A Look At The Uranium MarketAdventures in Capitalism
Last night, I had drinks with my good buddy Mike “Mr. Uranium” Alkin. As you can guess, we talked a lot about Mike’s favorite topic; uranium.
Let me preface this discussion by saying that uranium will always be special to me. I was a very early uranium bull in 2003 and had an oversized basket of uranium junior miners (there were like 8 publicly traded companies back then). I think the worst one was only up 10-fold from where I bought it. Some of the others were up 50 or 100-fold. Let’s just say it was one hell of a wild ride. I sold the last bits of my position about a year before the ultimate top (it was awfully bubbly already) and have followed the sector ever since.
I don’t know why, but I tend to receive an unusually large number of readers asking about uranium—which is odd given how obscure it is as a commodity. I’ve repeatedly answered that despite a spot price declining from a peak of around $135 per pound, you cannot have a bottom while production is greater than demand. Commodity bottoms take time and involve bankruptcies, facilities going on care & maintenance and above-ground stockpiles getting depleted. Despite my fondness for uranium, it just wasn’t time to play it (yet).
However, I’m warming up to uranium lately. Over the past two years, we’ve finally seen financial capitulation by producers. More than 40 million pounds of production has now come offline. Moreover, Kazatomprom (KAP – London) has reaffirmed that they will have minimal production growth until 2021. Simultaneously, not a week goes by without news of an existing reactor that will have its lifespan extended or a shuttered reactor that is restarting. For that matter, there continues to be news of new reactors getting green-lighted for construction—mostly in Asia and India. The rough math says that each reactor adds 500,000 pounds of annual demand—hence looking forward a few years, demand is growing while supply is down dramatically.
Using VERY rough numbers, in 2020, the world will use just under 200 million pounds of uranium, yet produce only 130 million pounds of primary supply. Just as importantly, SWU prices are rising, leading to less underfeeding supply. Call it a 30 to 40-million-pound deficit after taking into account underfeeding, reprocessing, MOX, etc. Even this understates the true demand as the nuclear fuel cycle takes at least two years to take raw U308 and turn it into fuel rods for a reactor. Most nuclear utilities prefer to keep 2.5 to 5 years of supply on hand—depending on if it’s a western utility or Asian—hence, new reactors need to order and stockpile material many years before the reactor is actually ready to start. This stockpiling demand on top of the existing run-rate demand leads to a larger deficit than the 30 to 40 million pounds noted above. For the first time in more than a decade, the chronic oversupply situation is reversing itself and above ground stockpiles are depleting.
The uranium market is different from most other commodity markets as it is a very closed market. There are only a handful of mines and about 450 reactors worldwide spread amongst roughly 60 nuclear utilities, along with a handful of physical traders active in the market. Equity investors tend to focus on the spot price, but most of the world’s uranium is transacted through multi-year term contracts. Many of these contracts were struck at much higher prices than today’s prices. As these contracts roll off, utilities have the choice of signing new term contracts (currently quoted in the low $30s per pound) or going into the spot market and picking up uranium at $25 per pound. What do you think utilities will do? Of course, they’ll go into the spot market. This is at the same time that Cameco (CCJ – USA), the world’s second largest uranium miner is now in the spot market buying physical uranium to fill its own long-term commitments to term purchasers. This is because it is cheaper for Cameco to buy spot than produce it at the McArthur River mine, which they recently put on care and maintenance until the uranium price is closer to $50. McArthur River is a behemoth, producing 18 million pounds of the highest-grade uranium in the world. Higher grades mean better economics. When the largest, highest grade mine in the world shutters–where the economics should be very good for them to produce a pound of uranium—that is saying that uranium prices at these levels simply don’t work. Think about that for a minute—it’s now cheaper to buy spot to fill sale commitments than to mine the stuff. As we all know, a commodity cannot forever stay below the marginal cost to produce it and Cameco’s decision is proof of that.
If you look back to the last uranium bubble (2003-2007), the precipitating event was the flooding of the McArthur River mine, which brought power plants into the spot market to secure additional supply in case of supply disruptions. Financial players saw what was going on and front-ran the sleepy utilities in acquiring uranium, which only further panicked the utilities into stockpiling material, leading more financial players into the mix. All of this transpired during a time when utilities had historically low levels of inventories to begin with. It was a perfect storm of panic from utilities. Remember, a multi-billion-dollar reactor isn’t worth much if you don’t have uranium to power it.
Following this panic to secure supplies, a whole lot of new uranium supply came online, mostly from Kazakhstan, and there was a 13-year bear market as utilities worked off all the excess inventory, they had panic stockpiled. They say history doesn’t repeat, but tends to rhyme. I’m pretty sure that financial players will come into the market this time as well. A few hundred million dollars of investor demand is a whole lot of uranium coming out of the physical market at a time when supply is already tightening, but that comes later, first uranium needs to recover a bit towards the marginal cost of producing the stuff which is in the $40 to $60 range depending on which mining CEO is lying to you.
I’ve been playing in commodity markets for two decades now. If there’s one constant, it’s that these things take longer than you think to play out. This is because there’s always more stockpiled inventory than expected and commodity users always find ways to make their own stockpiles last a bit longer, rather than paying up for supply as the bull market first begins—even though paying up a few percent is better than paying up a few hundred percent later on. These bull markets are all the same in that regard. The market is already getting tight, now we need some unforeseen event to tip the balance into a bull market.
So how am I playing uranium? Uranium Participation Corporation (U – Canada). UPC owns physical uranium and trades at roughly current NAV, representing a spot price of $25. Most importantly, the carrying cost is a bit under 1% a year. This means that I can be early and it won’t cost me much. What if I’ve totally mis-timed uranium and it takes 3 years for the market to recover? Well, I’m out about a dime in total management fees on UPC and I still have a near-perpetual call option on uranium recovering. Compare that with all the risk you take from owning a uranium junior that is constantly diluting you while waiting for the recovery to come. Sure, you may make more on the junior, but there’s plenty of upside in UPC and the risk is de-minimis—hence you can play it pretty large. Uranium has to more than double to incentivize miners to bring supply back online. Most likely, uranium overshoots and UPC is a good deal better than a double. Re-starting a uranium mine isn’t exactly something you can do overnight. When the price starts moving, I assume the utilities will all panic again and go into the spot market at the same time, bidding up physical supply—just like last time. Keep in mind that a lot of investors made fortunes front-running the utilities last time. I’ll bet you a signed dollar that they do the same thing again this time—only further fueling the uranium overshoot to the upside.
I don’t know when uranium will recover. I just know it will—especially when it trades for less than the marginal cost of producing the stuff. When the two largest players, Cameco and Kazatomprom both tell you they’re going to force the price higher, they’ll likely succeed—especially as I don’t see any other large producers stepping up with supply at a price of $25. Needless to say, I’m long UPC. I intend to add to it each month as we’ll be one month closer to when the above-ground stockpiles are depleted and the price begins to recover to the marginal cost of producing uranium.
For a guy who’s always looking for uncorrelated investments, this is a great one. Uranium doesn’t care about trade wars or global economic collapse. Nuclear reactors need their uranium and they’ll pay whatever the price is, to secure their uranium—especially when it’s such a small component of the costs of operating a nuclear plant. Now, it’s a waiting game. When will uranium buyers step into the spot market?
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Article by Adventures In Capitalism