4 Reasons to Invest in Uranium NOW
And the Best Stock to Consider
Published on November 25, 2020
The holy grail of investing is finding large mispricings with a clear and imminent catalyst to realign prices. These can be found due to market structure and non-economic factors, like human behavior (as discussed in my prior article on cycles), which causes people to extrapolate recent history beyond what is appropriate.
Many other investors and I believe that there is such an opportunity in the current uranium market. While the catalyst may not be imminent, it is likely inevitable. In this article, I will discuss why uranium is a good long-term investment now, some ways to invest, and, most importantly, the risks.
Why Uranium Now?
In the midst of pulling together this post (I admit it takes me a while!), the podcast MacroVoices did an episode on uranium here on October 15, 2020. The show’s guests manage investment funds dedicated to investing in uranium, and they provided a presentation that goes into depth on the investment opportunity. To get all the materials, you will have to register at the MacroVoices website, but I would recommend doing that anyway for all of the additional value they provide.
I believe the bullish thesis for uranium can be summed up in a few critical points:
- For uranium purchasers—principally utilities—demand is pretty inelastic (price-insensitive).
Compared to other forms of electricity generation, the fuel (uranium) cost in a nuclear power plant vs. gas or coal in a thermal plant is much lower relative to the total cost of running the facility over its life. So once a nuclear plant is built, buying the uranium is a relatively small cost; instead of price, the security of supply is the driver.
- Getting uranium out of the ground and converted into a fuel rod for a plant takes several years.
Going from uranium ore to the final fuel rod that goes into a reactor takes multiple steps—conversion, enrichment, and fuel rod assembly—which require a couple of years. This means the uranium being used in today’s fuel rods was mined a couple of years ago. But there’s more. Uranium mines have planning, permitting, and development periods that can last a decade. Thus, that same fuel rod made today came from a mine that needed to be permitted at least a decade ago. All in all, the time to supply new uranium production can take well over a decade.
- Supply is falling.
The current price is below the marginal cost of production for nearly all miners: The following chart from Yellow Cake plc shows a simplified supply curve for mining uranium.
Because of depressed prices and depletion, the supply of mined uranium is expected to drop well below demand in the coming years. Because supply is slow to respond, the deficit cannot be covered quickly. Price insensitive buyers will then compete to source their needs, boosting the price.
- Demand is expected to increase.
China and other emerging markets are currently building reactors faster than the expected declines in nuclear power use in Europe and North America. A case can be made that expected future shutdowns in the west will also be limited based on nuclear power’s critical role in providing low-carbon baseload power. Extending the life of existing nuclear power plants is the lowest-cost source of green energy, and many policymakers are beginning to realize this—more on this in the risks section.
The following shows the base-case expected future supply, demand, and shortfalls anticipated by the World Nuclear Association, the leading industry group. The figures below are measured in tonnes of uranium equivalent (tU).
The “Planned Mines” and “Restarted Idle Capacity” bars, which make up for the declines in “Current Capacity” and “Specified Secondary Supplies” are price-sensitive and likely require a price north of $45 to stimulate supply there. Finally, the above chart does not factor in COVID-19 related supply reductions from Canada and Kazakhstan, so the short-term deficit is likely greater.
Many power utilities have not been renewing supply contracts over the past few years, which means they will need to buy uranium in the market and renew long-term contracts. The chart below from Uranium Participation Corporation shows the expected amounts utilities will have to contract in the coming years.
In sum, there’s a compelling case for uranium prices to move higher in the coming years based on industry dynamics and current uranium prices. Because of the imbalances and slow supply response to demand, the run-up in price can be significant, as seen in other uranium cycles. The chart below shows the last cycle, where the commodity returned greater than 6x between 2005 and 2007.
So how should investors take advantage of the opportunity?
Ways to Invest in Uranium
Uranium is a commodity like oil, corn, and pork bellies, and there are several ways to invest.
First, you can own the underlying commodity. This is the least risky option, as your return is directly proportional to the changes in the price of the asset. Also, depending on how you own the commodity, there is no counterparty risk. There is an ongoing cost for owning the asset, and this varies depending on the commodity.
Next, there are futures markets for most commodities. Futures allow investors to benefit from price changes for a commodity linked to a certain date. There is no single price in futures markets, but rather a series of prices based on delivery dates. This is the key difference between futures and owning the underlying commodity. The other is that investors are only required to deposit a portion of the price when they enter the contract, thus allowing for leverage.
Finally, you can invest in companies that produce the underlying commodity, either in their equity or debt. Such companies allow investors to get additional performance on underlying commodities through operating leverage. For example, mining companies typically produce a metal for a specific cost based on the energy needed to haul and process the ore, the cost of finding the ore, the labor, etc. While this cost changes over time, it is somewhat independent of the changes in the commodity price. If the commodity rises in price beyond this cost, it is pure profit for the company. However, this also works in the reverse. There are also the risks of finding the commodity, market valuation, etc.
So, how do you choose which way to invest? That depends on where we are in the cycle for the commodity. If the commodity is near the lows of the past few years and maybe coming out of a bear market, it may not be clear that the commodity is done going down. Producer costs will be close to or above the current spot price of the commodity. In this circumstance, and without certainty on the timing of any catalyst, investors are probably better off investing with the least amount of leverage, which would lead to owning the underlying commodity.
Once a bull market is established, leveraged ways of owning the commodity, i.e., futures or the shares and debt of companies either directly or via ETFs, may make more sense. The options for investing in companies are limitless: owning baskets of stocks, exploration vs. production companies, etc. Suffice to say, there are more types of risks involved, and therefore more homework than just owning futures or the commodity.
These three options are slightly different for the uranium market due to the metal’s idiosyncratic nature. Option one only really exists for people able to invest large sums. Uranium is a highly regulated commodity (after all, it can make bombs), so it can only be stored in a few facilities worldwide, and the entry ticket is large.
Furthermore, since most of the market is conducted in long-term contracts, there is no functioning futures market. Therefore, in the specific case of uranium, most investors look to investing in companies. Fortunately, there are a few specialist companies that function like owning the underlying commodity, providing options.
YCA: The Best Opportunity Now
My assessment indicates that the uranium market is likely in the early stages of a bull market. At this point, I want to own the commodity with limited leverage. Why? One, in case I am wrong. Two, even if I am right, the risk-return is much better for owning the underlying commodity. Given the cost curve previously shown, most uranium producers likely require a price north of US$40-45/lb to restart production, bring planned mines into production, explore for new reserves to replace production, and be profitable. As such, the spot price of the underlying commodity must move more than 50% from current levels of ~US$30/lb (November 17, 2020) before many mines consider reactivating.
For most, there is no direct way to own uranium through futures or physical ownership. There are, however, two publicly traded companies whose only business is to own uranium: Uranium Participation Corp, ticker U on the TSX in Canada, and Yellow Cake plc, ticker YCA, listed on the LSE in the UK. These companies acquire, store, and sell uranium to allow their investors to benefit from the rise in uranium’s price over time.
As a business model, they buy or sell uranium based on the company’s market value vs. the underlying value of the company’s holdings of uranium and cash, which is referred to in the business as NAV (Net Asset Value). The company’s only costs are storage costs, the costs of being publicly listed (director and auditor fees), and management costs.
For example, let’s say YCA has a market capitalization equal to US$200 million, but the value of its uranium and cash holdings is US$250 million. The shares of the company are trading at a discount to the company/NAV’s underlying value. This would signal to investors the company may be cheap and worth buying.
The important thing to note here is that the company can do something as well. The company can buy back its own shares to take advantage of the discount. It can do this by using its cash or selling its uranium at a higher price than the market is valuing it. In reverse, if the market capitalization is at a premium or higher level than NAV, the company can issue new shares to buy more uranium.
For U or YCA, there is no mining risk, and both would likely have to move 50% plus before most mines became profitable. I personally prefer YCA over U for two reasons. First and foremost, YCA has a more explicit source of uranium supply than U, as YCA has a supply agreement with Kazatomprom to buy up to $100 million per annum at spot prices through 2027. This is not to say that U cannot secure supply, but it is much less explicit. Secondly, YCA has generally traded at greater NAV discounts and has been more aggressively buying shares to close the gap.
As of November 17, 2020, I estimate that YCA is trading at a ~30% discount to NAV while U is closer to 24%. This is based on estimated expense ratios of 2% and 0.8%, respectively, as a percentage of NAV. YCA has taken advantage of a persistent discount to NAV by purchasing close to 5% of its shares at a double-digit discount to NAV this year, much more than U’s ~1.5% over the same timeframe.
I should stress that this preference for YCA vs. mining shares and U is time-sensitive. If a bull market continues and prices rally or NAV discounts change, investors will benefit from adding exposures to the core mining companies (and even exploration companies) in the latter part of the bull market.
For my thesis, there are four main risks:
- Perceived environmental risk
- Catastrophe risk
- Higher base expenses for YCA
- Lower relative liquidity for YCA shares
1 and 2 above are sector-related while the latter are related exclusively to YCA and a relative disadvantage to U.
Earlier in this post, I highlighted that nuclear power should be a critical component of a low-carbon energy system. Nuclear and hydro are the only low-carbon baseload power sources widely available. Hydro is location-specific. It is also unlikely that many more hydro dams will be permitted in the western world due to their environmental impacts.
Despite the above fact, many environmentally-focused advocates have sought to shut down nuclear in favor of more wind and solar, despite their more varied outputs. The International Energy Agency, the OECD’s energy arm, researched this issue and found that the world would be better off utilizing its existing nuclear capacity to its maximum useful life rather than shutting it in favor of other renewable alternatives. This is a key risk, and although there are some signs of activists and policymakers becoming more pragmatic about the issue, it is not certain.
Specifically, in an article from June 12, 2020, titled The Covid-19 crisis is undermining nuclear power’s important role in clean energy transitions, the IEA highlights the danger of not extending the life of existing nuclear capacity where it is safe to do so. On a cost basis, extending nuclear facilities is the cheapest (as of 2018) in terms of USD/MWh of all low carbon energy sources, but this approach will require certain policy shifts that are not yet in place.
This price differential can add up. In its report from May 2019, Nuclear Power in a Clean Energy System, the IEA estimated that the costs of ignoring nuclear in transitioning to a sustainable energy system could cost as much as US$1.6 trillion.
The above issue is likely limited to the developed markets in North America and the US. In emerging markets, where nearly all the new nuclear reactors are being built, such concerns are more limited.
Catastrophe risk is real as well, but largely unpredictable—at least in terms of timing. The 2011 Fukushima disaster was the result of a larger than anticipated earthquake. If such an incident happened, it would certainly set the industry back. I believe the impact would be greater if it were to occur in a market like China, the country with the greatest expected growth in nuclear capacity. In such a circumstance, it would be better to sell and ask questions later, as it proved the case for nearly the entirety of the time after Fukushima in 2011.
YCA is a much smaller company than U, roughly half the size based on NAV or market cap, and its size leads to a higher running cost than U. While U burns ~0.8% of NAV a year in operating expenses, YCA burns ~2%. The difference can be compensated by the greater NAV discount and supply agreement, but investors should be aware of the trade-off.
Finally, YCA shares have less liquidity than U. This is a double-edged sword depending on your take, but most will penalize YCA for this, and the reduced liquidity is worth bearing in mind for holders.
For where we are currently in the cycle, I believe investing in uranium offers investors a unique asymmetric opportunity whose fundamentals are largely uncorrelated to the broader economy. Given that we are in the early stages of this process, owning the underlying commodity or a close proxy is the best way to invest. Based on that, a greater discount to NAV, and greater certainty of supply, I believe YCA is the best way to express that view. That said, I don’t think investors would go wrong in buying U, too, if their concern was diversifying single stock risk.
To your investing adventure,
The Castaway Capitalist
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The Castaway Capitalist owns shares of YCA
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