InvestorIntel reader Jeff Thompson a few days ago posted a question asking why Chinese rare earth prices had slumped so greatly. Well, Melanie Debono has an answer: the removal by China of its export tariffs which, so far as REE (rare earth elements) are concerned, has had a far greater effect on prices than the elimination of the quotas.

Two weeks ago, Debono, of Capital Economics in London, issued her initiating report on rare earths, saying that Capital expected “the prices of most REE to post sizeable gains in the coming years, even if they are unlikely to regain their 2011 peaks any time soon”. Now we have her second note on the subject, and the bottom line? Just this: “The recent price falls may prove temporary”.

In a client note entitled “China still controls its REE, despite ‘looser’ regime”, she sets out in brief the background to this story, along the lines that China still dominates the global supply and demand of REE. That country had managed to control supply by having a strong hold on both domestic production (via production quotas, a mining licence regime and resource tax) and exports (via a quota and tariffs). As we know, the World Trade Organization forced China to eliminate the export quotas and tariffs that allowed Beijing to effectively control prices.

Capital believes the removal of the tariffs, in particular, meant that international demand for Chinese produced REE would probably increase. And that would reinforce the dependence of end-users upon Chinese production. Unlike with the removal of the quota, which had consistently been higher than exports in recent years, and hence was not constraining REE export volumes, the removal of the tariffs will probably boost export volumes.

“Indeed, many (REE consuming) companies were reportedly running down inventories due to the high expense of buying REE and the uncertain demand outlook in recent years,” writes Debono. She argues that China should benefit from this pent up demand, especially with regard to heavy REE of which China has practically a monopoly. “And, given it produces the majority of REE, it will benefit a lot more than other producers,” she adds.

The removal of the export tariffs has led to a sharp fall in FOB China prices (which had included the tariff for both oxide and metal forms of REE). These FOB prices have now been able to converge to domestic prices, hence the big falls since May 1. (In other words, the price falls were not so much an indicator of falling demand than they were adjusting to the new non-tariff world.)

Looking ahead, Capital Economics believes that there are three reasons for the recent price falls to now be behind the industry.

One, Capital expects most industrial metal prices to rise in the second half of the year as ongoing stimulus in China boosts industrial activity. REE will benefit from this general improvement in prices on industrial metals.

Two, the change in China’s resource tax, from volume-based to value-based, is expected to lead to a rise in prices.

Third, persistent uncertainty surrounding China’s export regime should be an ongoing factor supporting prices.