As daily volatility continues to dominate the uranium sector, I feel the long-term outlook for how this cycle will end has become more and more predictable. Iām going to make some bold, speculative claims here that might end up being completely wrong, but thatās okay since Iām not trading on them anyways. Letās talk about the spot market first. This terrific piece by Segra Capital provides great insight into how the uranium spot market functions. Highly encourage any uranium investor who hasnāt read it to go and read it until you really absorb the content. The piece talks a lot about the carry trade, which Iāve briefly tried to summarize below.
A utility commits to buy material at a predetermined price and time in the future. A trader acquires those pounds in the spot market and ācarriesā them on their balance sheet until the delivery date. On the delivery date, the pounds are exchanged for funding.
Itās important to note that traders donāt necessarily acquire pounds in the spot market immediately after a carry trade agreement. They may or may not have pounds on their balance sheet between now and the delivery date. Some may refer to the situation where traders donāt have pounds to sell before the delivery date as being āshortā uranium.
Why does this sort of agreement exist? Well, utilities get guaranteed material without tying up their balance sheet. If utilities bought pounds and held onto them until the delivery date, it would increase their debt/equity ratio which then negatively impacts their credit rating. The carry trade is great for traders too because they get a guaranteed return on capital with a high-credit counterparty. Basically: traders are offering a service ā off-balance sheet financing ā to utilities.
But why use the carry trade over contracting with producers? In an oversupplied market where prices are far below marginal cost of production, itās clearly cheaper to buy material now from traders through the carry trade (for future delivery) then to have producers mine new material for higher prices. From the producer perspective, the carry trade is a problem. Producers are now competing with traders out the curve. From the utility perspective, the carry trade creates a potentially false sense of security by filling demand in the midterm market (2-5 years).
Now letās talk a little bit about Sprott and the uranium price curve. Sprott is a price insensitive buyer ā they will buy pounds at any price as long as SPUT is trading at a premium above 1%. This means traders can ask for higher prices now and Sprott will continue to lift their bid and buy. The result: backwardation ā current spot price is higher than future uranium prices.
When there is backwardation, traders can engage in a reverse carry trade. Traders who owe utilities material as part of a carry trade can sell the old material they are ācarryingā over to Sprott, buy future material to fulfill utility demand at cheaper prices than they sold to Sprott at, and net a profit. In this way, the reverse carry trade is an arbitrage along the uranium price curve. So whatās the impact of the reverse carry trade? Traders eat up forward material reducing long-term uranium supply. Segraās post said it best:
if traders compete with producers as forward sellers in a carry trade, they also compete with utilities as buyers in a reverse carry
Unfulfilled long-term demand means producers come back into the picture and can start building their sales books. This is how long-term contracting beginsā¦ Back to the original question ā how and when does this cycle end? Sprott recently filed for a 50/lb) ATM reload and said the NYSE listing process has begun. Sprott has purchased 22.5 Mlbs on Canadian markets ā the amount of capital flowing into the vehicle from US markets will be multiples higher, so the 1.3 billion was a practice round and now, sometime in Q2/Q3 2022, weāll be seeing Sprott unlock its full potential.
We saw China start contracting ā it wonāt be long before the West starts as well. Utilities would be wise to start contracting before the NYSE listing, but they may also take a wait and see approach. Either way, I predict long-term contracting en-masse will happen before the end of 2022. Long-term contracting will set a spot floor of at least 19 by the end of 2022.
I expect we hit this target even if there is a broader market crash. We may see short term capital outflows from SPUT causing it to trade at a large discount, but Sprott has been steadfast in saying they will not sell pounds back into the market. Spot price will probably fall with Sprott temporarily out of the market, and one might argue this will put utilities at ease and prove their āSPUT is temporaryā thesis. But I think this is unlikely given it just takes a couple of utilities to trigger widespread long-term contracting.
Speculation aside, I sometimes step back and think about how crazy this whole set up is. The market buys SPUT or URNM. Sprott makes management fees off of both. SPUT appreciation basically subsidizes long-term contracts for producers. Long-term contracting sets new floors for spot which creates gains for SPUT and URNM investors. Itās a win-win-win for Sprott, producers, and investors. Utilities lose but they donāt even lose that big because fuel is such a small portion of their operating costs. And for investors ā itās a chance to control your destiny.
That wouldāve been a great way to end this memo, but unfortunately thereās some more stuff I wanted to talk about.
Recently, thereās been a lot of discussion on the CRDN-miner tension in the Athabasca. Iām woefully unqualified to discuss the specifics of the situation, as all that retail investors get to see is restricted, political press releases every few months. My instinct is that large established miners like Fission and NexGen as well as smaller, engaged players like Standard have good relationships with CRDN and CRDN press releases are not targeting them. However, I could easily be wrong. Every mining investor, retail or institutional, should know that these are the sorts of bad things that happen to juniors. Anyone whoās done any research on uranium should also know that investing in AB juniors comes with massive permitting risk ā CRDN is just the beginning of that risk manifesting. I was hyper-vigilant of these risks during the last upleg of the uranium cycle, when sentiment was nauseously high, and nobody was thinking about permitting risk. I exited my Fission, Denison, and NexGen positions (excluding URNM) as they topped and in hindsight, timed the exit quite well. As my portfolio continues to expand in size, the CRDN fiasco serves as a reminder that if you want low-risk, go SPUT, and if you want miners, go Africa.
A topic I touched on in my previous memo, but I think will be discussed much more over the next few months is expense inflation. Mike Alkin talked about how technical reports for most producers/near-term developers are severely outdated. Expense inflation for some equities will doom their projects while for others, I feel it might actually improve their economics. Hear me out ā OPEX inflation with low CAPEX could result in a higher torque project, maybe? Also, if uranium prices are inflation adjusted, producers a lot of expense inflation should be covered by utilities. Assuming management is skilled enough to get sign at reasonable term prices, of course. Expense inflation will be tough to model even for individual equities because the only information I have to model with is outdated technical reports ā the only people who really have a great understanding of this are the ones in the weeds (management or funds with 10k+ hours in the sector like Sachem Cove). Where does this lead us ā back to physical. Inflation-adjusted term prices set a floor for spot which means SPUT, in theory, is an inflation hedge as well. Thatās not to say Iām all in on physical though. I think some miners (cough cough Global Atomic) still have great economics (check out their recent FS) and that URNM (or another well-constructed basket of juniors) will outperform physical over the course of the cycle just because of the massive capital inflows.
Thereās so much noise and overreaction in markets today. Apparently, everything is selling off today because ofā¦ the nu variant? Iām sure weāll forget about it in about a week or so, just like the Delta variant, Evergrande, fed announcements, and all the other silly catalysts for a market crash that have been thrown around the past few months. The market wonāt crash when everyone expects it to, it will crash from a point of peak euphoria. Maybe thatās just another bold, uneducated claim that Iāll regret, but again, itās not like Iām trading on it.
I know I said in the last memo Iād stop talking about uranium, but this sector just has so much knowledge sharing, news flow, and drama itās hard not to talk about. I did try and research a few other investment ideas and themes, like Vidler Water (water), Albemarle (lithium mining), MSOS (cannabis), Zillow (growth), but nothing really stood out when benchmarked against SPUT. Why buy any of those stocks when Iāll get better returns for lower risk with SPUT? Why buy anything but SPUT? If youāve read this memo and arenāt asking yourself the same question, youāre probably doing something wrong.