This past weekend, spot uranium prices jumped to $52/pound, as first announced by TradeTech LLC. Uranium miners were celebrating. When the spot price traded below $40/pound, some U.S. uranium mining projects may have been uneconomic. Because U.S. electric utilities have now begun purchasing above $50/pound, new hope emerges for many junior uranium development companies.
The question is: Will uranium stay at these levels. To answer our question, we turned to Gene Clark, Chief Executive of TradeTech. At our request, he wrote the essay, which follows, describing what may lie ahead and whether or not investors should consider junior uranium stocks for investment purposes.
Gene Clark: Speculating on the $50 Uranium Barrier
On August 31, 2006, the NUEXCO Exchange Value soared through the $50 level for the first time in its history, reaching $52 per pound U3O8. The Exchange Value is the longest running price indicator in the uranium market - in continuous publication since August 1968. The last era in which the spot price was anywhere near this level was in the 1970s, when the Exchange Value peaked at $43.40. That price, however, equates to over $100 in today’s dollars. So, in real terms, the current price of $52 is only half-way to matching its historical high.
Although it is tempting to compare the two eras, the situation today is vastly different from that of the 1970s. The 1970s were characterized by spurious demand, minuscule secondary supply, and a huge world-wide excess uranium production capacity--left over from the U.S. military production-incentive program. But perhaps the most important factor was the total embargo on importation of uranium for use in the United States. In contrast, today’s market has firm and predictable primary demand, very large secondary supply, large secondary demand, and marginally adequate uranium production capacity.
The large secondary supply (uranium not produced from mines and mills in that year) is currently about 40% of world supply. It has such components as excess inventory, enrichment tails stripping, recycling of used fuel components, and--most importantly--dismantled Russian nuclear warheads. Let me explain what I mean by "secondary demand," since I believe this might be the first time this phrase has been used in our industry. We have historically treated "uranium demand" as the requirement for fueling nuclear power plants: for natural uranium, the base requirements for feeding the enrichment process required for most nuclear power plants; in the case of natural uranium reactors, the input for fuel fabrication.
This treatment of uranium demand, although historically not too inaccurate, has become naïve, in view of the evolving sophistication of the market’s participants. This previous definition of demand can technically be labeled as "primary demand" and is also commonly referred to as "reactor requirements." Secondary demand, then, is uranium purchased from the market for purposes other than immediate use as nuclear power plant fuel. The real question, from the standpoint of trying to understand price formation and movement, is whether "secondary demand" is merely a minor perturbation at any given time in the market, or whether it is a major determinant of spot prices. And, if the latter, what impact does secondary demand have on long-term prices?
Before proceeding, let me state that I, personally and professionally—as well as TradeTech as an organization--have no inherent interest in which direction the uranium market moves. We are merely students of the market. We derive our income wholly from reporting and analyzing the market’s events and prices, rather than uranium brokering and trading or investing in nuclear companies. For that reason, our success lies in the ability to provide unbiased, accurate and detailed market information to our clients--those buyers, sellers, and investors.
Those who believe it is hopeless to analyze the markets may have adopted the point of view, expressed by the economist John Gay some 300 years ago: "The market’s mind oft shifts her passions, like th’ inconstant wind; Sudden she rages, like the troubled main, Now sinks the storm, and all is calm again." But, is the uranium market really that incomprehensible? Have we made such little intellectual progress in the past 300 years that we cannot even try to understand the market?
In uranium, we have a commodity for which there is no underlying substitute. Uranium is used for fueling nuclear power plants--plain and simple. (Technically, an electric utility could choose to dispatch a coal-fired power plant or a gas-fired one instead of its nuclear plant, but that would not be economical until the uranium price reaches $200 for the coal alternative or about $750 for the gas alternative.) Given that we know the entire roster of nuclear power plants likely to be in operation over the next ten years, we have a good chance of being able to project the world "primary demand' for natural uranium, to within a ±15% variation, at the extreme.
But, there is a “secondary demand” just as there is a "secondary supply" in this market. In the long run, the market’s trend is driven by primary demand, balanced against the supply from both primary uranium production and secondary sources. But, in the short run, we may have a situation not unlike the classic quip about the statistician who drowned in a river with an average depth of three feet. Knowing the average doesn’t necessarily help in survival! Likewise, knowing the trend that uranium prices should seem to take does not necessarily result in sound market decisions.
So, what is the nature of this secondary demand? Some of its facets are straightforward, and some are not. Over-purchasing (by utilities) from "take-or-pay" long-term contracts during periods of unexpectedly low nuclear plant performance, purchases by uranium producers during periods in which market prices are below their cost of production, over-purchasing from optional upward flexibility in long-term contracts, during periods when market prices exceed the embedded prices in these long-term contracts ("buy and hold'), large primary producers making strategic purchases that act to prop up market prices for new sales or to leverage sale prices in their existing long-term market-price-related contracts, and purchases by self-designated "hedge funds" to buy and hold for gains under anticipated future sales at higher market prices.
Given the intellectual acumen of today’s market participants, I cannot rule out other secondary demand categories that have not yet been identified. Also, I believe the above list is in increasing order of current influence on spot market prices. I mention above that uranium has no substitute market--that is, no other significant use than as fuel for nuclear power plants. While this is true in a primary sense, in the secondary demand market, money for uranium speculation is substitutable for money to be invested in other commodities markets. That is, when the price of uranium is accelerating at a rate competitive with the rate of return being experienced (or expected) for other investment opportunities, the purchase of uranium or uranium company equities becomes a viable investment option--as we have seen from the actions of speculators over the past few years.
In a transparent, competitive market, you can "pay now, or pay later"--meaning that any action that affects the market in one direction will cause an eventual reaction, and this reaction will tend to offset the impact of the original action. The advent of large secondary supplies in the 1990s has certainly helped to maintain low and predictable prices over a long period. The reaction has been that long-term uranium base prices were too low in the pre-2004 period to support development of new uranium production facilities. Since there seems to be little disagreement that new production is needed, what price is needed to justify investment in new production? The answer depends, of course, on how much primary uranium production is needed.
There is, after all, a supply curve for uranium, due to differing ore grades and other production cost factors. When the uranium price reached the $20 per pound U3O8 level, there was heightened interest by several of the large producers in bringing new projects online and, since those projects seemed to be the lowest cost, we can safely assume that roughly this level of price is the minimum required to add major segments of new capacity.
At the mid-$20s to $30 price level, numerous “junior” producers were advertising healthy anticipated rates of return on their prospective projects. At a sustainable price of $40 or above, many of the older marginal production centers look good for restart.
Although price is a primary consideration, uranium is not without its politics. For example, we estimate about 25 million pounds U3O8 of annual production is currently blocked from development in various parts of Australia, because of local political considerations, even though these projects would generate quite healthy rates of return at today’s price. But, politics can and do change.
What does all this mean for investors in uranium companies? One risk factor to consider is that the uranium speculator market segment is currently quite active, and that its purchase activities are effectively diverting uranium from the supply chain, even though that uranium is currently needed in the market.
That situation has been a major determinant of rapidly increasing price levels, after a period in which the market price was adjusting to meet the need for new production capacity. For a certain length of time, the speculators’ goals and actions are self-perpetuating. They want (and need) rising prices, and their market volume is creating much of the upward pressure on the spot price and, by historical linkage, on the long-term base price.
But, there is one simple rule to keep in mind: Secondary Demand + Time = Secondary Supply Since the speculators cannot "consume" uranium, eventually those pounds of uranium will have to be sold to realize any market gain. And, the more active the speculators have been in buying up material, the more active they are likely to be in selling the same material, with obvious implications on price pressure.
How these pounds will be sold will determine the impact on the market. In the one extreme, a rush to the market would have the largest impact, as much of the accumulated inventory would hit the spot market over a short period. At the other extreme, the speculators’ accumulated stocks might be absorbed in off-market deals by large primary producers. For those producers, most of the long-term transactions over the past few years have incorporated market-related pricing. Thus, it would be in these producers’ interest as a group to keep prices from falling. And, any pounds of uranium purchased by them for redelivery under long-term contracts would just keep an equal number of economical pounds in the ground for future production and sale.
For those junior uranium producers who have pre-sold significant future production, the price mechanisms in their sales contracts will let them "weather the storm" of any short-lived drop in the market price, because their deliveries will likely have either a base-escalated price or a market-related price with price floor, or both. Thus, a reasonably safe investment in a uranium company would be in one with a large portion of its potential production sold out. Those juniors in the exploration phase, or which consider themselves explorers only, will be more vulnerable to any market downturn.
In conclusion, one should be careful to recognize how much the uranium market is being driven by fundamentals (primary demand) versus non-fundamental factors (like secondary demand) and make one’s investment decisions accordingly. A major portion of spot market purchasing is currently coming from secondary demand. Although the fundamentals appear to have justified the transition to some new level of higher price, the problem may be how "we get there from here." We may be in for a roller coaster ride before the market is able to sort things out. It remains to be seen whether it turns out to be like Holiday World’s "The Voyage" with its three drops of over 100 feet and 24.2 seconds of weightlessness or like your neighborhood park’s kiddy roller coaster.
