The Other Yellow Metal

Editor’s note: Get and updated view on Elliott’s position on uranium stocks with his recent special report on the Best Uranium Investment to Buy Now – free!

In December 1951, an experimental nuclear reactor in Idaho managed to generate enough electricity to light four 200-watt light bulbs. Nuclear power became a reality.

In the 50-plus years since that first test, nuclear power has grown into a key global source of electricity. Worldwide, there are about 438 commercial nuclear reactors in operation, supplying 16 percent of total global electricity demand. Nuclear power is even more important in the US, where 104 reactors produce about 20 percent of the nation’s power.

And still more reliant on nuclear power are several European countries, including France, Germany, Britain and Sweden. In fact, France generates nearly 80 percent of its electricity using nuclear power.

Despite these successes nuclear power has been a controversial technology at times. Early promoters suggested that reactors would offer power “too cheap to meter.” Apparently, large American utility companies agreed; several hundred plants were commissioned between 1950 and 1974.

But construction of plants proved expensive due to regulatory delays, failure to adopt a single standard design for plants and opposition from anti-nuclear groups. In the end, less than half of the plants commissioned were built. And high-profile nuclear accidents like Chernobyl in Russia and Three Mile Island in the US served to tarnish nuclear power’s image still further.

The end result: No US utility has applied for a new nuclear plant construction permit since the 1979 Three Mile Island accident. And by the mid 1980s some were already calling nuclear power a failed experiment.

But nuclear power is far from dead. Fast-growing nations like China and India are planning to make nuclear power a centerpiece of their respective national electricity policies–these nations are already building new reactors and experimenting with advanced reactor designs. And high natural gas prices coupled with the negative environmental impact of coal-fired plants has put the nuclear option back on the table in the US. Some major US utilities are expanding existing facilities and/or considering the construction of new plants.

The fact is that nuclear energy is a cheap and environmentally friendly way of producing energy. And nuclear plants can also reduce dependence on foreign supplies of oil and gas. For a more in-depth look at the advantages of nuclear energy, I’ve prepared a report on the benefits of nuclear power available here.

The nuclear industry renaissance–at home and abroad–spells rapidly growing demand for uranium, the key fuel for nuclear power plants. Uranium, also known as yellowcake, is a naturally occurring metal that is mined from ground. In this issue, I’m adding the world’s largest producer of uranium, Canada’s Cameco (NYSE: CCJ) to the Wildcatters Portfolio. The company sits on 65 percent of the world’s known reserves of uranium; with uranium prices more than triple what they were in 2001, the company stands to profit handsomely.

In addition, I’m adding a more speculative uranium play to the Wildcatters Portfolio, Denison Mines. (Toronto: DEN, OTC: DNMIF). This company is a smaller producer but has the potential to expand rapidly. Denison trades in Toronto and over-the-counter in the US (for more information on buying Canadian stocks, click here). Some of the most promising energy plays in the world are based in Canada; all subscribers should consider taking the steps necessary to gain access to this exciting market.

Before I delve into Cameco and Denison in depth, let’s review the enormous growth prospects for the nuclear power industry and the implications of this growth on demand for uranium.

Present and Future

The world is rapidly recognizing the myriad advantages of nuclear energy. As a result, far from being a sunset industry, the nuclear industry is entering a period of global growth. This growth is putting a strain on the world’s available uranium production capacity.

In 2003 the world’s 438 nuclear reactors consumed about 180 million pounds of natural uranium. But only a little more than 50 percent of this uranium was actually mined in 2003; total mining production in 2003 was just 92 million pounds.

That 88 million pound shortfall has been met from a number of different sources. Utilities themselves hold some inventories of uranium for use in their own plants; over the past few years these inventories have been drawn down on average by about 30 million to 40 million pounds per year. Another 20 million pounds or so came from de-commissioned Russian nuclear warheads. The final chunk likely came from inventories held by Usec (NYSE: USU)–the U.S. government gave Usec 70 million pounds of uranium when it went public in 1997.

But this situation is unsustainable even if uranium demand remains constant for the foreseeable future. Utilities’ available inventories are already running low–some estimate that commercial inventories of uranium are less than 10 percent of what they were in the mid-1980s. Meanwhile, Usec has been a major net seller of uranium since going public in 1997 so the company’s stocks are also rapidly depleting.

That fact is that, even assuming uranium demand remains constant at about 180 million pounds annually, uranium mining activity must pick up to meet demand. According to Cameco, some prominent utility companies have already expressed interest in procuring additional supply to keep their existing nuclear plants running over the next few years. These utilities are signing longer-term supply agreements at much higher prices.

The spot market for uranium–the market for immediate delivery of yellowcake–only accounts for roughly 12 percent of total supply. Most utilities sign longer-term supply agreements to ensure that there’s plenty of uranium on hand to run their plants. Nevertheless, uranium spot prices recently touched nearly $30 per pound, up from less than $8 per pound in 2001. These spot prices indicate the pricing power uranium mining companies have been seeing over the past few years.

Current production is insufficient to meet demand even if consumption of uranium doesn’t increase. The reality of the uranium markets is that consumption is likely to grow, not to remain stagnant.

Check out the chart below depicting the US Energy Information Administration’s (EIA) estimates of electricity demand broken down by region. The EIA offers projections out to 2025.

 

 


Source: Department of Energy, Energy Information Administration, Federal Energy Regulatory Commission

The industrialized world will certainly see a jump in demand for electricity over the next 20 years–consumption is projected to jump about 42 percent between 2001 and 2025. But growth in the industrialized world pales in comparison to what’s expected in the developing world.

Developing nations are projected to see electricity demand jump over 125 percent in the same period. In fact, by 2025 the developing world will consume nearly as much electricity as the industrialized world. This growth should come as little surprise given the rapid economic expansion currently underway in countries like China and India.

These developing countries know well that fossil fuels are not the best answer to this problem. China is already struggling to nail down supplies of oil, coal and natural gas–the country’s massive effort to import these basic commodities is at least partly behind the aggressive jumps in pricing witnessed over the past two years. If China relies solely on conventional fossil fuels for power, rapidly rising electricity prices would become a huge impediment to future growth.

Coal currently accounts for roughly 70 percent of China’s electricity supply. But the nation has increasingly encountered trouble with pollution in its major cities. A World Health Organization (WHO) report detailed the world’s 10 most polluted cities–seven of those 10 are located in China. And the WHO estimates that corrosive acid rain now falls on nearly a third of China’s land area. The main culprit in all this pollution: coal-fired plants.

But nuclear power offers a way to avoid both high electricity prices and pollution. China and India are already rapidly embracing the technology with ambitious programs to expand nuclear generation capacity. In 2004, China had nine nuclear reactors with roughly 7,000 megawatts of generation capacity. By the end of 2005, the nation will start up two new reactors, adding about 2,500 megawatts to its nuclear generation capacity.

But that’s just the beginning. Beijing has also announced plans to build as many as 40 new reactors between now and 2020 to bring its total generation capacity to roughly 40,000 megawatts. That’s a quadrupling of the nation’s current capacity, at a pace of two or more new reactors every year between now and 2020.

India, like China, is an aggressive developer of nuclear capacity. India currently has 14 reactors and plans to add another eight reactors between now and 2010, more than doubling current capacity. Taiwan and South Korea are also planning to add new reactors over the next few years.

Nuclear in the Developed World

There’s also likely to be considerable growth in capacity in the developed world. The Japanese government has made it clear that the only way the nation can meet its environmental obligations under the Kyoto Protocol is to expand nuclear generation capacity. While there have been some construction delays, Japan plans to build 11 more reactors by 2010.

Europe is already more reliant than the US on nuclear power. France gets nearly 80 percent of its electricity from nuclear power and the French government is committed to continuing its nuclear program. The ruling party in Germany, in contrast, has tended to be anti-nuclear and has committed to phasing out capacity over the next three decades.

But it’s unclear how Germany will make up for the loss of its nuclear power (30 percent of electricity supply). Germany could, like many European countries, make up for its lost nuclear capacity by stepping up electricity imports from its neighbor–namely, nuclear-friendly France. This would hardly represent a phase-out of nuclear power.

The big wildcard for the developed world is, however, the US and its 104 nuclear reactors. The only firm plans for expanding nuclear energy in the US is for marginal capacity additions to existing plants and the re-starting of currently idled reactors. The EIA, for example, projects no new reactor construction in the US between now and 2025; the EIA is looking for annualized growth in nuclear electricity generation in the US of just 0.2 percent.

But this view may well prove conservative. The Department of Energy has initiated several programs to encourage the building of new nuclear power plants and President Bush has repeatedly mentioned the importance of nuclear energy to US energy supply. A more streamlined regulatory approval process has been developed.

Several utilities have already filed for early siting and design approval. None of this means that we’ll see major new plant construction in the US, but it suggests a strong possibility that new plants will be built in the US over the next 20 years.

How to Play It

Only a handful of companies have commercially recoverable reserves of uranium. Canada possesses the world’s largest reserves of high-grade uranium; its richest reserves are found in Saskatchewan’s Athabasca Basin.

Uranium prices are already on the rise with spot prices up 43 percent in 2004 alone. As you might expect, there has been an explosion in highly speculative uranium mining companies, mainly listed on the Canadian exchanges. Some of these smaller, speculative plays may well be worthwhile; I’ll profile some in an upcoming issue. For now, however, I prefer to focus on well-established producing companies with known reserves.

Sitting on some of the largest reserves in the region, Cameco (NYSE: CCJ) controls about 65 percent of the world’s total known reserves of natural uranium. Cameco produced 20.7 million pounds of uranium in 2004, more than 20 percent of the total quantity or uranium mined worldwide last year. For 2005, the company has targeted production of more than 21 million pounds as it expands capacity at its core mines in the Athabasca Basin.

Cameco has the potential to drastically expand production over the next five years. The company plans to continue ramping up production capacity at its Cigar Lake mine to a peak production level of nearly 19 million pounds annually. And Cameco is aggressively expanding into Kazakhstan, a country with large reserves of uranium.

Cameco’s Inkai mine in Kazakhstan could be a huge asset in future years; the company plans to start production there by the end of 2005. All told, the management team projects total production growth of approximately 40 percent by the end of this decade. Already, Cameco has committed to doubling capital spending in 2005 against 2004 levels–all that investment should help fund these expansions.

According to Cameco’s management, a few years ago utility companies were signing long-term uranium supply contracts at prices either in-line with or at a discount to spot prices. In other words, uranium mining companies were desperate to secure a market for their metal; that’s why they were willing to sign contracts at discount prices.

But recently, the tables have turned. Cameco has been selling as much as half of its production under long-term supply agreements. These agreements are being struck at $4 to $5 premiums to the spot price of uranium. The reason is simple: Utility companies are willing to pay up to secure long-term supplies.

Cameco has suggested that 2008 will be a pivotal year. Up to 2008, it seems that most utilities have some inventories or longer-term supply arrangements to cover immediate uranium requirements. After 2008, however, these companies will be uncovered and will need to scramble to secure adequate supplies.

Cameco is enjoying strong pricing in both the spot market and for longer-term contracts. It’s also one of only a few companies with the capacity to expand production meaningfully over the next five years. I’m adding Cameco to the Wildcatters Portfolio.

My second play on the uranium business is Denison Mines (TSX: DEN). Denison is far smaller and more speculative than Cameco, producing only about 1.4 million pounds of uranium annually. The company’s production comes mainly from its stake in the McLean Lake mine in Canada, the world’s fifth-largest uranium mine. The company’s proven reserves of the metal total approximately 13.5 million pounds.

Several opportunities exist for Denison. First, the company has several other properties on which it’s performing exploratory drilling, including additional acreage in the prolific Athabasca Basin. There’s significant potential for Denison to boost its reserves through greater exploration activity in the region.

The company has partnered with uranium giant Cogema on several uranium exploration projects. Cogema is controlled by the French government and is second only to Cameco in annual uranium production.

Secondly, Denison owns 22.5 percent of a uranium mill processing facility near Cigar Lake, one of Athabasca’s richest mines. This facility is scheduled to expand production significantly over the next few years. Processing revenues from the mill should be significant.

In another sign of managerial confidence, Denison’s management team bought all of a private placement of shares last year even though the shares were offered at a premium to the market price at the time. I’m adding speculative uranium play Denison to the Wildcatters portfolio.

Buying the Big Oils

Given the recent pullback in oil and oil-related stock prices, we recommend adding to positions in the big oil companies. Although prices could remain weak for a little while longer, long-term investors should act now. This is why we are changing parts of our advice in the portfolio.

Specifically, ConocoPhillips (NYSE: COP) and ExxonMobil (XOM) are now buys. Please see our April 27 issue, “Offshore and Overseas,” for a detailed look at ExxonMobil. Furthermore, we are changing some of the “buy under” recommendations; take a look at the portfolio tables for the details.

Finally, a word on oil services is warranted. It looks like investors have overreacted (as was expected) to the recent weakness in oil prices, thus taking profits from the service companies, too. The fear in this case was the assumption that lower oil prices will “pressure the multiples that the market is willing to apply to this group,” as an energy trader we talked to put it. Yet looking at the numbers, there is no reason why earnings should come down–especially in the near term.

As long as oil companies are spending money on exploration and production (E&P)–given their high levels of cash and market conditions, they will continue to do so–services companies will trade at high levels.

The same is true of most of the contract drilling firms such as Wildcatter Portfolio holding Noble Drilling (NYSE: NE). Noble traded through the recommended stop-loss last week as oil prices weakened; subscribers following the portfolio advice should have been stopped out of the stock.

The purpose of stop-loss recommendations is to keep you out of stocks that aren’t performing well. The stops should serve as a signal to get out of the stock and re-evaluate your position–stops will prevent you from holding on to a losing position, hoping for a recovery. In the case of Noble, however, I see no fundamental reason to support the decline; as outlined above it’s due only to general selling pressure in the oil patch.

My top reason for recommending Noble is the company’s ability to refit its two remaining baredeck (not fully constructed), semisubmersible rigs for extreme deepwater work. These rigs can be prepared for deepwater work at roughly half the cost of building a new rig from scratch.

Since there is only one semisubmersible rig scheduled for construction over the next three years, these rigs are in tight supply. Noble is the one of the only drillers with the capacity to add new semisubmersible rigs to its fleet quickly and take advantage of high day-rates in the contract drilling business. I am re-adding the stock to the Wildcatters Portfolio as a buy.

The Time is Now

By Yiannis G. Mostrous

In our first issue, we wrote: “The thesis of The Energy Strategist is that “cheap” oil prices are a thing of the past. … That said, current oil prices–above $55bbl as of this of writing–seem to be factoring in the worst possible short-term scenario: Continuing demand growth of 3 percent and zero non-OPEC supply response over the next 12 months. OPEC will continue to produce above demand for the next two months to build up inventories, driving oil below $50bbl in the near term.”

Since then oil prices did drop, very close to our 2005 “floor” target of $45 per barrel (bbl). And although prices could go a little lower in the near term, it seems that the risks are rather on the upside. Therefore, we are taking our oil price forecasts higher and now expect the price of oil to stay closer to $50 than $40 this year and closer to $55 in 2006. In addition, over the longer term–until the end of the decade–we expect that oil will be moving between $45 and $55, with the possibility that it can brake above $55 and approach $60.

We offer ranges instead of absolute figures because it is nearly impossible to predict exact prices. The important thing, though, is the direction (which is up) and the proximity to certain price levels (above $50 should be a fair assumption).

Our upbeat outlook is based on conclusions reached after further analysis of the factors we’ve identified as crucial to determining the long-term price of oil. Such factors are becoming more important by the day.

First are the financial needs of Saudi Arabia. As we wrote previously: “Oil is the main revenue source for Saudi Arabia, accounting for 75 percent of receipts. And the country was running a deficit during the years that the price of oil was relatively low.” A recent comment by his Excellency Ali Al-Naimi, Saudi Arabian Minister of Petroleum and Mineral Resources, indicating that $45/bbl is a price the Kingdom is comfortable with strengthens our conviction that oil prices will be adjusting upwards permanently.

We still expect Russian production to disappoint the oil bears in the next couple of years. We see no indications that the strong growth Russia has enjoyed in the past can continue given the current uncertainty regarding higher export tariffs and tougher regulatory control. Furthermore, given the decline in oil production in the OECD countries, the world is increasingly relying on emerging markets for an increased portion of its oil supplies. The uncertainty these markets (including Russia) often operate under does not make things better.

Given all the difficulties oil companies encounter in finding new oil and bringing it to the market at low cost (something that should become the norm), we all should adjust to higher oil prices soon. The more we choose to live in the fantasy world of oil dropping to the teens, the greater the shock will be when we finally realize the truth.

Keep in mind that if a global deep recession takes place, the price of oil will come down, and the stocks will too. Otherwise, the energy sector (with its ups and downs) will remain a solid investment for years to come.

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