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Ed Sterck: Spare Cash? Park It in Uranium

Source: Brian Sylvester of The Energy Report 02/17/2011
February 19th, 2011

BMO Capital Markets Mining Analyst Ed Sterck projects a very moderate $60/lb. uranium price in 2011, but that shouldn't stop you from investing in the uranium space. "This is a sector that is very prone to sentiment and, at the moment, the sentiment is building toward the possibility of a price spike," he says. He also expects to see more M&A activity in the sector, particularly among uranium juniors with reasonably priced projects. Read on to find out which companies Ed likes in this exclusive interview with The Energy Report.

The Energy Report: London, where your office is, is the financial capital of the world and uranium equities remain a large portion of your coverage universe. Could you tell us about the institutional investor appetite for uranium equities now and over the last four to six months?

Ed Sterck: Well, it's certainly picked up. When you look back 12 months, the uranium market was pretty uninteresting for the average institutional investor. Prices had remained fairly flat until about six months ago. Since then, obviously, the spot price of uranium has picked up markedly and with that, we have seen a return of investor appetites for uranium plays. I think that's slightly precipitated by people's recollection of the price spike of 2006–2007, and the response that company share prices demonstrated with the price spike. I think it would be fair to say a number of the investors looking at uranium again are hoping something similar will unfold.

TER: Are you seeing an increase to the $130/lb. range as was the case in 2007?

ES: My analysis is a little more subdued than that. I actually think that uranium supplies will be adequate for the next several years, and then enter into a deficit at the end of the current decade. If you were to look at the supply and demand picture as I see it, then I would expect the price to be determined by the marginal cost of production. On that basis, I am looking for a price of $60/lb. in real terms for the next couple of years, and then a little peak at $70/lb. in 2013 and 2014 before coming back to a long-term price of $60/lb. That said, the uranium market is small and very sentiment driven. So, there's certainly the potential for a price spike, perhaps regardless of the underlying fundamentals.

TER: You talked a little about institutional investors' growing appetite. Is there anything different about the types of investors entering the market this time around? Have you noticed anything unusual?

ES: No. I think it's a similar collection of people, though the generalist funds are looking at the uranium space at the moment. But I think there is a difference in the way investors are looking at each of the individual stock opportunities, certainly in terms of those companies that were exploration and development plays back in 2006–2007. Many of those companies are now in production, and I think there is more of a focus on companies producing meaningful amounts of cash flow. So, rather than just buying those stocks on the basis that the uranium price might go up, I think investors are being selective about which stocks they choose, expecting some stocks to actually have a great return for shareholders on a peak-cash flow basis.

TER: So the last run-up in uranium prices funded a number of projects, and the investors that got out of those stocks when uranium fell to below $40/lb. are coming back. But many of those projects are in production or coming into production and generating cash flow. So, those projects are far less speculative.

ES: They are probably far less speculative than they were in the past. What I was trying to angle at is that I think people were a bit less discerning about which stock they invested in back then—like anything with "uranium" in its name was worthy of investment given the price run-up. Now, investors are saying, "Okay, I expect this stock to outperform that stock on the basis that it's going to generate meaningful cash flow, whereas the other is going to struggle to give a decent return to shareholders."

TER: Do you think that's directly as a result of what happened in 2008?

ES: I think you've raised a good point there, and I think that it probably is. Some investors did get their fingers burned last time and perhaps now they are being a little more cautious. You know, once bitten, twice shy.

TER: What are some companies that you expect to generate solid cash flow that discerning investors are taking a closer look at?

ES: Well, one of the problems is there's a limited selection of pure-play listed producers out there—there aren't many options. Look at the biggest companies, like Cameco Corp. (TSX:CCO; NYSE:CCJ), the share price of which has performed extremely well over the last six months or so. Cameco sells its uranium production into a contract book, so it has less exposure to the uranium price than some of the other producers. Consequently, it might make less for an investor than some of the mid-cap producers. On the other hand, given Cameco's size and liquidity, it might be the only option for the generalist funds coming into the space. We look a bit further down the food chain, toward the mid caps that will demonstrate a great amount of growth in cash generation.

TER: What are some of those mid-cap names?

ES: One example would be Paladin Energy Ltd. (TSX:PDN; ASX:PDN). It was an exploration-development play back in 2006–2007, and it now has two mines in production. It's running into a few difficulties but, over the next couple of years, it should have a stronger production growth profile than Cameco. So, one would suspect—coming from a small base, of course—that the relative improvement in cash flow will actually be greater than Cameco's.

TER: You said in a recent research report that Paladin looks fully priced and is receiving a market premium for management and mergers and acquisitions (M&A) appeal. Do you see consolidation on the horizon in the uranium sector, or is that a little farther off?

ES: No, I think that will be one of the big themes this year, though I anticipate it will be the large- and mid-cap guys consuming some of the smaller companies with good projects. One recent example would be Paladin buying Aurora Energy Resources, Inc. from Fronteer Gold Inc. (TSX:FRG; NYSE.A:FRG). There are some political risks associated with that particular project, but that's the kind of transaction I expect to occur.

In terms of the bigger companies, there might be acquisitions or a merger of equals but I think both events are unlikely. For example, I think Cameco buying Paladin is unlikely—I don't think Cameco could afford Paladin right now. Acquisitions of mid-cap companies are more likely to come from higher up the food chain, perhaps by the power utilities, principally out of Asia, looking to secure production. We're talking about companies like China National Nuclear Corp. (CNNC) or China Guangdong Nuclear Power Co. (CGNPC) looking at a company like Paladin and thinking, "China's got a very ambitious nuclear growth program, which will require uranium to fuel it. Rather than buying a project and developing it ourselves, perhaps we should just go and buy current production." I think that's really why Paladin has M&A appeal because it's the only one of the senior or mid caps that actually doesn't have a significant minority shareholder or a shareholder with a potentially blocking stake.

TER: It probably wouldn't be all that strategic for Cameco to purchase Paladin's assets over some right in its backyard in the Athabasca Basin that belong to Denison Mines Corp. (TSX:DML; NYSE.A:DNN) or smaller companies like Hathor Exploration Ltd. (TSX.V:HAT). If Cameco wants to see tangible appreciation in its share price, could it be looking at M&A activity in the basin?

ES: My feeling is that Cameco already has a big land resource in the Athabasca. But the market gets so excited about companies like Denison and its Wheeler River project, which is starting to look really interesting. However, the market has given such a big premium to Denison for Wheeler River's exploration potential that Cameo might balk at paying the premiums currently demanded to acquire those assets.

Conversely, although it's not in Cameco's "backyard," buying assets in Africa might not increase its geopolitical risk, strangely. For example, Namibia, where Paladin's project is located, is probably one of the most mining-friendly regimes around at the moment.

TER: You mentioned Denison is receiving a market premium for the Wheeler River project. But in a recent research report you said the premium on Denison also involves its M&A appeal. So, if it's not Cameco, who would be looking at Denison?

ES: The other possible candidates out there include other mid-cap producers or even some of those power station organizations I mentioned. Of course, for a non-Canadian company to buy Denison, it would have to do so in conjunction with a Canadian company that would take a majority stake in the project because that is required under Canadian law.

TER: Denison recently said it would produce 1.2 million pounds (Mlb.) of uranium oxide this year. In your research, you said Denison's particularly sensitive to uranium price rises. Is that guidance in line with what you thought it would be?

ES: I think the guidance the company gave was a little better than I had anticipated, but it's such a small amount of production that it isn't a really big driver of the stock. The stock value is driven by its exploration portfolio and the market's expectation for Wheeler River rather than earnings from uranium sales.

TER: Why is Wheeler River so important to the company?

ES: Given that Denison's current production is a relatively small component of its valuation, its exploration projects are the main value driver. If we take a step back, projects in the Athabasca Basin tend to be very small, very high-grade deposits. As a consequence of their small size, they can be very difficult to find through geological exploration. So, an awful lot of money must be spent to make those discoveries, and for most companies that work will amount to nothing.

One of the reasons that Wheeler River is interesting is because Denison has encountered high-grade uranium in a large alteration halo, but it's also finding that the high-grade mineralization continues as the company drills farther away from the initial discovery. On top of that—and I think this is as interesting as the resource Denison has defined to date—the geological situation of the ore body is very analogous to Cameco's McArthur River deposit, which is one of the world's largest uranium mines. If Denison has something similar to that, it could be very appealing for the company indeed. However, the timeline to production even for a really interesting project like McArthur River is between 10 and 20 years. Even if Denison has found something really exciting, we're still a long way from seeing any uranium production even if it determines it's an economically viable deposit.

TER: Let's talk more about M&A activity. Do you expect that to be geographical in nature? Or should we look for more diversification in terms of exposure to uranium in a given locale versus another?

ES: Well there are a limited number of countries in the world that have economic uranium deposits at the current uranium price. Probably what we'll see is more people looking to acquire projects in areas that, in the past, faced political opposition to uranium mining but now are allowing mining. An example would be Western Australia where there are numerous juniors with small- to medium-sized deposits that might be available for a reasonable price. That's one of the things we could see happening.

There's also some interesting exploration happening in places like Mali and Botswana. We could see people looking to pick up some exploration portfolios hoping to find a new uranium-producing district. On the other hand, I'm not sure the senior companies are prepared to pay any price for assets. Historically, M&A across all commodities tends to be fairly price sensitive. If the market speculation that's building with the current increase in the uranium price translates into large market valuations for some of these projects, then they might not be that appealing to the seniors and mid-cap producers.

TER: But you're predicting $60–$65 uranium four years out, so it seems like the price will be fairly static.

ES: Yes, but by using my assumptions for production and sales, I can roughly calculate the implied uranium price the market is paying for uranium stocks. In most cases, it's significantly higher than the current uranium price. We're talking +$100/lb. for current producers and $60/lb. for exploration stocks, because the market's expectation is that uranium prices will continue to rise. Exploration stocks imply slightly lower uranium prices because the market is discounting development risk. However, if prices stay at $60–$65/lb. in real terms for the next four years, the market tends to get bored with things staying static, and I think we would probably see a reduction in those premiums. If I was a mid-cap producer with my price outlook—and I don't think any of them share it—I would probably choose to sit on my hands and wait to pick up assets at a cheaper price.

TER: Has there been a noteworthy increase in uranium juniors seeking financing for uranium plays, or do you think there will be?

ES: We haven't seen a significant amount yet, but given the uranium price rise and increasing investor interest in the space, we'll likely see a pick up in the number of juniors looking to capitalize on their higher share prices in order to raise capital.

TER: One junior, Australian-based Bannerman Resources Ltd. (TSX:BAN; ASX:BMN; NYSE:BMN), recently completed a $15 million private placement at AUD$0.50/share. That placement was oversubscribed. Is that telling us more about the demand for uranium equities or Bannerman's prospects for further growth?

ES: I think it's telling us more about expectations for future uranium prices than anything else. Bannerman is a company with a good management team; however, though its Etango Project is fairly analogous to Rio Tinto's (NYSE:RIO; ASX:RIO) Rössing mine, it suffers from a lower grade. In my mind, the oversubscription is an option on high uranium prices. Investors are expecting uranium prices to continue rising; and for Bannerman, based on my estimate, there will be a threshold price at which Etango makes sense. At that point, Bannerman's share price could reflect the improved project economics.

TER: In a recent research report, you said Bannerman basically needs $70/lb. uranium to show "appealing economic returns." However, you also said management could accelerate development if things change. You have a Market Perform rating on Bannerman right now. What do you expect from that junior in the short to medium term?

ES: Bannerman is in the process of finishing its feasibility study. Eventually, it will announce the study's findings to the market and how it proposes to go about developing the Etango Project. It wouldn't surprise me, though, if Bannerman accelerates the rate at which it's doing that work. We could get the results of that feasibility study sooner rather than later, probably around midyear.

TER: Have you visited Etango?

ES: I have, yes.

TER: What were you thoughts after your visit?

ES: From a technical perspective, it's fundamentally low risk because the style of mineralization is similar to the Rössing mine, which has been in production since the 1970s. It's really just the grade that's the issue. If uranium prices continue rising to the point that grade is no longer the controlling factor, then the project could look pretty appealing.

TER: What sort of grade are we looking at?

ES: The current grade is around 220 parts per million (ppm).

TER: What would be considered high, or even average, grade?

ES: If we look at what they're mining in the Athabasca Basin, you've got average grades there in the 18%–20% range. Now, compare that to Extract Resources Ltd.'s (TSX:EXT; ASX:EXT) Rössing South deposit, which it's renamed "Husab." That's considered to be a highish-grade deposit for an open-pit target in Africa, and the average grade there is around 470 ppm—that's 0.047% versus 18%–20% in the Athabasca. Although Athabasca Basin deposits are typically much higher grade than those in Southern Africa, the economic viability of the deposits can be fairly similar because you have fewer technical challenges in Southern Africa than you might have in the Athabasca Basin.

TER: The deposits in the Basin tend to be smaller, too.

ES: In terms of total contained pounds, some of Cameco's are fairly similar but with the high grade, the deposits occupy a much smaller volume of rock. The problem is, they're usually more than several hundred meters underground and saturated with high-pressure water. So, in order to mine them, you have to freeze the ore body by pumping a high-saline solution through the ore body at -35ºC. That adds to your costs versus an open-pit operation in Southern Africa.

TER: Could you tell us about some other uranium names that are poised to benefit from the current price environment?

ES: One of the other stocks would be Extract, which I already mentioned and which is one of my preferred stocks. Its Husab Uranium Project in Namibia is fairly analogous to Rössing South, so it should be fairly low risk. It does suffer from a relatively large amount of overburden, which has to be stripped off the deposit before it can be mined. But then it has the benefit of being a significantly higher-grade than Rössing.

TER: Do you think Rio Tinto would take a run at Extract given the Rössing deposit's proximity to Husab?

ES: Rio Tinto already has an effective 21% stake in the company, including an indirect stake through Kalahari Minerals plc (LSE:KAH; NSX:KAH), which has roughly a 45% interest in Extract. I think if Rio Tinto were to take out Extract, it would also have to buy Kalahari. That would be quite a difficult transaction for Rio to undertake. The company tends to be very conservative in the commodity prices it uses for internal evaluation of projects and investment opportunities. If we look at the way uranium prices have behaved in the last five years, Rio Tinto may be using a moving average, which would put the uranium price down to the low- to mid-$40s. For Extract, the implied uranium price is on the order of $60/lb., which might look too expensive for Rio Tinto currently.

TER: Are there any other companies you like?

ES: The only other significant producer is Energy Resources of Australia Ltd. (ASX:ERA), which is already 65% owned by Rio Tinto. I don't see that as being a significant takeout target. ERA's share price has underperformed the peer group significantly over the past 12 months due to a number of production issues that necessitated the company make spot uranium purchases to cover its contracted delivery commitments. Australia is suffering from an extremely wet season, which has resulted in ERA halting production for three months—something that's driven the stock price even lower. Although ERA is not having the easiest of times, its share price is now so low it might show some appeal on a relative-valuation basis versus the peer group. Potential positive catalysts include the wet season ending without the open pit being flooded and positive decisions on a move to underground operations.

TER: Please leave our readers with some of your thoughts on the uranium sector in 2011.

ES: As you know, I'm pretty cautious on the uranium price outlook. As I mentioned, this sector is very prone to sentiment and, at the moment, sentiment is building toward the possibility of a price spike. I'm telling my clients this is not a sector that I anticipate pulling back significantly—unless the uranium price gets too far ahead of the underlying fundamentals. It might not be a bad place to park any spare cash investors may have because they're unlikely to lose a significant amount of money by investing in the space, given the current sentiment.

TER: Thanks for talking with us today, Ed.

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.

Source: Brian Sylvester of The Energy Report 02/17/2011
February 19th, 2011

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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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