Chinese rare earths supply squeeze doomed

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"The Middle East has oil," Deng Xiaoping said in 1992, "and China has rare earths." The 17 chemical elements collectively known as rare earths—with sci-fi names like neodymium, lanthanum and cerium—are essential materials in key components of electronic devices, from cellphones to missile guidance systems. When your BlackBerry vibrates, it's thanks to a tiny neodymium magnet converting electricity into mechanical power.

China has about a third of the world's proven reserves of rare earths, and in the 1990s the country ramped up production. That drove global prices down, causing higher-cost mines and refining facilities in the rest of the world to close.

As a result, China now controls 97% of the world's production of rare earths. The Chinese are trying to do what Arab oil producers did in 1973 with their embargo: restrict supply, squeeze customers and raise prices. China slashed export permits for rare earths by 72% last spring, and another 35% earlier this year. That has sent prices of rare earths into the stratosphere. The country also introduced an export tax of 25% on some rare earths, encouraging electronics manufacturers to locate there if they want cheap prices and security of supply. China seems to have fulfilled its dream of becoming the OPEC of rare earths.

But here's the rub: Cartels hardly ever work. They sow the seeds of their own destruction. After OPEC's early success in the 1970s, when oil prices soared from about $3 (U.S.) a barrel to almost $40 by 1980, prices fell steadily for two decades. By 1998, the inflation-adjusted price of oil was lower than it was in the 1960s. If you artificially restrict supply and drive up prices, consumers and producers respond, and those responses tend to drive prices back down. (Of course, oil prices have jumped way up again over the last few years, but that's been due to exploding demand in the developing world, not OPEC manipulating supply.)

In the 1970s, as oil prices climbed, consumers cut demand. Drivers bought more fuel-efficient cars, homeowners turned thermostats down and businesses produced more with less energy.

The world's biggest oil user, the United States, saw consumption peak in the late 1970s, then fall sharply for almost a decade. By the late 1990s, the U.S. had 50 million more people and its economy had nearly doubled in size, but total oil consumption was no higher. Between 1973 and 1985, the U.S. energy/GDP ratio—the amount of energy needed to produce $1 of gross domestic product—declined by an average of 2.7% per year, compared with 0.5% a year over the previous 2 1/2 decades.

With rare earths, solutions on the demand side could come from people like George Hadjipanayis—a graduate of the University of Manitoba, chair of physics at the University of Delaware and the man who created the first neodymium magnets in the 1980s. Along with teams from the Ames Laboratory in Iowa and General Electric, Hadjipanayis is pushing to find alternatives that use less neodymium.

Then there's the supply side. Rising oil prices in the 1970s led producers to find and tap new sources. The same dynamic is at work in rare earths. Serious money is being invested to develop mines outside of China, including reopening old ones that are now profitable again as a result of higher prices.

Rare earths miners are now hot stock plays. Avalon Rare Metals Inc. of Toronto has seen its share price increase tenfold over the past two years, thanks to the mine it is developing at Thor Lake, NWT. Shares of Great Western Minerals Group Ltd. of Saskatoon and Ucore Rare Metals Inc. of Hammonds Plain, N.S., have surged on plans to ramp up production at mines in South Africa and Alaska, respectively. Quest Rare Minerals of Montreal is sitting on what it says is a huge deposit in Northern Quebec: Its stock price is up 100-fold since early 2009.

In late March, Australia's Lynas Corp. Ltd. was ready to begin production at a mine in Western Australia. A penny stock in early 2009, Lynas now has a market cap of $3.2 billion (AUS). Last year, Colorado-based Molycorp raised $394 million (U.S.) to reopen a California mine that was once the world's main source of rare earths.

As new supply hits the market, rare earths prices in the 2010s could follow the path of oil prices in the 1980s and '90s: down. An ad that popped up on my laptop recently was telling. It urged me to invest in "Rare Earth Exporters of Mongolia" in order to profit from "the Rare Earths Rush." When a gold rush has an ad agency, that's probably not a buy signal. But I couldn't help but see an omen in the ad's screaming headline: "Checkmate China!"