The sharp rise in the uranium price over the past six months or so coupled with more frequent warnings of a growing supply shortfall has sparked debate whether this increase is just a transitory phenomenon or whether it is the beginning of a more permanent shift to much higher prices. To address this question, during the next two weeks we will present cover stories that argue the opposing sides of this issue. The first, appearing below, will take the position that we are at the beginning of a giant wave that will produce higher and higher prices. After both of these cases are made, we would like you to vote on which one you believe is most convincing, and provide any comments you deem appropriate.

The party has been going on for some time now. For a while, it seemed like just about every piece of news about the uranium market was good from the standpoint of buyers. Starting in the late 1980s, massive new supplies started coming, first from the Soviet Union and then its newly freed republics. The Olympic Dam mega-project came on line in the late 1980s and expanded in the 1990s. McArthur River, by far the richest deposit in the world, also came on line during the 1990s. The mid-1990s also saw the release of uranium formerly locked away inside nuclear weapons. Shortly thereafter, the U.S. government decided to liquidate most of its inventories through the privatization of USEC.

Over the last couple of years, however, bad news has been raining on the party. There’s been a fire at Olympic Dam and a flood at McArthur River. A ship carrying uranium has run aground. Some of the inventory transferred to USEC was found to be contaminated. The gold price has increased, and uranium production is down. A delivery gets missed. And so on.

Sure, it might be pointed out that these are all short-term problems, and have been or will be rectified with little to no impact on the basic supply situation. But this isn’t the really bad news. The really bad news relates to how dramatically the underlying fundamentals of the market are changing. Demand has been steadily increasing, as capacity factors improve, uprates take place, and reactor lives are extended. This is not happening just in the United States, but all around the world. As a result, world uranium requirements are heading toward 200 million pounds by 2010.

The longer-term prospects for production, which on a world basis is less than 100 million pounds, is not good. There are few projects in the pipeline, little exploration occurring, and limited ability to squeeze additional output out of existing projects. And, even though uranium prices have increased over 25% this year, this increase has largely been offset by the growing strength of the Australian and Canadian dollars against the U.S. dollar. Consequently, there has been little incentive to spur exploration or production in those countries.

Then there’s Russia. Once the source of what seemed like unlimited uranium, things are much different today. Russia has sold most of its inventory, and its needs are expanding, both internally and for its captive export market. There are greater indications that Russia wants to retain as much of the HEU feed supply that it can, both now and in the future. In this regard, it seems increasingly unlikely that there will a follow-on HEU deal, as Russia seems to need the material itself or will hold it for strategic purposes, much like the U.S.

Granted, inventories resulting from mismatch between procurements and actual requirements will always represent some component of uranium supply, and we would assume HEU and tails will continue to meet a portion of uranium requirements, at least until 2013. But these supplies will not nearly be enough to fill the shortfall. Much of the price-mitigating aspect of a movement to lower tails has already been accounted for, as tails stripping already makes up a large component of supply. Utilities can select lower tails, but this just reduces the ability of enrichers to underfeed their plants and put the extra supply back in the market.

Irrational Expectations – The reaction to talk of any impending supply shortfall is that we’ve heard this warning a number of times before and nothing has happened. So, of course, this means that it can’t happen. Correct? The reality is that the party has been kept going by the appearance of HEU supplies and the liquidation of government inventories, truly extraordinary events. To say that price won’t move to higher levels is the same as saying that it is expected these extraordinary events will continue to happen.

This perennial optimism actually makes the future imbalance between supply and demand worse. Buyers don’t believe there’s a problem, so they delay contracting, failing to send the needed signals to producers. For their part, producers have been burnt so many times in the past that they are not about to invest more on the mere promise of an improving market. Consequently, nothing gets done.

This skewed view of the market is probably best exemplified by the contrasting situation between planning for future nuclear power plants and exploring for uranium. U.S. utilities are in the process of applying for early site permits, spending likely tens of millions of dollars to do so. They are motivated to do so because such an investment will shave years off of the licensing process once they get around to actually ordering a plant. Yet, somewhere in a parallel universe, uranium producers are for the most part not exploring for uranium, their version of an early site permit. This does not bode well for the future.

That 1970s Show - What’s going on now is reminiscent of what happened during the mid-1970s, when price exploded from $6 to over $40/pound, far over-shooting the long-term cost of uranium. In the 1970s, production was forced to expand rapidly to meet reactor needs that were largely dictated by inflated requirements in enrichment contracts. At that time, utilities and intermediaries were shocked to find that the uranium they had been counting on was not available, or at least not available at prices they were expecting, and price was bid up dramatically. Today, the reactor requirements are real, and the need to expand production is just as real, if not more so. As we have pointed out before, around 200 million pounds must be supplied by the 2010 mark or shortly thereafter, and we are dealing with a production base of less than 100 million pounds today.

In the 1970s there was a tremendous response in production to higher prices and also the U.S. was relaxing its embargo on foreign uranium, further contributing to the supply response. However, much of today’s supply is inelastic with respect to price, meaning that it will take rather large increases in price to generate more supply. Uranium that is produced as a byproduct of copper and gold will depend more on the price movement of the primary commodities. Russia and the U.S. aren’t going to decide to liberate more supply from weapons just because the uranium price increases. Regulatory requirements are stricter today, and thus it takes longer to get a project off the ground. Most of the trade restrictions on uranium have already been removed, so there is little to be gained by improving the trade situation.

If this is true, you might ask how things got so bad. One cause was the massive influx of inventories that depressed price to extremely low levels, causing a cutback in production and exploration efforts. In effect, inventory holders sold at the cost of the cheapest mines, not noticing that they were driving out higher cost mines and preventing new investment. Another has been the stealth-like quality of demand, with reactor requirements increasing significantly without much of the way in new reactors coming on line (at least none in the U.S.). A third factor was the over-reliance on the spot price, using what is essentially an inventory-driven price as an indicator of the future scarcity of uranium. In practice, the market has failed in the sense that it is not generating enough supply to meet future demand. We are thus setting up for a repeat of the 1970’s, when absolute scarcity caused prices to go sky-high, well above what would have been necessary if the proper signals were sent to the supply industry.

The recent market experience shows what happens when inventory either runs out or inventory sellers decide to stop selling, finally realizing that they are selling too cheap relative to long-run supply costs. Prices are bid up to higher and higher levels to induce remaining inventory holders to part with their remaining supply. At the same time, these prices have not stimulated any more production, and what expansion takes place over the next five to ten years will be modest at best. This is because the extended liquidation of inventories at too low prices has gone on so long that there are not enough uranium mining projects in the pipeline to replace the fire-sale inventory material when it runs out.

For those who think that this is just a transitory phenomenon, ask yourself the following question: What’s going to happen to make the supply situation better the next year, the year after that, or the year after that? We have already seen the situation develop where spot bids are met with no offers or incomplete offers. How long is it until the same happens when a utility goes out for long-term contract bids?

When the price increases begins to elicit some production response, it will be too little, too late, as supply will fail to keep up with demand, and higher and higher prices will be required to pry inventories out of the hands of their holders, if there are indeed any left. Ultimately, say 10 years from now, the requisite amount of new production will come on line in response to much higher prices. But, in the meantime, prices are likely to overshoot substantially.

It is perhaps too extreme to say that the situation will become so dire that reactors will be shut down due to a lack of fuel or because uranium prices have been pushed too high that it will be uneconomical to run a reactor. In any case, turn out the lights, because the party’s over.