On China, Rare Earths and Adaptive Markets

As the US/China trade spat lumbers on and both sides run out of new imports to threaten with tariffs, many pundits speculate China will soon seek non-tariff retaliation methods. One oft-touted tool: exploiting its alleged stranglehold on the supply of “rare earth elements”^[i] to hurt US companies reliant on them to produce goods ranging from memory chips and batteries to lasers and satellites. While the prospect of America’s high-tech engine sputtering without them sounds scary, we think this is a far-fetched scenario. In our view, rare earth metals are a case study in markets’ problem-solving power, not a potent economic weapon for countries (supposedly) controlling their supply.

First, a high school chemistry throwback: “Rare earths” refers to a group of 17 elements with similar chemical properties and many electronics applications. Contrary to what the name implies, they aren’t all that rare—some are as abundant as copper and lead. Nor are they difficult to find: In a single discovery last April, a team of Japanese scientists located offshore deposits with “the potential to supply these materials on a semi-infinite basis to the world.”^[ii] However, extracting rare earth minerals and transforming them into usable materials can be expensive, environmentally risky and physically dangerous.

Partly thanks to lower production costs and less concern about environmental dangers, China became the rare earths mining and refining leader in the 1990s—a position it has kept since. Last year, China accounted for about 70% of the world’s rare earths output—supposedly positioning it to hamstring US industry by blocking shipments.^[iii] Chinese officials seem happy to foster this impression. Last week, President Xi Jinping visited a rare earths facility in southern China—a move many interpreted as a shot across the bow. The National Development and Reform Commission—China’s economic planning agency—offered this cryptic musing on Tuesday: “Will rare earths become China’s counter-weapon against the US’s unwarranted suppression? What I can tell you is that if anyone wants to use products made from rare earth to curb the development of China, then the people of the revolutionary soviet base and the whole Chinese people will not be happy.”^[iv] On Wednesday, the state-owned paper People’s Daily issued a similar warning.^[v] This drumbeat helped fuel fears of a rare earths export ban.

However, history shows such a ban is feckless. China halted shipments to Japan in 2010 over a maritime dispute, sparking similar worries about the dangers of a Chinese monopoly. At the time, China comprised about 97% of global rare earths production—and Japan was the world’s top consumer.^[vi] The situation was seemingly tailor-made for inflicting maximum damage. But the embargo was largely a dud, for several reasons. China struggled to enforce it, as smuggling was rampant and producers exploited loopholes permitting the export of minimally processed alloys—compounds of rare earths and another token metal.^[vii] Japanese manufacturers, meanwhile, reduced their rare earths usage, switched to alternative materials or simply made do without.^[viii] Japanese industry didn’t close up shop. Rare earths might have been their best option, but they were far from the only one.

However ineffective, China’s export crackdown contributed to a spike in rare earths prices as companies rushed to stock up and investors mulled the possibility of inaccessible or unreliable Chinese supply. Predictably, this incentivized new production: Hundreds of firms globally announced new investments in rare earths mining projects while extant producers boosted output.^[ix] Prices soon fell—and kept falling over the next few years. The feared shortages never arrived, and China’s market share declined. If China attempted to block US firms from accessing rare earths today, we think a similar process would play out. In the short term, prices might surge—new mines don’t come online overnight, and fearful sentiment could hold sway. But many firms maintain rare earths stockpiles to protect against supply disruptions, likely limiting the immediate impact.^[x]

Targeting US firms would also be challenging. The US imported just $160 million worth of rare earths from China in 2018—0.02% of total imports from China and just 3.8% of total Chinese rare earths exports.^[xi] The vast majority of US usage comes via imports of goods and components from around the world with rare earths already built in. Fully cutting the US off would likely require disrupting established global supply chains across many industries—not a great look for a country striving to burnish its reputation as a trustworthy trading partner.

Beyond the implications for the US/China trade spat, we see a key lesson here about how firms adapt to changing circumstances—disproving dire predictions in the process. Rather than sitting around bemoaning shortages, companies respond to incentives—like high prices—and/or innovate around them. Obstacles like these are profit opportunities. Even now, smelling opportunity from Chinese saber-rattling, Australian and US mining firms are mooting new rare earths production facilities—2010 all over again.

For another parallel, consider the origins of the US fracking revolution. Years of high oil prices encouraged investment in new drilling and exploration technologies that unlocked new reserves, slashed drilling costs and drove down prices. OPEC—the subject of decades-long fears it could wield its supply supremacy as a weapon against import-dependent countries—has since lost much of its pricing power. Our takeaway for investors: Remember profit-seeking firms’ underappreciated ability to foresee, react to and solve such problems the next time you see headlines fretting this or that seemingly intractable resource shortage or looming environmental catastrophe.