Uranium: A New Cycle Beginning?

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(This story was originally published on 19 May, 2009. It has now been republished to make it available to non-paying members at FNArena and readers elsewhere).

By Greg Peel

The indications from the World Nuclear Fuel Conference held in Sydney last month were that China had sent a large number of delegates who engaged in discussions about uranium contracts and possible strategic alliances. China Nuclear National Corp vice president Jiangang Qin confirmed to reporters that his state-owned firm had held preliminary talks with a number of Australian-based companies. This news has Macquarie analysts excited. Is uranium back on the move again?

In early 2004 the global spot uranium price was around US$10/lb. In June 2007 it hit US$136-138/lb. A month ago the spot price had returned to US$40/lb. The bubble and burst of spot uranium was one of the most spectacular commodity events ever witnessed. And a lot of the early momentum was, unsurprisingly, sparked by the China story.

Various factors conspired to provide the initial momentum for the uranium price rally. Prior to 2004 the spot price had bungled along between US$10-20/lb for a decade. It had reached US$40/lb in 1979, reflecting what were the original glory days for nuclear energy. In the US, in France, the UK and Sweden for example, nuclear energy was being embraced commercially. But in 1979, the Three Mile Island incident occurred followed by Chernobyl in the late eighties. In the US and elsewhere, nuclear suddenly became a dirty word.

Earlier this decade, two new factors were in play. Firstly, the oil price also began to move. In early 2004 oil was US$30/bbl and by June of 2007 it had reached US$80/bbl. Secondly, the world became increasingly alarmed about global warming and the burning of fossil fuels. After 15 years in purgatory, nuclear energy was back in favour as a clean energy solution. The US decided it was time to build some new reactors. The UK decided it would discontinue plans to shut its nuclear reactors down. And China, which had begun voraciously consuming all the world’s resources, declared it would build a large number of reactors in order to take the country’s nuclear capacity to around 10% of energy demand. The fuse was lit and the uranium bomb exploded.

Like most of the world’s resource industries, uranium production had suffered from a period of neglect. Suddenly analysts realised that declared intentions from across the globe to build many more reactors meant uranium demand would outstrip supply for several years. The price of spot uranium began to rise exponentially. To make matters worse, leading global uranium producer Cameco in Canada announced its ambitious new Cigar Lake project had been flooded. Cigar Lake was one new source of uranium that would at least help to ease the demand/supply deficit. Management had no idea just how long it might take to restart the project. BHP Billiton’s ((BHP)) Olympic Dam project was being hailed as another expanded source, but plans to triple or even quadruple production were many years away. A good 40% of global uranium supply was coming in from secondary sources, such as the dismantling of Russian warheads, but this supply has always been slated to run out in 2013.

As the spot uranium price ran, so too did the stock prices of uranium producers. In Australia this included shares in veteran Energy Resources of Australia ((ERA)) and in newcomer Paladin Energy ((PDN)). But every miner/explorer with even the slightest hint of a claim on uranium resources saw their share prices rise spectacularly, even by the thousands of percent. Never mind that a good deal of Australian uranium lies in the states of Western Australia and Queensland where longstanding uranium mining bans still existed at the time.

Stock analysts were, as usual, slow to catch on. But when spot uranium raced through US$100/lb the race was on. Soon at least one analyst rang the bell and declared a target price of US$200/lb. Then it was all over.

The uranium bubble did not burst because of either a fall in the oil price, an easing of climate change fears or a waning of Chinese intentions. Oil soared on to hit US$147/bbl a year later, climate change concerns appear to grow more urgent every day, and China is maintaining its nuclear energy plans. Spot uranium collapsed simply because it had run too far too fast. At a more complex level, the price collapsed because uranium is just not a spot-traded commodity.

Buyers of uranium are mostly utility companies who buy on long term supply contracts. Spot market transactions do occur but they are infrequent and usually reserved for overcoming production shortfalls that fail to match contract obligations. But as the uranium price began to move, the hedge funds moved in. Speculators jumped over each other to secure what little uranium was being offered in the spot market. When uranium prices simply became too silly, utilities decided to teach the speculators a lesson. They stopped buying. A cavernous hole thus opened up underneath the spot price.

And now we have had the GFC and a subsequent reversal in all commodity prices. The uranium price had already taken most of its hit in 2008 even as oil continued to rise but the price continued to wane into 2009. Many a junior uranium miner saw its overblown share price collapse once again. Analysts advised that there was little point in investing in a junior with a patch of dirt and some vague claim to uranium reserves. The uranium price fall made more ambitious projects uneconomical. The GFC ensured funding evaporated. Even the larger, more reliable players of the world such as the ERAs and Paladins saw their ratings downgraded. It had looked for all the world like the great nuclear energy push was over.

But it wasn’t.

One thing a raging 2007 spot uranium market failed to fully consider was the very long lead-time involved in building a nuclear reactor. From planning to production, it can take ten to fifteen years. So while plans for global nuclear reactor building were expanding rapidly, there was no immediate corresponding effect on actual uranium demand. Certainly the uranium price deserved to be higher than US$10/lb, but US$136/lb (or US$138/lb) was ridiculous. This reality was not lost on the established utilities. The uranium spot price may have hit US$40/lb and now rebounded to US$51/lb last week, but longer term contracts have been trading at US$65/lb – a far more realistic measure.

So the uranium spot price has bubbled and burst and the GFC has taken its toll, but there has been little change to global intentions to build more and more reactors, and analysts still predict a period of supply deficit at least until new supply projects such as Cigar Lake, Olympic Dam and others come on stream.

If anything, China’s nuclear energy plans are now more ambitious than previously declared. China’s official nuclear power capacity goal remains at 40GW by 2020, notes Macquarie, but some officials have hinted this target might rise to as much as 70-75GW. The analysts are assuming 53GW.

Cameco has commented that the large majority of utility purchases in the uranium spot market this year have been Chinese. This indicates China may be intending to stockpile significant quantities. This is exactly what has been seen in the copper market, in which the Chinese have clearly been taking advantage of a much lower price not only to re-stock but possibly to build strategic reserves. Cameco has confirmed the Chinese have approached the company for supply agreements. Macquarie suggests overall Chinese demand for uranium could grow from 2% now to 8% by 2012-13.

One reason the Chinese have been able to upgrade their nuclear ambitions is because of their growing efficiency in building nuclear reactors. Macquarie notes China is taking a “cookie cutter” approach by internalising technology from French company Areva. It has already built five CPR-1000 model Areva reactors and has connected two to the grid. There are twelve reactors under construction, half of which are CPR-1000s, and Macquarie expects China will have built 28 by 2015, of which 21 will be the same model.

With each new reactor it builds, China is becoming better at it. Through replication of the one design the Chinese have cut construction time down to 4-5 years, and China’s cheap labour costs for what is a labour intensive exercise means it is building reactors at a cost of US$2bn per gigawatt, while in the US and Europe the cost is more like US$7-11bn.

Macquarie believes the aforementioned swarm of Chinese delegates at the recent Conference implies a sense of increased urgency. Also well represented at the Conference were delegates from Japan, Korea and India, all of whom have indicated their desire to secure long term supply of uranium. India in particular has announced its intentions to purchase not just uranium for direct use, but enough uranium to ensure no disruption to supply down the track. All the Asian participants are looking at not just strategic alliances, but at direct investment in production. The majority of M&A activity in the uranium space has recently been dominated by Asian utilities and state-owned groups.

The pattern is similar to the 1970s, Macquarie notes, in which various US utilities moved “upstream” to invest directly in uranium producing companies. This activity accelerated as the 1970s progressed before being snapped off in 1979 after TMI.

While the volume of uranium changing hands across the globe peaked in 2007 and sent the price spiralling down again, the analysts note that the volume of contract transactions, as opposed to spot market transactions, has continued to creep up even as the spot price has collapsed. The utilities may have stepped out of the spot market in order to deflate the price bubble, but they have continued to seek longer term supply. One would be forgiven for thinking utility demand might have fallen dramatically as prices reached silly levels, but the reality is longer term contract prices never reached such peaks. Conversely, long term contracts are being settled today at 30% more than the spot price. The nature of long term supply contracts is that prices are smoothed.

In this sense, while uranium cannot be compared to a spot market-dominated commodity such as copper, nor can it be compared to the contract markets of iron ore and coal. Those are renegotiated each year for annual supply. Uranium contracts involve offtakes over many years. Such transactions are negotiated on prices which assume more of a regression to the longer term price trend. But Macquarie believes even the longer term price indicators are telling an unreliable story now, for the Asians are bypassing the usual procurement sources and going directly to producers for supply deals. These do not show up on the price radar, and as such the effect of this increased demand is not being felt in prices.

Macquarie believes this is only the beginning of a cycle similar to that of the US in the 1970s. Asian direct investment in uranium producers has only just begun. We know how keen the Chinese have been to get their hands on Australian nickel (OZ Minerals) and iron ore (Rio Tinto) so who’s next? India and Korea have also indicated they would like to invest a total of A$2.2bn in direct investment and Canada’s Cameco is also sitting on C$805m of cash, indicating potential acquisitions are nigh.

While these numbers don’t seem enormous in the global scheme of things, it must be remembered that the uranium industry is tiny compared to the likes of iron ore or copper. The combined global market capitalisation of listed uranium companies is only A$20.5bn, says Macquarie. Cameco represents half of that, and laws in Canada prohibit that company from being sold to offshore investors. There is not a lot of a remaining pie for Asian investors.

National Australia Bank analysts note current global uranium demand is 180m pounds per year, representing 440 operable commercial nuclear plants which supply about 16% of world power. By 2010, the number of plants should rise to 470. In ten years time, NAB suggests global demand is expected to rise to 215m pounds. The bulk of this growth will come from Asia.

If anything is going to stop the accelerated growth in the number of nuclear plants in the world, it won’t be the price of uranium. Uranium cost is only about 5-7% of the total operating cost of a nuclear plant. There is plenty of room to move. And if prices do rise there is no substitute. Nuclear plants run on uranium and uranium only.

Current Western world mine production is around 115m pounds per year, notes NAB. By 2010 there is expected to be about 60mlbs of new production, meaning the market will still be in deficit. As the uranium price rises, it becomes more economical to enrich tailings from uranium production as a secondary source, but this will not close the gap either. While new mine capacity will be coming on to the market, there will also be some reserve exhaustion. ERA’s Ranger mine, for example, has a finite life span.

Canada based Desjardins Securities points out that a lot of the incremental production growth over the next few years will come from Kazakhstan while China will be the main source of demand growth. A long term price of US$50/lb for uranium is still sufficient to encourage new investment in mining projects. NAB is currently forecasting a long term price of US$50/lb, taking into account the supply catch-up which should begin to make its presence felt by 2012. In the meantime, NAB is forecasting an average 2009 price of US$52/lb, a 2010 average of US$70/lb and a 2011 average of US$80/lb.

Activity has began to hot up in the spot market. Industry consultant TradeTech, which survey participants in order to track spot prices(there is no official market place such as the London Metals Exchange), noted last week that the speculators are back in. Having no doubt been chastened by their experience in 2007, speculators will likely not be quite so aggressive this time around. It is unlikely the uranium price will see US$136-138/lb again anytime soon, just as US$147/bbl oil is a long way off. But that does not prevent the uranium spot price trading higher from here.

Macquarie notes that at the peak of the uranium price in 2007, uranium stocks traded in the range of 2x net asset value. That multiple expansion was, however, all about the uranium price, and the same sort of price explosion is not expected this time. A more modest price increase is the order of the day, but there is no reason, suggests Macquarie, why multiples could not return to 2x NAV. This time it will be all about possible direct strategic acquisitions pushing up share prices.

Macquarie also points out the spot uranium price has began to move up again at a time of low seasonal demand. While summer and winter are the peak periods of power demand for cooling and heating, spring and autumn are usually times in which utilities take the opportunity to perform routine maintenance, leading to a drop-off in demand. The northern summer is also a time utility executives take their holidays, which really leaves the northern winter as the peak demand period for uranium procurement. Notably, the uranium price peaked in the northern summer of 2007. So if things are on the move now, perhaps later in the year could see more price acceleration.

Prices of uranium stocks will nevertheless likely “look through” seasonal demand, the analysts suggests. Macquarie believes uranium stocks currently offer an attractive investment opportunity. Indeed, as the spot uranium price was continuing to fall to its low of US$40/lb earlier this year, uranium stock prices were already moving up. Now, they did so amidst the general stock market recovery and at a time when prices for other commodities such as copper and oil were on the rise, but Macquarie suggests Chinese interest has much to do with it.

“The fact that utilities have begun to make direct investment in uranium mines and equities supports our medium-term bullish view on the spot price as we expect the market to head into a deficit in the early part of the next decade,” says Macquarie. “We expect a continuation of the flow of funds from Asian utilities into this sector, which should attract more capital into uranium companies. We remain bullish on the outlook for this sector.”

But investors should also take note that what used to work in the pre-GFC raging bull market does not necessarily work now. Global economic growth recovery will most likely be slow and spasmodic as the global credit bubble continues to be unwound. This is not a time for the old “buy-and-hold” strategy, in which longer term investors simply buy stocks and put them in the bottom drawer, is appropriate. Investors must be more attuned to market developments.

On current demand and supply forecasts, the uranium market will remain in deficit at least into the next decade. At that point however, a rash of new supply should come on line. That is why, for example, NAB is forecasting a 2010 spot uranium price of US$80/lb but a long term price of only US$50/lb. The spot price should begin to decline again when supply catches up to demand. “When the decline starts,” suggests NAB, “it could be faster than expected”.

Thus there appears to be a window of opportunity in which investors might benefit from uranium stock investment. Analysts warn that prospective stocks need to have proven production and reserves and no problematic gearing levels.

Western Australia has now lifted its ban on uranium mining since the election of a Coalition state government. Under new Queensland Labor premier Anna Bligh, there has again been talk of a possible lifting of the ban but nothing has yet transpired. Her predecessor taunted and teased the state’s uranium industry, suggesting a possible lifting of the ban one minute and not the next.

The coal unions have much power in Queensland and are dead against uranium mining, erroneously believing it to be a threat to the coal industry. Nevertheless, a lifting of the ban some day, or maybe even federal intervention, is another potential catalyst for Australian uranium mining stocks.

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