By Chris Berry
- On Monday, the Wall Street Journal published an article titled “Commodities Rally is Half Baked” (sub, req’d).
- There are a number of reasons for this, but clearly excess supply is the main culprit.
- Not all commodities have under performed, however, and uranium offers an interesting and painful case study into how to equilibrate supply and demand.
An Unfortunate Validation of Our Thesis
Yesterday, the Wall Street Journal published an article titled “Commodities Rally is Half Baked” (sub, req’d). The gist of the article is that while 2014 started off as a positive year for commodity returns in general, the tide has turned and many commodities (as measured by various indexes) are now under performing the typical equity index as the latter continue to reach all time highs.
Our thesis of global excesses in labor, capital, and money across the globe keeping a “lid” on much of the commodity complex would appear to be in tact.
There are several reasons for the stumble in commodities including weather, but ample supply is the real culprit and this has affected various commodities from gold, to grains, to oil and gas. Regarding oil and gas, the WSJ article states,
“Despite four million barrels a day of global oil supply being offline—around the highest since the Gulf War—according to BofA Merrill Lynch, prices are down for the year. Rising U.S. supply and recent cutbacks in estimates for global oil consumption in 2014 are offsetting geopolitical turmoil. Meanwhile, a cool summer in the eastern U.S. has undercut an earlier rally in natural-gas prices.”
On grains and gold,
“Citigroup forecasts seasonal records for U.S. corn and soybean harvests. Having rallied 21% by the end of April, the Bloomberg Agriculture subindex is down 5.5% year-to-date. In the gold market, miners added 13% more supply in the second quarter, year over year, even as demand fell 16%, according to the World Gold Council's latest report.”
I’m somewhat disinclined to believe that the current gold price is due strictly to excess supply with discussion of price manipulation always looming, but the general thesis remains that until these global excesses are mopped up, successful commodity investing will involve focus on a narrow subset of raw materials – in our case the Energy Metals.
Add to this some quite frankly terrible economic data. Europe continues to stumble forward based on almost any economic measure and German two year bonds now have a negative yield. This means investors in German two year bonds are putting a hefty premium on safety but the more significant point is that essentially YOU pay the German government to take your money!
With the looming end of Quantitative Easing in the United States, the Fed shows no signs of altering its balance sheet and will maintain its size going forward (over $4 trillion). For all the pump priming we have endured with successive rounds of QE, the benchmark 10 year bond currently yields 2.37% as I write.
These are not signs of economic strength.
Pockets of Improvement and Opportunity
Despite the troubled macroeconomic picture, there are pockets of opportunity and several metals seem to be holding their own or showing slow and steady price improvement. One of the investment criteria I like to use is to find those metals/minerals that demonstrate near and long term growth potential at growth rates above global GDP. This is why lithium, cobalt, graphite, and scandium are among my current favorites. It should not be surprising to anyone that these metals and minerals have also shown price resilience in 2014.
Another metal is uranium, with the current spot price of $31.63 per pound (as of August 21, 2014). U3O8 has seen a 10% spot price rise in the month of August though is still down over 8% YTD.
There are a number of reasons for this, but the most apparent are geopolitical and labor-related. Russian agression in Ukraine has led to numerous economic sanctions with Australia threatening to ban the sale of uranium to Russia at the forefront. Despite the fact that Russia has plentiful uranium supplies within its border rendering any Australian or other uranium sale ban toothless, sometimes optics are more important than reality in moving markets and it appears that this is the case here.
Regarding labor issues, workers at Cameco’s (CCO:TSX, CCJ:NYSE) McArthur River mine and Key Lake mill have voted to go on strike, potentially curtailing output from the world’s highest grade uranium mine. With a licensed capacity of 21 million pounds of U3O8 and 2013 production of 14 million pounds, any significant work stoppage could result in 10 - 15% of global supply being interrupted.
Perhaps the most obvious answer to the uptick in uranium prices lies simply in the actions of uranium producing companies to bolster their balance sheets and remain profitable in the low spot and term price environments.
The recent earnings report from Uranium One is instructive in this vein. The release offered interesting detail on costs and realized prices:
“The average realized sales price of produced material during Q2 2014 was $29 per
pound, compared to $43 per pound in Q2 2013. The average total cash cost per pound of sold material was $14 per pound during Q2 2014 compared to $19 per pound for Q2 2013.”
So despite the cash costs falling, the average selling prices fell faster which hurt overall results. Like other mining companies, Uranium One has been shedding assets to streamline its operations and enhance returns. Late last year, the company announced that the Honeymoon deposit in Australia would be put on care and maintennance due to it being uneconomic at current prices. So weak results in Q2 were helped by the decisionmaking of company management regarding closing down future revenue streams (projects). A focus on organic growth, or squeezing more “juice” from the same lemons is the current way forward for uranium producers.
The challenging times for uranium investing are set to continue until a new supply and demand production level and price are attained. I still maintain that uranium will get much more exciting in the 2016-2017 time frame and I’m finding myself increasingly isolated in that view with other analysts thinking it could be 2018-2020 before the next leg up in uranium occurs.
The keys to watch going forward remain the same: First, watch for utilities and the deals they consummate for uranium. It appears that utilities are viewing uranium as a “falling knife” and are content to wait to enter into long-term deals in hopes of locking in lower prices in the future. This may seem penny wise and pound foolish, but with ample supply on world markets, this strategy seems prudent.
Second, maintain a focus on the lowest-cost producers or near-term producers in the uranium space. These companies should offer the best opportunity for near-term share price appreciation. Additionally, they are potential takeover candidates and are accretive to almost any current producer.
Finally, if you’re a true “believer” in the future of nuclear power (and it’s hard not to be with the growth projections in Asia), evaluating uranium hard rock development stories could be a wise move. You can think of these stories as long-term out of the money call options. Hard rock deposits by and large are not economic at current spot (or term) uranium prices, so if you see uranium at $75 or $80 per pound in the coming years (I don’t), purchasing shares in hard rock uranium development companies could lead to gains. Patience is key, though.
The recent uptick in uranium appears to be due to the fact that the commodity price has been too low for too long with a majority of global production operating below cost. This can’t continue indefinitely and we’ve seen how companies such as Uranium One are dealing with this reality. As this mindset takes hold across other commodities like copper and iron ore, the “turn” so many of us are looking for will finally be upon us. Until then, a focus on low cost production stories or Energy Metals with growth rates above global GDP is a prudent strategy.
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