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►On Target
Martin Spring’s private newsletter on global strategy
April 28, 2007 No.83
Boom Times for Carbon-Free Energy
Nuclear energy is back in the headlines.
The spot price of uranium jumped 19 per cent to $113 a pound at a recent
auction – only six years ago the metal traded at just $7 a pound!
The British Government is expected next month to scrap its ban on construction
of atomic power stations, clearing the way for a phalanx of new plants.
In the US the nuclear fuel company Urenco has got the go-ahead to invest $1½
billion in the nation’s second uranium enrichment facility.
Does all this activity signal investment opportunities?
Sprott Securities of Canada says in a new research report that global supply of
uranium, the fuel of nuclear power stations, is “very tight, with primary and
secondary sources just meeting demand.”
Any disruption in supply, unexpected delay in planned production increases,
political conflicts between major players – even just continued demand from
investment funds, which have been buying a quarter of uranium available on the
spot market – “could drive the market into an immediate deficit position.”
Even without such occurrences, there’s likely to be a shortage in three to five
years’ time as mine output isn’t planned to grow enough to meet increasing
demand from nuclear power stations and to offset decline in supply from
secondary sources.
Sprott predicts that uranium prices will continue to strengthen “over the next 20
years.”
RBC Capital Markets, who have also just produced a fat report on investing in the
sector, reckons that “we are in the middle of a uranium bull market” and “the
current market deficit, which is exacerbated by supply disruptions, continues to
point to higher prices.”
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Although mining giants such as Comeco, BHP Billiton and Rio Tinto own large
ore bodies in Canada and Australia, and while they and smaller groups are
opening up resources in Africa, Central Asia and North America, it’s a struggle to
bring new production on line.
Because uranium can be used to make nuclear weapons, its production and
trade, by international agreement, is subject to tight regulation -- which blocks or
slows new ventures.
Capital costs are soaring because of worldwide shortages of mining resources –
experienced managers, geologists and engineers, skilled construction workers,
equipment and transport capacity. BHP Billiton says it expects expansion of its
Olympic Dam mine in Australia to cost $10 billion – and pessimists say the
eventual cost is likely to be much greater.
As with other kinds of mining, there are the physical risks. Flooding of the Cigar
Lake venture in Canada, planned to add 10 per cent to world supply of primary
metal, delayed by several years its coming into production. After-effects of
flooding at the Ranger mine in Australia will cut world supply by 2 or 3 per cent
next year.
For more than 20 years demand for uranium has exceeded mine output, the
deficit being met from secondary sources. Stockpiles of “yellowcake” – uranium
oxide, or U3O8 – were accumulated when prices were depressed. Weapons-grade
material, no longer needed with the ending of the cold war, is diluted and used to
make fuel rods. But most of those sources are running out.
Meanwhile, demand for nuclear fuels is growing. Currently there are 28 new
atomic power stations under construction, nearly all of them in Asia, with 64
more in the planning stage and a further 158 proposed.
New demand about to hit the market
Cameco estimates that as from 2010 about ten new reactors will be coming on
line every year. Sprott Securities suggests that each will need 17 to 22 million
pounds of uranium before start-up, with a reload of half-a-million every eight to
14 months thereafter, depending on the size and type of reactor.
“For the fuel rods to be fully fabricated and tooled for use, the uranium must be
purchased/mined, converted, enriched and fabricated.” As that process will take
at best 2½ to three years, the additional uranium demand needed for reactors
scheduled to start generating in 2010 could hit the market as early as this year.
The world’s top ten uranium producers are already “having difficulty meeting
demand of today, let alone preparing for the demand of tomorrow.”
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A further complication is increasing demand from investment funds, which are
buying uranium and withholding it from the market. It’s estimated that over the
past two years that’s been soaking up 5 to 7 per cent of global production.
Although nuclear power has long faced strong political opposition because of its
perceived risks, that opposition is eroding, preparing the way for construction of
new reactors outside Asia.
The climate change hysteria favours nuclear power, which doesn’t produce
greenhouse gases. And, unlike alternatives such as ethanol and biodiesel, it
doesn’t divert farm output from food to fuel, forcing up food prices.
The high costs of fossil fuels, low interest rates on borrowed capital and design
efficiencies have made nuclear power a commercially attractive alternative to
other major energy sources.
Nuclear power also reduces dependence on imported oil and gas, as uranium is a
small proportion of total costs (about 7 per cent), and most of it comes from
politically “safe” countries – Canada, Australia, the US.
Winning the public relations war
The industry is winning the public relations war as safety fears fade -- there
haven’t been any dangerous accidents for decades – and it becomes clear that
there are safe ways to dispose of radioactive waste. The new atomic plant under
construction in Finland will encase high-level waste in steel and copper
containers to be buried in hard granite that has been geologically stable for a
billion years.
If you want to buy into the nuclear energy story, how should you do so?
Sprott Securities suggests that investors “should remain focused on three sub-
sets of uranium stocks – producers, imminent producers, and those development
stories with fundamentally solid assets aggressively moving towards production.”
One problem with the established producers is that most of their output is tied
up in long-term contracts to supply nuclear power stations at prices now very low
compared to those on the spot market. In the fourth quarter of last year, for
example, Cameco realized only $22 a pound on its sales although the spot price
averaged $65.
For the next five years, 85 per cent of global mine production is locked into such
low-price contracts.
The good news, of course, is that the established producers have low costs, yet
own the highest-grade deposits – Cameco’s mines in Canada have ore grades as
high as 25 per cent, compared to less than 1 per cent in the case of some new
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open-cast mines. So they should experience huge earnings growth in future years
as sales are made at higher prices.
The bad news for investors is that many of the best uranium assets are owned by
the two mining giants BHP-Billiton and Rio Tinto, whose other interests are so
huge that their shares provide minimal exposure to the nuclear fuel.
The big pure play is Toronto-listed Cameco (CCO), the world’s largest producer,
with four operating mines in Canada and the US, major ventures also in Canada
and in Kazakhstan, and even a stake in nuclear power generation.
It has enormous high-grade ore deposits and managerial/technical expertise, and
Sprott Securities is forecasting earnings per share to triple, to $3.15, over the
next couple of years. It offers good upside potential at lower risk than most other
options. It’s RBC Capital Markets’ “top pick” uranium stock.
Other mining companies deserving consideration include:
► Denison Mines (DML, Toronto), with a seasoned management team,
production in North America and a large portfolio of exploration prospects. It
plans to ramp up its output five-fold over the next four years and is Sprott
Securities’ “top pick.”
► Paladin Resources (PDN, Sydney) has started production at its Langer
Heinrich mine in Namibia and has an equally substantial prospect, Kayelekera, in
Malawi. Soaring profits should raise its earnings-per-share ratio to 15 times (the
same as projected Cameco levels) in a couple of years.
► Uranium One (UUU, Toronto) is a newly-formed combine with actual or
incipient production in Kazakhstan, South Africa and Australia. Ambitious
development plans could ramp its output to 12 million pounds a year (the same
target as Paladin’s) in five years’ time.
► Uramin (UMN, AIM London) expects its Trekkopje open-cast mine in Namibia
to come into production next year and has other African interests.
► Energy Metals (EMC, Toronto) is perhaps the most interesting speculative
stock, with a large portfolio of ore deposits in the US. It expects to start
production next year.
Justin Reid, analyst at Sprott Securities, suggests that “US-focused companies
with solid assets” that have started the process to get operating permits and are
“backed by good operating teams” could be takeover targets.
Other interesting investment possibilities include:
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► Geiger Counter (GCL, London), a new fund with a diversified spread of about
50 holdings in physical metal and the shares of producers, developers, explorers
and service providers.
► There are several other funds that only invest in uranium itself, such as
Uranium Participation Corp. (U, Toronto), and Nufcor Uranium (NU., AIM
London). They tend to trade at high premiums on net asset value.
► Areva (CEI, Paris) is the world’s biggest nuclear engineering group. It mines
uranium, designs and builds power stations, makes fuel rods and processes
nuclear waste. Although 95 per cent owned by the French government, the
remaining 5 per cent is in listed non-voting shares.
There are high risks of various kinds in all uranium investments. The spot
market is so thin that it could collapse should bullish sentiment evaporate for
any reason. Mother Nature can turn nasty, as it did with the devastating floods at
Cigar Lake and Ranger. A reactor accident could trigger a renewed upsurge in
public hostility to nuclear power.
Yet it’s hard not to be bullish about a resource sector where supply is likely to
remain under stress for years to come, relative to steadily rising demand.
Dangerous Bubble in the Credit Markets
The continuing narrow spread between yields on the riskiest and least risky
credits shows that markets remain confident that the developing unpleasantness
in the dodgiest sector of US housing finance – “sub-prime” lending to high-risk
borrowers – will not expand into a much wider debt crisis.
That would be dangerous for the US and world economies – and really bad news
for equity investors.
One who believes that such a crisis is a high-risk possibility is the strategist at
CLSA Asia-Pacific Markets, Christopher Wood.
He says that much of the lowest-grade mortgage paper – once famously described
as “toxic waste” -- is buried in the $4 trillion global market for collateralized debt
obligations.
CDOs are packages of loans of different types and risk ratings sold to investors,
mainly financial institutions. Many contain significant proportions of high-risk
debt. The two riskiest classes of loans amount to 40 per cent of the US market in
mortgage-backed securities, for example.
Current delinquency rates in sub-prime mortgages alone already suggest
potential losses of $170 billion, Wood says, “even if, optimistically, there is no
further deterioration in house prices.”
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Last year a quarter of all new mortgage loans in the US were sub-prime. Most of
those have not yet adjusted to higher interest rates -- most such mortgages start
with a low rate to attract borrowers. The rate ratchets up later.
CDOs’ lack of transparency has deferred marking-down of their values now, to
reflect the lower market value of higher-risk components, “at the potential cost of
a greater shock to the system later.”
Investors ignorant about what they have been buying -- but hungry for yield – will
wake up to what is contained in “these leveraged synthetic structures.”
Wood warns that US housing debt is “a deflationary disaster waiting to happen.”
But credit risk is spread much wider than that. The core of the problem is that
banks have been lending money on terms that make no sense, because they have
no intention of retaining the loans on their balance sheets. They have been
packaging them and selling off the packages to unwary investors.
The private equity boom has also been built on razor-thin credit spreads.
As investors become more cautious about buying into or holding such higher-
default assets, “the risk will grow that hitherto easy access to cheap credit will be
cut off” by investment banks – “to the chagrin of the world’s leveraged
speculators.”
Wood reports that one product recently being marketed to high net worth
investors employed 30 times leverage to offer a guaranteed annual return of 10
per cent.
That such a product could be sold “with a straight face, highlights the scale of the
potential unwind if risk tolerance ends. It also underlines the fact that the rich,
especially the asset-rich cash-poor rich, will be badly hurt in such an unwind.”
The booming private banking industry “has been encouraging investors globally
in recent years to exploit cheap financing to capture seeming ‘guaranteed’
returns” and better income yields.
“The affluent have been doing it increasingly with leverage, either directly
themselves or by investing in fund-of-funds or hedge funds which are themselves
leveraged.”
Fed to the rescue
However, the good news for investors is that “at the first sign of real financial
distress in terms of rising credit spreads and falling share prices,” the Fed is
likely to start cutting interest rates.
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“If this view is wrong and the Fed continues to worry about inflation amid growing
market panic about a perceived housing meltdown, then the short-term downside
risk for Wall Street-correlated equities will be much greater.”
However, any such distress will represent a giant buying opportunity in equities,
especially Asian shares, “for those with cash left to invest.”
Platinum is Outperforming Gold and Silver
I have long been a fan of platinum as an investment. I even launched the world’s
first newsletter devoted to it in 1988, with a subscription uniquely priced at one
ounce of the metal. It failed -- at that time hardly anyone was interested in
investing in platinum.
Today it’s a different story. The six platinum group metals (PGMs), of which
platinum and palladium are the most important, are attracting increasing
investment interest.
They are, after all, much rarer than gold or silver. Very few ore bodies are rich
enough to be mined primarily for the PGMs, and those are almost exclusively in
South Africa. However, a lot of metal is won as a by-product of nickel mining in
Russia and Canada.
Platinum has risen 18 per cent in dollar terms over the past 12 months,
compared to silver’s 14 per cent and gold’s 9 per cent. But it’s difficult to quantify
the level of investor interest in the PGMs and assess its importance in driving up
their prices.
The GFMS consultancy says in its latest report on the industry* that, in contrast
to the gold investment market, where data on bar hoarding, retail investment and
holdings of the various exchange traded funds provide crucial information, “the
universe for platinum and palladium is significantly more opaque.”
Most investment activity consists of purchases made by institutional investors
such as hedge funds directly from holders of stocks such as Russian state
entities. Those are rarely on public record.
If you ignore stock movements, and just look at primary supply – mined and
recycled metal – relative to primary demand, palladium has been in heavy over-
supply for years and platinum has moved from shortage into over-supply.
Yet despite such negative fundamentals, prices of PGMs have been rising for
years, which suggests strongly supportive investment demand, especially for
palladium.
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The Fundamentals
2001 2006 5yr Chg 2001 2006 5yr Chg
Platinum Palladium
Thousands of troy ounces ---
Supply
South Africa 4,167 5,445 31% 2,003 2,819 41%
Russia 811 961 18% 2,626 3,164 20%
Canada & US 347 357 3% 780 1,004 29%
Total mine supply 5,387 7,006 30% 5,514 7,255 32%
Autocatalyst scrap 650 855 32% 280 764 173%
Total primary supply 6,037 7,861 30% 5,794 8,019 38%
Demand
Autocatalysts 2,507 4,166 66% 5,325 4,456 -16%
Jewellery 2,836 1,700 -40% 280 981 250%
Electronics 370 434 17% 800 1,219 52%
Chemicals 295 350 19% 255 410 61%
Dental 699 633 -9%
Other industrial 685 1,065 55% 65 202 211%
Total primary demand 7,018 7,715 10% 7,424 7,902 6%
Primary surplus or deficit -981 145 -1,629 117
Source: GFMS Platinum & Palladium Survey 2007
________________________________________________________________________________
GFMS says that although a primary surplus for platinum of 145,000 ounces
emerged last year, “true growth in investment demand… was a good deal greater”
than this relatively small figure of net movements into stocks suggests.
Although solid fundamentals specific to the metal have been “instrumental in
generating buy-side interest from the investor community… a good part of the
demand was related to bullish sentiment for the overall precious metals complex.”
However, “in contrast to gold, where smaller retail players and especially high net
worth investors have been relatively active, such private investors have been
largely absent” from the platinum market, where the buyers are institutions,
particularly hedge funds, “with a short to medium term view.”
This is likely to change with the imminent listing in Zurich and London of ETFs –
exchange-traded certificates that give direct ownership of bullion, so making it
easy for individual investors to buy into the metals.
The two investment banks that have just launched them reckon they should add
150,000 oz to demand over the next 12 months, but Peter Ryan, GFMS’s senior
consultant, reckons they could lift demand by more than 250,000 oz this year, as
the market for platinum remains extremely tight.
Investors remain the main propulsive force behind rising prices for all precious
metals, but the arrival of ETFs for platinum and palladium should give an extra
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boost to their prices, as they did for gold, where ETF demand absorbed 8.4
million oz last year alone.
I see no reason to change my long-held view that you should hold about 10 per
cent of a balanced investment portfolio in precious metals, with perhaps a
quarter of your holdings in platinum.
* Platinum & Palladium Survey 2007. £275/$495 from GFMS Ltd. Email: info@gfms.co.uk
Tailpieces
Markets revert to type: One of the interesting things I’ve noticed about the way
investment markets have behaved recently is that major asset classes no longer
rise or fall in unison. Since the start of the year, bonds have been falling in value
when equities have been rising, and vice versa.
This suggests that abundance of cheap credit is no longer the main driving force.
Prime drivers are once again earnings prospects for equities, inflation prospects
for bonds.
UK dottiness diary: Goldsmiths College, part of the University of London, has
called for a ban on playground football because the game is played almost
exclusively by boys, leaving girls to be static observers. No drum majorettes there,
then.
Down in Devon, the Totnes local authority is considering re-covering its furniture
in plastic instead of leather, to avoid offending vegetarians. I presume there’s a
booming market in the town for plastic shoes. But maybe not. They’re not
carbon-free.
A woman was surprised to be told by an official that he had been instructed by
“Brussels” (European Union headquarters) to affix a bright yellow notice on an
electricity supply mast in the middle of her lawn facing her living room windows,
warning her not to climb the pole.
“I am a 74-year-old widow with knee and hip replacements,” she wrote to a
newspaper. “I have known that pole for 40 years, and never once has it occurred
to me to attempt to climb it.”
Canuck cock-up: I hear that many thousands of Canadians have lost their
citizenship and are having to reclaim it. According to Lloyds TSB International, a
little-known law that applied between 1947 and 1977 decreed that if you lived
outside Canada on your 24th birthday and failed to sign the correct form, you
automatically lost your citizenship. Not nice to find out you’re a non-citizen of
your own country when you apply for a passport.
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Trouble brewing on the ranch: After a delay of perhaps six months, meat prices
are going to rocket because of rising costs of feedstock, driven by diversion of so
much grain to ethanol production. BMO Capital’s erudite strategist Donald Coxe
warns: “Consumers could get burned at the steak this summer.”
Call the ethics police: Did you hear about the top civil servant at a major
international body who arranged a job for a female colleague worth $190,000 a
year tax-free, and was photographed with her on a nudist beach, him wearing
nothing but a baseball cap?
No, it’s not whom you think. It’s the first vice-president of the European
Commission in Brussels, Günter Verheugen, who appointed economist Petra
Erler as his chief of staff and, although married, was caught on camera with her
au naturel at a Baltic resort.
Amazingly, this high-level scandal has produced little international media
interest, even though Verheugen’s conduct clearly violated the Commission’s code
of conduct, which he helped draft. That requires officials to behave, “in their
official and private lives… in a manner that is in keeping with the dignity of their
office.”
But then he isn’t a Rightwing American, so clearly the chattering classes reckon
different ethical standards apply.
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