A “Yellowcake” ETF

On July 24, Westinghouse Electric signed a deal to build four nuclear reactors in eastern China. The price tag on the deal is $8 billion. This is just one tiny piece of the puzzle. China plans to spend approximately $50 billion to build 30 nuclear reactors by 2020. This will increase its nuclear energy production by 40 gigawatts. That’s basically enough power to supply all of Spain with electricity. The growth in the nuclear market has resulted in a very large increase in the demand for yellowcake.

I’m not talking about the cake your grandmother brings to your birthday party, either. I am talking about refined uranium (U3O8). The price of uranium has seen a kind of growth second to no other commodity, equity index, or virtually any other investment vehicle available. From 2003 to the present, the spot price of uranium went from $7 to $130 per pound without declining once. That’s a 1,700%-plus increase over a five-year span.

I’m here to tell you that this amazing price run is not over yet, not even close. In fact, this market is just barely starting to catch the public eye, but once it becomes mainstream, the uranium market will really take off.

Uranium: Supercycle

Uranium is the perfect case study for discussing the notion of a supercycle. A commodities supercycle refers to the extended periods of time when either supply exceeds demand, followed by demand exceeding supply, or vice versa. This cycle extends of a period of several years. Let me explain its relevance to uranium.

Most of the demand for uranium came from the U.S.’s and the USSR’s amassing nuclear warheads. After the fallout of the Cold War, and the incidents at Three Mile Island and Chernobyl, the demand for uranium plummeted. Nuclear power plants that were planned for production were canceled at a very rapid pace. And to add further downward pressure, much of the demand that was still left was fulfilled by recycling old Soviet warheads, which is a process that goes on today.

For all of these reasons, the spot price of uranium slumped to a low of $6.50 per pound. Being that uranium miners’ revenues directly depend on the spot price of uranium, this drove the majority of them out of the market. This is the lag period when supply greatly overexceeded demand. In this case, it was fueled by a couple of extraneous factors.

Let’s fast-forward to 2003. The green energy movement is starting to take hold of the media, public, and Washington alike. Geopolitical tensions are making it essential that nations secure energy resources and become less dependent on politically unstable regions — especially the Middle East.

So nuclear energy is back, except there’s only one problem. There are very few uranium mines still in production, and exploration efforts are essentially nonexistent. It was around 2003 that we began to transition from excess supply to excess demand.

Time to get the shovels digging, the leach operations running, and the mills churning… That’s easier said than done — these processes take time.

An exploration company needs to be formed, and funds need to be raised. The company then needs to either lease or buy land for exploration. The next step involves using radiometric and magnetic survey equipment to prioritize potential exploratory drilling locations. Before any ground is broken, the company needs to obtain permits. This step might be the most underestimated as far as time consumption and difficulty are concerned. The inability of a company to obtain a permit is essentially the end of that company.

Assuming that the company does get its permits, it has to conduct numerous drilling tests. The test samples need to be treated with chemicals and then assessed for further testing. Again assuming that everything goes well with the drill tests, the company can go ahead and set up a mining operation, whether it be a leach setup or a more conventional mine. Infrastructure needs to be set up, and workers need to be brought in. During this whole process, time is ticking away. Once the ore has been removed from the earth, it needs to be transported to a mill for further processing. The product is eventually refined into the final product, U3O8.

Notice my use of the word “assuming.” Those are very big assumptions, and that’s why a very small minority of these companies actually make it to the production phase.

Just look at all of the places where a company could hit a dead end. Operating capital could dry up. There could be a failure to obtain permits. What if there’s no uranium on your property?

The production of these mines takes time and money. Even if everything goes well, you are talking at least six years until a mine becomes operational from initial exploration, and it’s for this reason that there is a long period of time during which demand exceeds supply. This shortage will always show up in price, and that’s exactly what we have and will continue to see. This has directly shown up in the supply and demand for yellowcake.

Uranium Supply

The theory of commodity supercycles clearly explains why supply has lagged behind demand and will continue to do so over the coming years. But there is another story behind the supply shortage in uranium.

Uranium deposits often occur in geologically fragile areas. In other words, uranium mines are susceptible to disruptions. This is a risk with any mine, but the risk is higher with most uranium mines. Just look within the last eight months — two major mines have been flooded, which caused significant delays in future production.

The two mines are Cameco’s Cigar Lake operation and Energy Resources of Australia’s Ranger mine.

Let’s start with the situation at Cameco. On Oct. 23, 2006, Cameco announced that its Cigar Lake operation had experienced flooding in parts of the underground mine due to a collapse of rock formation.

This mine was planned to come into production in 2008. After the flood, Cameco announced that production would be delayed one year. It looks like the company was a little optimistic, because it recently came out and said that the remediation process was taking longer than expected. It pushed the expected production date back to 2010.

The impact of this flood is very significant on the market. Cigar Lake had the world’s largest undeveloped high-grade uranium deposit. The proven and probable reserves are estimated at 226.3 million pounds of U3O8, with an average 21% grade. It is very easy to see the significance of delaying this planned production from the market.

The other operation mentioned was the Ranger mine. The incident here was different. The flooding at the Ranger mine was not a result of geological instability, but a result of Mother Nature. Tropical Cyclone George was the cause of the flooding at the Ranger mine:

This is a very significant loss in production. Energy Resources of Australia’s planned production was revised down to 7.5 million pounds of uranium. That’s a four million pound decline, or 4% of total world production. That four million pounds of uranium is estimated to be worth $340 million.

Energy Resources of Australia claimed “force majeure” on its contracts for sales. In other words, because of unforeseen events, it has exited ALL of its contract obligations for delivery of U3O8.

Situations like these are unable to predict and carry devastating implications for the supply of U3O8. Remember that these two incidents occurred within the past eight months. Although one can’t say when or where, you can bet that we haven’t seen the end of scenarios like the abovementioned ones.

Uranium Demand

The demand side finishes the bullish picture for uranium. The main catalyst is the move to green energy. Nuclear power plants have no carbon emissions. The growth of nuclear power is just beginning, but planned production is expected to greatly increase the demand for uranium.

Here is a list of the amount of power plants planned for production: U.S., 34; China, 40-plus; Russia, 42; S. Korea, 11; and many others. That is combined with the 448 nuclear power plants currently in production.

The end result of this is an annual rate of consumption currently running at 188 million pounds of U3O8 per year, compared with an annual mine production of 100 million pounds of U3 O8 per year. The difference is made up in excess ore pilings and old Soviet warheads being converted into nuclear fuel.

For a brief snapshot of the market, last month, active supply (the amount of U3O8 for sale) was approximately two million pounds. Active demand (buyers currently seeking uranium for shipment) was 4.4 million pounds. These buyers are the reason that the price of yellowcake has been getting bid up at such an extreme pace. And not all of these buyers were able to secure U3O8 for shipment.

The uranium market is very transparent. This makes the supply and demand fundamentals extremely easy to read and interpret. Supply disruptions have increased the shortages of available uranium for delivery. Junior and intermediate miners are all racing to get production online, but the general public has trouble understanding the time and money it takes into turning these properties into profitable ventures. The use of nuclear energy as an alternative to carbon-based fuel sources has really set into place the emergences of a fantastic bull market.

There is going to be a very innovative way to play this market. In mid August a nuclear energy ETF was released here in the U.S. The ticker is NLR. It follows the DAXglobal Nuclear Energy Index. This is an ETF that invests in the following fields: uranium mining, uranium enrichment, uranium storage, nuclear power plant builders, nuclear fuel transportation, nuclear equipment and generation. This is really exciting stuff and its price will very likely jump, being that it is one of a kind here in the U.S. Given a good buy price, this one is a safe and potentially highly profitable way to play the uranium market.

Regards,
Nick Jones

September 4, 2007