Wednesday, September 29, 2010

Uranium: How to play it and Why

  • It's something of an afterthought today, but Uranium was a really trendy investment a couple of years ago as crude oil was getting up near $140/barrel.

That was the summer of 2007, and right around then Mike and I were visiting a very large, very successful, very famous New York-based hedge fund that will remain nameless. Trust me, though. You've heard of these guys.

In every trader's office was a gigantic white board. We have a white board in our office too and it's where we sketch out all of our early-stage ideas. So I made a point to pay attention to the stuff on their white boards. It was sort of like being allowed to have a free peek at what goes on inside the mind of geniuses.

On nearly every single white board was "Uranium." Sure, that was then and this is now and a lot has changed since the world was staring down the barrel of peak oil and stratospheric power bills. But investing in nuclear energy was one of their major long-term macro ideas.

If this idea was good enough for one of the best hedge funds in the history of hedge funds, might it be good enough for the rest of us? Our long-term macro thesis is that we are on the doorstep of a decade of hardship and investors are going to have to work a little harder than they did during the last few decades.

Could Uranium and nuclear energy make life a little easier and more profitable for us all?


How nuclear works

Nuclear reactors are pretty cool. You know we like to talk about other things aside from the nuts and bolts of investing so I'll give you a quick, non-technical explanation of how it works. Remember that it is all connected; you never know where knowledge will take you, however insignificant it may seem at first.

Uranium-235 is one of the few elements that can undergo a fancy process called "induced fission." For the non-scientists, "fission" is just a fancy way of saying "division." Anyway, if you put a chunk of Uranium into a reactor and throw some neutrons at it, one of those Uranium-235 atoms will split and in the process release a couple of extra neutrons. Those neutrons will then collide with other U-235 atoms and cause those little atoms to split and release some more neutrons. The chain reaction continues. Every time one of these atoms split, energy gets released. It releases quite a bit of energy too: one little uranium fuel pellet contains the same amount of energy as an entire ton of coal!

If you put these Uranium fuel rods in some water when you throw neutrons at them, the surrounding water will heat up as all this energy is released. When the water heats up it turns into steam. Then we use that rising steam to turn a big turbine which generates electricity the same way a windmill does.

It's actually quite simple.

The good news about Uranium is that it's naturally occurring in the Earth's crust and there's a whole bunch of it out there. According to the OECD, there's enough uranium on the earth to last for at least a century at current consumption rates. It's not the solution to the world's energy demand woes, but it's a part of it.

The future for Uranium

Here's a chart of Uranium prices: (Click to enlarge)

saupload_uranium_jul10.pngYou guys have been hanging around long enough here to see what that chart's all about. It's a bubble!

As you can see, Uranium prices didn't really go anywhere for a long time. A lot of that had to do with the fact that pretty much everybody in the world stopped building nuclear reactors after Three Mile Island and Chernobyl, and so there wasn't any new demand. Politics also played a big role too as politicians weren't sure how to sell the issue of storing the nuclear waste. Keep in mind nuclear power plants don't pollute and there are plenty of ways to safely process the waste. But, whatever. The phrase "nuclear waste" carries certain connotations. Public perception and politics are the biggest hurdles for the industry and its future.

I doubt Homer Simpson has helped either.


But that perception is slowly changing as traditional forms of energy are getting more expensive and demand for electricity continues to rise. The U.S. has indicated that it seems to favor coal since we have so much of it, but nuclear energy will play a role too. It was a big part of Obama's and John McCain's campaigns, but Obama hasn't been as aggressive about pushing nuclear since he got elected. Hmm.

In any case, we're all getting a little more open-minded about the idea again and according to Gallup, support for nuclear power is at an all time high of 62%. That's good, but still nowhere near the support we show for other forms of energy. Ultimately, the only thing that will get the U.S. to really embrace large-scale nuclear development will be higher prices for coal, oil, and natural gas. The U.S. has a pretty good track record of compromising its moral values when it involves lower cost or higher profits.

On a cost-per-megawatt basis, nuclear is cheaper than wind and way cheaper than solar. But it's still more expensive than coal and natural gas, which in this country is suuuper cheap. (C'mon people, get on board with the Pickens Plan!) The Department of Energy just published a fairly comprehensive report about the relative cost of various forms of energy. It's worth a look. Watch these annual reports from the DoE and when you see nuclear becoming a relatively cheaper option I'd expect the U.S. to start to show legitimate excitement for it.

Other countries feel much differently about nuclear energy. France generates about 80% of its electricity from nuclear plants and they have the cleanest air of any industrialized country and the cheapest energy in all of Europe. South Korea is increasing its number of reactors by 50% and will eventually be generating over half of its electricity from nuclear sources. Would you believe that even the United Arab Emirates, the third largest oil exporter in the world, has proposed construction of 11 nuclear power plants? India currently has 6 plants under construction and another 23 on the way. China has a major energy need in the coming decade and nuclear power plants will play a major role over there. Last month, China made a big public announcement that they were going to buy a bunch of yellowcake this year and in the years to come. They're planning to build at least 60 new nuclear reactors in the coming decade and have proposals to build 120 more.

It takes a while to get a new reactor built and fully operational. But that's a lot of additional Uranium that the world is going to need. I think that the expectation of future demand has put in something of a floor in prices over the last couple of years. The bubble euphoria has died out and the market is now starting to look ahead towards the future with some sense of rationality. Prices make sense again.

On the supply side there was about 50,000 tons of uranium mined last year around the world. All of that uranium already had demand from the current marketplace, from existing nuclear reactors. To put China's plan into perspective, they alone may be demanding an additional 20,000 tons/year of uranium by the end of the decade. That new supply is going to have to come from somewhere or the price of the existing supply will need to increase to clear the market. It's simple economics, and quite beneficial if you're in the business of mining uranium.

That's a good way to execute our investment thesis too, from the supply side.

How to play it

This is a long-term investment. Uranium is for investors who are looking out a decade or two and want to add some interesting, alternative investments to their portfolio. A lot can happen between now and then. You can't just put on the trade and hop through the wormhole with profits waiting for you on the other side.

Anyway, the easiest and most direct way to do it is through the stock of a company that mines it.

Cameco (CCJ) is the first to look at. They're the biggest. They're a Canadian company which scores them points right off the bat. Canada has a better base currency and a government much less prone to monkeying around with the private sector. The regulation up there is not as onerous and inefficient as it is in this country, nor does it carry the same degree of political correctness, which matters with something like nuclear energy.

China has a contract with Cameco to buy a bunch of uranium over the next 10 years. There really aren't that many companies in the world as engaged in mining Uranium, so barring any meltdowns in China (and I mean that literally) the demand will be there for Cameco's product.

Cameco has an excellent balance sheet, too. They've got about $1.5 billion in cash, about $5 billion of Uranium reserves, and less than $1 billion of debt. They generate good free cash flow and their 34% profit margin is outstanding relative to their peers. If I'm going to make an investment in a company for the next decade or so, that's the kind of corporate foundation I'd like them to have.

It trades over 20 times next year's earnings. So the stock is a little pricey. But at least there's some firmness in the foundation. There are far too many stocks out there that trade at high multiples based only the promise of an idea, with neither sales nor a balance sheet to back that up.

Generally speaking, I'm a fan of the perspective that the ubiquitous Dennis Gartman is always promoting. He wants to own stuff that hurts if you drop it on your foot, stuff like gold, copper, steel and coal. He also likes the stock of companies that dig this stuff up out of the ground and sell it to countries that need it. Cameco is squarely in that category.

Paladin Energy is another to take a look at (PALAF.PK). They're based in Australia and they have a couple of mines working in Africa as well. They're a much smaller miner -- only about $115 million of revenue last year -- though they seem to be on the rise, developing new mines. They're not a bad bet if you want a little more spice.


Olympic Dam Uranium Mine

BHP Billiton (BHP) owns the world's largest Uranium deposit, Olympic Dam in South Australia. But Uranium is a relatively small portion of all the stuff BHP Billiton mines. If you want a bigger, broader, more diversified mining company then check 'em out. Their stock is somewhat expensive as well, trading a little over 20 times next year's earnings on the back of a simply phenomenal decade. The next 10 years aren't going to resemble their last, but relative to the rest of the market, you can do a whole lot worse than a company like BHP. They produce all the stuff that the developing world needs and they're a direct play on resource-driven global growth. Even we market bears need a little bit of that in our portfolio.

I also just noticed a nice interview over at Seeking Alpha that covers a bunch of other different uranium-related companies. Most of the names are small, but the article is a great supplement to this one.

From the demand side

You can also buy the stock of a power company that operates the plants. Exelon (EXC) is probably the best and certainly the biggest of breed. Over 90% of their power plants are nuclear and they operate the largest fleet in the nation and third largest in the world. It's a pure play on the energy generation side, a way to take advantage of rising U.S. demand for nuclear power should that someday happen.

These guys get me a little more excited, if only because they're a little more boring. I told you I was an odd bird. Exelon trades at only 10 times next year's earnings, but hey, they're a utility. Growing revenues isn't exactly their gig, but that could happen if the U.S. gets more serious about nuclear plants. They pay a 5% dividend which is very cool. And they only have about $11 billion of long term debt against $25 billion worth of power plants and another $25 billion of cash, receivables, and other assets. Their operating margins are also fantastic, underscoring the efficiency of nuclear power in general and their plants in particular.

It's interesting to see that trait on both sides of the uranium coin. Remember what we all learned in our college Econ classes? Firms with higher margins have better pricing power. That's really important in the world of commodities -- it's profitable for shareholders when demand is strong, and should demand weaken there's already a built-in cushion to absorb some of the slack.

Electricite de France (ECIFF.PK) operates the biggest fleet of reactors in the world and they've been doing it for a long time. Despite their $75 billion market cap, their stock only trades on the Pink Sheets in the U.S. If your broker offers global trading and the ability to buy stuff on the French exchange (Euronext) you might be better off doing it that way. Be aware of the currency risk, too. Your stock will be denominated in Euros!

If you'd rather not deal with that hassle, another option is the Market Vectors Nuclear Energy ETF (NLR). Electricite de France is the single biggest position in that fund and Exelon is number two. Plus, you get exposure to a basket of other energy companies and uranium miners. This fund was launched almost exactly at the peak of the Uranium bubble, which probably shouldn't come as a surprise. It was a sign of the times. The ETF hasn't performed very well since then, which also is not a surprise since Uranium prices have collapsed. But now that prices have stabilized there is potential on path from here forward.

PKN and NUCL are other exchange traded funds you can buy to get a basket of nuclear names, but these funds are quite a bit smaller than NLR.

As with any stock, these companies will fluctuate with the market. My guess, though, is that these are much better bets to outperform the market over the next decade than a lot of other companies out there.

A final caveat

Ultimately, I'm of the belief that the best way to play alternative energy is through traditional energy companies. All these wind, solar, and nuclear companies may be great investments some day, but there doesn't exist a world in which alternative energy does well and traditional energy does not do well. That's a tricky concept, so I'll repeat it a different way: a wind energy company is only a good investment if the price of coal or crude oil gets very high. Should that happen, then a coal miner or traditional oil & gas company has also been a very good investment. I think that traditional energy is a lower risk way to play alternative energy.

But when it comes to alternative energy, Uranium is clearly the way to go. The margins are much better than wind or solar, and it's a much more practical way to generate electricity (on a cost-per-megawatt basis). I know Greenpeace still hates nuclear, but surely they have to understand that wind and solar can't come anywhere close to satisfying the world's energy needs, and certainly not at the price it would cost to do so. Nuclear energy is an interesting middle ground, a blend of practical efficiency and less environmental impact than coal or gas.

Odds are this kind of thing will probably be a pretty boring investment. There are a few risks -- both general economic risks and uranium-specific risks -- to consider, and make sure you consider them and size the trade appropriately. In aggregate, it boils down to an investment with:

  1. limited downside
  2. quantifiable and stable upside
  3. the chance for substantial appreciation if the cards fall a certain way

Most of the stocks in this sector are trading at relatively low levels, having been forsaken by investors for flashier opportunities. I don't think that's such a bad thing, though. I like out-of-favor investments where you buy a little bit and stash it away. I think the odds are high that the U.S. gets really excited about nuclear energy and Uranium again at some point in the coming decade. I haven't a clue when that could happen. But when it does these companies will get exciting again and the market will reward them with higher multiples.

We're still in the first inning of a brand new game for nuclear energy.

(The above article is by Jeffrey Dow Jones of Draco Capital Management. Blog: The Draconian)