the best to invest in?

A: This is the reason that the makeup of an ETF’s board of advisors is the most critical aspect of the ETF. If such an ETF does not have people knowledgeable and experienced in real world mining, end use product development, and manufacturing management along with corporate finance, then the risk of the ETF’s failure to make proper choices is very high. This is my key objection to most of the schemes that have been proposed for rare metal themed ETFs; the advisors are all financial experts who know little or nothing of the real worlds of natural resource production, R&D management, manufacturing management, or end product marketing.

I find to my dismay that small investors think they are going to make money, while helping to fund the companies in the ETF’s index.

The purpose of an ETF is to first and foremost make money for its founders.

The function of the ETF (do not confuse purpose with function!) is to make it possible for small investors to reduce the risk inherent in betting on just one horse to win. It is a bet that if any one of them wins, you win i.e. a sure thing. The first problem is finding out if there is a race at all, and to find out which of the horses is likely to die of exhaustion, long before reaching the finish line.

The avowed function of the ETF is to allow ‘good’ companies, the ones chosen by the ETFs, to receive capital through the ETF’s purchase of their shares or of their metal. In practice this means that the ETF can participate in IPOs or private placements, or by choosing the stock for its portfolio, encourage institutional investors to buy into an IPO.

Note well that the only value a company gets from its issued shares trading in a market, is in the net worth of the company (its value) being maintained high enough to enable the company to get credit and financing for new projects as it needs them. I say this because it is not a trivial point for small investors, who somehow think that buying a share of stock in a company, after its IPO, is somehow money that goes directly to the company. I apologize to those who think, as I did, that this is an obvious error of judgment; but it is not.

For an ETF to make money for its investors, the net value of the ETF’s holdings must increase, so that new investors in the ETF will pay more for shares than those who bought them before.

The shares of the companies making up the ETF will only increase in value and maintain that value if those companies are doing well in their intended purpose. Whether or not that happens depends on the financial management, the manufacturing management, and the marketing management of the company as well as on the market fundamentals of the underlying rare metals, no matter which metals they are.

Judging the probability of the commercial success of a natural resource producer or end user, is a complex undertaking, requiring real world experience, and it is almost impossible for any single person or small group of persons to be successful at such judgment.

If you are a small investor in for the ‘action’ to make (or lose) a quick buck, who believes that the trend is your friend, and that a rising tide lifts all boats,. then invest in any rare metal ETF that comes along with a word in its name that you have heard a lot.

If you are a long term strategic investor, study the makeup of the fund’s personnel and then look at the choices they’ve made and then invest. The long term investors are the ones supporting our economy and letting it grow. That’s the trend to follow.

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1 John Petersen July 21, 2010 at 2:22 am

Given the reality that mineral content is an exceedingly small percentage of consumer product value and the vast bulk of the value is added by post-mine refining and manufacturing processes, I’d be very cautious about investing in a mining ETF for industrial metals.

2 Olivier Vallee CFA July 21, 2010 at 4:18 am

The question really is what is the lithium being used for. According the SQM figures (which are slightly lower than USGS but somewhat more detailed) glass and ceramics made up 21% of lithium demand in 2006, falling to 15% in 2009; lithium for lubricants went from 17% to 13%. Lithium for batteries went up from 20% to 26%.

Battery use is such as small part of demand that buying a lithium fund on the belief that electric cars will be popular (itself a risky bet) may be misguided. Of the 26% mentioned there were essentially no lithium batteries made for hybrid-electric cars.

I myself don’t expect battery share to increase significantly before 2013-2015, but at that point the tail may indeed start wagging the dog.

3 stephen July 21, 2010 at 6:04 am

I recall an elderly Shetland lady once telling me, “There’s nothing common about commonsense.” Thank you Jack, for your own astute, crystal-clear and commonsense guidance.

4 prescient11 July 21, 2010 at 10:16 pm

Lithium is the head fake play. Same with tantalum.

5 Raymond Gabb July 22, 2010 at 7:44 pm

Can you list publicly traded companies that mine rare earth elements excluding lithium.

Thank you

6 Jack Lifton July 22, 2010 at 7:57 pm

Raymond,

I am not aware of any publicly traded company outside of China that is currently mining rare earths other than Australia’s Lynas. And in that case I believe that although Lynas now has ore above ground that it is waiting until its separation plant in Maylasia is ready to process, i.e., crush, float, and mill to a concentrate in Australia, before shipping it out to Maylasia. I believe also that there is one privately owned mine in Russia’s Kola Peninsula that is producing ore, which is concentrated at the mine or in the Ukraine and then separated and refined ultimately at Silmet in Estonia. I think that the total production of the Russian owned operations (including Silmet) is less than 2000 metric tons a year.

Lithium, by the way, is NOT a rare earth element; it is a rare element today when defined by its current annual production rate. It is not rare in terms of known resources and reserves.

Best regards,

Jack Lifton

7 prescient11 July 22, 2010 at 10:37 pm

Mr. Lifton,

Looking forward to your post on RES, excited to see how their gold play is progressing as well.

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