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Some Thoughts On Cameco And Therefore Mostly On Uranium And Nuclear Power

|Includes: Cameco Corporation (CCJ)

In general

As far as it comes to resource companies value investors are often quite reserved. That is because suchlike types of companies are foremost and manly driven by their underling commodity. To succeed in such an operational levered business you have to make sure that you are the cost leader, otherwise you won't have a competitive advantage ("MOAT") and it's a long shot. The problem is that commodity prices are even harder to predict than business metrics of non-resource companies. There are a lot of macro factors and more complexity to bear in mind. But when something becomes extreme cheap then a value investor's attention might shift to it…

As implied before, in the following we will mainly focus on the commodity uranium, nuclear power and the main factors (from our point of view). Cameco may then be the company of choice as it is the biggest player in the market (~18% of production) and among the price leading producers with also extensive reserves.

A quick notion at the beginning: since we of Searching Value see investing more as an art than an exact science, we feel comfortable with Keynes: "It is better to be roughly right than precisely wrong." So we do not feel the need for "hundred-percent-exact-figures" and always want to use conservative calculations to have a kind of safety margin.

Introduction

From the high in 2007, while the commodity boom, uranium went down ~70% to a $40-level in 2009/2010. Then in 2011 the sadly Fukushima catastrophe happened, caused by a tsunami. In consequence the Japanese nuclear plants were put under status "operation suspended". Also Germany directly decided to completely shut down all their plants until 2022. Since all that, uranium is now down another 50%. In comparison to this last uranium drop, Cameco could hold its level pretty much. All in all you can see (following chart) how dependent Cameco is on the uranium price given the strong correlation over the long-time horizon.

Source: Forbes, SIX Financial Information Deutschland GmbH, IMF, own calculations

In the "bigger picture" the decline of the uranium price goes in line with the overall energy commodities. Moreover according to GMO, valuations of commodity producers are near all-time lows relative to the S&P 500. So in part the depressed uranium price is linked to the whole energy decline and specifically to the sad and dramatically Fukushima catastrophe in 2011 and the reactions/actions on it thereafter.

Source: IMF, S&P Dow Jones Indices

Despite this fuel declines and the Fukushima catastrophe, nuclear power has always beenhated and is associated with the "bad". (I might be a bit biased as a German.) But are these low price levels the "new reality"? Is this all realistic in the longer run? We think there is a lot of disinformation and a much more emotional- than rational-driven debate.

A behavioral view as reason for undervaluation

In the following we want to show a shortened conceptual model (based on the Keynesian beauty contest) which might explain the situation at least in part.

Who are the players in the "uranium-nuclear-power-game"? There are the first-level thinkers (say "the crowd"), driven by (superficial) personal feelings. They view nuclear power as bad and outdated ("the age of nuclear power is over"). Here Fukushima and the developments thereafter appear as a strong anchor. Therefore they avoid uranium and uranium related companies or are active against nuclear power via political activities controlled by NGOs. Next there are the second-level thinkers (say speculators) who consider the behavior of the entire first-level thinkers (which are against uranium) and therefore they might come to the conclusion to not invest or even short everything related to uranium in the market. This may, as a component, explain the depressed price development so far. While watching this price decline, the crowd feels confirmed ("There is no future for nuclear power"). Finally, we come up with the third-level thinkers (say value investors) who question if the second-level thinkers are right with their assumptions. They might conclude that the acting of the second-level thinkers is based on the behavior of the first-level thinkers (a kind of trend-driven acting) and come to the solution that this emotional-driven initial reason can't stay true in the long run, because it ignores the facts of supply and demand. As consequence the third-level thinkers see an opportunity in this short-term driven situation and decide to invest long.

Now, before looking at the supply and demand side, we want to turn to the emotional-driven motives. We want to look at the fears related to nuclear power in general and want to give answers in a more rational perspective.

What do we humans fear specific on nuclear power?

First, the safety of the plants. For us humans risk is often really abstract and it is misunderstood. So the fear of a worst case in relation to nuclear power plants is somewhat present especially after Fukushima, though such an event is really unlikely and not nearly as dangerous as (possibly) associated. When you look at the studies about deaths per PWh, nuclear energy is one of the safest, if not the safest energy form (before all renewable energy forms.) You do not need to take the hard numbers for granted in the following chart. It is just to show that this is a biased discussion. When you focus more on the range, you can see, that nuclear power is relatively overvalued in terms of the real risk and that the renewables (associated with "clean" and "all electricity problems solving technology") are probably not as save as assumed. Surprisingly coal is not as hated as nuclear power but much more people died by this technology.

*All rates are a combination of direct deaths and epidemiological estimates

Soure: Forbes, own calculations

What we often don't get right is the risk that comes along with dangerous acting on a misunderstood or wrong calculated initial risk. After 9/11 people feared flying with planes and switched to cars for longer drives. This sadly led to significant more traffic deaths in the following months. Directly after Fukushima the real hazard came by overreacting. The urgent measures caused by the fear of contamination were in a way ragged so that there were tragically deaths by stress and shortage. We do not want to downplay, but in this kind of emergency rule, human mind is even more open minded to these, in some extent, completely absurd imaginations of the effects of radioactive rays.

Second, the problem of radioactive waste which must be stored to infinity. We first want to say that there is a not so unlikely opportunity that the waste does not have to be stored "forever". Technology evolution likely will bring us a new generation of reactors which can use (nearly all of) the actual waste. But from the standpoint of today we want to counter the waste debate with an image (as we humans are so heavily effected by visualization), to get a better idea of the quantity of waste. The globally produced nuclear waste since the beginning of the nuclear power age is storable at some 4 football fields in 18ft high fuel rods.

Third, the fear of an attack with nuclear weapons. Here the argument against is that there are much more countries which had nuclear weapons before they operated a nuclear power plant. Indeed the decommissioned nuclear bomb materials are used as a secondary supply source for the power plants. Like it was the case with the Russian HEU Agreement ended in 2013.

To conclude it is the image and the history in our minds. There is the image of the destroying atomic cloud. Hopefully not, but biochemical attacks or natural epidemics have the real potential of mass destruction. Only because we have never encountered before does not mean that the potential threat is not around. Again we do not want to harm nuclear energy. You have to take it very seriously! Our point here is, that this emotional-driven debate caused by (unreasoned) fear leads to irrational behavior. The above mentioned risk takes place mainly in our minds. At some point in time illusion might end up…

Business environment

The main consumers of uranium are nuclear power plants (~90% of uranium production). These plants naturally have a stable and very high demand with a capacity factor of over 80%. (The highest among all other power plant technologies.) Moreover when nuclear power plants are build they typical ran. This is guaranteed by regulation. (Here sunk-costs may work in favor.) The price, utilities are paying for the commodity uranium to suppliers like Cameco, is only a fraction of their costs. The majority goes to enrichment and fuel fabrication. So when (and if) prices finally increase, nuclear power plants have economical advantage in regions, where they are price-taker and can't pass on their generation costs. Precise, when fuel cost double in the competitive power market in America, electricity costs for coal and gas rises 3 resp. 6 times faster than for nuclear.

A few words on renewables and energy efficiency

In the stock market you compete against the most powerful and intelligent people. So in terms of the efficient-market hypothesis (EMH), everything is always priced in. With all the declining charts above in mind, is there no more energy needed at all? Or are the renewables disrupting the conventional energy sources?

We will see later on that it is not the end of more energy demand. As it comes to renewables,

probably the best way to evaluate which kind of energy fits best for energy supply or to which kind of energy source you should shift the energy mix is the energetic factor, the EROI (energy returned on invested). In short, it shows the relation between the "produced" electricity over the whole lifecycle of a plant and the whole accumulated energetic expense, for building the plant, operating it, maintaining it and so on. You can say, it shows you how efficient any plant is. The EROI is well discussed and scientists do not all coincident in opinion on the specific factors by energy source. With this in mind (and Keynes) we do not want to take the figures in the table below fixed. But you roughly can say that renewables mostly represent the least efficient electricity generating form if they are at all economically reasonable. (There is intervention in the energy market by heavy renewables subsidization). On the other side, nuclear power shows up with the highest usability, even higher than the "dirty" coal plants. That is truly an argument. When looking to China and the concentrated mega cities with partly heavy fine dust pollution, its heavy investing in nuclear power plants shows up this rationality.

Source: Weißbach (2013)

A quick note on the CO2 issue

As it comes to the CO2 debate and climate change, it is not important which view you have on this in personal. You can fear a nuclear plant (as we have seen above) but please not for their CO2 emission. Nuclear power is one of the least CO2 emitting energy sources and therefore it is liked or at least viewed neutral by the government. On that front there is pretty much no taxability.

The fundamentals of supply and demand or the rational perspective

In general, to consume the production has to come in first. Production itself again depends on the (estimated) demand. With this in mind we want to start with the demand and then turn to the supply side of uranium.

It is estimated that, until 2035, the world electricity consumption growth at ~2% p.a. This growth will be foremost driven by the Non-OECD countries.

Source: Cameco

Nuclear power, as a base load energy, will play a great part of the energy mix with projected growth rates of ~3% p.a. until 2025.

Source: Cameco

Within the next few years some 40 new reactors are expected to come online, nearly half of them in China alone. Cameco is well positioned with ~41% of its portfolio transitioned to Asia.

Source: Cameco

As an indicator for new demand you can compare the average electricity consumption of households from Europe and the world with China and India. Both countries had proper growth rates in the past and we belief that will go on. When looking at the electricity-gap, just to fit with the world standard consumption, both countries have huge upside potential. (Not even talking about Europe.) That chart should also clarify that (cheap) electricity is a requirement for a country to prosper and get out of poverty!

Quelle: Enerdata, Worldbank

On the supply side there is estimated that some 75000t uranium were produced in 2016 and that a bit more than that was consumed. The secondary market - stored uranium in various forms - must fit suchlike gabs. This has always been the case. Today we are in a foremost production-driven market compared to 2003 and the years before, where secondary supply had a much bigger impact. Infect, when looking at the uranium spot price these days it is priced at the 2004/2005 levels when uranium just turned out of the inventory-driven market. Back then yearly production was at ~41000t uranium for roughly the same amount of nuclear power plants as today. The rest was supplied by price pressuring secondary market. Due to Fukushima there are some 50 Japanese reactors that actually do not operate plus the shutdowns in Germany. That causes oversupply and lifts the uranium stockpiles. This near-term development challenged and challenges the uranium price. But when you think of the production curve, how low is the spot price likely to go, with cash costs of produced material at ~$16 for Cameco?

Where is the bottom?

Compared with the other commodities, the uranium price cycle is somewhat longer. On the one hand, you can't come up with nuclear plants when suddenly needed. On the other hand,

most of the supply is delivered via long-term contracts which cause longer price adaptions.

When considering the near-term downside scenario, the truth is, we can't really say for sure, where it all bottoms out. We are aware of the Zeno's paradox, meaning uranium price can have an infinite series of 85% decreases. (Uranium went down 85% from ~$140 to ~$20.) But here is why we don't think it's very likely. Consider the following scenario. Assume spot price levels at around $15 and consider that all of the supply is delivered by long-term contracts (in reality approx. 20% of the volume is transacted over the spot price). We would get prices at some $23-$28. When looking at the global production curve we estimate that in this case half or even more of the (needed) supply has to be sold under cost of production. The miners can't operate for less than their cost of production for long and even the long-term contracts of the still profitable ones run out slowly as times goes by. This increases pressure for bankruptcies and consolidations. With a further widened production-consumption-gab this kind of feedback loop pushes economic conditions even more in favor of the (remaining) low cost producers. The miners would shift their combined long-term- and market-contract mix much more to the latter and were willing to wait (leaving the uranium in the ground) until the uranium price rallies again.

Favorable long-term view

Cameco predicts a consumption-production-gap of ~1/3 by 2025. In that longer run, according to Cameco, the demand has to be bridged with completely new supply. These supply fitting mines take some 7-10 years until built and are yet not in development. New mines will only be build when they can operate profitably. That is only possible at 3-4 times the actual price-level. While looking at these levels we are confident that the market will mean revert to the costs of future production in the long-term.

Source: Cameco

A quick note on thorium reactors

We don't see thorium reactors as a risk for the uranium nuclear power. As it is high promising and may correct all the problems we have with the actual nuclear reactors, it is all still much up in the air. There are lots of small projects and high capital investments are required. The physically beautiful concept is challenged by big material issues, which have to be solved by engineers. Maybe the future for thorium is also not so much in the electricity generating field as the infrastructure is mostly given.

Valuation and Summary

We know we are in a commodity business and we know that there is high operational leverage. We also know that prices are depressed. But all the (emotional-driven) political actions that have happened after Fukushima are now greatly priced in. Indeed we guess herein lays the greatest risk. As power plants take lots of years to complete, a "quick" execution by government can take them offline. With looking forward to more reactor restarts from Japan and new demand coming online by entirely new reactors over the next years, especially from China, we are quite optimistic on Cameco. Moreover we see a nearly "dry" spot market at a $20 mark and believe that the still profitable working miners like Cameco focus on cost cutting and reduction of market activity. If then at a time the utilities' requirements kick in, operational leverage will work in great favor of Cameco.

Source: Cameco

As we don't know what's going on in short-term ("speculation"), we are doing time arbitrage and wait for mean reversion to finally kick in. Meanwhile Cameco's management accelerates its production and is well prepared with its low debt-to-equity ratio of ~20% for the last years.

With the favorable long-term economics, we are quite comfortable with being in rather too early than too late. As the uranium history has shown, chances are not bad, that when the market shifts its view on supply and demand metrics, prices can quickly skyrocket (like with a ketchup bottle).

So if our thesis is correct and Cameco is e.g. under conservative assumptions at least a double you may still ask: when will it play out, given the hard to predict uranium lifecycle and the related macro factors? Then our best answer is: we have time! When calculating with a compound annual growth rate (OTCPK:CAGR) of approx. 15% (take the 10% CAGR of the S&P 500 over the last 29 years as opportunity cost) you can spend Cameco a holding period of 5 years to finally work out. (See next chart.)

Source: own calculations

Now with regard to the 80/20 rule we hopefully came up with the main questions and the right answers in our thesis. Given our thoughts we think that at the actual price level Cameco has a very attractive risk/reward profile.

Last but not least you can take the aluminum and copper price as an indicator for electricity demand. The electrical stakes of the metals are 73% resp. 60%. It seems that both indices have bottomed in late 2015 early 2016 and they stay near or above the 2004/2005 levels.

Source: SIX Financial Information Deutschland GmbH, own calculations

Disclosure: I am/we are long CCJ.

Additional disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article discusses one or more securities that do trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.