Would You Have Made a Fortune in Uranium? (Part 1)

In order to create a fortune worth any mention, it is necessary to at least one very important thing. And that is, to behave differently from everyone else.

Specifically, to do this in the world of investing, we need to have at least a certain degree of the following:

a. A different mental model of the world (or “thesis”), relative to everyone else. 

b. (i) Different and better information on the world than everyone else has.

and/or

b. (ii) A different and better way of analysing the same information that everyone else already has.

-We can either (i) start with different (better) information, and hence find better opportunities; or, we can start with the same information as everyone else, but then analyse it, and then up acting differently 

(c) The mental flexibility to abandon our fixed ideas and prejudices, and adapt to the situation as quickly as possible, usually under uncertain conditions

(there are other ways to be successful, such as by having access to particular forms of financing, but we can leave the more niche ideas for now)

All of the above are the analytical traits you need. But there is also one other element, that of psychological toughness. 

How would you react to catching a tiger by the tail? Assuming you had a good thesis, it started to be proved right, and your investment is now up significantly – Are you going to bail out or are you going to stay in? Or add to your positions?  What information do you use to decide?  Can you hold on to a big gain and not fear losing it? 

This apparently small difference in thinking under pressure will determine a large portion of your ability to bag that fortune.

Note: it might take a while to read this article in full, and to do so carefully. Try to put yourself in the moment – what would you have done at any given step? Check your emotions – is your investment going well? Please do not read this series carefully unless you are not planning to make a fortune.

 

Now, let’s head back, all the way back to….

…the year 2000….

Illustration of French forecast for the year 2000

…when the least interesting thing on the planet is digging on rocks, especially radioactive rocks.

There are some interesting things about the uranium market that have drawn our attention, however, and these are:

It is quite clear that the price of uranium itself is very low. All of the uranium miners have been complaining about it some time, and in fact very few of them can make any money.

It is a market with long cycles (it takes between 10 and 20 years to build a mine), a history of government interference that has led to a huge overhang of inventory, with concentrated production dominated by a few miners, a thinly traded market in the underlying metal, non-transparency in inventories and contracts, and a price that has been declining for ages.

In general, the performance of the rock-digging business depends primarily on how much rocks you dig up, and how much you get for them. For instance, if the cost to dig a bag of rocks is $8 and the selling price is $10, then the gross profit will be $2. If there is $1 of other costs before pre-tax income, then we get to 2-1 = $1 of pre-tax income.

Now, if the price of the rocks doubles, then the income goes from $1 to: $20 (selling px) – $8 (digging cost) – $1 other costs = $11 of pre-tax income, which is 11x up, on only a doubling in the rock price!

This is called “operational leverage”.  

Although a rock-digger’s profits depend on volume of rocks x price of rocks – cost of rocks, since the volumes dug up do not tend to increase hugely until the price justifies more spending on the digging, by far the most important thing we need to worry about is the price of the rocks. 

Uranium is no different, except that the price and inventory cycle is extremely long (knowing this is important)

Production was falling off a cliff in the early 90s (triggered by a Chernobyl in 1986 and US-USSR nuke-reduction treaties), bounced in the mid-90s (partly due to the bankruptcy of one trading company that had uranium inventory, leading to an “artificial” tightening of the uranium market), and then resumed falling again until 1999-2000, which is where our story starts.

There is not a lot of information available about this market. The major players almost all keep quiet. There is little information other than from Cameco’s financial documents.

However, we are getting our inner detective out, now that we know that prices are unreasonably low.

H. Poirot: Is that under-priced uranium with inventories being drawn down?

Essentially, due to the fact that this is a long-run cycle industry, our thesis is that the business should be going from this:

To this:

How do we know where we are in this process? We don’t. No-one really knows. Everything is secretive. We have a few indicators to go on, however.

An excellent overview of the situation we are facing was given by Cameco (CCO CN), in 2000:

First, the former Soviet Union republics entered the western world uranium market and sold large inventories at fire sale prices throughout the 1990s. Uranium was not the only commodity to suffer from these marketing practices in the past 10 years. Second, the cold war ended and suddenly the large stocks of Russian and US uranium from weapons became potentially available and threatened an already weak market. Third, many electric utilities changed their uranium inventory and procurement strategies as their markets became deregulated in the United States and elsewhere. As the utilities moved to open competition, they naturally looked for every opportunity to decrease their uranium inventories and, more than ever, their cost of uranium.

The simple facts remain that the industry continues to produce half of what utilities consume, that almost no new mines are being developed and that inventories continue to be drawn down at high rates.

And this was, in fact, when the shares of Cameco, the largest publicly-traded producer (second largest producer in the world after KazAtomProm, of Kazakhstan), bottomed:

The uranium price at the time looked like this:

CCO’s share price at this time looked like this:

….how ugly! 

Who would want to buy into a dying dog like that?

Now, let’s firstly mention that CCO was supplying about 20% of the global uranium market at the time. 

To put that in perspective, Saudi Arabia in 2018 has less than 10% of global oil market share. The difference of course is that uranium is stored in multi-year inventories, because no one wants to find out what it looks like when a power plant runs out of fuel. By contrast, oil is bulky relative to its usage, and at best we can store a few months of use – at the time of writing, OECD oil inventories (called “stocks”) were 2.84 billion bbl and consumption is about 47 m bbl/ day, so OECD oil stocks cover about two months of consumption – note, however, that once this level drops then shortages start to appear, and hence the comfortable level of oil stocks is way above zero.

So CCO has about double the market supply concentration in uranium as Saudi does in oil, but of course the huge inventories out there dampen the price of uranium. Moreover, don’t you think that uranium can’t go that high anyway, because of its strategic nature, and the fact that governments have big stockpiles? Maybe. But on the other hand, it is a very thin market – only about 15% of volumes go through the spot market (most are on long-term, opaque contracts), and no one really knows what is really going on with those stockpiles. We know that inventories have been falling for years, but how much? This awful market has continued for years – who is to say it won’t remain weak for another decade?

This is the sales (brown) and operating income (blue) of Cameco over the period Mar 1992 – Mar 2000:

Sales have been doing fairly well, but not operating income. Analysts have been forecasting continued pain in the uranium sector, and nobody is really that keen on CCO shares. 

Helpfully, CCO gives an outlook on the uranium market in their annual report (AR). 

The below bar chart is a forecast of consumption and production as of 1999 for the next ten years, from their 1999 AR (published at the time of the above chart).

Note – This is actually not news as of 1999. CCO has been consistently whining about the excess inventories filling the gap between power plant consumption and primary (i.e. mine) production. 

Also note that Cigar Lake is a CCO property, and McArthur River is CCO’s biggest mine.

Chart – extracted view of future consumption and supply, from CCO’s annual report

Essentially, it is pretty clear that without CCO, the uranium market is going to be massively undersupplied. The reason why pricing has been so low is the combination of the inventory overhang with the non-transparency of uranium inventories.

CCO has been cautious on uranium pricing for some time, and in fact they have been investing in a nuclear power plant project.

Here is their comment on prices:

The lower demand, the removal of US trade restrictions on all but Russian uranium and the presence of cash-hungry inventory sellers caused the spot price to soften during much of the year before leveling off in the fourth quarter at its lowest point since December 31, 1973.

Long-term contract price indicators published in the industry fell by 8% during 2000 to $9.25 (US) per pound U3O8. This occurred despite a modest increase in total long-term contracting in 2000. A low spot price leads buyers to expect plentiful and inexpensive supplies causing a negative impact on long-term contract prices.

The increase in long-term contracting seems small, but it is significant, because it means that serious buyers are getting more interested, if only at the margin, in securing supplies.

They tell us that excess inventories (excluding e.g. strategic military stockpiles) fell by 35 m lb in 2000, to 150 m lb. In 1999, the drawdown was 45 m lb, but somehow excess inventories were both 150 m lb in 1999 and in 2000. 

Nonetheless, 150 m lb of U308 is about one year of use in 1999/ 2000, and this is the level at which utilities really need to wake up and start paying attention to security of supply.

———————–

Welcome to 2001!

———————–

In 2001, CCO updated their highly-enriched uranium agreement with Russia, and fixed prices at the low level of the time.

The uranium price looked like this as of CCO’s annual report:

Note that the long-term contract price (grey) is higher than the spot price (blue)

An IAEA report released in 2001 included the following table:

Notice how they expect production to continue declining from 2001 to 2005. This is great news for us, as potential uranium investors!

This is CCO’s share price just prior to their earnings release:

Chart – CCO: white line; S&P500: orange line

Just after earnings:

Their results were quite good, and this is what the analyst community and traders are mainly reacting to here. 

However, there is something else, in the comments: 

From their annual report (Apr 2001):

When will uranium prices improve? It is impossible to know with certainty and our track record in forecasting price trends has not been very good. At year end, uranium spot market prices were about $7 (US) per pound, near historic lows, compared with about $16(US) in 1996. At Cameco, we believe they cannot go much lower as world uranium production is less than half of consumption and most of the world’s mines are simply uneconomic at such prices.

Although they say that they cannot forecast prices, they have, perhaps inadvertently, given a huge “buy” signal through these two important facts:

    1. Pricing cannot go much lower due to most mines being uneconomic at these price levels

    2. Inventories have fallen to a level that is significant 

These two facts alone should make us establish a position in either CCO itself or, more realistically, some of the more speculative miners that are moving towards production.

It is also noteworthy in the charts above that the CCO share price seems to have bottomed just as the S&P 500 (SPX, orange line) has topped out.

Let’s hold on to our positions and watch what happens. 

Around this time, nuclear power started to be viewed differently due to the combination of the California energy crisis of 2000-2001 (thanks, Enron!), increasing input costs for competing electricity generation plants (gas and coal), and increasing understanding of global warming:

———————–

Welcome to 2002!

———————–

This is a comment from CCO’s 2001 annual report, published in Apr 2002:

Generally, from a marketing perspective, one should mention two noteworthy developments. In 2001, and for the first time in five years, the uranium price ended the year above its starting point.

Comparing the uranium demand with our best estimates about potential supplies, we at Cameco believe that new uranium production capacity will be needed, in addition to what is planned, including Cigar Lake. We also believe that the uranium price will have to move well above its present level for this to happen.

This is what uranium price looked like:

At this was CCO’s share price at the time of the earnings :

Everything is looking great, right? How do you feel about your new investment?

Well done, you can sit back and relax.

Until… 

…wait…something bad is happening…

Chart – White line is CCO, orange in top panel is another uranium company. Bottom panel – S&P500.

Perhaps you should get out of this investment? Just take your losses and run. The overall stock market is falling, and the newspapers are full of negative stories. 

Just because the uranium market may have bottomed does not mean that the stock cannot for another 50% from here. Are you going to sell?

Maybe we should think a bit about what caused the decline.

This decline was due to Bruce Power, a nuclear power company that was then 15% owned by CCO. It had 4 reactors at the time. 

The other 85% was owned by British Energy, which was at risk of going bust (this would be pretty bad for CCO). 

However, the British Government stepped in and loaned a lot of money (c. 400m GBP) to British Energy to make sure that it had enough working capital to keep operating (very good for CCO).

However again, part of the deal at the time was that the British Government needed financial guarantees from Bruce Power. 

This meant that if British Energy continued to screw things up, then Bruce Power could go bankrupt and CCO’s ownership in it would be worthless (bad). 

On top of that, two genius analysts decided that this would be a great time to downgrade the stock. 

Obviously, it is pretty typical for an analyst to downgrade when the stock is down, and then upgrade when the stock is up – and this is exactly what happened during this period with CCO. 

The analysts, Victor Lazarovici and Ian Howat (at two different banks), decided to respectively downgrade the stock to CAD 37 (from CAD 45) and from CAD 30 (from unknown), which is about where the stock was at the time (the above chart is adjusted for splits). Well done guys!

Note that, in the above chart (top panel, orange), Paladin Resources is shown as an example of another uranium company, and it has received essentially zero interest lately.

CCO’s stock manages to recover when the market figures out that the uranium mining operation is worth a lot more than Bruce Power, so a 50% decline is too much.

Then, in Apr 2003, together with their annual results, CCO announce the flooding of their massive McArthur River mine (the mainstay of their uranium production). 

The headline reaction was obviously bad. McArthur River is their main mine, and their second source of income was their Bruce Power investment. 

They said it would take several months to dewater the mine.  Maybe now is the time to sell?

This time another genius analyst, Greg Barnes, lowers his target price due to this issue.

However, since McArthur River is such a large contributor to world production, this is actually bullish for the uranium price, and hence positive for the stock.

A simple cause-effect mode of thinking would lead to an expectation of the gains in the uranium price to reverse. However, this is not what happened – the market for the metal and for CCO’s (and other miners’) stock started to take on a momentum of its own. Identifying this sign was extremely important, considering that we already knew that we were either past or near the end of the inventory-liquidation stage of uranium inventories, and even slight tightening of supply may lead to higher prices.

This is the uranium price at the time of the mind-flooding announcement: 

Source: The Tide of Fortune