by Thomas Kirchner, CFA
Uranium prices more than doubled since pandemic lows.
Natural gas prices explode in Europe, also North America.
Conflict in Ukraine, winter temperatures and Nordstream 2 are key factors to watch.
It has been 17 months since oil futures prices turned negative due to buyers unable to take delivery in Cushing, TX. This week, a similar squeeze is developing in a more esoteric segment of the energy market: uranium futures. This comes as disruption in natural gas markets signals significant risk of price hikes throughout the winter months.
Uranium rally
Uranium and its associated futures prices has risen from pre-pandemic levels of below $20 per pound to current levels in the high $40s. During the pandemic, the initial spike into the $30s was attributed to mine closures in Kazakhstan due to Covid outbreaks. Two thirds of uranium comes from just a handful of mines in Kazakhstan (41%), Australia (13%) and Namibia (11%) [i], so it is not a surprise that the disruption in one of the top mines affects the overall market. Add to that the discrepancy between uranium consumption and production: for more than a decade, uranium consumption has exceeded production, so that inventories are gradually being depleted (pun intended). Unless mining capacity is expanded, the production deficit can only get worse: 50 reactors are currently under construction and will supplement the currently operating 445 reactors and increase capacity by 15% by 2040, around 300 are in various stages of proposal [ii]. Against this clearly supportive backdrop stands the decarbonization trend, where many see nuclear as a CO2-free substitute to fossil fuels.
The strong investment thesis has led to financial investors seeking exposure to the metal. Unlike in other commodity markets, uranium futures are illiquid, which is probably a reflection of the high degree of concentration in the market with a limited number of producers and consumers. Physical uranium is challenging to invest in as storage and transportation require special equipment and licenses.
The Sprott Physical Uranium Trust launched in August fills that void. It launched with $300 million worth of uranium and has begun raising and additional $1.3 billion in equity from investors. It has been estimated that Sprott's purchases in its first month have increased demand by 3%- that is in just one month[iii]. Sprott is no longer alone: Uranium Royalty Corp announced last week that it has purchased physical uranium equivalent to roughly $120 million[iv]. Now that physical uranium has become financialized, we expect investment demand to become a significant driver of price performance, especially to the upside.
The good news for consumers is that the cost of uranium is a comparatively small component of the cost of electricity generated by nuclear power stations, where depreciation of the enormous investments required to build the plant dwarf the cost of the consumable.
Natural gas price explosion
Unlike uranium, the cost of natural gas contributes significantly to the cost of electricity from gas-powered plants. The recent increase of natural gas prices in Europe, and to a lesser extent in North America,
NYMEX gas futures have risen from a low of $2 during the Covid-panic to a recent high round $5[v]. In Europe, the increase has been even more dramatic. Gas for delivery in the Netherlands increased from a pandemic low of around 13 Euros to a recent high of 42. The situation is even more dramatic in the UK, where gas futures hit a recent high of 189 from a Covid-nadir in the low 30s[vi], a six-fold increase.
Unlike oil, which is easy to transport through pipelines and takers, the gas market used to be local and depended on pipelines. However, the increase in LNG transport capacity in recent years has broken down geographic barriers, and the gas market is now much more global than it used to be. That means that substantial price differentials between regions will lead LNG operators to ship gas from where it is cheaper to where it can be sold for more. LNG is one of the last markets where substantial arbitrage profits can be made. This is mainly due to constraints in terminal capacity. Nevertheless, due to LNG, natural gas price spikes in Europe will, over time, raise natural gas price levels in North America.
Causes and outlook
The increase in natural gas prices in Europe is attributed to unusually low inventory levels for this time of year. Russia has delivered less gas than typical over the summer, which is the season in which storage tanks would normally be replenished. This raises the question as to why Russia has delivered less gas than normal. The three main transit routes from Siberia to Western Europe run through Ukraine, Eastern Europe and underneath the Baltic Sea, where a second pipeline, the controversial Nordstream 2, is about to be opened. One explanation for the low summer deliveries may be a desire by Russia to demonstrate to Europeans the necessity of the new Nordstream2 pipeline. Europe is likely to be undersupplied this winter unless this pipeline becomes fully operational. Another explanation could be the military situation in Ukraine: there have been rumors that a flare up of violence in the Dombass region is imminent. Therefore, Russia may have cut deliveries in order to minimize transit fees that would otherwise have been paid to Ukraine's national gas company Naftogas. These fees amounted to $2 billion in 2020 [viii], which is significant for a country whose GDP is only $153 billion[ix].
We believe that high gas prices pose a substantial economic threat due to the importance natural gas has both as a direct source of energy for industry and households, and for electricity production. At a time of generally rising inflation, increases in natural gas prices could have an effect similar to the oil shocks in the 1970s if they persist for an extended period of time. The factors to watch will be winter temperatures in Europe and Asia, which was a big LNG importer last year due to an unusually harsh winter, as well as the opening of the Nordstream2 pipeline. Should we experience a combination of harsh winters in Europe and Asia, or a failure to open the Nordstream2 pipeline, energy costs would pose a significant risk to the economy. Moreover, a flare-up in hostilities in Ukraine could also lead to further price increases in natural gas.
[i] 2020 production per “World Uranium Mining Production” World Nuclear Association, September 2021.
[ii] “Plans For New Reactors Worldwide” World Nuclear Association, August 2021.
[iii] “Uranium spot price reaches nine-year high as Sprott resumes purchases ” S&P Global Platts, September 15, 2021.
[iv] “Uranium Royalty Corp Expands Physical Uranium Holdings to 648,068 Pounds of U3O8 at a Weighted Average Cost of US$33.10 per pound U3O8” Press release on newswire.ca, September 15, 2021.
[v] Front month of the NYMEX contract. Quoted in US$ per BTU. Source: Bloomberg.
[vi] Front month of the ICE contract. The price is quoted in pence per therm, not in BTU. Source: Bloomberg.
[vii] Front month of the ICE contract for Dutch delivery. The price is quoted in € per MWh. Source: Bloomberg.
[viii] “US-German deal addresses Ukraine gas transit” Argus Media, July 22 2021.
[ix] For 2019. Source: World Bank.
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Thomas Kirchner, CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund (EVDIX, EVDAX) since its 2003 inception. Prior to joining Camelot he was the founder of Pennsylvania Avenue Advisers LLC and the portfolio manager of the Pennsylvania Avenue Event-Driven Fund. He is the author of 'Merger Arbitrage; How To Profit From Global Event Driven Arbitrage.' (Wiley Finance, 2nd ed 2016) and has earned the right to use the CFA designation.
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