Earlier this week, China announced its plans to slash its export quota for rare earth metals (REM) by 27 percent in 2012, the Middle Kingdom’s third consecutive year of such export cuts. As a result, China will only export about 30,000 tons of REMs next year.

REMs are found in a wide array of consumer gadgets, from laptop computers and iPods to flat screen televisions and hybrid cars. They’re also critical in green energy applications such as solar panels and windmills. Global demand for REMs currently runs about 136,000 tons per year and is expected to rise to 185,000 tons annually by 2015.

Given such demand, China’s cuts are causing consternation among REM users, particularly since China currently produces about 95 percent of the global supply of REMs. Nevertheless, China’s actual exports of REMs will likely remain in line with 2011 levels despite the cut in the quota itself. That’s because demand for REMs slackened this year due to weak economic conditions.

But even in an anemic global economy, demand for REMs could easily outstrip supply due to their broad application in manufacturing and industrials. And should the macroeconomic picture brighten even slightly, then that increases the likelihood of a shortage of these crucial raw materials.

In the US, consumer confidence has risen to an eight-month high as unemployment has fallen, providing a potential boost to consumer spending. And while incomes in the US are largely stagnant, China’s middle class has expanded to such an extent that it’s now larger than the entire US population. At the same time, China and a number of other emerging market nations are pursuing economic policies to strengthen their domestic consumer economies so that they’re no longer as dependent upon exports. China’s burgeoning middle class will likely want to enjoy the same high-tech gadgets that their peers in the developed world have taken for granted.

As a result, we expect demand for REMs to rise over the coming year, particularly if there aren’t any notable economic shocks, such as the collapse of the European Union.

So why is China limiting REM exports? It’s largely a strategic decision.

China will benefit from the pricing power that results from constricting the supply of REMs to the global market, while retaining ample supply to continue building its own domestic stockpile.

And there’s little the West can do about it.

Mining and refining REMs is costly and toxic, so Western nations–including the US–ceded their production to emerging market nations where concern about the environment wasn’t as paramount. Prior to the 1980s, the US was actually self-reliant in terms of REM production, but has since become wholly dependent on imports–primarily from China–to meet demand.

Bills have been introduced in Congress that would provide incentives and loan guarantees to encourage the redevelopment of American REM mining. In fact, mining outfit Molycorp (NYSE: MCP) owns a property in Mountain Pass, Calif. that was once a prolific producer of REMs until compliance with environmental regulations made the mine uneconomical. The company still operates a separation plant at the location and expects to reopen its mine there sometime next year. But after nearly 30 years on the sidelines, it will now take anywhere from seven to 15 years for the US to rebuild its industry to provide sufficient REMs to meet domestic demand.

Market Vectors Rare Earth/Strategic Metals ETF (NYSE: REMX) offers the best way to play the supply and demand imbalance of the global REM market.

The exchange-traded fund (ETF) tracks a basket of 24 companies involved in the mining, refining and recycling of REMs, including a 5 percent allocation to Molycorp. The ETF is also geographically diversified, with 10 percent of assets allocated to Japan, 20 percent to Australia and 11.6 percent to China. It also includes an 11.2 percent allocation to Africa, with the remaining assets spread across North and South America.

While the fund is down by about 40 percent so far this year, we expect to see a recovery as the year progresses. Even so, this is a high-risk play because the eurozone remains a significant area of uncertainty amid the global economic recovery.

Check out our free REE stock investing report for more tips on investing in rare earth metals. 

What’s New

No new exchange-traded products were launched last week.