Back From Vacation With Several Updates

It’s been a relaxing couple of weeks, but it’s time to get back on the saddle. There have been a number of important developments in my core investments that need to be covered thoroughly. This will be a longer post, so grab a cup of coffee and let’s jump right in.

Uranium - Reaching Boiling Point

The US ban on Russian EUP became law on May 14th, and will go into effect on August 11th (90 days). I’ve already covered the implications for the uranium fuel cycle here, but there are a couple of additional developments that took place last week that will exacerbate the upward pressure on nuclear fuel prices. Two days after the ban, Russian state-owned uranium supplier, Tenex, retaliated by issuing a force majeure notice to US utilities, stating that they must get an exemption waiver within 60 days to ensure their existing contracts are honored. Utilities have also been told to make financial arrangements to prepay their contracts.

In other words, if you are a US nuclear power operator with an existing contract with Tenex, you need to let Tenex know whether you’ll be getting a waiver from the ban even before the ban goes into effect. You will also have to make a prepayment for all future contractual obligations, as Tenex does not want to assume the future risk of non-payment due to an inability to obtain a waiver. This increases the upfront financial obligation on utilities, and also dramatically shortens the time window for them to figure out whether they’ll 1/ qualify for a waiver and 2/ find alternative sources of fuel supply.

Why did Tenex do this? There is a lot that remains unsaid with Tenex’s notice, but based on my talks with industry experts, there are a couple of theories. The first is that Tenex wants to inflict the maximum pain possible by throwing sand into the gears of a fuel cycle that is already stretched. Tenex knows that there is little flex in Western mining, conversion and enrichment, and by giving utilities such a short window to source alternate supplies, they might squeeze prices parabolically higher, and/or force the US government to offer a significant number of waivers, which would be an embarrassing admission of the US’ reliance on Russian fuel supplies. The waiver application process doesn’t start until 30 days from signing, which would leave the DOE with only a few weeks to process dozens of waiver request applications for utilities to meet the 60 day deadline.

Another theory is that Tenex would be more than happy to cancel its current contracts with Western utilities, as they were signed when uranium prices were a lot lower. By giving US utilities such a short window to obtain waivers, Tenex is hoping that many utilities will be forced to cancel their contracts, allowing Tenex to sign new contracts with China and India, at much higher prices reflective of the current market / pricing environment. As a reminder, since 2022, spot uranium prices are +100%, while spot conversion and enrichment prices are +200%.

Either way, the implications for uranium prices are bullish. Even if a number of utilities manage to get waivers and continue to buy fuel from Tenex, the waivers only last until 2028, which in fuel cycle terms is like tomorrow. Even with the waivers, US fuel buyers will have to hustle and get contracts in place with Western enrichers as soon as possible, leading to overfeeding and increased U3O8 demand. Utilities will also have rethink their contracts with Kazatomprom (KAP), given Russia’s increasing influence in Kazakhstan. While larger utilities like Constellation are well covered until 2029, a number of smaller US utilities are likely to be caught short, and may have to buy in the illiquid spot market, leading to violent moves in spot price. It’s important to remember that US utilities have been contracting below replacement rate for several years. Last year, of the ~160mm lbs of LT contracts signed, only 20mm lbs were signed by US utilities.

To add fuel to the fire, the US plans to start soliciting bids worth as much as $3.4bn to buy domestically produced EUP in the coming weeks for its domestic uranium reserves. Importantly, the uranium used to fabricate the EUP must also be sourced from domestic producers. This plan is part of the $2.7bn funding unlocked with the passing of the Russian ban, to support the domestic conversion and enrichment fuel cycle. These developments are all unambiguously bullish for Western uranium enrichers and miners, and uranium spot prices. I’ve taken advantage of the pull back in prices over February and March to leverage up my uranium positions, with an outsized allocation to spot uranium through SPUT / U.UN.

NexGen (NXE) - Ugly Financing, But A Signal For What’s Coming Next For Uranium

On May 8th, NXE (which I’ve held as a core uranium investment since 2022) announced that it had entered into an agreement with MMCap (a Canadian hedge fund) for the purchase of 2.7mm lbs of U3O8 in exchange for a US$250mm convertible debenture issued to MMCap. The debentures have a 9% coupon over a 5-year term, and are convertible into NXE shares at 30% premium to the average 5-day VWAP prior to the announcement of the transaction, which represents a conversion price of C$14.70 per share. NXE will also issue 909K shares to MMCap as an “establishment fee”. The deal represents ~4% dilution to the current shares outstanding, and an implied U3O8 purchase price of US$95.37/lb. With a 9% coupon rate, and assumed 5% interest on cash (opportunity cost), NXE would need uranium prices to more than double for this instrument to make sense (14% compounded over 5 years is ~2x), assuming NXE stock price doesn’t rise above the conversion price (the cost of capital of a convertible bond is non-linear, rising with the stock price when stock price rises above the conversion price).

The market reaction to the deal was understandably negative. Not only is the convertible extremely expensive, it was also issued at a time when the Company was in the middle of marketing a C$224mm equity offering in Australia. The equity offering closed at a price above the closing price of the stock the day the convertible was issued, something the equity deal participants would have found infuriating (I was surprised the equity offering wasn’t repriced to reflect this). The lack of timing consideration illustrates management’s lack of capital markets experience at best, and a disregard for its shareholders at worst.

Despite the amateurish execution of these financing transactions, there is a silver lining in the recent developments. As a reminder, NXE is by far the largest and most important uranium developer, with the potential to produce ~30mm lbs of U3O8 per year. For comparison, the two largest uranium producers in the world, KAP and Cameco produce ~55mm lbs and ~36mm lbs per year, respectively. The nuclear industry desperately needs NXE’s Arrow to come into production for the uranium market deficit to improve, and for the world to realize its green energy ambitions, including the development of SMRs. What does it mean then, if NXE decides to issue a really expensive convertible to purchase the very commodity that it’s supposed to produce in the future?

It seems to me that this transaction is a signal that NXE management team are looking to hedge a scenario where Arrow production may be delayed. The uranium market’s cumulative deficit to 2030 is ~180-200mm lbs, and this assumes Arrow comes online 2028 / 2029. If Arrow doesn’t come online this decade, we can expect uranium price to be multiples of where it is today, as the deficit will be truly astounding. Another reason why NXE would want to buy physical uranium is to support the Company’s marketing / contracting discussions. Any utility looking to sign contracts with a developer will want to know the backup / contingency plan in case production is delayed. Having significant physical uranium in reserve helps NXE assuage such concerns, assuring utilities that they will get their uranium on time, even if the mine production is behind schedule.

In conclusion, I don’t like the deal. I wish NXE management had bought physical uranium earlier, and been smarter about financing the purchase (Denison is a good example of this). However, using the 80/20 rule, it still doesn’t break the thesis for owning NXE. In a historic bull market, you want to own the largest, most prolific assets under development, and even if management makes mistakes along the way, you’re still going to be ok. At a US$100 - US$150 / lb uranium price, NXE will generate average annual EBITDA of between C$3.4bn and C$5.2bn over the first 5 years of production, and will be one of the largest mining companies in the world in terms of earnings power. Today you are paying a market cap of C$6bn for those future earnings, and for the liquidity. NXE is one of the few uranium stocks with sufficient liquidity for large institutional investors looking to play the thesis. And if NXE management does something truly disastrous that puts the mine development at risk, I’ll be paid handsomely on my physical uranium position, which is many times larger.

Oil - Time To Take A Bullish Bet

At the end of March, I started trimming my energy positions and got out of my WTI call spreads. The reasoning was that sentiment, after turning extremely pessimistic, had turned bullish due to a combination of continued geopolitical risks, underwhelming US production growth, and solid economic data. With positioning normalized, the risk / reward of being long oil was no longer as attractive. Recently, crude positioning has become bearish again. Refiners have been on maintenance, inventories in the US have been building, and refining margins have been weak. However, there are signs that things may be turning around.

The EIA’s data on implied US demand is starting to turn up.

Refining margins / crack spreads, while still below the March highs, are showing some signs of having reached a bottom and are rebounding.

Brent time spreads have been weakening, but have remained in backwardation.

While oil stocks have been building, refiners are scheduled to come out of maintenance in the coming months, creating a 3.5-4mm b/d demand impulse for oil, which should push oil inventories lower.

If refinery throughput matches forecasts, US crude storage should fall below 450mm bbls over June and July, which should be supportive of a move in WTI back to US$80+.

From a technical perspective, WTI prices have tested the US$76-77 area (see yellow horizontal support lines on the chart below) since the beginning of May, and have held so far.

Last but not least, trader positioning has been flushed out, and is now down sharply to make new lows for the year.

With OPEC+ extending its cuts to mid-June, there should be no major surprises on the supply side. As long as demand holds, margins continue to heal, and refiners start drawing on crude, there is a good chance that oil positioning will have to rebalance and push WTI crude prices back up. To play this setup, I’ve bought US$80 strike WTI calls on September futures for ~$2.30 per contract.

Copper - Too Much, Too Soon

Since I wrote about the copper thesis, prices have gone up in a straight line, with spot prices peaking at around US$5.2/lb on Sunday, May 19th, before pulling back to US$4.76/lb currently. While I maintain my longer-term bullish view, I think copper positioning has become too crowded, and I reiterate my stance to avoid adding to positions here and limit exposure to 10-15% of NAV.

We’re also seeing a short-term supply and demand response that should help temper the recent price spike. On the supply side, this is happening in the form of increased scrap de-stocking, given the widening of scrap discount (the bigger the discount of scrap copper price to cathode and concentrate price, the greater the incentive for buyers to defer primary consumption and pull on scrap inventory). This scrap response has prevented Chinese cathode stocks from experiencing their seasonal inflection from build to draws (see red line representing 2024 in the chart below, compared to prior years).

On the demand side, China is now suffering from a buyer’s strike, as copper fabricators (buyers of copper concentrate) are pushing back on higher prices. At $10k/t copper price, Chinese fabricators are unable to pass higher feedstock prices on to consumers. The quote below from a director at Citic Metal illustrates this. The increase in copper price has happened too fast for consumers to digest.

The export arb between Chinese copper prices and London Metals Exchange (LME) is also quite attractive for China to sell inventories to international customers.

Looking beyond the near-term headwinds, copper prices should remain healthy going into H2 2024 as the market is expected to be in a 450Kt deficit for the year. Chinese end-user demand is tracking 7% YoY, and while that may slow down temporarily in response to higher prices, consumption can only be deferred for so long as green and grid channel investments are necessary for China to maintain its economic growth. Ex-China demand is tracking unchanged YoY, after falling 2% in 2023. AI is emerging as a new demand growth vector, as AI data centers have significantly higher power density. GS expects AI copper demand to be 80Kt this year, doubling to 160Kt by 2026. Copper is used in data centers for 1/ power distribution, 2/ grounding and connections and 3/ plumbing and HVAC.

There is not much respite for the bears on the supply side either. The Cobre Panama mine is now no longer expected to restart this year, removing 190Kt of supply for 2024. Mine supply is expected to grow 2% this year, down from 6% growth forecast in the middle of 2023. This represents the weakest period of global copper supply growth since the 2020 COVID shock.

The biggest medium-term risk to the copper thesis is likely on the demand side. If the Chinese property sector woes continue, or worsen, then Chinese non-green demand could falter and take some of the wind out of the sails of the price momentum. Recent data from China suggests that both industrial and retail credit demand is contracting, suggesting that economic growth could slow. EV sales in Q1 are also tracking weaker, with the world’s two largest sellers, Tesla and BYD, having to cut prices to stimulate demand. It’s too early to say if this is a structural shift, or a temporary bump in the secular EV trend, but it’s important to monitor.

From a technical point of view, a flush back and consolidation at the 50dma at $4.44/lb would be healthy, and an attractive point to add to positions. If Chinese economic weakness worsens, we could see a pullback all the way down to the 200dma at around $4.00. A drop below $4.00 is probably where I would get more aggressive, and add a substantial chunk of capital to work, including options.