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A Commodities World Tour

David Forest
October 14th, 2009

You never know where the next big commodities story is going to come from. The great thing about the natural resource sector is that it is so diversified across the globe. In macro-finance, the game is driven by a handful of powerful nations. But in the commodities world, even out-of-the-way countries can have a sizeable impact on markets. What happens in Chile makes a big difference to the lithium market. Developments in New Caledonia (it's an island in the southwest Pacific) have a real bearing on the nickel industry.

This week we look at a few developments from different countries around the globe that have potential for big effects on commodities prices. The first comes from a well-followed locale: Australia. BHP Billiton announced this week that its Olympic Dam copper-uranium-gold mine in South Australia suffered a major mechanical failure. We'll look at why Olympic Dam is so special (particularly to the uranium industry), and what effect a mine shutdown might have on the markets going forward.

We'll then jump to a less-discussed nation, India. While most eyes in the commodities space have been on China this year, India is quietly clawing its way out of the financial crisis and once again setting itself up to be an important player in terms of demand for a number of natural resources. We'll look in particular at the coal market, where India could turn out to be a major "sleeper" in its effects on world prices. A coal crisis is brewing here, and its shock waves will be felt around the globe.

And just to make sure we get our fill of macroeconomics, we'll close out the letter with a look at some intriguing data on the U.S. bond market. The past week was a landmark one for American bonds. I won't spoil the surprise except to say that this involves the Federal Reserve and has some critical implications for inflation, the dollar and commodities. Read on to find out more.

Olympic Dam Goes Boom

All eyes in the resource world turned to South Australia this week. Major miner BHP Billiton reported that its Olympic Dam copper-uranium-gold mine was largely shut down following a mechanical failure at the facility. Although BHP has been relatively quiet about the accident, it appears that Olympic Dam's problems are the result of a failure in the main mining shaft. A loaded ore "skip" (a container used to lift ore from deep in the mine to surface) apparently broke loose near the top of the shaft and feel to the bottom, damaging equipment in the shaft used to transport ore.

It's difficult to say at this point exactly what the effects of the accident will be. But this is a serious incident, especially if haulage equipment in the shaft has been badly damaged. This could result in the shaft being closed for months for repairs. Which means no ore can be brought to surface for processing via this route. There is an alternate shaft at the mine. But this has only 20% of the ore-moving capacity as the damaged shaft. The bottom line appears to be that Olympic Dam's ability to transport new ore to surface will be reduced for some time. It's unclear at this point whether BHP has enough ore stockpiled at surface to last through the repair time. If not, the mine will have to cut back on its production of copper, uranium, gold and silver. There was some speculation that the accident may have helped lift copper prices this week. Indeed, copper jumped about 10 cents on Wednesday and Thursday, following news of the mishap. Understandable given that Olympic Dam is the fourth-largest copper deposit in the world.

But as important as the mine may be to the copper market, it is even more critical to the uranium sector. Olympic dam produces nearly 10% of the world's uranium, about 9 million pounds U3O8 yearly. To have this production go offline is a significant setback to uranium supply.

The Odd Ducks of Uranium

And supply problems are an important issue for uranium. That's because of the unique geology of global uranium deposits. For most metals, worldwide exploration and development is guided by mineral deposit "models". Geologists identify a certain type of deposit in one area and then go search for similar deposits elsewhere in the world. For example, a porphyry copper-gold deposit (a type of deposit where ore is found within coarse-grained igneous rocks) looks relatively similar whether in the Philippines, Chile or British Columbia. By understanding the characteristics of a porphyry deposit in any one of these locations, a geologist would be reasonably well prepared to parachute into other porphyry-prone terrains and start exploring. The model holds true around the world. But things are trickier when it comes to uranium. Yes, certain types of uranium deposits have been recognized in several countries around the world. Roll-front uranium ores, for example, are found in the U.S., South America, Australia and Russia. But the world's most important uranium deposits are "odd ducks". They don't appear to belong to a family of deposits around the globe. They may in fact, be completely unique.

The most striking example is the Athabasca Basin of western Canada. The Athabasca is one of the world's most important regions in terms of uranium supply. This basin produces 20% of global uranium.

But more important than the scale of production is the grade. The Athabasca's McArthur River mine is the world's largest uranium producer, accounting for 15% of global output. The grade of McArthur's proven ore reserves is 14.6% U3O8. This is stunningly high-grade when compared with the world's other major mines. The world's second-largest producer, the Ranger mine in Australia, grades 0.19%. Two orders of magnitude lower than McArthur River. And the Rossing mine, the world's third-largest producer, is an order of magnitude lower than that, at a grade of 0.042%. In fact, of the top ten producing mines in the world, the next highest grade to McArthur River's 14.6% is a meager 0.84%. And that's at the Rabbit Lake mine, also located in Canada's Athabasca Basin. Large, high-grade deposits like McArthur River are just not the norm in uranium. Unlike with other ore deposit types, we have yet to "scale out" the McArthur model and find similar high-grade deposits in other parts of the world.

And if McArthur River is freakish in terms of grade, Olympic Dam is freakish in terms of size. To be sure, the uranium grade at Olympic Dam is ultra-low. About 0.05%. Were it not for the fact that this low-grade uranium occurs with copper, gold and silver, the deposit might not be mined at all. In fact, you could argue that Olympic Dam is just a copper mine where the owners were forced to extract uranium "impurities" in their metals. But in this case it just so happens that the impurities are worth hundreds of millions of dollars yearly.

But the important thing about Olympic Dam is the amount of uranium it contains. The deposit by far contains the largest uranium resource of any currently active mining project around the world. Current estimates are that Olympic Dam contains 5 billion pounds of U3O8. By contrast, the world's next-largest major deposit holds just 650 million pounds. No other deposit has been discovered globally that comes close to matching Olympic Dam's scale. Combined, the Athabasca Basin and Olympic Dam account for 30% of the world's uranium production. This is a lot of ore coming from deposits that appear to be completely unique.

Pushing the Envelope

The unique geology of the world's major uranium mines has a big effect on the industry's production cost curve. For most metals, the cost curves are (not surprisingly) curve-shaped. Most of the metal is produced from a few standard deposit types. At the low end of the cost curve are the best specimens of these deposits. The largest, the highest-grade and the best-located (in terms of strip ratios and access to infrastructure). These have the lowest production costs. As we move upward along the curve, grades decrease and deposit geometries get worse. Costs increase. We get a more-or-less continuous spectrum of quality around the world.

But uranium is different. Instead of a curve, the uranium production cost profile is more of an L-shape. At the lowest end we have the monsters of the industry. The Athabasca Basin and Olympic Dam, which can deliver a pound of uranium for around $10 in production costs.

But moving up the curve, we don't get the gradually rising costs that we see for other metals. It's not like there is another McArthur-type mine with a bit lower grade, and then another with a yet lower grade and so on. Remember from the above, we get an orders-of-magnitude change in grade as we move up the curve. From nearly 15% to below 1%. There is no in-between to smooth things out.

The result is that at the far end of the uranium curve, costs rise exponentially. Around 90% of global uranium supply can be delivered for $20 per pound. But the remaining 10% of mines need much higher prices in order to turn a profit. These are small and/or low-grade mines. Production costs here run up to $45 per pound. At the upper end of the curve, production gets expensive very quickly.

Which is why the potential loss of production following Olympic Dam's accident this week is so significant. If the mine were to be reduced to 20% of capacity for six months (which some people close to the situation say might be the case), the uranium sector could lose 3.5 million pounds of production. Or 7% of global output.

This could be enough to push higher-cost producers into business in order to meet market demand. In such a case, prices would likely rise significantly in order to cover producers' costs. In the past, such supply disruptions have triggered rapid and steep price movements. And given the still-odd structure of the uranium sector, it could happen again.

David Forest
October 14th, 2009

Note: The information provided in this newsletter is based on the independent research of Dave Forest and Notela Resource Advisors Ltd. and is intended solely for informative purposes and is not to be construed, under any circumstances, by implication or otherwise, as an offer to sell or a solicitation to buy or trade any securities or commodities named herein. Information contained in this newsletter is obtained from sources believed to be reliable, but is in no way assured. All materials and related graphics provided in this newsletter and any other materials which are referenced herein are provided "as is" without warranty of any kind, either express or implied. No assurance of any kind is implied or possible where projections of future conditions are attempted. Readers using the information contained herein are solely responsible for verifying the accuracy thereof and for their own actions and investment decisions. Neither Dave Forest nor Notela Resource Advisors Ltd., make any representations about the suitability of the information delivered in this newsletter or any other materials that are referenced herein for any purpose whatsoever. The information contained in this newsletter does not constitute investment advice and neither Dave Forest nor Notela Resource Advisors Ltd. are registered with any securities regulatory authority to provide investment advice. Readers are cautioned to consult with a qualified registered securities adviser prior to making any investment decisions.The information contained in this newsletter has not been reviewed or authorized by any of the companies mentioned herein.

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