Edward Sterck: Uranium Companies Poised for a Comeback
Source: Brian Sylvester of The Energy Report (9/8/11)
This year has brought uncertainty for the uranium sector. Since the tsunami and subsequent radiation leaks in Japan, developers and investors are questioning the best steps moving forward. In this exclusive interview with The Energy Report,Edward Sterck, an analyst with BMO Capital Markets in London, updates us on the sector's status and offers advice on the best companies to support in the coming months and years.
COMPANIES MENTIONED: BANNERMAN RESOURCES LTD. - BHP BILLITON LTD. - CAMECO CORP. - EXTRACT RESOURCES LTD. - FIRST URANIUM CORPORATION - HATHOR EXPLORATION LTD. - KALAHARI MINERALS PLC - PALADIN ENERGY LTD. - RIO TINTO - URANIUM ONE INC.
The Energy Report: Edward, let's quickly sum up 2011 for uranium. Spot prices for yellowcake have fallen from a high of around $74 a pound (lb.) in January to around $51/lb. now. Most of the decline can be attributed to the tsunami in Japan that caused radiation leaks at several reactors there. After the Japanese problems, chatter started about substituting thorium for uranium in nuclear reactors. Then negative long-term policy decisions started trickling in from Japan, Germany, Italy and Switzerland. Your long-term uranium price of $60/lb. makes you sound less-than-bullish on the sector. What, if anything, is going to pick up the uranium sector, dust if off and send it upward again?
Edward Sterck: The biggest driver is likely to be the uranium price. I haven't actually changed my uranium price forecast post-Fukushima because I had a conservative price estimate previously with a long-term price of around $60/lb. in real terms. But in terms of potential positive catalysts, the main thing needs to be reinforcement of positive sentiment from China once it announces that its safety review will allow it to continue to license new reactors. I would also like to see some buying picking up in the spot markets from organizations such as China Guangdong Nuclear Power Group and China National Nuclear Corporation. Those are the things that the market needs to see before belief in the uranium space returns to investors' minds.
TER: August is typically a slow month for uranium sales, but what about September and October?
We usually see volumes pick up in September and October. I think we'll see the same this year as well although a couple of things are overhanging the market at the moment, making utility fuel-procurement officers a little more cautious on the spot market.
The first is that some Department of Energy material still has to be liquidated into the market. It's not a significant quantity, but fuel-procurement officers may be waiting to see how that plays out before committing to purchases. There are also fears in the market that Germany or Japan may liquidate inventories. Obviously, that would be to fuel-procurement officers' benefit. That's one of the reasons they could be holding off as well. It's a small market and prone to sentiment. If anything, I think Germany and Japan would probably look for bigger buyers rather than just selling piecemeal into the open market, potentially through block sales to countries such as China.
TER: You talked about whether China will license new reactors and move forward with its nuclear program. The country wants to boost power output by 45 gigawatts by 2015. Is there any path to that other than nuclear?
ES: China's main electricity generation focus is still fossil fuels-coal-fired powered generation-but it has a big focus on clean energy as well. Nuclear is likely to be a core part of that strategy, as well as renewables, simply given the amount of airborne pollutants that the coal-fired power generation is pumping out into the atmosphere over China. China's general population in certain areas suffers significant respiratory illnesses related to the pollution problem, hence the drive for clean energy.
Nuclear power is likely to remain a core part of China's power strategy going forward. You also get advantages with nuclear power in terms of base load power generation in that, unlike in coal, you can stockpile uranium to the extent that you can actually cover your fuel demands for several years. It gives an element of energy security that other forms of power generation cannot.
TER: China's Sichuan Hanlong Group Co. Ltd. recently made an all-cash offer of just a little over $0.51/share for Bannerman Resources Ltd. (BAN:TSX; BMN:ASX), which is developing the promising Etango uranium project in Namibia. Earlier this year Kalahari Minerals plc (KAH:LSE; KAH:NSX), the major shareholder of Extract Resources Ltd. (EXT:TSX; EXT:ASX), which also has a uranium project in Namibia, had acquisition discussions with China Guangdong Nuclear Power Group. The Chinese obviously want to secure uranium projects, and they want to do it on the cheap. Do you expect that trend to continue?
ES: A number of Chinese power state organizations, like Hanlong Group, are securing strategic resources for China's future. It is certainly possible that we may see further moves in the uranium space.
In terms of investor-friendly strategies, we could be looking at things that are a little more marginal, like Bannerman for example. The Etango Project has scale, but it's low grade and doesn't necessarily make economic sense at current uranium prices. However, if you are a Chinese power state organization with effectively a 0% cost of capital, then the economics of these projects could look considerably different and you've obviously got a very different investment timeline to your average investor as well. They're looking at this over a 10-, 20-, 30-year time span, whereas your average investor is looking for a return in a much shorter time period.
Extract's Husab project has probably got a little more appeal due to its larger scale and higher grade versus Bannerman's Etango project. However, despite the fact that CGNP's approach for Kalahari failed, it is more digestible than Extract and it is possible that Kalahari may be the way to play the M&A side of Husab, rather than investing in Extract directly.
TER: Kalahari is the majority shareholder at Extract. Is that a potential takeover target?
ES: I think it is. Its Husab Uranium Project is world-class in scale. The share structure does make it rather difficult, though, with Kalahari in there for 43%. Rio Tinto (NYSE:RIO; ASX:RIO) has a pretty significant minority stake in Extract as well, and there's also a Korean group in there. That does make it more of a challenge for any potential acquirer to take out. If anything, I think Kalahari is possibly the cleaner target and would probably be the first port of call for any company looking to take out Extract or gain a significant stake in the Husab project.
TER: Bannerman was granted environmental clearance for infrastructure required to service its Etango Uranium Project. Does that make it more of a takeover target?
ES: Any piece of licensing or environmental approval that's secured makes the project more appealing for a potential acquirer.
TER: Do you expect larger uranium companies like Cameco Corp. (CCO:TSX; CCJ:NYSE) or BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) to acquire smaller uranium explorers or producers while share prices remain in the doldrums?
Cameco has a lot of organic growth internally, so it doesn't necessarily need to go out and make acquisitions. That said, it did recently launch a hostile bid for Hathor Exploration Ltd. (TSX.V:HAT)that did come as a bit of a surprise. Hathor's primary asset is the Roughrider deposit, which is located in the vicinity of Cameco's existing assets in the Athabasca basin and that could demonstrate synergies.
BHP's uranium commitment is focused on the Olympic Dam expansion. The company's criteria for project development is truly world-class in scale.
At the moment there is not really anything of significance out there in the uranium space that seems to be available. There are several world-class projects, but they are largely tied up. Rio Tinto is possibly a bit more likely to be inquisitive in the space, but it's going to be very price dependent. Like BHP, it is looking for projects with significant scale, and there aren't many at the moment.
TER: What leads you to those conclusions?
ES: Rio Tinto's been more actively picking up shareholdings in the uranium space than the other two. Cameco's got a lot of organic growth anyway, and until now hasn't been that active in the way of picking up listed uranium companies, even with its first mover advantage at the beginning of the 2006-2007 uranium boom. In terms of BHP, I'm really just looking at the approach the company has embodied in other commodities.
TER: In a recent report, you suggested that Cameco is greatly undervalued. You have an Outperform rating on Cameco based largely on its hedging strategy and greater uranium sales in the latter half of 2010. But for a long time, Cameco has created some doubts among investors due to the instability of its large uranium projects, like Cigar Lake. Has Cameco managed to get things under control in the Athabasca Basin?
ES: As far as we can see, the situation at Cigar Lake is under control. I'm actually going to visit the project in September, so I'll have a better idea exactly where Cameco stands after that site visit. But the company appears to be progressing with the project in line with the schedule that it laid out to investors. I'm sure it is doing everything in its power to make sure it doesn't run into the same problems again.
With respect to my Outperform recommendation, relative to Cameco's own history, it does appear somewhat undervalued at the moment. One of the risks to my recommendation is that we could see some erosion of valuation multiples in the market as a result of economic uncertainty combined with a reappraisal of multiples post-Fukushima. Of course, this would potentially apply to all of the uranium stocks that I cover.
TER: You also said it was based on an increase in forecast prices for the fuel services division. What does that mean?
ES: Long-term, the cost of fuel conversion services has generally gone up worldwide over the last couple years. That wasn't fully reflected in my forecast, so I've adjusted my forecast to take into account that Cameco cannot effectively charge a higher fee for its fuel conversion services.
TER: You also have an Outperform rating on Uranium One Inc. (UUU:TSX), which recently reported a five-fold increase in second quarter profits on higher production and better uranium prices. For 2012, Uranium One has provided production guidance of 12.5 Mlb.-2 Mlb. more than the company is slated to produce this year. Is that a realistic target?
ES: I think it is. Uranium One's assets in Kazakhstan are performing extremely well. The structure there is that the mines are operated by subsidiary companies. At most of those operations, the staff has a very good understanding of how to undertake in-situ leach mining. Uranium One is the only company in the mid-cap peer group that has been consistently hitting (a) its guidance and (b) analysts' estimates in terms of both production and earnings. I don't see any reason for that to change in the near term.
TER: Uranium One is 51% owned by Russian interests. Is there any danger there?
ES: It does concern some shareholders. Personally, I'm quite comfortable with it. Any significant transaction between Uranium One and its 51% shareholder, Russian state-run ARMZ, is subject to minority shareholder approval. So there are controls in place.
In terms of risks associated with Uranium One, its operations are largely in Kazakhstan. The Russian interest in Uranium One very much reduces the political risks in Kazakhstan. Obviously, Kazakhstan is an independent country. It treads its own path. But, it was part of the Soviet Union previously. So I think having Russian governance involved with Uranium One probably alleviates some concerns regarding political risks in Kazakhstan.
TER: Paladin Energy Ltd. (PDN:TSX; PDN:ASX) recently cut its 2012 output guidance to between 7.4 Mlb. and 7.9 Mlb. down from the previous forecast of 8.2 Mlb. Most of that is due to the delays at its stage-three expansion at the Langer Heinrich Mine in Namibia, Africa. Why do you have a market performance rating on that company given its projected shortcomings?
ES: I think Paladin will actually hit the design capacity production targets at both the Langer Heinrich operation and also at its Kayelekera operation in Malawi. The main problem with the company has been that it has overpromised results to the market and under-delivered. It does have the technical ability to follow through on its targets, but it is simply likely to take longer to get there than it is telling the market. So at present I don't really see any fundamental problems with the company that would suggest tagging it as an Underperform.
TER: Your target for Paladin was $3.50 in June. It's $3 now.
ES: I revised on the fact that the company is taking longer to get there than expected. And then, obviously, the outlook for nuclear power-or the market's perception of nuclear power and uranium-has been somewhat reduced post-Fukushima. And I think that the market is applying smaller valuation multiples to the uranium companies than it did previously.
TER: Are there some other uranium names that you follow that you would like to discuss?
ES: I'd like to mention First Uranium Corporation (FIU:TSX; FUM:JSE), which is now primarily a gold stock despite its name. It has had a pretty troubled history, and it definitely represents a higher risk-and potentially a higher return investment. The problems that it has encountered have been in relation to its underground operation, which has been fairly technically challenged. The company is struggling to get it up to the production rate that will alleviate problems with grade control. If it achieves that production rate, it should bring costs down to reasonable levels. It's also had a couple of issues at its Mine Waste Solutions tailings retreatment facility, which has encountered some regulatory issues that the company has now overcome.
Looking ahead, I expect it to eventually get to the production rates that the company is guiding toward. It's just going to be a fairly long and potentially painful process. However, being primarily a gold company, I think we can ultimately see gold production on the order of 400,000 ounces a year five or six years out, which makes it comparable to some of the mid-cap gold companies.
TER: First Uranium's earnings/share are about negative $0.19 a share in 2011, but you project that to go up to positive $0.05 per share in 2012. Is gold strictly to account for that?
ES: It's a combination. The gold price has obviously been very strong, but production has improved as well. Mine Waste Solutions is actually cash-flow and earnings positive. It's really just the Ezulwini Mine that's dragging earnings at the moment. Come the third and fourth quarter of the coming fiscal year, I expect things to be looking better at that operation. As always however, First Uranium remains a higher-risk investment and there are certainly some refinancing risks associated with some debt that is due in June of 2012.
TER: Do you have any other thoughts on the uranium sector before we let you go?
ES: I'm actually feeling slightly more positive than I was pre-Fukushima. The rationale is that the main drivers of growth in nuclear power haven't really changed. The countries that were planning to expand their installed nuclear capacity were countries like China and Russia and India. They're not changing their plans materially as a result of the accident that happened in Japan.
On the other hand, if you look at the supply side, pre-Fukushima, everyone was trying to put a uranium mine into production given the great excitement about the outlook for nuclear power. My analysis at the time suggested that we were going to have a significant oversupply of uranium. Now that there's greater uncertainty in the outlook for nuclear power in investors' minds and we've obviously got general economic woes in the world that have pushed markets lower and negatively impacted investor sentiment, I think that the financing of new production is likely to be more challenging than it was pre-Fukushima.
In summary, the supply/demand outlook is one in which we're less likely to see an oversupply scenario. We could see tighter markets perhaps. I also think we still need a production expansion going forward to meet expected demand. On that basis, to a certain extent, this scenario actually plays into the hands of the established producers that are all pretty well capitalized. They are unlikely to need to come back to the market for additional financing and they could benefit from higher uranium prices next year or the year after.
TER: Thank you for your insights.
Edward Sterck covers uranium, diamond and platinum group metal mining companies for BMO Capital Markets. He joined BMO in 2007, prior to which he was a mining analyst at Hargreave Hale. Before working in mining research, he spent more than four years trading government bond futures on a proprietary basis. Edward holds a bachelor of science in geology with honors from the Royal School of Mines, Imperial College London.
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1) Brian Sylvester of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Bannerman Resources.
3) Ed Sterck: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None.
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