Uranium – It’s all about supply (Part 1)

Investors have pummelled uranium producers ever since the Fukushima incident in March. Some producers have lost more than 60 percent of their value while analysts have maintained their buy recommendations.  Many have focused on the effect of reduced demand for uranium caused by a change in countries’ energy strategies. So far only Germany and Switzerland have changed their energy strategies.  Germany aims to eliminate the use of all nuclear power by 2020 while Switzerland has decided not to build new nuclear reactors. Apart from the lack of alternative strategies or common sense, if Germany and Switzerland actually succeed in transforming their electricity generation (23,591 MWe), this demand loss will be more than replaced by 2013 with 32,692 of new MWe plants coming online elsewhere. 

Currently 376 GWe is produced from nuclear plants globally, and if all reactors under construction are completed by 2016, which is a feasible estimate, then total nuclear electricity generation will be 440 GWe, a 17 percent gain. This figure could potentially balloon to 1,000 GWe if the time frame is stretched to 10 years and beyond (chart 1).

Supply is key!
Therefore the question is not whether the demand for uranium will be there, but rather whether uranium producers will find a demand/supply equilibrium in the market. In 2007 the disruption to mining activity, led by the flooding of the huge Cigar lake Mine in Canada, as well as the fear of lack of supply from Russian Nuclear Warheads and commercial inventories sent shockwaves through the uranium spot market resulting in a price spike of over $80/kg (chart 2).

Volatility in the spot price directly affects the long-term contract price even if contracts are negotiated years in advance (chart 2). Because most uranium is sold in long-term contracts (approximately 80 percent), nuclear generator operators lock-in production for multiple years in advance and most deals are not publically known and are therefore not subject to normal price discovery, leaving miners in the dark. Miners look to lock in these long-term supply rates which can greatly affect capital expenditure budgets for future mining activity and therefore affect future supply.

Approx. 25 percent of uranium used in generators today does not come from regular mining sources. Thirteen percent of this is sourced via the18 year-old Megaton to Megawatt (M2M) programme in the U.S. whereby the U.S. buys HEU (highly enriched uranium) from decommissioned Russian nuclear warheads. More importantly this is set to end in 2013 removing this presently cheap uranium supply from the market. Russian authorities have already stated they will not continue the programme as they can sell the remainder of the HEU at higher prices today.

The crux is whether uranium mines, which are notoriously difficult to approve and develop, can supply the market in time should there be a supply squeeze post 2013. Add to this additional expected nuclear generation capacity of 45,938 MW, being completed between 2014-2017, and we might witness a very dangerous supply shock.

A question of price and Cigar Lake!
Another question which relates to supply is the break-even cost of uranium producers. This is highly dependent on the concentration of uranium ore, with some analysts estimating that a price of 65-80 USD/kg is necessary to spur investment (current long term price is $60/kg).

Another supply uncertainty is the Cigar Lake mine in Canada, operated by Cameco, the largest uranium producer globally, with the potential to supply 20 percent of the uranium market with low cost high grade uranium. This mine flooded in 2006, adding to the massive price spike in 2007. Re-opening of the mine has constantly been delayed but it is now expected to re-commence production in 2013. This is significant because the cost curve of uranium producers tends to spike at around the 70,000 tonne demand level (chart 3).

Given that the current demand for uranium is approximately 70,000 tonnes a year, general supply disruptions as well as the unknown effect of the end of M2M, may force the curve to shift left in 2013. Furthermore, if Cigar Lake re-opening plans fail this might cause a large shock to the expected supply for the industry leaving utilities scrambling for contracted long-term supplies, creating tension in the spot and contracted market, therefore causing a boon for producers’ share prices, which we will discuss in Part 2 of this article.