The recent move by China to establish a rare earths industry association to exert greater control over the fragmented sector, the introduction of export quotas and other tightening measures last year and increasing global consumption of rare earth minerals have heightened concerns among major users over potential supply disruptions, price hikes and the future availability of the minerals.

The anxiety came to the fore in March, when the United States, the European Union and Japan filed a suit against China with the World Trade Organization, urging the trade body to commence talks and compel China to relax the restrictions. Under WTO rules, export restrictions of vital materials are prohibited.

Rare earth minerals are used in a wide variety of high-tech applications and industries, ranging from energy-efficient lighting, iPhones and defense equipment to wind turbines, permanent magnets and electric motors.

Although China has about 30 percent of the world's rare earth deposits, it currently supplies 97 percent of the world's rare earth after producers in the US and elsewhere began to cease production from the mid-80s due to environmental concerns and the availability of low-cost imports from China, where wages and environmental standards were significantly lower.

Dependence on China

The dependence of many downstream producers on China to supply the much-needed rare earth for industrial production has led to fears that China may leverage its power to achieve certain objectives. Such sentiments may not be entirely unfounded, especially after China temporarily halted rare earth exports to Japan last year following a territorial dispute.

For every commodity in demand, there have been attempts by the major producers to organize themselves into cartels in order to extract higher selling prices. The Organization of Petroleum Exporting Countries has been a significant player in setting oil prices since the 1970s.

In recent years, we also have witnessed how an iron ore pricing mechanism was fixed by the three biggest global miners, keeping prices at elevated levels.

Would China's attempt to exert greater control through the restructuring of the domestic rare earth industry to shore up its ability to set prices? That industry has long been undermined by illegal mining and lax enforcement of production quotas by local governments keen on a greater share of the revenue and jobs generated by the industry.

The evidence seems to suggest that China did gain a greater degree of pricing power immediately after the imposition of export quotas and other curbs, but its influence on prices has waned as time passed. During the first two months of 2011, the value of Chinese rare earth exports rose 568 percent year-on-year to US$314 million, while the export volume was stable, inching up 0.3 percent to 7,084 tons.

Initially, downstream users did not have sufficient time to seek other alternatives or reduce their consumption of rare earth minerals. However, the trend of rising prices was reversed last July when a majority of downstream customers halted production or operated at reduced capacity.

The move by Chinese authorities to compel the industry to use specialized invoices in order to curb illegal sales and smuggling ironically helped lower prices even further because small producers with unidentifiable sources began to dump their inventory.

Inner Mongolia Baotou Steel Rare-Earth High-Tech was selling neodymium oxide for about 80 yuan (US$12.7) per ton on December 16, and in the first half, prices rose to about 150 yuan per ton, according to the China Securities Journal.

Rare earth export volume during the first three quarters of last year fell 65 percent from a year earlier to 12,000 tons, while exports for the first 11 months hit 14,750 tons, or just 49 percent of the full-year quota.

The drop in demand showed the rare earth minerals industry is not immune to the forces of demand and supply and may have allayed market fears of sustained rare earth price increases.

According to our data at CapitalVue, China's production of single rare earth metals fell from about 2 million kilograms in June to about 1.5 million in September, and 993,000 kilograms in November. This corresponds to the drop in rare earth prices and export volumes.

Efforts to diversify

Notwithstanding the decline in prices, there are moves underway to reduce rare earth dependence on China.

Japan's Hitachi recently unveiled a prototype 11-kilowatt electric motor that does not use rare earth, and efforts are underway to restart idled rare earth mines in the US. These moves however, involve long gestation periods and are fraught with difficulties.

Due to the pollution and contamination risks from the operation of rare earth processing plants, it is political suicide for governments in most parts of the world to approve the establishment of rare earth plants.

In places where such plants have won conditional approval, there were protests by the local populace, as witnessed in the case of the Lynas Advanced Materials Plant in Pahang, Malaysia.

Compared with its customers, China certainly has more cards to play because it will take a long time for any serious competitor to emerge.

Whatever the motives may be behind China's move to impose export quotas and other curbs, it will encourage foreign users to move production into China. One cannot deny the heavy environmental cost that China is paying.

According to an Economic Information Report, Jiangxi, a province with significant rare earth resources, earned 32.9 billion yuan from the rare earth industry last year, but the sum required to clean up Ganzhou, a city in the province, totaled 38 billion yuan.

Price hike

Further price hikes in rare earth minerals are likely to be inevitable if demand rises further and China realizes the cost of cleaning up the environment for future generations.

"There is oil in the Middle East; there is rare earth in China," said Deng Xiaoping in 1992.

However, for China to enjoy the benefits of its rare earth deposits the way Middle Eastern nations did from oil, investments in sustainable mining practices are required and elevated rare earth prices may become the new normal.

CapitalVue provides China capital market, fundamental, and time-series statistical databases for institutional investors, investment banks, government organizations, academic institutions, and corporations. See more at www.capitalvue.com