Uranium Squeeze Update

Why prices aren't squeezing higher despite Sprott's active purchasing in the spot market

In September I wrote a piece on how the ‘squeeze’ in the uranium physical market might play out. I surmised that since the spot market is fairly illiquid, at some point prices will start ‘gapping’ higher given the unavailability of pounds to fill Sprott’s constant bid in the market and that this would encourage utilities to finally come to the table to negotiate new long-term contracts at prices that would incentivize offline production to come back online ($55-60+ / lb) and incentivize development of new uranium projects ($70-90+ / lb).

Since then, Sprott purchased an additional ~13mm lbs (46% increase) and also increased its ATM offering size from $1.3bn to $3.5bn. The fund currently holds 41mm lbs of U3O8 and is currently averaging ~200K lbs of uranium purchases PER DAY. It still has ~$800mm to deploy. For context, nuclear fuel consultants UxC forecast annual uranium demand of 200mm lbs and supply of 135mm lbs for 2022. An average 1GW nuclear reactor requires 450K lbs of uranium per year. So in other words, Sprott has acquired 30% of annual uranium supply, or enough fuel to power 90 nuclear reactors for a year.

Despite this torrid pace of uranium purchasing, spot prices have been stuck in the $40 - $50 / lb range. After briefly breaching the $50 / lb mark in late September, prices have failed to make higher highs. Some have argued that this is evidence that the uranium bulls were too optimistic and that there is more excess inventory out there than originally thought. Uranium miner share prices have also been under pressure. So where is all this uranium coming from?

Art Hyde of Segra Capital wrote a brilliant piece explaining what’s happening. Based on Segra’s conversations with utilities and traders, Western utilities have not been selling inventories into the spot market as most utilities are running on cycle-low inventory levels. In the East, Japanese utilities have significant quantities of unused uranium that was bought pre-Fukushima, but these purchases were made at much higher prices (near the top of the uranium cycle) and selling them at today’s spot price would force the utilities to recognize a loss for accounting purposes. Japan is also in the process or re-starting a number of its reactors, so the nuclear fuel might come in handy soon. And finally looking at China, their inventory levels are quite low relative to their build out plans. In fact China is a buyer vs. a seller at the moment.

It turns out that the pounds being supplied to Sprott in the spot market are not coming from ‘excess’ inventories from the utilities, but from three other ‘secondary’ sources:

1/ Hedge funds who bought physical uranium as a long-term investment in 2017 / 18 and can now finally monetize their gains in an efficient manner thanks to Sprott’s entry into the market. Pre-Sprott, the hedge funds would face an illiquid spot market where traders would be able to easily front run any major seller given the small number of market participants and high visibility of trading partners’ activities. Now these funds can sell to Sprott without moving the spot market too much. Hedge funds who want to retain upside exposure have been engaging in swaps where they exchange their physical uranium holdings for units of the Trust, a more liquid and efficient vehicle for long exposure.

2/ Utilities that have ‘flex volume options’ on their contracts with uranium miners are exercising these options to profit from the rise in spot prices. Art shared the following example:

• A Utility signs a 3 year 1-million-pound market related contract in June 2018, at the time the spot price is $23 and the 3-year forward price is $27

• The producer asks for a Floor of $20 in exchange for a ceiling of $40

• The Utility asks for a flex-option of 20% meaning that they can ask to receive either 1.2 million or 800,000 pounds at the time of delivery.

In this scenario if spot price jumped to $50 / lb, the utility can make a $2mm profit by exercising their 20% flex (200K pounds), buying at $40 / lb cap price and selling at $50 / lb spot price, netting a $2mm profit.

3/ Reverse carry trades. In a normal carry trade a utility enters into a contract with a uranium trader to lock in supply over some period of time (say 3 years). The trader then goes into the spot market to buy the physical commodity and ‘carries’ it on their books until delivery / expiration. The reason why carry trades have been so popular in recent years is because it’s cheaper for the utilities to buy pounds from traders vs. entering into contracts with miners. With the uranium market in oversupply post-Fukushima, traders could source excess inventories cheaply and sell them for a profit on the forward curve which was in contango. The miners on the other hand typically require longer-term contracts at prices that cover their long-term cost of production, cost of capital and offer an attractive return on investment.

By acting as a source of cheap uranium supply in the near / mid-term, carry traders have prevented uranium miners from successfully contracting with utilities. However, in doing so they have also played a role in mopping up excess uranium inventories and providing a constant bid in the spot market, preventing spot prices from free falling during periods of over supply. In essence, carry traders have brought future uranium demand forward by buying in the spot market today to deliver to Utilities tomorrow.

Sprott’s entry into the market has changed this dynamic. With Sprott pushing up spot prices, the forward curve has now gone into backwardation and traders are finding it profitable to ‘reverse’ their carry trades. This means that they can sell the pounds they bought for future delivery to Sprott today for a profit, and then go long futures contracts to fulfill their delivery obligations to their Utility counterparties at expiration. Let’s walk through an example:

A trader and a utility enter into a carry trade in 2019 where the trader agrees to deliver a pound of uranium in 2023 at a price of $30 / lb. Let’s also assume that the spot price at the time is $25 / lb, so the trader buys at $25 / lb today and realizes annualized return of ~4.7% over the four years (minus carrying costs). Now assume in 2021 Sprott’s entry into the market causes the curve to go into backwardation; spot prices rise to $55 / lb, while the 2023 futures price is $50 / lb. By selling the pound into the spot market at $55 / lb, the trader recognizes a gain of $30 / lb, or 120% in just two years. Concurrently the trader enters into a futures contract to buy a pound of uranium in 2023 for $50 / lb, for deliver to its utility customer for $30 / lb. So in 2023 (i.e 4 years later) the trader loses $20. The IRR on this transaction is much higher than the original carry trade, so traders will be incentivized to continue to sell pounds to Sprott with the market in backwardation.

These developments are bullish for the uranium mining sector longer term. By reversing their carry trades, traders are now pulling future supplies forward, setting up for an even tighter forward market where utilities will have to compete with carry traders for future primary supply to fulfill their long-term needs. This will give uranium miners a lot more negotiating leverage when signing contracts. Similarly, hedge funds and utilities that are selling pounds to Sprott today are ensuring those pounds won’t become available for commercial use in the future. The structure of the Sprott vehicle ensures that pounds that are sequestered into the Trust never go out. All of this means that while spot prices won’t spike in the near term (the higher spot goes the more pounds come out of carry trades into reverse carry trades), the outlook for the next few years is becoming incredibly bullish.