The Energy Report: There's a lot of "news" swirling around uranium (i.e., Russia has a moratorium, China is building dozens of nuclear facilities, recession is pausing development of nuclear facilities and more.) What is the truth regarding uranium? What should investors in this sector be watching?
Merrill McHenry: Let's start with the last question first. If investors had to watch one thing in the uranium market, it would be the uranium "term price." That is the long-term contracting price for uranium suppliers and (utility) buyers. Over time, the spot and term prices will tend to converge (i.e., if the spot price drops too far below the term price, utilities will purchase additional inventory and store it).
The spot market is more illiquid than most think; and it is far from realistic for the sector to be affected by minimal spot volumes—sometimes they are as low as one or no transactions. In effect, too often the small tail of the spot market wags the dog (sector). Investors need to look at the big picture of the sector, and it is fine.
The ‘truth' on uranium is the secular (long-term) bullish case never went away—people and human behavior just accentuated a cyclical (short-term) correction. It's human nature that people overreact and chase prices on the way up, and, while in a panic, bail shares on the way down. I have been on both the "buy" and "sell-side" and I know how people do not want to buy when they should—and vice versa. (It is called "group think.") Human nature also has people mistakenly thinking in absolutes, when in the end most things are relative. Even "experts" do this. These factors often wrongly affected investors' perspectives, and I would say this was the case with the uranium sector. Investors should remain objective as well as aware of this.
Uranium's spot market massive price rise from its long-term range in the $10 range was a parabolic moon shot to $138. I keep telling people any asset (i.e., commodities) that does a parabolic price rise is going to have a crack in the vertical price rise [note the chart] where the meddle of the bullish thesis will be tested. That is the time to see about the real secular case.
Technically speaking, giving up one-third or two-thirds the parabolic price rise frequently happens, just as stocks may have similar cyclical rally retrenchments. If the secular case really exists, then the asset will hold a new pricing equilibrium and a new paradigm exists; the asset will not fall back to the previous trading range. Low and behold, uranium did not fall back to the previous multi-decade $10 range; a new supply and demand equilibrium was established in the $40 range—off approximately two-thirds from the parabolic high.
China stepped in, filled its North American and European storage contracts, and started taking physical delivery. India stepped in, and the utility spot buyers resurfaced. We have endured the highest spot market volume in 13 years of TradeTech data this year from the remaining financial players liquidating inventories. We are over 20% ahead of the next closest record and yet the new uranium floor is over four times higher than the previous paradigm. This is where you see the secular bullish case. The new uranium pricing paradigm held and a new floor was put in place for a new bullish cycle within a secular bull market. This is when one should start buying aggressively. There was a selling exhaustion on the stocks—the good thrown out with the bad—and the sector was/is oversold versus its long-term fundamentals.
The bottom line is the vast majority, if not all, nuclear reactor construction projects have gone ahead. Those are in China and India, and they are either state or quasi-state sponsored projects. Moreover, this year China added three new reactor projects, to 24 under construction, with its stimulus funding. China currently has only 11 nuclear reactors.
People's tendency to think in absolutes misses the real point about demand growth—over the last year, what the private sector took (if any), the public sector more than gave. Largely, unlike other commodities, the credit crunch effects on the private sector did not hit uranium's fundamentals. I am minimally concerned if U.S. reactor projects are delayed because those are 10 to 12-plus year project completions. What I do care about are China and India's ("Chindia") much nearer term reactor projects—those are four to six year and current uranium demand situations, respectively. Those are the main uranium secular drivers—and the truth is both actually got better.
The U.S. private sector projects have always been awaiting Congressional and DOE loan guarantees. They still are. In my book, the U.S. "if" of incremental uranium demand is so far down the road as to be of minor investment consequence.
Theoretically, any investment's value is the net present value of the future cash flows. The sector's cash flow changes due to Chindia's changes in uranium demand in five years, and currently, is of far greater investment value than potential changes in U.S. uranium demand 12 years hence. Typically, those outlier years are of minimal impact on TradeTech's uranium pricing forecast models as well.
I want to emphasize that the only thing better than bullish supply and demand factors are exogenous events. Both China and India have recently had favorable exogenous events that will greatly affect uranium demand. Both are seeking to buy well beyond current needs.
Only this year India entered the spot market after a 34-year Nuclear Suppliers Group embargo (due to India's 1974 nuclear test and refusal to sign the Non-Proliferation Treaty). India is not only seeking uranium for it is current needs, but also after years of shortages and a strong national sentiment towards nuclear sovereignty, is seeking to buy sufficient uranium for all reactors for the entire service life of those reactors. Needless to say, that is and will be quite a bit of additional uranium demand. Investors should note, that was not factored in the market one year ago; it is a new and significantly bullish event.
Korea also has good sector news. Korea Resources Corp. expressed they are seeking a US$1 billion uranium mine.
So, we have had three major future uranium players—India, China and Korea—come forward with billions of dollars in additional uranium demand over the last year; and actually increasing reactor builds over plans. The uranium sector has had nothing bearish in the last year even close to those bullish factors.
As for uranium supplies, the continuing theme of 2008 was "lowered production guidance becomes a norm." My total of production cuts for 2008 was 4.7mlbs, which by way of relative comparison was roughly two months of a typical year's spot market volume. At the margin, that is a bullish number as well. Also, people do not realize the rate of existing mine depletion. Based upon current estimates, by 2020, six of the world's top 10 uranium mines will be depleted, and the top two mines will be entering the latter stages of production.
In summary, while many unknowingly ditched the sector, arguably the uranium space has a better price floor and verifiable new pricing paradigm in place than most—if not all—commodities. To use the street phrase, for uranium what has transpired in the last year—"It's all good." The exogenous events significantly boosting uranium demand for China and India are far greater than the minimal and distant "ifs" of private sector reactor delays. Not to mention China has actually boosted reactor construction; while India made no delays and entered the world market.
TER: To what extent is any pending gap between supply and demand reliant on increased demand from new facilities being constructed versus on-going operations of existing nuclear facilities?
MM: Here are the stats:
- World electricity growth is forecast to grow 85% by 2030. Approximately 4%/yr.
- 435 current reactors supply 370 Gwe and require 78,500 tonnes of uranium oxide
- 31 reactors under construction—approximately 27 Gwe
- 222 planned & proposed—187 Gwe
- Each additional Gwe requires 195/t year of uranium and 3X for initial load.
- Uranium production has to ~ double (on current consumption) to offset TENEX end in 2013 (if Russia does not replace any TENEX uranium supplies).
Source: World Nuclear Association; Merrill W. McHenry
As for the uranium price equilibrium the players know the backdrop, and while new reactor growth will have ‘date certain' for commencing operation requiring uranium, the utilities set the reactor uranium purchases up with longer lead times and somewhat discretionary timing as to when to secure "X" amount of contracted and/or "Y" amount of spot uranium. Add to that the massive additional purchases beyond specific and current reactor needs by Chindia and uranium pricing becomes determined more and more by utility discretion than specific timing needs. One should also note much of the spot market volume has traditionally been as a backstop supplement to long-term utility uranium contracts. With the exception of Taiwan, most nuclear utilities do not primarily supply their reactors from the spot market. Another component of utility purchases is the old "like sheep in a pin" analogy. Old time uranium traders often claimed the utilities would jump to purchase uranium like ‘like a flock of sheep following the first sheep out of the gate'. The point is utilities are competitive and will chase supplies if they think others making purchases are on to something (e.g. production cutbacks), and it can strongly move the spot uranium market if the participants get excited. ("Group think" by utilities.)
TER: Do you see certain geographical areas for uranium exploration being better for investors, like Canada's Athabasca Basin? Western U.S.? Other global?
MM: The interplay between the variables— capital expenditures (capex), cash cost of extraction, size of the deposit, average deposit grade, sovereign risks, etc. make it incorrect to make geographically mutually exclusive choices. Unfortunately, it is not so simple. However, each region has its idiosyncrasies. African and East European countries have various and changing sovereign risks (at the moment Niger has heightened sovereign risks); Canada's Athabasca basin has cost issues from deposit depth (and potentially flooding—see Cigar Lake); the Western U.S. has an element of permitting risk, and the lower hanging fruit/larger deposits are largely done. Namibia, with its larger potential size bulk deposits and sovereign desire to develop mines, is attractively leveraged from a risk/reward standpoint. One could say Australia, with the largest uranium resources in the world (approximately 40%) has some of the best combination of factors—but it is a difficult market for foreign investors to access, handle additional share price volatility, and become educated on. Even for non-Australian projects (i.e., Namibia), Australian-listed companies are some of the best opportunities. In time, more of the Australian companies will offer dual-listed shares in Canada.
There are major stock market/business culture differences among countries as well. For example, having come from the U.S., I can vouch for shell-shocked surprises in share float size differences. Relative to market cap, Canadian share floats on explorers may be something like 10 times what a U.S. investor may be used to. (Caveat: there is no U.S. close sector comp, a rough approximation based on ~20Yrs U.S. experience.) The U.S. also had a bad end to the 1970s resource stock bull market biasing U.S. investors against the dreaded "penny stock." Most of the rest of the world has no idea how biased and derogatory the "penny stock" label is in the U.S.
For most in the U.S. foreign uranium stock share prices and share floats optically make them a ‘non-starter.' A bias I find unfair based on a relative risk/reward basis (aka "Treynor ratio.") Canadian investors would do well to keep in mind share floats here vs. the U.S. when they balk at the proportionately larger Australian mining company share counts. While I do shy away from the really larger share counts (or hold my nose/ be very precise on price if I really want the stock), it is relative. What typical Canadian share floats are to U.S. investors, Australian floats are to Canadian investors. Not only is it driven by country industry norms, but it is also driven by the relative size of the investor base. When there are far less investors trading shares in Australia than the U.S., Aussie companies are more inclined to issuing shares to increase trading volume. While that may not be our preference an investor is well served to realize the norms exist, they are relative, there are some reasons for them, and they should not always be a categorical deciding factor.
As a rule, keep in mind that the larger the share float, the more the company's shares will tend to track the sector. Thus large float companies are more difficult to get ahead of the company's prospects—so timing the buy with some ebb and flow of the share price becomes more important. The best times to buy those stocks are more challenging as you have to be very contrarian; the cheapest share prices are when the sector is very oversold and seemingly you are alone in buying the shares.
TER: From an individual investor's point of view, provide your perspectives on investing in juniors compared to seniors.
MM: Investors need to be aware of the lifecycle of the company's property portfolio. What stage(s) the projects and/or exploration is at. Aside from the price of uranium (systemic risk), the smaller and/or more early project stage the company, the more company risk (unsystemic risk) will affect the share prices. Technically, you would call that volatility the stock's "sector beta." That is, the stock's volatility relative to the sector.
Sector beta encompasses many company factors (e.g. management, financing, cost of production, etc.) but in general, a company's sector beta is reduced proportionate to the visibility of the cash flows (how soon, and to what degree the company is producing uranium).
Often investors wrongly perceive the risk of their investment as category wide (systemic risk), when in a larger measure the company's sector beta is the greater stock volatility factor. When an investor wants a stock from the sector, the investment(s) chosen should be with recognition of the company's sector beta; again, which is based on the stage of the company's land package—production at one end of a continuum vs. exploration at the other end.
Someone who is conservative may best have sector exposure via a major (i.e., Cameco Corp. (TSX:CCO)), which has an advanced property portfolio with significant production, and projects ramping toward various stages of development. Keep in mind many of the producers have longer-term uranium pricing contracts; so if an investor wants to be in the sector because they feel uranium is going up in price, a major producer will slowly only adjust sales and earnings to the new spot market prices ("repricing"), depending on the company's order book/strategies.
Most of us break the sector down into Producers (what I call "Tier 1"), Developers ("Tier 2"), and Explorers ("Tier 3"). A typical, modest sector knowledge investor may be best served by having a Tier 2 company. Several of the Tier 2 companies (i.e., Mega Uranium Ltd. (TSX:MGA) offer diverse portfolios of developing projects (Lake Maitland in the MGA's case) with plenty of early-stage exploration for the future. A more advanced and therefore typically less volatile (lower sector beta) Tier 2 company would be Denison Mines Inc. (TSX:DML) (NYSE.A:DNN). To my thinking, perhaps the best width (geographically diverse) and depth (development to production) prospective uranium portfolio is Aussie company Toro Energy Ltd. (ASX:TOE). TOE also has world-class management to execute on its portfolio. (The story is tempered by TOE's huge share float.)
For someone more experienced perhaps a diversified Tier 2 and Tier 3 portfolio is suitable. Obviously, keep in mind the risk increases significantly as one moves earlier in project lifecycles.
I concentrate on advancing Tier 3 companies; but keep in mind, I spend significant time following the sector and companies. I would note, given recent market conditions, many of the Tier 3 Explorers are simply not exploring—but they are burning company capital in wages and salaries to the detriment of the future exploration budget. While I can appreciate some companies really do need to wait for a better financing time—implicitly for a worthy project—I would not recommend investors own a company that is burning capital but not really exploring. By "really exploring," I do not mean picking up rocks ("grab samples"), I mean the company has near-term drilling plans. Many of those exploration companies standing pat may not be around in the future. In any event, this is not the market environment for investors in exploration companies to own shares in companies where management seems to be paying themselves first.
TER: What favorite uranium companies, seniors or juniors, are you following?
MM: One of my favorites is Strathmore Minerals Corp. (TSX.V:STM) (OTC:STHJF). There is simply no way to overlook 159.658mlbs of STM's 43-101 and Historical (non-43-101 compliant) uranium resources. Most explorers and many developers should be so lucky. On an EV/Lb basis, the company is one of the cheapest in the world. (I have one of, if not the largest, compliant uranium database in the world.) If you exclude companies whose projects have little chance of producing I would say STM is definitely the cheapest in the world. Many of STM's projects are lower cost and simpler technologically, in situ leaching ("ISL") projects. STM owns significant and diverse land packages in the premier historical uranium producing districts in the U.S. While the "Church Rock" project in New Mexico (with 14.8mlbs) may not produce owing to the current Navaho opposition (the adjacent, also called "Church Rock" project by Uranium Resources Inc. (NASDAQ:URRE), is in litigation and negotiation with the Navaho tribe.), in time I expect STM's other roughly 145mlbs of uranium to get produced. Moreover, when modern geological exploration techniques and drilling are applied to STM's older projects they have been able to expand the historical uranium resources. I expect that to continue. While I have had some concern about STM's ability to execute (cut expenses, marketing) the company President David Miller is very capable and seasoned; and STM has Japanese trading giant Summitomo Corp. ("Summi") as a $50mil JV partner on its more difficult/expensive "Roca Honda" NM project. In short, I expect Mr. Miller can, and Summi will, be able to carry the ball and get the projects developed. At the end of the day if STM cannot monetize these lbs someone will—note, STM's market cap is $11 million less than the $50 million Summi is paying for only roughly 12.5mlbs of STM's 160mlbs in projects. If it were politically viable (it is not), Summi would do better to buy the company, recapture the other 40% of the JV, and gain roughly 145mlbs in resources!
Another favorite, which I have let the cat out of the bag a bit, is Pitchstone Exploration Ltd. (TSX.V:PXP). In my opinion, perhaps the best-kept uranium exploration secret in Canada has been PXP's greenfield Namibian project. I would say that is because the project and its potential not only flew under investor's radar—but management's as well! PXP has a 55% interest in two properties from Manica Minerals Ltd. through Manica's wholly owned subsidiary Cheetah Minerals Exploration Ltd. The two properties are large; Kaoko and Dome projects total approximately 300,000 ha. It is important to note approximately 70% of these projects are under desert sand overburden which render airborne radiometrics useless. While this will require more ‘blind drilling' from widely spaced drilling "fences" based upon gravity surveys, it does not rule out the prospects merits. After all, Extract's new Namibian world-class "Rossing South" development project was a self-described "blind target" as well.
I personally and/or my family own the following companies mentioned in this interview: Strathmore and Pitchstone (owned before interview proposed)
I personally and/or my family am paid by the following companies mentioned in this interview: N/A
Merrill W. McHenry, MBA, CFA, has been in the investment business for 25 years. As a portfolio manager he managed over US$1.5 billion in two U.S. mutual funds, and set up an international mining merchant bank. As an analyst he has worked both the buy and the sell sides; and currently provides contract research for Tier 1 and Tier 2 Investment Dealers, as well as prominent global investors. Mr. McHenry is a member of the CFA Institute, and the Toronto Society of Financial Analysts. He is owner of the domain name, and previously ran the website Uraniumanalyst.com . He can be reached at [email protected].
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