Description

The current crisis has created large distortions in many securities. We recommend a low-beta, uncorrelated investment that has recent crashed in price: Yellowcake PLC (YCA LN), a holding company whose sole asset is physical uranium. In the short term, YCA LN shares fell sharply in the crash this week and are trading at an ~30% discount to its unlevered NAV, despite that uranium prices are uncorrelated to the markets and the underlying market is driven by electricity generation, which is unlikely to be impacted if the global economy tanks. . We also note that YCA LN has been an actively repurchasing shares during the selloff, albeit at a slow pace. We believe shares are likely to reweight sharply once the current panic subsides and believe YCA’s ~200p trading price in February is a realistic target, yielding an ~32% return. Longer term, we believe uranium is an attractive investment over the next three years as current spot prices are substantially below marginal cost. At 152p per share, YCA LN is discounting an ~$17/lb. price for uranium, which compares to a marginal cost of ~$40/lb. and is a 15% discount to the 15-year lows seen in 2016. In the next three years, we believe it is highly likely uranium prices will revert to marginal cost and rally further to at least $45/lb. to incentivize new supply, yielding a three-year price target of ~400p, up 170%.

Our fundamental uranium thesis is simple: Spot prices are well below marginal cost, implying an inevitable reversion to the mean, and significant capacity was closed in Summer 2018, providing a catalyst to reduce excess inventories ahead of a significant utility re-contracting wave in the next five years. Further, the impact of Trump’s uranium task force put the brakes on US utilities’ ability to make long-term purchasing decisions in 2019, and as the group finalizes its decision, we believe a significant wave of demand could hit the market in 2020 and 2021.

Uranium is a relatively simple market with predictable supply and demand over time. On the supply side, uranium is directly mined (i.e., not a byproduct), with capacity clustered in a small number of large players. On the demand side, the end use is power generation, where the number of reactors is trackable and utilization relatively constant across the economic cycle. However, the challenge in analyzing uranium is that there are large, opaque global inventories. Governments and utilities stockpile multiple years of inventory, typically without public disclosure, and the line between strategic reserves and available-for-sale inventory is blurry. This inventory opacity is always part of uranium markets but was further complicated by the Fukushima disaster in 2011, after which Japan shuttered all its nuclear capacity, effectively turning off 15% of global demand and flipping the market into significant oversupply. However, only 20% of the uranium market is spot sales; most supply is provided under long-term contracts. Uranium miners thus continue to operate profitably and sell at prices 50-100% above current spot, with any excess crushing the spot market. As a result, spot uranium prices have traded in the low-to-mid $20s per pound for the last three years compared to a marginal cost of $40/lb. on current mines and a >$50/lb. price needed to incentivize new supply. I estimate prices can rally to ~$45 in the next three years, which is a blended average of marginal cost and incentive price. Longer-term, as in the next five years, prices must rally over $50/lb. to incentivize construction of new mines to meet global demand beyond 2025.

While a strong near-term catalyst is difficult to predict, as evidenced by the expected rally in 2019 that failed to materialize, the outlook in the next three years is quite strong due to utility contracting needs. The majority of global demand will become uncontracted in the next five years, with significant uncontracted demand starting in 2020. For the last five years, long-term contracted uranium volumes have fallen significantly to roughly half the volume from the 2005 to 2012 period. As utilities were largely covered on current demand from prior contracts and spot prices were roughly half the price of existing contracts, utilities have had no real pressure to enter long-term contracts significantly above spot. That will begin to change in 2020, and particularly in 2022. For instance, the USA, which represents roughly ~25% of global demand, will shift from ~90% contracted in 2018 to ~40% contracted in 2022. European utilities have a similar story, albeit more backend weighted. As utilities typically look to contract volumes at least one or two years in advance, the end of long-term contracts represents a tremendous increase in potential spot market demand over the next three years. Further, the majority of uranium mines are uneconomical at spot prices are only staying afloat based upon contracted prices agreed to from 2005-2012. Simply put, the end of long-term contracts will either result in higher spot prices or mine closures… which then would drive higher prices.

Putting it together, in the short term, we think YCA LN shares can rally back towards 200p once market volatility subsides, which is slightly above the return of buying the S&P 500 and betting that it returns to recent highs, yet YCA has little fundamental downside risk from a recession. In the long term, uranium prices must head higher in the next few years to incentivize additional supply.

Risk Factors

Nuclear Reactor Meltdown – While there have been two events in ~70 years, another Fukushima-esque disaster could result in regulatory efforts to shutdown additional reactors, hurting uranium demand

Early Mine Restarts – Early mine restarts, particularly out of Kazakhstan, would put downward pressure on uranium prices

Excess Inventories – Global uranium inventories are opaque and there could be more available for sale than expected

Catalyst

Panic subsides in market

Utilities begin recontracting uranium volumes