Betting on the perfect storm
As value investors, we usually shy away from resources and materials because the factors influencing their price are inherently unpredictable – namely macro factors, the inability to reliably measure and forecast supply and demand, and the timing of cycles – not to mention the poor capital allocation of most miners.
Most of the time we conclude that our time is better spent elsewhere. However, at a recent investment conference, Paladin (ASX:PDN) presented a bullish case for the global uranium market which triggered our interest, and this report.
The uranium market is in an interesting situation where the price is now sitting below the cost of production while demand is strengthening, setting up the stage for a significant change in uranium prices.
The bear market has been savage, with the spot price falling 85% from 2007 highs and reducing the number of Uranium focussed stocks from over 500 to around 40.
Significant upside potential with limited downside risk
Uranium is a unique proposition in the sense that statistics for market demand, and to a lesser extent supply, is entirely measurable – all nuclear reactors and facilities report their statistics to the World Nuclear Association.
We can know how many new facilities are being built, how much uranium they consume, and what future demand will look like (through government mandates). This ability to reliably measure most variables in the industry is the distinguishing feature that separates Uranium from other commodities, making the ability to forecast much less haphazard.
The current environment has led us to make a compelling case for uranium as an investment with an asymmetric return profile: a significant upside potential with limited downside risk.
Our analysis suggests that supply is being reduced just as demand is starting to increase due to various drivers that should continue. There is a cross over point where we expect the market to tighten and drive prices higher.
Betting on the perfect storm
This trade focuses on an outcome within the next 2-4 years. While demand is increasing and supply falling, there are enough variables to make an exact timing uncertain. Significant supply and demand imbalances exist for uranium which, we expect, will push the price back up to at least $50-60/lb by 2020-2022.
Both bull and bear cases are explored here and an asymmetric return profile established suggesting the probability of the bull case playing out heavily outweighs the bear case.
Most notably, the bull case suggests that the current price, which is below the cost of production, will be forced higher due to a mix of supply cuts, utility demand increasing as discretionary supply depletes, and contract renewals.
Industry insiders believe that many utilities will have no inventories by 2022 at the current drawdown rate. This is highly unlikely to happen.
Uranium is mainly sourced from medium-long term contracts, and another variable playing out right now is that 75% of contracted supply comes off contract between now and 2025. Most utilities are mandated to hold at least 3 years worth of supply stockpiled. Our analysis suggests most are at or below this figure now.
The obvious bear case revolves around Japanese demand, one material wildcard in this trade. While Japan has been slower than expected in switching its fleet of nuclear reactors back on, the Abe government remains (publicly) pro nuclear with a goal to get nuclear back to 20% of electricity production.
However, at current prices, the market is already factoring in a scenario with little to no Japanese demand, hence limited downside potential. Given the supply side of the industry is adjusting to an environment of lower demand, we feel that this negativity is priced in.
The Black Swan style risk in the uranium market is another Fukushima style disaster that leads to global rebuke of nuclear power and a significant shutdown of generating capacity. While this can’t be considered impossible, it would be highly unlikely considering how safe Nuclear has proven to be over the last 50 or so years with very few major problems and Fukushima has put utilities on notice all over the world to be prepared for almost anything.
On balance we consider the risk/reward scenario attractive with huge potential upside.
In our full report below we explore the bull and bear cases in detail, before then looking at potential catalysts and investment strategy, and listing some options for getting exposure to this trade. We also provide a list of useful resources.
We have risked a small portion of the portfolio on this trade, with the view that odds favour us making good profits for our investors.
At this point, the situation appears compelling.
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