By: The Energy Report
Source: Tom Armistead of The Energy Report
The natural resources space has been difficult in recent years. Potash prices collapsed, uranium spot prices hit a nine-year low, the gas market was in glut. Only oil has stayed strong. But Peter Epstein of MockingJay Inc. has found some gems in the resource rubble, and foresees better times ahead. In this interview, Epstein tells The Energy Report how to read the cryptic graphite market, how to catch the next wave in potash, and offers his thoughts on when investors might catch a break in the uranium market.
The Energy Report: Why are you excited about the oil and gas space right now?
Peter Epstein: Oil and gas is unique in that it hasn't budged when so many commodities have fallen precipitously in price. Coking coal prices, for example, are at multiyear lows. The iron ore price has fallen below $100/metric ton. The uranium spot price has fallen to a nine-year low. But oil prices have held in the $90–100/barrel ($90–100/bbl) range on West Texas Intermediate crude for three or four years, steady and strong. Natural gas prices collapsed in 2012 but have come back fairly strong, only recently giving back a bit of the gains. That's why I like oil and gas. It's a strong commodity. Even with all this talk about a slowdown in China, which causes lots of commodities to fall, oil and gas sticks in there.
TER: Oil, gas and mining industries are tarred with the same brush by environmental advocates, who describe them as dirty, polluting and environmentally destructive. Can these industries be made attractive to investors who put a premium on environmental considerations?
PE: Companies are learning the hard way that they have to have a social license to operate, as well as address the increasingly long list of permitting and environmental hurdles. Extractive industries that are dirty and polluting have to clean up their acts. But this is not a new problem; it's been going on for years—or even decades—depending on the jurisdiction.
Another negative impact for such companies is the longer time frame to production, created by a myriad of factors above and beyond environmental considerations. A longer time frame means more difficulty funding projects, and therefore a lower net present value. Project hurdle rates have to rise to account for the higher risks and longer time frames. This means that industry-wide cost curve increases and commodity prices have to rise in response. Margins will be squeezed somewhat, even if companies enjoy higher commodity prices in the long term.
TER: What do companies have to sacrifice to achieve environmental goals?
PE: Companies have to give up profits to meet these new realities. But companies that approach dirty and polluting industries in innovative ways, frequently with the use of technological advances, will be rewarded.
TER: When uranium's price stalled around $35/pound ($35/lb), everyone bet it was about to rise again, because it couldn't go any lower. Then it stalled again, at about $28.50/lb. What will make uranium mining profitable and attractive again?
PE: For the first time since April, the spot price has a $3 handle on it, with Ux Consulting quoting it at $30/lb on Aug. 11. It appears that spot uranium may have bottomed at about $28/lb. If the spot price rebounds to even just $35/lb, that could be bullish for the sentiment of uranium juniors.
Let me point out that the spot price is not the same as the long-term price that most utilities contract at. Make no mistake, $28.50/lb was a nine-year low and a depressed price. Most uranium mines around the world can't do business at $28.50/lb—or at $35/lb. Many analysts believe the price at which new greenfield projects would get the green light is $60–75/lb. That might sound high, but in the months leading up to the terrible Fukushima disaster in March 2011, the long-term uranium price was steady at around $70/lb.
Globally, the cost per pound to produce uranium has not gone down over the past three years. All mining costs are generally increasing because of the factors we've discussed: permitting costs and time frames, environmental concerns, etc. The market needs a higher uranium price, and we will see a higher uranium price. It's a question of when, not if. Many pundits point to the restart of some Japanese reactors, all of which are currently offline. I agree that this will be a positive sentiment booster, but that alone will not be enough to move uranium prices by all that much, in my opinion.
Instead of focusing on Japan, the market should be watching China and India, both of which only generate 2–3% of their electricity from nuclear power. That has to change—and it will. Given their severe air pollution problems, the Chinese are going to build new reactors as fast as they can. They will also continue ramping up hydropower, wind, solar—you name it. But nuclear power generation in China is going to be a larger part of a growing pie. China is sitting on $2–3 trillion ($2–3T) in U.S. Treasuries, and it will happily buy hard assets in the form of uranium or uranium enrichment facilities. The Chinese are very active, up to a state-owned entity level, in terms of building nuclear power stations.
Some analysts point to in-situ recovery operations as potentially profitable. These have low costs and can be profitable at a uranium price of, say, $40–45/lb. But the size of these projects is typically too small to move the needle globally.
Finally, I would point out that utilities have not been contracting for long-term supplies of uranium since they feel no urgency to do so. That will have to change. Utilities can't wait until 2017 to contract 2018–2023 uranium supplies. As soon as next year, utilities will be back in the market and the long-term price of $45/lb will rise.
As a commodity that's hit a nine-year low, uranium is out of favor. A lot of the uranium stocks are oversold. But I think there are opportunities in small names.
TER: Some projections for nuclear power plant construction in China suggest that even with as much construction as it wants to do, the country still won't exceed 10% of its total power needs. Is that going to greatly increase uranium demand?
PE: China expects to start building something like six new reactors every year for the next five years, and that's going to keep ramping up. If your question is how long will it take to get 10% of its electricity from nuclear power, it could take 10–15 years. China thinks long term, and has a lot of U.S. dollars that it would like to transform into hard assets. And it's not just the Chinese who are actively going after uranium and nuclear power. It's Russia as well, and India.
By the way, both China and India are very active in building hydroelectric dams. But that kind of construction gets an unbelievable amount of scrutiny in terms of the environment, and the fact that tens or hundreds of thousands of people must be moved out of villages to build these dams. Hydroelectric development in China and India may come to a quicker end than people realize. Then, of course, you have coal. The World Bank, the International Monetary Fund, the U.S. and some other major international bodies are saying they're not going to fund Third World coal power plants anymore. Those factors all lead to more nuclear power development.
TER: The potash space was shaken up in the last year by the collapse of the cartel in Russia. How is that affecting the potash space in North America today?
PE: Potash is a generic term that refers to a group of potassium-bearing minerals, naturally occurring potassium salts and the products produced from those salts. Potash is a plant's main source of potassium, and is used in fertilizers. For muriate of potash (MOP), prices collapsed after that event. It took a couple of months, but the potash price fell from more than $400/metric ton down to about $300/metric ton. Prices differ around the world, so I'm using a benchmark price that a lot of people refer to.
MOP is widely used in all types of farming, but it contains a chloride ion that can be detrimental to plant growth, especially fruits and vegetables. Sulfate of potash (SOP) is different. SOP improves yield, quality, taste and shelf life. These attributes are valuable to farmers, so SOP trades at a premium price to MOP.
SOP prices barely moved at all. It's almost like they're two different products. SOP is a specialty product with one-tenth the market of MOP. A third-party study suggests that demand for SOP would be 2–3 times greater if existing users could ensure security of supply, and if new users were introduced to SOP versus MOP. The premium of SOP over MOP has moved quite a bit because SOP prices were virtually unchanged during the Russian cartel turmoil, while MOP prices fell 25%.
You can make SOP, but you need MOP as a feedstock to start with. If you have to start with MOP and spend money to process it, the margin is not going to be that strong. Since it is an expensive process, not many companies do it. That's why the MOP market is 50M metric tons/year, and the SOP market is about 5 million tons. For MOP, in Saskatchewan alone, there's a huge amount of production.
TER: You have an extremely diverse portfolio of companies that you follow. Can you offer some advice for investors looking to build that kind of a portfolio for themselves?
PE: Investors in natural resources have not been happy campers for the last two or three years. I think it's important to stick with companies that have cash on their balance sheets. Stick to companies already in your portfolio, even if they're down 60–70%, with good management teams that are 100% committed to the company, not management teams involved with five different companies at once. And watch out for the cash burn of companies. You want the cash burn to be minimal, so that your companies can live to fight another day.
TER: Peter, I appreciate your time and your insights.
In 2011, CFA Peter Epstein left his senior analyst position at a $3B hedge fund and formed MockingJay Inc., a consultancy for companies in the natural resources space and an informal investment adviser to high-net-worth investors, family offices and funds. The company's mission is to increase awareness of select natural resource companies. Epstein's areas of expertise include uranium, coal, potash, gold and oil & gas. He has published hundreds of articles on investment sites such as Seeking Alpha, The Motley Fool and Au-Wire.com.
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