Oil and natural gas hog the limelight when it comes to the energy markets, for good reason: oil remains the world’s primary transportation fuel and gas is the fastest-growing fuel for power plants right.

But quietly, nuclear power is on a roll. Uranium miner Cameco (NYSE: CCJ) has been the top-performing stock in The Energy Strategist portfolio since we recommended it in May. And smaller uranium miner Denison Mines (Toronto: DEN) has been perking up recently.

The reason is simple: nuclear power is the only viable means of meeting the world’s rapidly rising demand for electricity. As I explained in last week’s Flash Alert, India and China understand that fact and are aggressively building out their nuclear power programs to meet demand. Dr. Manmohan Singh, Prime Minister of India, made it absolutely clear in his presentation at the National Press Club last week that nuclear is the only way of meeting India’s electricity needs without putting severe strain on the global oil and natural gas markets.

In the Western world, too, there’s a growing realization that while wind and solar power can make a contribution to the global electric grid on the margin, these technologies–no matter how well developed–cannot replace traditional power plants. There’s an obvious shift in sentiment in the US and Europe in favor of reexamining the potential of nuclear energy.

The good news for investors is that future growth in nuclear power continues to be underrated; stocks benefiting from nuclear power’s resurgence still have plenty of room to run. In this issue, I’ll examine some of the problems with alternative, renewable energy supplies–problems that have placed the nuclear option firmly back on the table even in countries that have traditionally been opposed to growth in nuclear power.

In addition, we’ll examine the global nuclear power market, including the market for enriching and processing nuclear fuel. I’m adding some related companies to the How They Rate coverage universe, including US enrichment giant Usec (NYSE: USU) and two speculative uranium mining plays, Uranium Resources (OTC: URIX) and UEX Corporation (Toronto: UEX).

Before we delve into the latest on nuclear power, it’s worth mentioning that with second quarter earnings season for the energy sector in full bloom results have been solid across the board. That said, the oil and gas services group has offered the most extreme upside surprises for investors. This reflects the beginning of a new spending cycle on exploration and production.

The simple fact is that the reserve replacement ratios for most producers have been very low in recent years. That’s because these companies aren’t finding new oil reserves fast enough to offset their production. They’re producing more oil and gas than they’re finding.

The offshoot of this is that both the integrated and independent producers are hiking their exploration budgets, hoping to reverse or at least arrest the decline of reserve replacement ratios industry wide. Higher exploration and production budgets spell more drilling activity, more spending on services to find and evaluate reserves and, of course, spending on ways to squeeze more out of existing reservoirs.

This new exploration cycle will benefit our driller recommendations such as Noble (NYSE: NE), GlobalSantaFe (NYSE: GSF) and Todco (NYSE: THE). It is also feeding into the pockets of services recommendations Schlumberger (NYSE: SLB) and Weatherford (NYSE: WFT).

For a more complete rundown of the implications of recent earnings reports, I will be eagerly awaiting reports due out over the next three days from several of our portfolio recommendations. I’ll issue a Flash Alert after I’ve listened to the conference calls and fully reviewed the reports.

Another Alternative?

In the May 26 issue of The Energy Strategist I detailed the advantages nuclear power holds over natural gas as a fuel for power plants. Topping the list is cost.  The cost of generating electricity from natural gas varies wildly with the price of gas itself. Commodity prices make up roughly 80 percent of the cost of gas-fired power. Not so with nuclear–only about 20 percent of the cost of a kilowatt-hour of electricity is due to the cost of mining and processing uranium into fuel.

As outlined below (“War Games”), it’s likely that oil and natural gas prices will remain high on average for some time to come. The natural gas market, due to the wider availability of liquefied natural gas (LNG), also looks to become more globally competitive in the future. This will lead to larger, more volatile moves in natural gas generation pricing in the coming years. Nuclear power, if more widely deployed, could reduce that volatility.

Another advantage of nuclear: it’s environmentally friendly. Coal is a key global power source and will remain the world’s most important source of electric power for at least another 20 years. Unfortunately, coal does produce significant and dangerous pollution, notably sulphur and mercury. And even gas-fired plants release some pollution into the atmosphere. Nuclear plants, in contrast, have almost no impact on the environment.

But I’m often asked about other forms of alternative power. After all, solar energy, wind energy and wave-generated power all get plenty of media attention. Such technologies seem like clean, logical alternatives to gas or nuclear plants.

The fact is that these alternative energies have a role to play in the electricity grid of developed countries. Nevertheless, none of these technologies can replace conventional power plants and, even with recent technological advances, large-scale implementations of such alternative technologies have been beset with problems.

Apart from hydroelectric power, wind is the most widely deployed and promising alternative energy. Germany’s experience with wind energy offers some illustration of the limitations of the technology that prevents more widespread adoption.

The German government has been perhaps the most aggressive in the world in encouraging renewable energies. It began researching a wider role for wind energy as far back as the 1980s, and in 1991 passed a law requiring utilities to hook up to local renewable energy generators.

By far the boldest move was the nation’s Renewable Energy Act of 2000, which offered significant subsidies and generation targets for renewable energy generation. Not surprisingly, as the chart “Germany’s Windmills” shows, wind power generation capacity has ballooned in recent years and projections call for continued expansion in the coming years.



Source: E.ON

Germany led the world in wind power capacity construction for years and by 2003 was the world’s largest generator of wind power. Germany accounted for half of Europe’s installed wind generation capacity and about one-third of total world capacity. Unfortunately, Germany’s massive wind effort has not been the panacea that some envisioned, nor has it significantly reduced the country’s dependence on fossil fuels.

The main problem is that wind power isn’t suitable for base load generation, the minimum, continuous electric supply that must be available at all times on the grid. Electricity is always being consumed, but obviously not at a constant rate–more electricity is consumed, for example, in the middle of a hot summer day than at 3 am when the temperature is in the 60s. The minimum required supply in a given day is base load. Base load power supply needs to be available at all times and be easily predictable.

Wind power is unpredictable for the simple reason that the wind does not always blow at a constant rate. According to German electric and transmission utility E.On (NYSE: EON), Germany’s installed wind capacity topped 14,000 megawatts (MW) in 2003, about 6,000 MW of which was in E.On’s area of operations. But E.ON reports that, on average, less than one-sixth of that capacity–1,000 MW–was available to the grid. In other words, for a vast majority of the time, Germany’s wind power plants were generating nothing close to their rated capacity.

Wind power isn’t particularly effective at meeting demand during peak times, either. The problem here is, once again, the weather. Consider the times when electric power is in most demand, during summer heat waves or winter cold snaps.

The last few weeks offer an excellent example. The temperature near my office in the Washington, DC, area approached 100 degrees Fahrenheit with high humidity several days last week. The extreme heat afflicted most of the Midwest as well. Air conditioning systems are in near-continuous use.

According to the National Weather Service (NWS) a large, high pressure system full of tropical air has stalled right over the middle of the country. Those who care to browse the NWS website will find that high pressure systems are often associated with extreme heat waves (and bitter winter cold snaps) around the globe.

There’s another feature of such weather patterns–unusually light winds. Wind is normally the lightest right at the center of a high pressure system, right where the weather is most oppressive. Wind power turbines are not well equipped to offer power when that power is most needed.

A similar heat wave hit Europe back in the summer of 2003. The weather phenomenon outlined above is exactly why E.ON reports that wind power’s contribution to the grid was near the lows for the year in the middle of that 2003 heat wave.

To remedy this problem, generators can employ what’s known as shadow capacity, traditional coal or gas-fired plants that are held in reserve and can be activated quickly to meet demand when wind power drops unexpectedly. Shadow capacity requirements for wind power can be as high as a whopping 80 percent of the installed capacity. That means that for every 1,000 MW of installed wind capacity, about 800 MW of traditional power needs to be held in reserve. Ironically, far from reducing Germany’s dependence on fossil fuels, the nation’s construction of wind capacity is pushing demand for new conventional plant construction.

Two additional major problems spring from wind’s unpredictability. The first is grid management. The problem is that energy on an electric grid cannot be stored; power consumed must always equal power generated at a given time. If there’s a loss of balance it can cause a dramatic failure of the grid (the 2003 blackout in the Northeastern part of the US springs to mind).

With traditional power plants, that’s not so much of a problem. Demand can be forecasted with some degree of accuracy and it’s relatively easy to control electric output from coal or gas-fired plants. Wind is a different story. Predicting power output entails predicting the speed at which the wind will blow at any given moment.

While companies like E.On have spent millions developing sophisticated wind-speed forecast models, modeling power output from wind farms is a highly complex and unpredictable business. Additional and expensive safeguards have been required to ensure that sudden spikes or drop-offs in generation don’t destabilize the grid.

Finally, there’s a basic infrastructure problem. In Germany, wind farms are located along the coastal regions and offshore because that’s where the strongest, most predictable winds blow. These are not highly populated parts of the country. In contrast, traditional facilities are normally located adjacent to major population centers. The problem is that the grid near the nation’s centers of wind power production is not set up to handle such a high load of electricity. Germany’s grid needs investment to handle all this new wind power, and installing the needed lines is an expensive process that requires a lengthy regulatory process.

Return Of The Nuclear Option

My point in detailing all these problems is not to disparage wind power. Rather, it’s to point out a simple fact: even if the developed world spends enormous sums on alternative technologies it will not eliminate dependence on fossil fuels.

Germany is a wealthy, advanced and fully developed country. Demand growth for power in the nation is slow and the government has made developing renewable energy a cornerstone of policy. But Germany’s wind power experiment has been, at best, a modest success.

India and China, for all their progress, are still poor countries. Both are also seeing extraordinarily rapid electricity demand growth. Neither is in a position to implement the sophisticated “fixes” and redundant shadow capacity that Germany has used to make its wind power system function.

India and China need to rapidly ramp up the scale of their respective grids to meet surging demand. Wind power cannot fulfill that role.

Even in the West, the contributions of wind and solar power are grossly overplayed relative to that of nuclear energy. In 2000, German Chancellor Gerhard Schroeder announced a plan to totally phase out nuclear power over a 32-year period.

Renewables were often cited as an alternative to make up for the 30-percent of German’s grid that’s currently served by nuclear power. But there’s likely to be a change of government in Germany soon, and several opposition groups have announced plans to alter that plan and extend the operating life of the country’s existing plants.

Across the English Channel in Britain, much the same story is emerging. Even after considerable investments in wind, solar and wave-generated power, according to Prime Minister Tony Blair’s chief scientist, Sir David King, renewables aren’t yet able to replace traditional power plants. King is recommending another generation of nuclear plants to reduce dependence on fossil fuels.

Despite all this, the US Department of Energy and other non-governmental groups are forecasting only slight growth in nuclear power over the next 20 years. It’s only a matter of time before these estimates are revised higher and the world catches on to the nuclear growth story.

Nuclear Mining

The main fuel for nuclear power plants is uranium. As I explained in depth in the May 26 issue, global uranium supplies are already very tight and prices are on the rise. The market continues to under-appreciate the growth potential of the nuclear industry, while the supply problem is set to get even worse.

Let’s review the main beneficiaries and a few more speculative plays.

Uranium is a naturally occurring metal that is only slightly radioactive in its natural state. In fact, it’s a rather common mineral in Earth’s crust. In its natural state, uranium occurs as uranium oxide (U-3O8). With a yellowish color, this ore is colloquially referred to as “yellowcake.” Yellowcake is composed of two main components, U-235 and U-238. The stable U-238 accounts for more than 99 percent of mined uranium. The unstable U-235 is the isotope used to create a nuclear reaction and produce energy.

The first step in producing uranium fuel is mining natural uranium. There are a few ways of doing this; two of the more common methods are surface mining and in-situ leach production. The former is akin to strip mining coal or any other mineral; the latter involves pumping acid down a hole and dissolving the uranium. Acid and liquid with dissolved uranium is known as pregnant liquid–this can then be pumped back to the surface and the natural uranium separated. In the chart “Fuel Costs,” the cost of nuclear fuel is broken down by process. As you can see, mining accounts for roughly one-third of the cost of nuclear fuel.

(For more information on my favorite uranium picks, check out my recent report on Investing in Uranium Stocks.

Fuel Costs



Source: E.On

My favorite plays on uranium mining are Wildcatters Portfolio members Cameco (NYSE: CCJ) and Denison Mines (Toronto: DEN).

Cameco, which sits atop the world’s purest deposits of natural uranium, is the blue-chip play on the industry. Its McArthur River mine contains ore that’s more than 20 percent composed of U-3O8 and can be mined using a simple surface drilling technique. In contrast, some commercial uranium mines in Australia are closer to 0.1 percent to 0.3 percent U-308. McArthur River, and Cameco’s other major mining operation, Rabbit Lake, sport some of the lowest production costs in the world, about $7 to $8 per pound of U-308. When you consider that U-308 currently trades at about $30 per pound, the company’s earnings leverage is obvious.

Cameco’s properties are also among the only in the world capable of being scaled up to rapidly boost production in a relatively short period of time. If you own no other uranium company, Cameco should be the one.

Denison Mines owns a piece of a U-3O8 rich McLean Lake mine in Canada, from which it’s already producing roughly 1.5 million pounds of uranium annually. Denison is also working with uranium giant Cogema, a company owned by the French Government, on exploring several new properties in Canada. Denison is smaller and more speculative than Cameco but still rates a buy.

Denison also administers a fund, Wildcatter Portfolio holding Uranium Participation Corp (Toronto: U), which holds 2.15 million pounds of yellowcake in storage. A direct play on higher uranium prices, Uranium Participation Corp is a buy.

Those investors seeking more speculative exposure should consider Uranium Resources (OTC: URIX) and UEX Corporation (Toronto: UEX). Both stocks are too speculative to be part of The Energy Strategist portfolios, but I will track both stocks as buys in the How They Rate table.

Uranium Resources owns a series of uranium mines in Texas and New Mexico, states with considerable reserves of yellowcake. The company has recently started to produce and sell uranium, and in the most recent quarter Uranium Resources actually turned a small profit on those sales. Production should be over 600,000 pounds of uranium this year and well over 1 million pounds next year. Supply contracts are outstanding for about 300,000 pounds of uranium to be delivered annually from 2005 through 2008.

The problem with Uranium Resources is that its production costs are about $11.00 per pound. That’s fine with uranium prices now close to $30 per pound but it was disastrous in the late 1990s when prices rested under $10. To keep itself alive in those lean years, the company issued a boatload of shares, diluting its shareholder base.

Uranium Resources recently secured yet another offering of shares in May, raising an additional $1.5 million. This money will finance future expansions of Uranium Resources’ mining operations. Provided uranium prices remain high, this stock has the potential to turn the corner on profitability for good. If that happens, the stock should see some very impressive gains.

I can’t overemphasize this point: Uranium Resources is highly speculative and if you decide to buy the stock you should take only a relatively small position.

UEX Corporation is partly owned by Cameco and has extensive exploration joint-venture agreements with both Cameco and Cogema. UEX has undertaken a very aggressive uranium exploration campaign in the Athabasca Basin, the same basic geographical area where prolific mines like McArthur Lake are located. Cameco contributed some of these properties to UEX.

UEX recently received some solid news from its drilling program. It appears that there are several very high-grade veins of U-308 on one of the properties (known as Shea Creek) that UEX has on lease from Cogema. The stock was up about 30 percent in one day on this news.

If the find pans out, UEX has an option for as much as a 49 percent interest in this project. While UEX isn’t actually mining any ore–it’s still in the exploration phase–the fact that it’s working so closely with the two most respected firms in the business is a major plus. UEX is a buy in the How They Rate table, but like Uranium Resources, it should be considered a high-risk, speculative play.

The Supply Chain

Once uranium is mined, it’s not ready for use. The U-3O8 must be separated from the impurities in the ore then treated with chemicals and acids and mixed with fluoride gas to produce uranium tetrafluoride (UF-4). This process is known as conversion. Cameco is the world’s second-largest owner of conversion capacity behind the French government. As the chart “Mining Costs,” conversion accounts for roughly 5 percent of nuclear fuel costs.

Enrichment is a far more important process. Uranium tetrafluoride produced in conversion is a powder at room temperature, but turns into a gas at 54 degrees Celsius (about 130 degrees Fahrenheit). In the process of gaseous centrifuge enrichment, the UF-4 is heated into a gas is then fed into a centrifuge that spins the gas rapidly.

Because U-238 is heavier than U-235, the U-235 tends to accumulate near the center of the centrifuge while the U-238 moves to the edges. In this way, the unstable U-235 used in the nuclear generation reaction can be isolated. The point of this is to enrich the uranium from its natural state of less than 1 percent U-235 into 4 to 5 percent U-235–this product is called low enriched uranium (LEU). LEU is the fuel used in power plants. The enrichment process accounts for more than 40 percent of the cost of manufacturing nuclear fuel.

The same uranium can be enriched even further into highly enriched uranium (HEU). Nuclear weapons, for example, are made of uranium enriched to as much as 90 percent U-235.

The enrichment industry is highly politicized and protected by trade barriers. Four players hold more than 95 percent of the world’s enrichment capacity. The only approved uranium enrichment company in the US also happens to be the largest in the world–Usec (NYSE: USU). European enrichment capacity is government controlled; similarly, Usec was once part of the US government, but was fully privatized in 1998. Right now, Usec’s enrichment capacity is 100 percent utilized–it has no spare capacity to enrich more uranium.

At first blush it would seem that Usec is an excellent play on the nuclear growth story, but there are a few problems.

The “Megatons To Megawatts” program was originally agreed to by the US and Russian governments in 1993. The idea was to reprocess about 500 tons of HEU from Russian nuclear warheads into LEU for fuel by 2013 to help prevent proliferation of nuclear material; that fuel was to be sent to Usec in the US. From a political perspective, the deal is working, as HEU is being reprocessed and the full 500 tons will be reprocessed by 2013.

But the actual details of the original agreement were Byzantine. Basically, the Russian government handles the actually down-blending of HEU fuel into 5 percent U-235 (LEU) uranium hexafluoride. Usec was then required to purchase the LEU at a fixed price (two-thirds the 1993 market prices for the uranium).

Usec did not actually buy all the uranium, only a piece of it, the enrichment component. The feed component–natural uranium that could be processed into nuclear fuel–was still owned by the Russian government.

After processing it’s impossible to separate a feed component from an enrichment component–this is just a theoretical construct that’s part of the 1993 agreement. Usec handled this by accepting shipments of natural uranium from utility companies; instead of enriching that uranium, Usec simply sold the utilities the LEU from Russian nuclear warheads. The natural uranium from the utilities was held in storage in US warehouses on behalf of the Russian government (as US law prevented it from being exported back to Russia).

The deal became a disaster by the late 1990s. The 1993 pricing structure was very unfair to Usec and the company began hemorrhaging cash when uranium prices fell after 1993. What’s more, the Russian government refused to sell its stockpile of warehoused natural uranium at the low US market prices.

In the end, Usec managed to renegotiate the terms of the deal. The new terms involved adjusting the LEU prices Usec pays to levels more reflective of market prices. It remains unclear just how profitable the “Megatons To Megawatts” program is for Usec. At best, it offers the company a relatively low return on investment.

Even ignoring Megatons to Megawatts, Usec faces some daunting challenges over the next few years. The company is planning a major expansion of its enrichment facilities, the American Centrifuge Project. This will be necessary to meet strong demand for enrichment services, but won’t be completed until the end of the decade.

American Centrifuge, still basically in the planning stage, is estimated to cost over $1.5 billion. This seems a high price for a company with a market capitalization of less than $1.4 billion and nearly $500 million in debt.

I fully believe that the American Centrifuge project will be a positive for Usec and that the company will eventually be a great play on the uranium market. However, the miners are better, more leveraged plays right now. Until I get some more visibility on the progress of Usec’s expensive expansion I’m unwilling to recommend the stock. I’ll be tracking Usec in the How They Rate Table as a hold recommendation. For more leverage to the nuclear story, I prefer the small-cap miners I recommended above.

War Games

By Yiannis G. Mostrous

Long-term readers know that The Energy Strategist’s view is that the price of oil is currently affected on the margin by two factors: limited spare capacity of the producers and strong demand growth from Asia. Since we foresee no circumstantial changes, we expect the price of oil to remain above $50 per barrel for the next 12 months.

An unexpected supply disruption could send prices soaring, and drive the global economy into deep recession. This is precisely the scenario a team of former top government officials considered while taking part in a simulated exercise (war game) a month ago.

“Oil Shockwave” is a war game exercise developed by Securing America’s Future Energy (www.secureenergy.org) and the National Commission on Energy Policy. In this half-day exercise, participants get involved in a series of principals meetings of the president’s cabinet over a seven-month period in order to advise the chief executive on how to respond to a series of events that affect world oil supplies. The event starts six months into the future, in December 2005, to provide some distance from current events. Former members of the oil industry, current and former military officials, national security experts and other specialists are providing the simulation scenarios.

The outcome of the most recent exercise was that the US will be in a very difficult situation, given its dependence in foreign oil and the fact that its government would be unable to influence developments once a serious terrorist act or other disruption takes place.

Former CIA director Robert M. Gates, who took on the role of national security adviser, said, “The scenarios portrayed were absolutely not alarmist; they’re realistic.”

Although neither our investment recommendations nor our market forecasts are based on such scenarios (nor should they be), in the current environment investors should be aware of the above-mentioned possibilities as well as the fact that these scenarios are being seriously contemplated in the higher ranks of the oil industry, the government and the military.

We continue to recommend a high allocation in energy stocks. From the majors, we prefer ExxonMobil (NYSE: XOM), ConocoPhillips (NYSE: COP), TOTAL (NYSE: TOT) and Royal Dutch Shell (NYSE: RD).

Liquid Energy Part II

In the July 13 issue we wrote about the increasing importance of LNG as an energy source. As the growth is strong (LNG liquefaction capacity will double in the next five years), identifying the major players is of paramount importance.

Last time we talked about the companies that will continue to benefit from the trend. Here we’ll take a look at the major players in the production end of the equation, and how their actions will affect prices for years to come.

Very few investors recognize that although OPEC countries account for a little more than 20 percent of global gas production, they actually control 50 percent of the global gas reserves (see the chart “Global Natural Gas Proved Reserves”). As LNG increases in importance, so will OPEC efforts to affect global prices and to become, as in oil, the dominant force.

Source: BP Statistical Review

The fact that a spot market for LNG is rapidly developing will make OPEC’s grip on the market tighter. Because LNG is transported by ship instead of through a static pipeline, carriers have the opportunity to deliver the cargo to the destination where prices are higher at the time of shipping.

The price of gas is becoming more global in nature, given the change in transportation method as well as the fact that OECD countries’ production is declining. The locality the price of gas used to enjoy and the security it used to provide, since more gas is demanded from outside suppliers, no longer prevail.

As gas production in OECD declines and demand increases, countries and regions around the world will start competing for LNG shipments. Given that spot pricing is gaining in popularity, the markets should experience price increases.

Asia, where LNG is already extremely popular (Japan is the largest buyer of LNG in the world), will again be driving prices higher as its economic development continues. At the same time, countries that were previously well stocked (the US and the UK) will need to adjust their gas market in the new realities, altering economic assumptions regarding their energy needs.