On our editorial calendar for this week we planned the first of two articles on bullish and bearish arguments for future movements in the uranium price. However, once we thought about it, we realized that this space could be better occupied by another topic. This does not mean that we couldn’t come up with bearish arguments; it is just that we are at a stage where it is not even a close call if one has to pick between price going up or going down.
This decision was crystallized by the nature of questions that we have been asked recently. One question is what could happen to push price down. Aside from the possibility of a reactor accident, this is a difficult question to answer. Another question that we have been asked is what steps can be taken to help shore up supply over the next five to ten years. This is also a very difficult question to answer.
These questions lead us directly to the subject of risk and how it is currently being addressed in the market. There is now more risk that price will increase than decline, and an additional element of risk is whether sufficient supplies will be available in the future. This risk is reflected in market behavior, particularly in contracting for long-term supplies, and it is instructive to trace how the allocation of risk has evolved.
Price Risk and Long-Term Contracts – This time last year the long-term and spot prices were about in equilibrium, although both prices had been under upward pressure for some time. Several months later, the long-term price was several dollars higher than the spot price. This change reflected growing concern about the availability of supplies out in the 2006 and later timeframe, and utilities were willing to pay a risk premium that was higher than the $1-$2 historical risk premium that the long-term price commanded over the spot price to lock in future supplies. Producers were also able to reduce or eliminate the quantity flexibilities in long-term contracts and eliminate options, shifting more risk about future market developments away from themselves onto buyers.
Of course, the classic way of dealing with price risk is through market price contracts. Typically, price is allowed to fluctuate between a floor and ceiling price, which locks in the downside and upside of the price paid under the contract. (These are known as limited price risk contracts.) Traditionally, the price referenced as the market price has been the spot price, and usually at a discount. At times when spot supplies were plentiful, long-term contracts had no floor prices, but suppliers had the opportunity of not delivering if price fell below a specified level.
The recent changes in market price contracting are especially revealing when it comes to the issue of price risk. Producers have been able to get floor prices that are higher than spot prices at the time the contract was signed. Discounts off of the spot price have disappeared. Indeed, producers have been able to command premiums over the spot price to the extent that they have signed contracts that reference long-term prices instead of the spot price.
Perhaps the most revealing aspect of how the allocation of price risk has evolved is the treatment of ceiling prices. Quoted ceiling prices have gone from $30 to $40 and higher and in some cases ceilings have been eliminated altogether. This demonstrates a type of price risk asymmetry in that the opportunity for the contract price to go much higher than its present level is much higher than its opportunity to go lower (if it has any opportunity to go lower).
Supply Risk – You may ask the question why a utility would sign a contract with a high ceiling price or no ceiling price. The answer is that, unlike producers, utilities must contend with supply risk as well as price risk (this is another type of risk asymmetry). In this context, although signing a market price contract with no ceiling means that a utility is taking on all of the price risk, the utility is at least addressing the issue of supply risk.
In recent weeks, we have also heard more about utilities grading producers in terms of supply risk. We have heard rankings such as A, A-, etc., and terms such as “top tier” and “just below top tier” applied to producers. Some utilities are compensating for this greater supply risk by holding more inventory. In this respect, it would seem that somehow the relative amount of supply risk associated with a particular producer should be translated into the price paid to that producer due to the costs associated with holding inventory.
There is also clearly an increasing concern about supply diversification, another way of addressing supply risk. However, there are not a lot of producers with which to diversify supply, especially in the out years, and this has added to the worries on the part of some utilities about supply risk.
Price Risk and the Spot Market – Price risk is not just confined to the long-term contract market, but it is also manifest in how traders and other suppliers approach the spot market. In an environment where the spot price is increasing and is notably below the long-term price, traders are more likely to be buyers than sellers. Any potential seller of spot material runs the risk that price may appreciate considerably in the upcoming months, so offerings may be limited or prices sought for deliveries further out in time may be higher than what can be accounted for by just the cost of money. It is easy to see in this environment why offer prices have continued to increase.
Price Risk and Investor Behavior – The prism of risk is also an instructive way of viewing investor participation in the spot market. Investors are clearly willing to take on price risk in return for the chance to sell uranium at higher prices in the future. This risk could be considerable, given the relatively illiquid nature of the spot market, and some in the industry believe that this participation will lead to increasing price volatility. (In some respects, it already has.) This has reportedly sparked worries on the part of uranium producers about what might happen to price once investors decide to liquidate the inventories that they are building. However, producers can insulate themselves from this risk to some degree if they are successful in tying market price contract to long-term prices instead of spot prices.
Again, we are dealing in the realm of price risk, not supply risk. The uranium that investors are buying consists of inventories that are being transferred from one group to another, and will eventually find their way back into the market. Thus, the situation with the investors is unlike that of China, which is building a number of reactors and, as a big consumer of uranium, is competing with utilities for future uranium supply.
The Bull Back in 2003 – The last time we presented bullish and bearish covers on consecutive weeks was in November 2003 when the spot price was $12.75, or about half of the current level. In a “bullish” editorial entitled “The Party’s Over” (The Ux Weekly, Nov. 3, p. 1-2), we presented the basis of why price would move much higher. Although the editorial engaged in a bit of hyperbole, for the most part it laid out what we will believed were compelling arguments why price was likely to move much higher.
One of those arguments was contained in the following paragraph:
For those who think that this [the price rise] 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?”
In hindsight, not much has happened to improve supply prospects since then. In fact, that same statement is pretty much applicable today, despite the fact that prices have increased considerably over the intervening 18 months. The difference is today that this price/supply uncertainty is reflected in the terms and conditions of long-term contracts whereas it was largely not addressed at that time.
Up until that time it seemed like producers and utilities were largely at an impasse when it came to contracting for deliveries in 2006 and later, resulting in large unfilled requirements beginning in 2006. Now, contracting focus is being shifted out to beyond 2010, and in some cases to 2015 and beyond. As a way of compensating for price risk for delivery in those later years, base-escalated prices in long-term contracts are stepped up to higher levels than are being sought for delivery in earlier years.
The point is that the further you go out in time, the higher the risk premium because the greater the uncertainty with respect to the market situation. This is understandable – a lot more can happen with respect to supply and demand in ten years than in five years. How successful will the Chinese nuclear power program be? Will more HEU be blended down following the end of the current deal? Will enrichment capacity be expanded significantly? Will producers expand output in a timely manner?
There are still a number of utilities that believe that price will “roll over” and they are better off waiting to cover in the future, or, if they cover now, they are signing market price contracts. Either way, they are taking on an increasing amount of price risk. Of course, in the case of those that are not signing contracts, they are taking on supply risk as well.