Uranium: value and volatility assured

2 Aug 2011 by Jim Fickett.

First, the supply cost curve suggests a long-term equilibrium price a little above the current one, so the downside is limited. Second, there will likely be a supply squeeze later in this decade and, as long-term contracts are usually negotiated several years in advance, the approaching squeeze will likely begin to drive prices up next year.

With threats of sovereign default on all sides, many are wondering how to preserve value. The financial news often moans that investors are stuck with US Treasuries, because no other market is big enough or liquid enough to replace the Treasury market. For the market in aggregate this is true. But for the small investor there are many other options, including various commodities and the debt markets of smaller countries.

Even in today's generally overvalued markets, there are opportunities to buy real value cheaply. One such opportunity is in uranium, temporarily beaten down by the Fukushima disaster.

To set the stage for discussion, here is the Red Book summary graph (based on data through 2009) of the long-term balance between uranium supply and demand. The black bars are actual mine production, the grey bars are two estimates of potential production, and the dashed lines are (a) actual production through 2008, and (b) high and low estimates of demand after that:

Note that mine production was far from enough to satisfy demand in 2000-2008; the gap was filled from secondary supplies, most importantly the conversion of excess nuclear weapons into reactor fuel. The so-called Megatons to megawatts agreement between Russia and the US, for conversion of excess weapons to fuel, is currently supplying about 9000 tons of uranium per year – and covering a large fraction of the supply-demand gap in the above graph. The program will end in 2013, so that mine production will need to ramp up considerably to fill the gap.

The main purpose of this post is to update the above analysis with a more recent one from RBC Capital Markets.

Barry Hillman kindly pointed me to a Forbes report based on an up-to-date quantitative analysis from RBC Capital Markets. Forbes was reporting on a research note giving an interim update to an extensive quarterly forecast from RBC. FT Alphaville has made available the full quarterly analysis from RBC for Q2, released 20 April. The quarterly report is 32 pages, and makes it clear that the RBC analysts are doing their homework, tracking individual production forecasts from all significant mines, many changes in government plans and policies, and reactor and inventory requirements worldwide.

Here is a graph showing actual mine production, total supply, and total demand through 2010, together with RBC forecasts from 2011 to 2020:

It is good to use all detailed information available, and to make forecasts as accurately as you can but, in the end, it must be admitted that the whole forecast will end up changing very significantly over the coming years. So what can we take away from this?

First, low prices and negative sentiment recently mean that many new mining projects have been delayed, and there will almost certainly be at least a short term supply disruption in 2014, when Megatons to Megawatts ends. That will ensure volatility, which always presents opportunities.

Second, RBC is quite sure of a large shortfall in supply beginning in 2017. This is because current prices are not high enough to spur the investment in new mining ventures that are needed, and it takes a long time to plan, permit, and bring into production a new mine, especially in the very heavily regulated uranium sector. You might think that a shortfall, even a fairly sure one, if 6 years away, would be of little importance for the current market. But reactor requirements are very predictable, and the nuclear power industry normally begins negotiating long-term contracts several years in advance of the need. That implies that a predicted shortfall will probably begin to affect prices in the next year or so.

Here is the RBC analysis:

Uranium is somewhat unique in the metals world. Utilities’ uranium needs are very predictable in volume and timing and absolutely necessary. As a result, utilities can and will purchase uranium well in advance of deliveries. Therefore, utilities are normally looking to establish long-term contracts every year and, in each year, they will purchase a portion of their future needs. This activity continues until their needs are close to 100% covered as each year approaches.

Based on our forecast of available uranium supplies (mine sourced and non-mine sourced), we do not think that there is sufficient uranium to cover the needs of 2018-2020 (and certainly not beyond that time frame). As a result, we expect that at some point in the next 12-18 months, utilities will begin to see an increasingly tight long-term contract market, to the point where there is all but no supply availability. This, in our view, will be the stimulus that will cause the uranium price to recover. …

We believe that most major uranium producers have sold the vast majority of their production through to at least 2016. Yet, there remains a substantial portion of future demand uncovered (30% to 40%) between 2016 and 2019. Some of the newer entrants to the producer category, like Paladin, Denison and Uranium One, likely have material available for contracting in those years, but according to our estimates they will not have enough to satisfy the forecast demand. We think that in late 2011, utility requests for contracted material in 2016 and beyond will be met with fewer and fewer offers and then perhaps none. We believe it is this sequence of events that will provide a significant stimulus to both the spot and term prices and bring them to a level that is sufficient to incentivize new exploration, development and, eventually production (whether a four-year head start is sufficient is questionable). Our uranium price forecast incorporates this timing. …

We continue to see a large supply-demand gap opening in the near term and growing significantly post-2016. While this seems many years away, we believe the uranium price will need to reach higher levels in order to spur the development of new projects to fill this gap, and those projects will likely take many years to bring into production.

All this suggests that there will be price rises in the next few years. What about safety? Safety comes from the fact that, although there is no shortage of uranium deposits, the quality of the deposits available implies a cost of production that puts a floor under the current price. The current spot price is $52. RBC says,

We are forecasting a long-term uranium price of $55/lb ($US 2011) starting in 2021. Our long-term price is based upon the 90th percentile of our cash cost curve forecast.