Americans have been bemoaning U.S. dependence on foreign oil for decades and a domestic alternative still seems a distant dream. Meanwhile, the world has changed. On one hand, that dependency now stretches across a broadening spectrum of raw materials, from molybdenum and tungsten to zinc, nickel and chromium to the decade's darling on the periodic table—the rare earths. And on the other, huge emerging economies, primarily that of China, are driving up demand for the raw materials needed to develop infrastructure and making it clear that their own domestic needs take priority.

That adds up to what mining analyst John Kaiser describes as "the big theme that underlies the base metals and all the specialty metals markets"—the concept of security of supply—and it's a global issue. In this exclusive Energy Report interview, John identifies a few investment opportunities that are emerging to forestall lack of access to some key ingredients of economic growth. He also registers a clearly optimistic note in anticipating "a period of scientific breakthroughs that's going to pump up the world in a very big way."

The Energy Report: You've previously discussed security-of-supply concerns in the context of China's growth. In addition to unloading U.S. paper assets, China is intent on developing its internal infrastructure to further develop its domestic economy. So they're taking their U.S.-denominated reserves and solving this security-of-supply problem by acquiring deposits and assets around the world to ensure control of key raw materials needed for their long-range plan.

John Kaiser: Let's back up a bit, because the context is much broader than that. For nearly 20 years since the collapse of the Soviet Union, globalization and free markets have allowed producers anywhere in the world to sell raw materials anywhere they want. But that window seems to be closing. Supply channels are fragmenting, which will shake the just-in-time concepts we've become accustomed to. No longer will companies be able—or willing—to say, "We'll order the raw materials when we need them and pay whatever it costs."

The worrisome implication is that the future production from these deposits that the Chinese acquire and develop through state-owned entities will flow directly back to China and bypass the global commodity markets. It is often the case that other branches of the Chinese government will fund infrastructure projects that secure the cooperation of the host country with regard to mine development and off-take agreements. The recent deal Afghanistan negotiated with China on its copper deposits is a good example of a deal that defies the economic logic to which bidders from the western mining industry must adhere. China is not putting these deposits into production so that it can make a profit selling the metal output into the commodity market.

We are shifting to a place where we can't count on molybdenum or rare earths or nickel or chromium to be available when we need it. So end users are looking up the supply chain all the way to where the mining industry normally sits. This is especially the case with the more obscure metals which are tiny but critical inputs for technology and other goods. They're saying, "We have to make sure that we have the raw material inputs in place to execute on our long-term plans, whatever they are." This is one reason why the rare earths sector has become such a media buzz item—although it's only a $2 billion a year market at most.

The big theme that underlies the base metals and all the specialty metals markets is the concept of security of supply.

TER: Are the insecurities due more to insufficient supplies or the fact that we can't produce raw materials at a fast enough rate to satisfy increases in demand?

JK: It's really both. Until the past year, we had a supply-demand imbalance that began to be felt in 2003, but the mining industry didn't believe it was real until 2006. By then it was so well advanced that, because of the three to six years it takes to mobilize new supply, supply hadn't been able to catch up. Demand hit the wall in 2008.

Then, even though demand didn't pick up all that much last year, base metal prices bounced back surprisingly well, especially given that the warehouse inventories for metals such as zinc, nickel and copper are far above their 2006 and 2007 levels. Much of the raw materials that were used during the past decade went into the construction of infrastructure and productive capacity that will not generate scrap metal for another couple decades. This is the opposite of what prevailed during the nineties after the collapse of the Soviet Union when strategic stockpiles were dumped and Russia's creaky infrastructure was looted for scrap metal.

TER: So where does that leave us today?

JK: Two things appear to be happening now. One, end users or state entities are engaging in long-term strategic stockpiling to make sure their industries will have raw materials available down the road. Countries such as China are even engaging in what I call distributed stockpiling. They have extended credit to thousands of manufacturers, enabling them to buy more metal than they need. Secondly, low interest rates have created a carry trade that has resulted in speculators buying raw materials. This makes the situation a bit precarious because if a rise in interest rates forces speculators to unload all their investments and flatten out the carry trade, a glut of raw materials may hit the market and result in a price slump.

TER: With stockpiling and speculators buying raw materials, why are major companies looking upstream to secure the supply?

JK: Because of the uncertainty created during the past two years, the mining industry shelved a lot of projects. In fact, a lot of the deposits taken over in the last few years are no closer to production than when they were taken over. So the supply shortage persists. If the global economy rebounds, an off-take of all this speculative raw material that's being hoarded would flatten out supplies over the next few years.

The end user industry is not particularly worried about the near term. They're far more concerned about what happens five years out and beyond. For example, there's enough rare earths supply for the next three to five years. It's what happens down the road, especially if total demand scales up, that has everybody concerned. Long-range planning needs to be done now and there is now a strong awareness that some of these materials come from parts of the world that are potentially unstable.

In addition, we may see the global supply channels disrupted as the United States and possibly Europe deal with trade imbalances created by the disparity in cost structures with China. That disparity prevents the western world from competing in terms of manufactured goods. A form of protectionism may emerge in which it's not so easy to move copper or nickel to any point on the planet.

TER: Will protectionism take the form of trade embargos or import taxes so that goods or resources from China are priced similar to what we pay in the U.S.?

JK: Globalization and free market theory say the old-fashioned tariff system to allow domestic industry to be competitive with cheaper imported goods is bad because it makes everything expensive for everybody, but we now find ourselves in an anomalous situation. Part of the world with a very large population spent a good part of the past century trapped in a communist rut and ended up with a fairly low standard of living. Now, all of a sudden they throw off half the trappings of communism and start competing with the rest of the world on sort of capitalist terms.

The wrinkle is that they're doing it from an enormous cost advantage in the form of an abundance of people willing to work for very low wages in a setting where health and safety costs are minimal. They also deal with very little in terms of emission controls, which is the complete opposite of what has evolved in the western world.

Finally, because China is a new type of central command economy that outsources production, its ability to make things happen at home and abroad is not constrained by free market principles. Of course, businesses always move production to wherever they can get it done the cheapest. In terms of very, very cheap goods being available in the western world, this has enhanced our standard of living. But in the process, it has hollowed out our industrial base, shifted us into more of a service economy and accumulated a massive trade deficit which is not sustainable in the long run.

TER: So what are the options?

JK: There are no happy options. If we throw up big tariffs, the cost of everything will go way up. If we bully the Chinese into allowing their currency to rise against the U.S. dollar, everything will become more expensive as well, but we'd at least be able to justify building factories again. What I think will happen is that the concern about fossil fuel dependency and climate change, and the resulting interest in changing the energy infrastructure in much of the world, will give rise to rules that say we do not want goods subsidized by processes that harm the environment, such as is happening in China.

TER: Another form of protectionism.

JK: Yes, green protectionism. It's a different type of protectionism that encourages the relocation of manufacturing capacity back to places like the United States and restores viable long-term economies. Although it will further fragment global trade, it is my view that some sort of green-based protectionism will be the strategy to deploy over the next three to five years.

TER: Will that be a government strategy or a grassroots strategy?

JK: It's not going to be ground up from the people because everybody will always want to buy the cheapest good available. Sure, a small percentage will go to the green store and buy more expensive clothing made in an environmentally sound manner, but the majority will still go down to Wal-Mart and, of course, Wal-Mart sources its goods in the lowest-cost jurisdiction in the world. That's not going to change.

So it has to be a top-down legislative strategy, but it also has to be developed and implemented very carefully. Doing it too abruptly would pull the rug out from under China. We want to level the playing field, but nobody wants to see China implode. Even in strictly economic terms, we need China's large population (and India's) to become consumers of the kinds of goods that westerners take for granted.

The obvious hope is that an emerging middle class in China will erode the competitive advantage of the China Price, but my concern is that this will not happen fast enough to salvage western economies and keep smaller emerging economies alive. I see green protectionism, possibly implemented in the form of a transportation distance tax, as a transitional measure that offsets the cost structure disparity.

TER: But all the alternatives you offered—bullying the Chinese to decouple the currency, put tariffs in or implement green protectionism—would increase prices in the short term.

JK: Yes. We're facing a period of relative wealth deflation. The era of consumption that we became accustomed to during the past decade—with the help of consumer debt and mortgages we couldn't afford and so on—has come to an end. The last year has been absolutely miserable for a lot of people. They are in the process of adjusting to a new reality, which will be a lower consumption footprint. This does not mean Americans will become as poor as the average Chinese citizen, whose standard of living is on an improvement track. Having a lower consumption footprint need not be a bad thing if people learn to view their standard of living in terms of quality of life rather than quantity.

TER: Even in an era of wealth deflation, where do you see opportunities for investment and wealth creation in light of these themes you've been talking about?

JK: The area that has fascinated me particularly in the past year has been the rare earths. A lot of the functionality of green technologies, in fact, depends on the addition of these elements. The security of supply problem with the rare earths is that in the last 20 years, China has emerged as the overwhelmingly dominant supplier. In part, it's because they have an abundance of such raw materials, but it's also partly because they extract them under conditions that are not acceptable in the West. Combining that supply situation with their low-cost structure has enabled the Chinese to marginalize rare earth deposits everywhere else.

Yet we talk about electrifying the car industry. We talk about turbine technology providing wind power. We talk about creating huge fields of solar panels. If all of this becomes reality, demand for rare earths will scale up dramatically, maybe 10-fold over the next 10 to 20 years. So the end users are saying, "Oh, boy, we're dependent on China." China itself has come out saying they need to do these things too because they have lousy coal reserves and a minimal oil reserve base. They're making noises about making sure domestic needs are taken care of first, which creates a problem in the western world. If we want to build our wind turbines and hybrid cars, we better secure a raw material supply that cannot be commandeered and used for national policy purposes.

So we're scrambling to get the rare earths deposits we found decades ago into production, so that raw material inputs are available for the plans of the western countries to transform to a more green-based energy infrastructure.

TER: Are there some specific companies involved in this scramble that interest you?

JK: I've actually created an index of about 14 companies in that space. One in which I have a personal investment is Quest Uranium Corporation (TSX-V:QUC). They've done sufficient drilling at their Strange Lake deposit in northern Quebec this past summer to outline a very significant deposit. It's world-class in size, reasonable grade, and has a full distribution of all the rare earths metals, from lights to heavies. I suspect perhaps even a consortium of end users will end up acquiring this project and developing it almost like a private rare earths warehouse.

TER: Any others?

JK: Rare Element Resources Ltd. (TSX.V:RES) has the Bear Lodge deposit in Wyoming and Ucore Uranium (UCU:TSX.V) has the Bokan deposit near Ketchikan in Alaska. They're not huge in the sense that the Strange Lake deposit is. Bear Lodge is a fairly good grade light rare earths deposit and the Bokan project is more dominated by the heavy rare earths. The USGS actually spent a bunch of money documenting the nature of the Bokan deposit in the late '80s when we were still concerned about where the Soviet Union was going with its policies.

Both Bear Lodge and Bokan are very interesting because the U.S. government is now investigating its own security of supply for the rare earths through the RESTART bill. The military in particular—which spends a good portion of its $600 billion annual budget on hardware—has awakened to the fact that some functionality of its critical hardware depends on rare earths inputs that now come only from China. Some consortium of defense contractors could end up taking over these projects and developing them as small-scale mines. They'd use government funded R&D to figure out process technology for getting these elements out of the mineral assemblages within which they are embedded, and probably share that technology with the private sector so other deposits can be developed to ensure the commercial market also has a supply as well from other rare earth deposits outside of China.

TER: Except for Rare Element Resources, the companies you mentioned are obviously involved in uranium as well as rare earths. What's your outlook for uranium?

JK: Quest and Ucore both started as uranium exploration juniors. Because rare earth deposits can occur in geological settings conducive for uranium deposits, it is natural for open-minded geologists to recognize the rare earth potential of certain projects. Both companies have now shifted their focus to rare earths. I think the uranium sector will make a comeback in 2010. Uranium prices went way up in the past five years because it is very difficult to get new uranium supply on stream and we had a temporary spot market shortage. We now see uranium in the $40 to $50 range and it might increase $10 to $20 or so longer-term.

The hope is that the Obama administration warms up to the idea that nuclear energy is an excellent carbon-free source of electricity. The Chinese have lots of uranium-based nuclear power reactors on the drawing board, but they are also looking at thorium, another candidate for nuclear energy but without the weapons-making capability. I don't see demand for uranium going through the roof the way it can for the rare earths. The difference between uranium and the rare earths sectors is uranium essentially has two uses. One is to make nuclear weapons, and we really don't want demand to go up there. The other is for nuclear power, and that demand can be quantified quite well in advance.

In contrast, the rare earths have a wild demand dynamic because ongoing R&D keeps coming up with ways to work with these elements' interesting properties. All kinds of technologies already exist that can't even be commercialized because there's not a sufficient supply of these rare earths in existence.

As the additional rare earth deposits get into production, the logical economic objection is that all this new supply will glut the market. But not in this case. As the supply becomes available, end users will have the confidence to commercialize applications with functionality superior to prior applications, so I would expect the supply to actually be readily absorbed.

Not only that, you also will see a scramble to make more efficient use of these rare earths, particularly if China stops subsidizing the cost structure of rare earth production and allows the price to rise. There's something called Jevons paradox that drives the scarcity people crazy; namely, in response to scarce supply of a raw material, you engage in R&D to increase the efficiency of its usage and as a result total demand for it actually goes up. This would not apply to uranium because of its limited uses, but it would certainly apply to rare earths and other technology metals.

I think we are on the frontier of a material science boom coming on the heels of three decades dominated by information and biotechnology booms. An awful lot of money, both from the private sector and government, will go toward seeing if we can push elements to do far more than has ever been done before. One area is, of course, efficiency and durability. But another area is emerging as the new Holy Grail. If you can produce energy at a lower per-unit cost than the current norm, and the "fuel" for doing so is readily available, you will give the world a massive boost in its overall wealth or standard of living.