Huntleys wrote an article on this very subject last week. I dont...

Huntleys wrote an article on this very subject last week. I dont know whether I should do this but here it is in full:
The Rudd government is talking a hard line on
global warming and carbon pollution reduction.
Regardless of the veracity of global warming
science, Rudd can decide to take a sledgehammer
to coal fired electricity and coal mining. The
proposed Carbon Pollution Reduction Scheme
(CPRS) amounts to a tax on energy and potentially
exports. A "tax" consumers will ultimately be forced
to bear! Australia is particularly reliant on fossil
fuels, coal for electricity and oil for transport. We
produced 584Mt of carbon dioxide in 2008, 1.5% of
global emissions. On a per capita basis we are
roughly on par with the US, 4.5 times greater than
China and 20 times higher than India. But this figure
partly reflects the high carbon intensity of our
exports, carbon produced here but consumed
overseas. For example, in FY09 Australia produced
317.7Mt of black coal and 82.4% was exported.
The government committed to cut Australia’s
carbon emissions by 25% from year 2000 levels by
2020 to 415Mt. That relies on a global deal to
stabilise CO2 equivalent at 450ppm or lower, due to
be decided at Copenhagen in December. Agreement
will be difficult. We doubt major growth countries
like China and India will be prepared to place their
economies at a comparative disadvantage. With
low per capita emissions compared to developed
countries, they could in fact argue for a per capita
increase. That is their argument to date, which of
course sidesteps the major point: the total volume
of emissions.
It’s against this background we start to explore
alternatives. What investments will provide a
hedge against aggressive carbon policy? Hydro has
merit but limited Australian opportunities were
privatised by Industry Funds Management. RIO
acquired hydro power with its Alcan purchase in
2007. It is currently eeking value from those assets
via aluminium production, though competing with
every other low cost energy deposit in the world.
Capturing a green premium would help RIO if
competitors were made to pay a carbon cost but
even so it’s barely enough to shift RIO’s dial. The
state of the aluminium market is more important
and thanks to Chinese overinvestment, it’s messy.
Wind and solar are generally unattractive. There
may be niche plays that make sense but as
potential baseload electricity they are unattractive.
Total costs are high. Power companies built on
wind and solar could be vulnerable in times of
lower pricing. Investing in industries reliant on
subsidies is a risky strategy. Governments will not
underwrite large profits and public opinion can
change policy. Subsidised industries can be wiped
out with the stroke of a pen.
Uranium is a potential insurance policy, on this
measure. The mushroom cloud threat is on the
other side of the equation but for the moment those
concerns take a back seat to greenhouse. Nuclear
power has an operating cost advantage over gas
and a carbon advantage over coal. Further it is a
way to reduce energy reliance on less politically
stable countries. A little goes a long way though
the number of suppliers is low. High capital costs
are a drawback but in the long run nuclear can
provide cheap reliable power. For the far sighted
Chinese we can see the appeal, it can help them
build a long term competitive advantage. Cameco
says there are 436 nuclear power stations
operating in 30 countries producing 15% of global
electricity. Compared to coal, the 172Mlbs U3O8
consumed saved 3Bt of carbon dioxide emissions.
Canadian uranium major, Cameco, expects 115 new
reactors to be built by 2018 and 18 closed,
expanding capacity by 20%. Current capacity is
390GW. Paladin takes a much more aggressive
view and suggests global capacity may double
thanks to China. We think it’s likely the truth will be
somewhere in the middle. In July the China Daily
reported Beijing's desire for 86GW of nuclear
generating capacity by 2020, compared to just 9GW
now. The plan is part of the alternative energy
development plan which includes 150GW of wind energy over the same time. India wants 20GW of
nuclear capacity by 2020.
Each new reactor consumes roughly 500,000lbs of
uranium – approximately US$25m in annual fuel
costs. That compares to 3.5Mt of coal, worth
approximately US$245m, 12 million barrels of oil
worth roughly US$800m or 77bcf of gas worth
nearly US$400m. Fuel is less than a quarter of the
production cost for a nuclear power station. Oil's
utility in non-generating applications dictates a
price premium over energy products. Still, there is
potential for the uranium price to close the value
gap given the backdrop of emerging world growth
and carbon limits.
Supply
The world consumed 172Mlbs of uranium in 2008
of which around two-thirds or 114Mlbs came from
mines. The remainder derived from reprocessing of
secondary sources including old military stocks.
Assuming a price of US$50/lb, the uranium fuel
market is worth almost US$9bn a year. That's just
6% of total primary energy demand versus 38% for
oil, 32% for coal and 26% for gas. BHP's relatively
modest 4,000t of uranium production in FY09
contributed just 5% of global supply. But in energy
equivalent terms that was 2.5 times more than the company's total oil and gas production of
137.2mmboe. Uranium revenue is barely a blip for
BHP but the energy output dwarfs arguably its most
valuable segment, oil and gas. BHP expects nuclear
to be the fastest growing source of energy demand
over the next two decades.
Importantly, much of the globe's uranium supply
comes from two first world countries – Australia
and Canada. No doubt this has enhanced uranium's
appeal. But many recent additions to supply come
from less desirable locales, Kazakhstan and Africa.
If uranium is to be viewed as a hedge against
higher energy prices – driven by either underlying
demand or carbon policy – it makes sense to stick
with miners in first world countries. Over the next
10 years, Cameco expects an additional 40Mlbs a
year of uranium supply will be needed to satisfy
world demand. That may prove conservative if the
carbon taxes are embraced globally or China and
India move more strongly into nuclear.
So how do you play uranium? We look for the same
attributes as for any mining company – sufficiently
large, low cost, high margin, long life, first world
location, conservative gearing and quality
management. There are probably only five that
warrant consideration for most investors; BHP, Rio
Tinto, ERA, Paladin (PDN) and Extract (EXT). There
are many more hopefuls, but it’s a bit like the tech
boom. Few if any will make it into production and
picking the 1 in 100 winner probably needs as much
luck as skill. BHP, RIO, ERA and PDN are already
producing. PDN has sovereign risk. EXT sits next
door to RIO’s Rossing mine and also looks to have a
good chance.
The table shows how the uranium exposures stack
up on resources and reserves. BHP is the clear size
leader via Olympic Dam, the largest uranium
resource in the world. Grades look comparatively
low but the vast majority of Olympic Dam’s revenue
comes from copper with modest contributions from
gold and silver. BHP also has a resource at Yeelirrie
in WA, estimated in 1982 to contain 116Mlbs grading 3.3lbs/t. Not meeting current reporting
standards, Yeelirrie was not included in BHP’s
resource statement. The project was mothballed
with Labor’s adoption of the three mines policy in
1983. Work restarted now the WA government
allows uranium mining.
ERA has a sizable resource base, decent grades and
excellent exploration upside. But roughly half of the
current known resource is quarantined at Jabiluka.
It cannot go ahead without permission from
traditional owners. More recently the company
re-accelerated exploration programs at Ranger-3
Deeps, generating impressive drill intercepts and
bringing potential expansion into play.
RIO’s exposure to uranium comes via its 68.4%
shareholding in ERA and 68.6% interest in the
lower grade Rossing mine in Namibia. The
company put its foot on Rossing South, taking a
15.1% interest in EXT. Rossing South's grades are
also low at 0.97lb/t though meaningfully higher
than Rossing’s reserve grade of 0.75lb/t.
PDN is building up production at Langer Heinrich in
Namibia and Kayelekera in Malawi. Approximately
60% of resources are in Africa and the remainder
in Australia. All reserves are in Africa. Cash costs
are relatively high but production is yet to reach
steady state.
Key for the investor is leverage. How much exposure
do I get for my dollar? The gold bugs have a funny
way of looking at a large resource. They buy shares
on the basis that the shares entitle the holder to a
portion of the resource. That resource is like gold in
a vault, even though it may take 40 years to mine. If
the price goes up, so too does the value of the gold
in the vault and the share price – with leverage. By the same token, uranium can be viewed as energy
in a vault. If the price of energy goes up, so too does
the value of the energy resource and the share
price. The market isn't looking at uranium in quite
the same way as gold. It’s potentially a cheap
option. We like cheap options!
Enterprise value (EV) is a commonly looked at
measure of worth. It is derived by adding market
capitalisation to net debt – basically the value
applied to a company’s assets. It can be instructive
to look at EV versus uranium reserves and
resources though non-pure uranium plays can cloud
the issue. On the EV/reserve and resource measure,
ERA is superior to PDN. Jabiluka in limbo does not
get full value. EXT is cheaper still but attracts a
pre-production discount. BHP and RIO's massive
multiples are nonsensical given their diversified
structures. Given BHP is over forty times larger than
ERA, we’re amazed uranium resource leverage is as
large as one sixth of ERA’s. Olympic Dam is a
monster orebody.
ERA’s resources are hosted in two relatively high
grade, low cost orebodies. PDN has a number of
smaller, lower grade deposits, mostly in Africa.
PDN’s Australian resources require a few years to
mature and/or government policy changes. Of
the diversified majors, BHP offers more exposure to
in-ground resources. But Olympic Dam will take
a century to mine so it's an "energy vault"
situation. Some sort of structural change like a
uranium spin-off may be needed for full market
value to accrue.
In terms of instant earnings leverage, it’s hard to go
past pure plays. ERA stands out from a quality and
sovereign risk point of view. We include stated
expansion plans, except in ERA's case where we
assume a 50% increase. Jabiluka if developed
would bring further upside which we don’t include
and exploration can also surprise. Of the up-andcomers,
EXT appears to offer greater leverage than
PDN but it first needs to get into production. The
Rossing South prefeasibility study was recently
completed. Capital costs are estimated at
US$704m and US$23.60/lb cash costs are close to
the industry average. RIO currently offers more
earnings leverage to uranium than BHP. BHP could
become a stronger exposure if the Olympic Dam
expansion and Yeelirrie development go ahead. RIO
too has Jabiluka which we don’t include, so there
may not be that much between the two. Uranium
earnings are relatively small for both. BHP and RIO
offer minimal earnings leverage and share price moves will rely on the concept of uranium as a
stored energy resource.
From a portfolio point of view, BHP should work as
an exposure to uranium. Olympic Dam is an
amazing energy vault and the share price leverage
it could bring is impressive given uranium earnings
are currently negligible. It is a cornerstone resource
holding and it has a diversified energy portfolio that
covers a lot of bases, more than RIO. For those who
want more instant exposure to any uranium
earnings uplift, ERA is the stand out. A small
weighting as an energy hedge makes sense. In an
energy constrained world, expect ERA to be a
winner and that may at least some of the way to
offsetting pain elsewhere in a portfolio due to any
energy bubble.
A cautionary word with the pure plays. While we
think the long term outlook is positive, uranium is a
relatively small commodity market. Small markets
can be pushed around by speculators. They are also
more prone to oversupply – demand can be
temporarily overestimated by enthusiastic
producers – leading to a significant fall in earnings.
That could seriously hurt the likes of PDN and EXT,
both in the early stages of life. ERA will survive as
it did through the depressing 80’s and 90’s thanks
to proven low costs, strong contracts, and a strong
balance sheet with net cash. BHP and RIO would be
barely affected by temporary uranium oversupply. We
currently rate both BHP and RIO Buy, and ERA a
Hold. Opportunities to pick up ERA have proved
somewhat elusive. PDN and EXT are not rated.