Uranium Supply and the Effects on Cameco (CCJ)

Investment Summary

• Supply side analytics show slowing production and draw down of inventory
• Boom era uranium exploration created myriad production assets easily exploited in the event of a dramatic price increase            
• Companies continue to delay new explorations and recognize impairment charges
• Weaker suppliers are propped up by joint ventures with larger competitors and government interests

The major uranium producing companies continue to produce less uranium than they sell. The tactic is to reduce inventory levels while also reducing operating costs. The depletion of inventories is meant to decrease the available supply of uranium. As the chart below shows, over the past three fiscal years three of the largest uranium producers have used inventories to cover 16.6% of sales.

The top seven uranium producers in the world, less Cameco have decreased production by 21% percent. Production levels will continue to decrease while companies rely on their cheaper reserves. As spot prices react to marginally lower inventories and production levels, we anticipate variable priced contracts to recognize a marginal increase in average realized price over the next three years. Due to the limited nature of speculation in the spot price market, it takes drastic supply events to create a swift increase in price. The continued decrease in production is slow and calculated, which lends itself to a more gradual long-term increase in average realized price.

In 2007 when prices climbed more than 100% in one year, production only made up 60% of annual demand.  That dramatic price increase flooded the uranium exploration market with capital, anticipating long-term high prices. As companies began pouring money into mine development and ramping up production, Japan was hit by a tsunami. The tsunami deactivated large nuclear stations, drastically reducing global demand. The tsunami created a nuclear energy panic attack and fear swept through the market. The inventories that had been built during the boom era found nowhere to be delivered and new mine developments produced more uranium than was needed. The increased production capabilities and inventories are still having an effect on the market today. The market is weary of the production capabilities if prices increase. Mines that have slowed can easily be ramped to increase production. Exploration projects that have been set aside can easily be reevaluated if the market makes them profitable. The ease by which uranium companies could ramp up operations creates a very slow price environment.
    

As production continues to ramp down companies are realizing impairment charges on new mine projects that are being delayed due to the low price environment. The charges are cut into the short-term earnings of the companies, but are vital to the long-term financial health of a company operating in this environment. Net income numbers are healthier than they initially appear. They are skewed downward mostly as a result of many one time non-recurring costs such as impairment charges or write-downs of deferred tax assets.
      

Cameco and Areva are two of the two largest uranium-mining companies in the world. In 2015 they provided almost 40% of the world’s uranium. They both exclusively mine uranium and have joint ownership of the two highest yielding mines in the world. These high yielding assets allow them to maintain high production levels even in a low priced environment. The absolute highest average cost per pound for these companies are $30.97 and $34.11 respectively, while their average realized prices were $45.19 and $52.29. These large profitable companies have joint ventures with many smaller uranium companies at lower yielding mines. Six of the ten largest mines in the world are operated by two companies. Companies are legally required to split the production of joint venture wells. While the capital expenditures are proportional for both companies operating, the larger company brings with it resources and infrastructure to better maintain production levels. In many instances, the larger company does not have the option to buy out the smaller company because the country the mine is in requires a non-foreign operator to be involved in production.

Furthermore, many companies both large and small have governments holding equity in the companies. Areva is in talks with the China National Nuclear Corporation to buy equity in the company. This not only gives Areva a capital resource, but also monopolizes China’s growing demand for uranium. Kazatomprom is a uranium producer wholly owned by the country of Kazakhstan. The state ownership allows it a continuous flow of capital even when it is operating in the red. These factor ultimately lead to the conclusion that it will take drastic price decreases for any major competitor to stop production altogether and declare bankruptcy. The market will remain fairly price competitive into the medium term, with only slight increases in spot price.

      Conclusion                                                                                                                                    

For every factor that could influence a price increase there is an equal and opposite factor preventing it. Production and inventory levels are being slowly and steadily drawn down which lends itself to a slow and stable increase in price. The boom era of uranium created a reserve of production assets that can be deployed in the event of a substantial price increase, effectively mitigating it. At a spot price of around $50-$55, reserves found during the boom era become profitable to mine. These reserves create a price ceiling that weighs on the market. Serious competitors will not stop operations unless prices continue to fall dramatically. The troubled companies are propped up by state interests and benefit from joint venture operations. We forecast a five-year spot price target of $42 per pound and a ten-year target of $50 per pound while current spot prices are at $30 per pound. 

Through discounted cash flow modeling we combined projected uranium prices and projected sales volume to get a present value of the company. The price target for Cameco is $13.32 per share, a 10.6% premium to the current share price.