Time to Buy Energy Stocks
September is statistically the stock market’s weakest month of the year. But this year the S&P 500 defied the bears, rallying nearly 9 percent–its best September performance in over 70 years.
Although I wouldn’t rule out a bout of profit-taking early in the fourth quarter, a pullback is by no means a sure bet. More important, the energy markets is set for a sizeable fourth-quarter rally that will likely take crude oil and many energy stocks to new 2010 highs. Now is a good time to position your portfolio for the coming move; investors should regard any short-lived pullbacks as a buying opportunity.
Stocks leveraged to oil and coal offer the best upside prospects for the fourth quarter. I’ve called for a year-end rally for some time, a forecast that rests on three key pillars: improving fundamentals in the global oil market, the US economy exiting a soft patch that started in May, and the potential for another round of quantitative easing among central banks.
Over the long term, opportunities in the uranium production and nuclear power become more compelling as this global industry embarks on the most aggressive build-out in three decades.
In This Isssue
The Stories
Commentators who suggest that there’s a glut of global oil based on US petroleum inventories have their heads in the sand. Here’s my outlook for oil prices. See Glut Busting.
The spread between two key oil price benchmarks reveals a great deal about fundamentals in the global oil market. See West Texas Intermediate or Brent.
Improving economic conditions also bode well for a stock market rally and energy demand. See Improving Economic Prospects.
Another round of quantitative easing will also support stocks and energy commodities. See Rising Cash Lifts All Boats.
The global nuclear power industry is in the early stages of a multiyear growth spurt similar to what the industry experienced in the late 1970s and ‘80s. What many have referred to as a nuclear renaissance will generate tremendous wealth for investors over the next few years. See The Next Leg Up for Uranium and Playing the Nuclear Story.
Want to know which stocks to buy now? Check out the Fresh Money Buy List.
The Stocks
Cameco Corp (TSX: CCO, NYSE: CCJ)–Buy < USD30
Shaw Group (NYSE: SHAW)–Buy in Nuclear Power Field Bet
Paladin Energy (TSX: PDN, ASX: PDN)–Buy in Nuclear Power Field Bet
Uranium One (TSX: UUU)–Buy in Nuclear Power Field Bet
Denison Mines Corp (TSX: DML, AMEX: DNN)–Buy in Energy Watch List
Uranium Participation Corp (TSX: U)–Buy in Nuclear Power Field Bet
Babcock & Wilcox (NYSE: BWC)–Hold in Energy Watch List
Seadrill (NYSE: SDRL)–Buy < 31
Peabody Energy Corp (NYSE: BTU)–Buy < 54
Suncor Energy (TSX: SU, NYSE: SU)–Buy < USD43
Chevron (NYSE: CVX)–Buy < 90
Penn Virginia Resource Partners LP (NYSE: PVR)–Buy < 26
Schlumberger (NYSE: SLB)–Buy < 85
Weatherford International (NYSE: WFT)–Buy < 26
Afren (LSE: AFR)–Buy < GBP1.30
MacMahon Holdings (ASX: MAH)–Buy < AUD0.75
Knightsbridge Tankers (NSDQ: VLCCF)–Buy < 22
First Solar (NSDQ: FSLR)–Sell Short > 110
Diamond Offshore Drilling (NYSE: DO)–Sell Short > 60
When asked why he changed his opinion on a particular issue, British economist John Maynard Keynes reportedly replied, “When the facts change, I change my mind. What do you do, sir?” The facts have undeniably changed for the crude oil market over the past few years; however, many pundits continue to resist this new reality.
For many years, US petroleum inventories outside the country’s Strategic Petroleum Reserve (SPR) could tell you a great deal about the path of oil prices.
The SPR is a government stockpile of oil that’s intended for use only during national emergencies and isn’t readily available for consumption. Although the exact definition of what constitutes an emergency depends upon politics and who occupies the White House, the oil therein isn’t readily available for consumption. Accordingly, oil held in the SPR is typically excluded from measures of total petroleum inventories, which include gasoline and all other refined oil products in storage.
To say that US oil inventories are frequently referenced in the business media would be an epic understatement. If you tune into any financial television station on Wednesday morning at 10:30 am EST, you’re likely to be treated to a shot of a reporter standing on the floor of New York Mercantile Exchange (NYMEX) announcing the inventory statistics in real time. Often this report is followed by 10 minutes or more of commentary and analysis.
Inventory data from the US Energy Information Administration (EIA) is often erroneously used as a basic proxy for oil supply. That is, when US inventories are elevated and heading higher, some commentators will assert that crude prices should fall because the world oil market is well-supplied. This sophistic logic underpins the common fallacy that the world faces a glut of oil.
Though common in the financial media, such analyses overlook an inconvenient truth: US oil inventories have been a spectacularly poor indicator of crude oil prices for the past seven years. Crude prices may gyrate in the immediate aftermath of weekly US inventory reports, but trends in this data set aren’t of much use in timing longer-term moves. Check out the graph below.
Source: Energy Information Administration
As you can see, US crude oil inventories fell steadily from mid-1998 to early 2003, hitting two decade lows on March 14, 2003. Over this period, oil prices rallied from $10 to $15 a barrel in late 1998 to the mid-$30s per barrel in early 2003. It’s at this point that the relationship breaks down.
US oil inventories reversed course in 2003 and hovered near a three-decade high by September 2010. At the same time, oil in storage at the Cushing Hub reached an all-time high earlier. Meanwhile, inventories in the developed world stand at the highest levels since 1998. Nevertheless, oil prices have nearly tripled from March 2003 to September 2010.
Why did this relationship between US oil inventories and crude prices break down? Domestic supply and demand conditions are no longer the sole drivers of global oil prices. Although the US is by far the world’s biggest oil consumer, it’s no longer the primary source of demand growth.
Source: BP Statistical Review of World Energy 2010
Between 1999 and 2009, US oil consumption has declined by more than 800,000 barrels per day, largely because of the Great Recession. Meanwhile, demand from all countries in the Organization for Economic Cooperation and Development (OECD)–a proxy for the developed world—has tumbled by more than 2.1 million barrels per day.
The developing world accounts for nearly all growth in oil consumption. Chinese demand increased by more than 4 million barrels per day over this period, while India and Saudi Arabia each added another 1 million barrels per day to global consumption. Astoundingly, non-OECD oil demand expanded by more than 2 million barrels per day from 2007-09.
This trend has been underway for decades. Over the past thirty years demand from non-OECD nations has soared from less than 28 percent of the global consumption to 46 percent. That number will likely eclipse 50 percent within the next five years.
Investors can no longer afford to subscribe to an outdated, US-centric view of commodity markets that focuses solely on the EIA’s oil inventory statistics.
And don’t fall into the trap of thinking that this is the first time in history that crude oil prices have risen despite rising US inventories.
Source: Energy Information Administration
This graph tracks monthly US petroleum inventories from 1956 onward. As you can see, inventories increased steadily starting early 1956 and accelerated in the early 1970s until 1980. But on an inflation-adjusted basis, oil prices soared more than sevenfold between 1972 and 1980.Then, as now, crude oil prices were driven partly by factors that had little to do with the US–namely, the oil embargoes of the 1970s.
Finally, don’t confuse inventories with supply. The US has 1.14 billion barrels of crude oil in storage outside the SPR, a number that sounds enormous until you consider that the nation consumes close to 19 million barrels of oil per day. That amounts to roughly 60 days of supply.
Comparing global oil production to consumption provides a better read on the crude market. It’s estimated that the world will consume nearly 88 million barrels of oil per day in 2011; clearly, oil inventories provide only a temporary buffer between production and consumption.
OPEC’s spare capacity is the only meaningful source of leeway on the supply side. These fields could be brought on-stream as needed to meet rising demand. Right now, OPEC has spare capacity of about 5.6 million barrels per day, a level that protects against near-term shortages.
But as global oil demand continues to increase, questions emerge about how quickly producers can expand output, especially those outside of OPEC. Not only is output from traditional exporters such as Mexico on the wane as fields mature, but new projects in the deepwater and other challenging environments require many years and billions of dollars in capital to complete.
Higher oil prices would incentivize production from deepwater fields and Canada’s oil sands. There’s no magic number, but non-OPEC producers would need prices to average more than $70 a barrel to justify the massive up-front costs.
Even with higher oil prices, the global economy recovery means OPEC will need to dip into its spare capacity to meet rising demand. Within three to five years, spare capacity could easily drop to record-low levels as a percent of daily consumption. Periods of tight OPEC spare capacity, such as early 2008, correspond to huge run-ups in crude prices.
As spare capacity disappears dwindles, the world will also become increasingly vulnerable to near-term shocks such as geopolitical events in the Middle East or weather-related supply disruptions.
The bottom line: High US oil inventories do not indicate that crude prices are likely to fall because of a glutted global market. It’s all about flowing barrels, not oil stored underground in Texas or crude booked as reserves on some company’s accounting statements.
Instead of analyzing weekly inventory data, investors should focus on oil demand in the developing world, OPEC’s spare capacity as demand rises and the oil prices needed to tempt non-OPEC producers to spend on new projects. All three of these fundamentals point to sustained higher prices.
West Texas Intermediate or Brent
West Texas Intermediate (WTI) and Brent crude oil are the two most widely quoted benchmark oil prices. WTI is the benchmark that underlies oil futures traded on the NYMEX; Brent is the basis of the London-traded Intercontinental Exchange (ICE) futures contract.
Analysts continue to debate about which benchmark is more relevant. Most investors should monitor movements in Brent crude and the relationship between Brent and WTI prices; Brent increasingly reflects fundamentals in global oil markets better than WTI.
In the Feb. 17, 2010, issue of The Energy Strategist, A New Dark Age for Refiners, I explained the main factors that differentiate different types of crude. For example, WTI crude has a standard American Petroleum Institute (API) gravity of 39 degrees and a sulfur content of 0.34 percent. Oil with API gravity higher than 31 degrees is considered “light” oil and is easier to refine than heavy oil. Crude with less than 0.5 percent sulfur is dubbed “sweet.” Because sulfur is a pollutant that must be removed during the refining process, sweet oil is more valuable than “sour” crude that contains more sulfur. WTI is light, sweet crude oil.
Brent, named after an oilfield in the North Sea, is also light, sweet crude oil. But standard Brent crude has an API of just over 38 and a sulfur content of 0.37 percent; Brent crude is slightly heavier and sourer than WTI. Assuming all other factors are equal, one would expect WTI crude to be worth slightly more than Brent. In fact, over the past 27 years, WTI has traded at an average premium of $1.22 per barrel.
Let’s examine this relationship in percentage terms. Here’s a graph of the percentage difference between spot WTI and Brent crude on a weekly.
Source: Bloomberg
As you can see, WTI historically has traded an average of 5.6 percent above the price of Brent. Also note two additional lines on this chart, “+2 STDEV” and “-2STDEV.” These lines show a statistical measure known as standard deviation. When the spread between WTI and Brent is above “+2 STDEV,” the price of WTI is unusually high relative to Brent crude oil. Conversely, when the spread is below “-2STDEV,” WTI is unusually cheap relatively to London-traded Brent.
Two other points are worth noting. First, the WTI-Brent spread has generally traded well below its long-term average. The percentage premium has generally hovered between the mean and “-2STDEV” lines with a few notable spikes below that lower bound. This reflects a sea change in the relationship between WTI and Brent prices over the past five to seven years; namely, Brent has become more expensive relative to WTI.
Chemistry doesn’t explain this shift. The properties of standard Brent and WTI crude haven’t changed over the past 27 years, and WTI remains slightly easier to refine and lower in sulfur that Brent. Instead, this change likely reflects trends in global oil markets.
The market typically has regarded Bent crude as a key international benchmark, while WTI is considered the standard price in the Americas. Brent tends to reflect traders’ perception of international oil supply and demand conditions; WTI has a closer tie to US market conditions.
Because oil demand has increased substantially in markets outside the US over the past decade, the price gave between Brent and WTI has expanded. In short, when Brent is expensive relative to WTI, international oil supply and demand conditions are tighter than in the US. This is the situation that prevails today.
This brings me to my second point about this graph. Instances where the WTI-Brent spread dips below “-2STDEV” occur more frequently over the past six years. These downward spies have typically marked periods when oil prices strengthen.
For example, the WTI-Brent spread spiked two standard deviations below the mean in late April 2007, signaling that Brent prices were unusually expensive relative to WTI. That is, WTI traded at a significant discount to Brent. At the time, WTI commanded less than $65 per barrel. Three months later WTI had rallied to $78 a barrel, closing some of the gap.
The same pattern played out again in late 2008 and early 2009. In late 2008 Brent traded a significant premium to WTI, which hovered around $38 to $40 per barrel. By the end of March 2009, oil prices had soared to over $50 a barrel.
Today, the WTI-Brent spread is approaching levels that are two standard deviations below its mean. As of the end of last week, Brent crude commanded a premium of nearly $2 per barrel to WTI. Although US oil supplies should be sufficient in the near term, this spread reflects concerns that accelerating growth in emerging markets is tightening the global supply and demand picture.
Brent has already taken out its August highs and is sitting just $4–less than 5 percent–away from its May 3, 2010, high of $88.45 a barrel. It’s only a matter of time before Brent leads WTI to a new 2010 high.
My economic outlook remains the same: The US and global economy will not suffer a double-dip recession. Furthermore, the sovereign-debt crisis in Greece and other peripheral economies across the EU will not morph into a second act of the 2008 credit crunch. These two fears drove this summer’s selloff.
As I’ve projected since summer 2009, the US–and, to a lesser extent, other developed countries–is experiencing a lumpy, subpar recovery from the 2007-09 recession.
But traders’ expectations have changed throughout 2010. In the first few months of the year US and EU economic data appeared to turn for the better; in April, for example, the US added more than 240,000 private-sector jobs, prompting some to conclude that the US was experiencing a classic V-shaped recovery.
Then US economy hit what many a soft patch. Once again, many investors jumped to the equally erroneous conclusion that the US was headed for a double-dip recession. In late June and early July fear of a double dip was ubiquitous.
But in late August and September investor sentiment began to shift once again. Improving economic data made fears of a double-dip recession a thing of the past.
The uptick in the US economy suggests that country has moved beyond the soft patch. Similarly, the EU isn’t falling apart at the seams because of Continent-wide efforts to bring budget deficits under control. Most important, evidence is growing that China has engineered a soft landing for its high-flying economy; growth has slowed from the hyper-accelerated rate of the first quarter but hasn’t collapsed. In fact, recent data suggest that the economy may be reaccelerating.
Economists are famous for developing and analyzing obscure indicators. Despite my training, I always fight the tendency to over-think the data; in my experience, a handful of time-tested economic indicators provides the clearest picture of economic trends. If you try to interpret every piece of data released each week, you’ll quickly succumb to information paralysis and confusion. The graph below tracks one of my favorite indicators.
Source: Bloomberg
The ISM Manufacturing and Non-Manufacturing Purchasing Manager Indexes (PMI) provide a quick measure of growth in the US manufacturing and service industries, respectively. Interpreting these indicators is relatively straightforward: Readings above 50 suggest growth, and numbers below 50 indicate contraction.
However, investors often forget that a decline in the indicator doesn’t mean that the economy is shrinking; rather, a decline suggests that the rate of growth is slowing.
For example, the Manufacturing PMI topped out at 60.4 in April 2010, whereas the September reading came in at 54.4. This decline indicates that manufacturing portion of the economy isn’t growing as quickly as it was six months ago.
That’s not entirely shocking. The fastest growth in every recovery typically occurs in the first few quarters as the economy emerges from recession. In this case, a wave of inventory restocking accelerated manufacturing growth; companies cut inventories to the bone during the downturn and were forced to replenish their stocks. A reading of 54.4 is consistent with continued expansion in the manufacturing sector.
Meanwhile, September’s Non-Manufacturing PMI–a much larger component of the US economy–suggests that the pace of growth picked up. The index jumped from 51.5 in August to 53.2. Analysts had expected a reading of 52.
China’s Manufacturing PMI suggests that the economy experience a classic soft landing and is enjoying another uptick in growth.
Source: Bloomberg
Chinese Manufacturing PMI sank to a low of 51.2 in July but has increased for two consecutive months to 53.8. This reading trumped consensus estimates reflects a pickup in China’s growth.
The recent rally in stocks and commodities reflects investors’ returning confidence that the US and global economies are unlikely to sink into recession in 2010 or in early 2011.
Rising Tide of Cash Lifts all Boats
The final pillar of the year-end rally in stocks and commodities is easy money courtesy of a second round of quantitative easing (QE). Several central banks, including the Federal Reserve and the Bank of England, engaged in quantitative easing during the 2008-09 financial crisis. Traders have dubbed this second round “QE2.”
The concept of QE is simple: A central bank buys financial assets such as government bonds or mortgage securities directly from financial institutions. Because central banks effectively create money to purchase these assets, QE increases the supply of money in the financial system.
Generally speaking, QE pushes down yields on government bonds because the central bank buys these bonds, boosting prices and reducing yields. QE also tends to put downward pressure on the value of a nation’s currency; in the case of the US, QE should constrain any rallies in the dollar. Finally, QE is designed to combat deflation by creating inflation.
The size of the Fed’s balance sheet provides a good indication of the scale of its QE efforts.
Source: Bloomberg, Federal Reserve
The bonds and other securities that the Fed buys appear as assets on its balance sheet. The total assets on the Fed’s balance sheet have increased steadily from about $500 billion in the mid-1990s to just under $900 billion in mid-2008.
QE and other programs bloated the Fed’s balance sheet from 2008 to early 2010. In May 2010, the Fed’s total assets stood at more than $2.35 trillion–nearly triple the size of its holdings in 2008.
The Fed had planned to reduce the size of its balance sheet as the economy recovered and the need for extraordinary stimulus declined. But that scenario hasn’t played out according to plan. As economic data deteriorated in the summer, the Fed grew increasingly nervous about withdrawing monetary stimulus too early.
In August the central bank announced that it would reinvest principal repayments from the securities it holds. In other words, as the bonds the Fed holds are paid off, the central bank will buy more bonds. This form of quantitative easing will ensure that the Fed’s balance sheet remains bloated.
More recently, a series of Fed statements and speeches from Fed Chairman Ben Bernanke and other key policymakers make it clear that the central bank intends to go even further and resume the purchase of Treasuries. In other words, QE2 will expand the Fed’s balance sheet even further.
And the Fed isn’t the only central bank that’s setting sail with QE2. On Oct. 5, the Bank of Japan (BOJ) lowered the target for its benchmark interest rate from 0.1 percent to a range of 0 to 0.1 percent. Although the move is a fairly meaningless policy shift, BOJ also announced it will purchase as much as USD60 billion worth of financial assets, including government bonds, commercial paper, corporate bonds, exchange-traded funds and real estate investment trusts.
The latter policy is quantitative easing, pure and simple.
QE is a controversial policy tool and could stoke inflation and further shred confidence in the US dollar. The central bank also assumes the risk that it could lose money on the assets it purchases.
The rapid expansion of the Fed’s balance sheet troubles me. But one thing is certain: The influx of money to come from another round of QE should push up the prices of all assets. Two of the most likely beneficiaries are stocks and commodities such as oil and basic materials.
With the global economy showing signs of bouncing back from its summertime soft patch, QE2 may not be necessary. However, this contention is a moot point; more quantitative easing appears likely regardless of the economic data. QE is the third pillar supporting a rally in energy stocks.
Playing Oil and Coal
As I noted in the introduction, coal (outside the US) and oil are likely to benefit the most from a year-end rally. Demand for both commodities will increase as growth in emerging economies remains strong.
I covered the basic fundamentals for oil earlier in this report and discussed coal at great length in the Aug. 18, 2010, issue, A Tale of Two Industries.
My top oil and coal picks appear in my Fresh Money Buy List at the end of this issue.The global nuclear power industry is in the early stages of a multiyear growth spurt similar to what the industry experienced in the late 1970s and ‘80s. What many have referred to as a nuclear renaissance will generate tremendous wealth for investors over the next few years.
The oil price shocks of the 1970s prompted many countries to stop producing electricity from crude oil.
In the US, for example, the power industry’s use of petroleum has declined by more than 90 percent since peaking in 1978. To put that into perspective, total US net electricity generation has also soared more than 73 percent since 1978.
The nuclear power industry was a major beneficiary of the rise in crude oil prices in the ‘70s, and the subsequent decline in the use of crude to produce electricity through the 1980s and 90s. After the oil price shocks, utilities the world over sought a power source that fit two key criteria: a lack of dependence on imports and costs that don’t vary excessively with commodity prices.
Nuclear power fits the bill on both counts. The key nuclear fuel, uranium, is mined in a number of different countries, including the former Soviet Union, the US and Canada. Although many countries with a nuclear power industry import some uranium, the sheer quantity of material and total cost is minimal in comparison to oil. If you’re worried about energy security and supply embargoes, uranium is a far better choice than oil.
Moreover, the cost of nuclear power has little relationship to the price of uranium fuel. According to data from the EIA, variable operating and maintenance costs (mainly refueling) for a nuclear power plant represent just under 8 percent of the total cost of electricity generated in a nuclear reactor. That compares to 24 percent for a conventional coal plant and 60 to 70 percent for most natural gas turbines. Even a doubling or tripling in natural uranium prices has only a modest impact on the cost of generating power.
These advantages catalyzed a nuclear power construction boom in the late 1970s and early 1980s.
Source: Energy Information Administration
This graph tracks global nuclear power capacity from 1980 to 2007. Note that there’s a big different between installed capacity and electricity generation. Installed capacity measures the total potential power output of all plants operating at full capacity. Generation is the amount of power actually produced; as you might expect, the total amount of power generated will always be less than global capacity.
Capacity is the purest measure of the number of new plants that are built and brought online. As you can see, global nuclear capacity grew quickly in the 1980s and slowed dramatically after 1990. Through the ‘80s global capacity increased by more than 140 percent, an annualized growth rate of more than 9 percent. In contrast, total nuclear capacity grew just 9 percent in the 1990s.
It’s also instructive to look at total global consumption of nuclear power.
Source: BP Statistical Review of World Energy 2010
Nuclear power consumption grew at an impressive pace from 1965 to 1990. As nuclear power capacity growth hit a wall in 1990, the rate of growth in nuclear power consumption also slowed but didn’t stop completely.
This incremental growth occurred as electric power companies became more adept at operating their existing nuclear facilities. On average, US nuclear power plants are operating at more than 90 percent of their peak capacity. In 1980 the average capacity factor for US nuclear plants in 1980 was just 56 percent.
There isn’t much room for upside in capacity factors. Future growth in nuclear power consumption will require the construction of new nuclear power facilities.
The spot uranium market–the market for immediate delivery of material–is small and illiquid. Most uranium used in the world is contracted under long-term supply deals; the spot market typically accounts for roughly 10 to 20 percent of total volumes consumed each year.
Nonetheless, spot uranium prices are a good gauge of general sentiment surrounding the prospects for nuclear power and uranium supply and demand. Here’s a graph of uranium prices since 1995.
Source: Bloomberg
Uranium prices have been on a rollercoaster ride over the past decade. In the late 1990s up until late 2003, prices hovered around $10 per pound. But between 2003 and 2007 spot uranium prices went parabolic, climbing to just shy of $140 per pound in early June 2007.
Uranium prices have pulled back sharply since then, hitting a low of $40.50 per pound in April 2010. But prices didn’t come close to their 2001-03 lows.
The uranium market is showing signs of life again. After flat-lining in the low $40s per pound over several months, prices climbed as high as $48 per pound in September, before falling back to $46.50. Producers, utilities and investors all increased the volume of their activity.
This is the opening act of what’s likely to be the next leg higher for uranium. I expect uranium spot prices to climb above $60 per pound in 2011, though there will be plenty of volatility along the way. The three main catalysts for this move: the biggest global nuclear plant building boom since the 1980s, a slowdown in uranium supply growth and rising mining costs.
This time emerging markets, not the developed world, are at the vanguard of the nuclear renaissance.
Source: World Nuclear Association
When I talk about nuclear energy at investment conferences, skeptics argue that it’s difficult to site and construct new plants in the US without enduring major delays. That’s true, but the US is largely irrelevant to the present-day growth in nuclear power.
As of Oct. 1, there were 441 nuclear reactors operating worldwide. Total capacity stood at 376,000 megawatts (MW) and generation accounted for 13 to 14 percent of the world’s electricity. Meanwhile, 58 new reactors (total capacity of 60,484 MW) worldwide are at some stage of construction. Once completed, these new facilities would increase nuclear capacity by 16 percent.
As you can see, most of the plants under construction are in developing countries. China is in the process of constructing 23 reactors with a total capacity of nearly 26,000 MW. Only looking at plants where construction is underway, China is roughly tripling the size of its nuclear fleet. Russia and India are also building their nuclear power capabilities.
And plants under construction are only the beginning of the story. The World Nuclear Association (WNA) also maintains statistics on plants that are “on order or planned.” Construction has not yet begun on planned reactors, though major regulatory approvals and financing are in place. The WNA estimates that these plants are likely to be operation within the decade. Here’s a look at planned nuclear plant construction.
Source: World Nuclear Association
Globally, there are 152 planned reactors with total capacity of 167,401 MW–roughly equivalent to the capacity of existing reactors. Emerging economies also account for many of these planned reactors. In fact, China, India and Russia alone account for about half the world’s planned nuclear facilities.
The WNA also tracks proposed reactors, plants that are in an earlier stage of planning and would likely take 15 years to be constructed. These plants are the least likely to be built. Nonetheless, the WNA estimates that there are 337 proposed plants with a total capacity of 382,825; most of these plants would be sited in developing countries, though some developed countries have aggressive longer-term plans for reactor construction.
A major building boom is underway for nuclear capacity. Over the next decade I expect capacity growth rates to resemble those of the ‘70s and ‘80s.
And more nuclear power plants equals rising demand for the key nuclear fuel, uranium. To incentivize mined supply growth, uranium prices will need to rise significantly over the next 12 to 24 months.
According to Cameco Corp (TSX: CCO, NYSE: CCJ), the world consumed about 170 million pounds of uranium in 2009. With a construction boom underway, consumption will expand roughly 3 percent annually through 2019. That will push total global consumption to about 230 million pounds by the end of the decade.
In 2009 total global primary uranium production–output from mines–was just 132 million pounds. In other words, of the 170 million pounds of uranium consumed, only three-quarters came from mines, the remainder comes from secondary sources such as inventories, reprocessed nuclear warheads and recycled nuclear waste.
But secondary sources ultimately run out. A classic example is a program for reprocessing Russian nuclear warheads into fuel rods for power plants. The Russian warhead reprocessing deal has been produced roughly 24 million pounds of uranium each year, a sizeable portion of the secondary supply that’s bridged the gap between uranium consumption and mine output.
The Russians have repeatedly reiterated that this reprocessing deal will sunset in 2013. Most analysts expect the Russians to continue supplying nuclear material from reprocessed warheads but that the amounts will decline. Cameco Corp conservatively estimates that Russian reprocessed supplies will halve from 24 million pounds to 12 million pounds annually. Some analysts project a much bigger decline.
Given all of these inputs, Cameco Corp estimates that the gap between total uranium supply (primary and secondary sources) and demand will amount to roughly 135 million pounds over the next decade. Much of this shortfall will have to be filled with new mined supply.
But there are a few major obstacles to mined supply growth. The rapid run-up in uranium prices from late 2003 to mid-2007 catalyzed a new round of mine development in countries such as Kazakhstan, which is now the world’s largest producer. Production has increased about 30 percent since the 2007 and 12 percent in 2009.
This flurry of new mine developments is beginning to slow. In addition, most analysts estimate that new the cost of mining uranium is north of $31 per pound; spot prices in the mid-$40s offer little incentive to invest billions of dollars in new projects. And mining costs are likely to head higher as producers are forced to tap expensive-to-produce deposits in more remote parts of the world.
Although there’s plenty of uranium supply in the near term, slowing production growth and accelerating demand over the next few years threaten to produce a supply squeeze in the long term.
And there are indications that some nuclear power producers have concerns about longer-term uranium supplies. In 2009 China was active in the spot uranium market, securing supplies to fuel its new reactors. But the country now buys some of its uranium under long-term contracts, locking in supplies. For example, China Nuclear Energy Industry Corp inked a 10-year supply deal with Cameco Corp for 23 million pounds of uranium.
And China National Nuclear Corp is also beginning to invest abroad to secure supplies, a strategy that Chinese companies have used to ensure access to other key commodities. In this case, China is exploring for uranium in Mongolia, Niger, Namibia, Zimbabwe and far-flung areas.
The Energy Strategist’s Nuclear Power Field Bet includes a number of names that should benefit from the nuclear renaissance. Most of these recommendations are either uranium producers or companies involved in the engineering and construction of nuclear power facilities. Uranium mining giant Cameco Corp also appears in my Fresh Money Buy List.
Here’s a review of some of our favorites and some new additions to our coverage universe.
Please note that our Energy Watch List is simply a coverage universe, a listing of stocks that we follow and our latest advice. The Energy Watch List serves as a guide for subscribers who may hold stocks that aren’t currently recommended in the model Portfolios.
Our favorite picks will graduate to the model Portfolios, while the timeliest picks appear in the Fresh Money Buy List. New subscribers should regard stocks in the latter list as a starting point for constructing an energy-focused portfolio.
Cameco Corp (TSX: CCO, NYSE: CCJ)
Cameco Corp is the 800-pound gorilla of the uranium mining industry and produced more than 21 million pounds of uranium in 2009, roughly 16 percent of global supply. In 2009 Cameco was the world’s second-largest uranium producer, but the company plans to double its production by 2018.
One of the cornerstones of this expansion is the company’s long-delayed Cigar Lake project in Canada. This project’s peak annual output will be roughly 18 million pounds of uranium, of which Cameco is entitled to half. Cigar Lake was supposed to begin producing years ago but a cave-in and flood has taken years to repair. Lately, management has repeatedly stated that it is now on-track to start production from the mine in mid-2013.
In addition to Cigar Lake, Cameco is opening up new sections of its massive and prolific McArthur River mine in Canada. These new zones will allow the firm to boost production by as much as 85 million pounds in total over the next decade. And at Cameco’s Inkai joint venture (JV) in Kazakhstan, the company produced 1.3 million pounds of uranium in the first six months of 2010, exceeding the 1.1 million pounds produced in the entirety of 2009.
Cameco has the advantage of low mining costs. MacArthur River and Cigar Lake are the richest operating mines in the world, boasting ore grades that hover around 20 percent. (The global average is less than 1 percent).
I also like the company’s strategy of selling a portion of its production under long-term contracts and a portion on the spot market. This gives Cameco some upside during strong uranium markets while providing a degree of stability when spot prices decline. Cameco Corp is a buy under USD30 on the Fresh Money Buy List and continues to rate a buy in my Nuclear Power Field Bet.
Shaw Group is an engineering and construction firm with heavy exposure to the nuclear power industry.
Shaw supports the Westinghouse AP1000 nuclear reactor design and owns 20 percent of Westinghouse. Shaw is working on four AP1000 reactors in China and has begun site preparation work on the SCANA Corp’s (NYSE: SCG) Summer and Southern Vogtle reactors in the US.
In addition, to new plant construction, Shaw is a major player in maintaining and updating existing nuclear power facilities. About a third of US nuclear plants have completed or are working on updates, and Shaw has been involved in about half of these projects. The remaining 67 reactors are all candidates for similar work; Shaw is well placed to win more than its fair share of deals. Shaw Group rates a buy in my Nuclear Power Field Bet.
Paladin Energy (TSX: PDN, ASX: PDN)
Paladin Energy is a \fast-growing uranium producer with a focus on Africa. The company has two operating mines in Malawi and Namibia.
The Kayelekera mine is located at the northern end of Lake Malawi in south-central Africa. The project is wholly owned by Paladin, though the firm has issued a 15 percent equity stake to the nation’s government as part of its agreement to develop the project. In the most recent quarter, Kayelekera produces more than 500,000 pounds of uranium, up sharply from the prior quarter.
In recent months, production has been running north of 200,000 pounds per month, and Paladin appears to be on track to meet its maximum designed output of 3.3 million pounds per year. Ramp-up at Kayelekers took longer than expected, but that’s not uncommon in the global mining industry.
Paladin’s Langer Heinrich mine is located in the Namibian desert, not far from the massive Rossing uranium mine owned by global mining giant Rio Tinto (ASX: RIO, NYSE: RTP). Langer Heinrich is producing at close to its full rated capacity of 925,000 pounds per quarter, or roughly 3.9 million pounds per annum. Two additional planned mining expansions will take production up to 5.2 million pounds per annum over the next few years.
Outside of Africa, Paladin is participating in several Australian uranium mines. These projects are either still in the exploration stage or in some stage of pre-development. While none will provide an immediate boost to production, all are attractive over the long term, and Australia is a natural supplier of uranium to key markets like China and India. Paladin Energy rates a buy in my Nuclear Power Field Bet.
Uranium One just finalized a complex deal with Russia’s Atomredmetzoloto (ARMZ), the fifth largest uranium producer in the world. Under the terms of the deal, the Russian energy giant will contribute its stakes in two key Kazakh uranium mines, Akbastau and Zarechnoye, as well as $610 million in cash to Uranium One. In exchange, ARMZ is now the majority owner of Uranium One. Existing Uranium One shareholders will receive a special dividend of USD1.06 as part of the transaction.
Uranium One’s mines are first rate. The company had four operating mines in Kazahkstan prior to the ARMZ deal: South Inkai (70 percent share), Akdala (70 percent share), Karatau (50 percent share) and Kharasan (30 percent share). All are low-cost mines with average cash costs of between USD9 and USD21 per pound.
The two additional mines it’s acquiring in the ARMZ deal are also existing producers with cash costs of $20 to $25 per pound. Plans are in place to boost production even further; Uranium One estimates that it can achieve steady state production of between 18.3 and 20.3 million pounds of uranium per year once all of its mine developments are complete.
Majority ownership by a Russian firm is a turn-off for some investors, but I regard the transaction as a big positive both in terms of the assets acquired and the political influence of a major Russian partner in Kazakhstan. Uranium One rates a buy in the Nuclear Power Field Bet.
Denison Mines Corp (TSX: DML, AMEX: DNN)
Denison Mines Corp is a uranium producer that boasts three producing mines in the US and Canada as well as some promising avenues for future growth. In 2009 Denison produced 1.426 million pounds of uranium and 501, 000 pounds of vanadium, a metal that’s used in advanced steel alloys for jet engines and other applications. Some of Denison’s US uranium projects actually produce more vanadium than uranium, adding significant value to its production.
But Denison’s production costs are relatively high; cash costs are in the mid-$30s per pound. When uranium prices fell into the $40s in 2009 and early 2010, Denison actually put some of its US mines on care and maintenance, mothballing them until pricing improves.
In Canada, Denison’s big mine is McLean Lake. The firm owns 22.5 percent of the project, and France’s AREVA (France: CEI, OTC: ARVCF) is the operator. But production from this mine is also being scaled back temporarily because the uranium mill that serves the operation is being put on care and maintenance.
By far the company’s most exciting growth prospect is Wheeler River in Saskatchewan. Denison is the operator, but Cameco owns a 30 percent stake; the presence of Cameco affirms Wheeler River’s long-term growth prospects. Denison produced some promising drill results in the region that found high ore grades on par with the likes of Cameco’s Cigar Lake development.
Denison has a long-term plan to increase its production to 10 million pounds per year. To accomplish this feat, uranium prices would need to be sufficiently high to make is economically feasible to expand its smaller, higher-cost mines.
I’m adding Denison Mines Corp to my Energy Watch List coverage universe as a buy but prefer other plays on uranium mining.
Uranium Participation Corp (TSX: U)
Uranium Participation Corp is a fund managed by Denison Mines Corp. It’s a simple concept: Uranium Participation buys and stores physical uranium and uranium hexaflouride (UF6). In total the fund owns 2.374 million pounds of UF6 and 7.25 million pounds of uranium. Therefore, the value of the fund tends to track uranium prices.
Uranium Participation Corp rates a buy in my Nuclear Field Bet.
Babcock & Wilcox (NYSE: BWC) has a long history of involvement in the US nuclear industry, dating back to its contributions to the Manhattan Project. A leading equipment and services provider to the industry in the 1940s and 1950s, the company designed and produced reactors for the world’s first commercial nuclear-powered ship and played an important role in the development of commercial nuclear power facilities. In subsequent decades the firm expanded into nuclear fuel production and won a number of management and operations contracts (M&O) of large nuclear sites operated by the Dept of Energy.
Early this summer the firm was spun off from McDermott International (NYSE: MDR), which specializes in the construction of offshore oil and gas equipment and infrastructure. This strategic move enabled Babcock & Wilcox to preserve its relationship with one of its biggest customers, the US government. Recent changes to acquisitions regulations prevent federal agencies from contracting with firms incorporated outside the US, rules that would have jeopardized 33 percent of Babcock & Wilcox’s revenue had it remained a part of its Panama-incorporated parent.
Today, Babcock & Wilcox operates two business segments: Power Generation Systems (64 percent of revenue) and Government Operations (36 percent of revenue). These divisions strike an important balance between the cyclical power industry, where business ebbs and flows with the economy, and the predictable stability of government contracts.
The past few years have been a case in point. Restrained capital expenditures among utilities and industrial firms have weighed on demand for boilers and emissions-control solutions, reducing the power segment’s project backlog by 45 percent from its peak in 2007. Meanwhile, the backlog in Government Operations is up 42 percent over the same period and should reach a record high at the end of 2010. Stable funding for existing operations and stimulus-related spending on Dept of Energy (DOE) clean-up programs are a big part of this growth.
Although the firm sold its reactor business to Framatome (AREVA NP) toward the end of the last build-out, nuclear power-related activities contribute to both operating segments.
Power Generations Systems controls 30 percent of the North American market for replacement nuclear steam generators, though such equipment accounted for only 6.8 percent of the segment’s revenue in 2009.
Government Operations, on the other hand, derived 86.8 percent of its revenue from nuclear power. In addition to providing nuclear reactors for submarines and aircraft carriers, Babcock & Wilcox also enjoys M&O contracts at complex sites such as the Y-12 National Security Complex, the DOE and National Nuclear Security Administration’s Pantex plant, and Los Alamos National Laboratory. Acquired in 2008, the company’s Nuclear Fuel Services subsidiary is the only non-government entity licensed to possess and process highly enriched uranium.
These legacy nuclear power operations, coupled with the firm’s strength in steam generation equipment and emissions-control systems, provide a solid base for management’s longer-term expansion plans.
Not only is the company leveraging its leadership position in steam generation to grow its exposure to the booming Indian and Chinese power markets–a recent joint venture with an Indian vendor looks particularly promising–but investments in innovative nuclear-power technologies also offer upside.
With a full-blown nuclear renaissance underway in emerging markets and renewed support among for nuclear power among US utilities and policymakers, Babcock & Wilcox has invested heavily in areas that stand to benefit.
Most recently, the firm announced that would invest a $100 million in USEC (NYSE: USU) alongside Toshiba (Tokyo: 6502, OTC: TOSBF) in three separate stages. Back in the heyday of US nuclear power, utilities simply purchased uranium and sent it to one of the enrichment plants built and operated by the federal government as part of its nuclear weapons program. In the 1990s the government sold this facility to United States Enrichment Company, the present-day USEC.
Although the firm’s World War II-era plant produced 28 percent of the world’s supply of enriched uranium in 2009, the company faces competition from URENCO’s modern enrichment facility that recently began operation in Eunice, TX and AREVA’s planned centrifuge in Idaho.
USEC has been working on a next-generation “American centrifuge” in Ohio, but its initial application for $2 billion worth of loan guarantees was rejected by the DOE. Babcock & Wilcox and Toshiba have already invested $75 million in USEC, and delivery of the next installment hinges on the DOE’s approval of the loan guarantee. The investment represents a bet on increasing demand for nuclear fuel both at home and overseas.
In addition to its stake in USEC, Babcock & Wilcox is also working on a smaller, modular nuclear reactor called mPower that is far less expensive to produce, boasts a construction time of less than three years and would operate for five years before a refueling outage. Factory-constructed and shipped to the site for installation, this lower-cost reactor would enable smaller utilities to gain access to the advantages of nuclear power.
Management doesn’t expect the technology to enter widespread production anytime soon, but the company has secured a test site for its first prototype, which should be operational in 2011. The firm has also formed an alliance with engineering and construction firm Bechtel.
Although management’s plan to reinvest the proceeds from its legacy operations into higher growth businesses and emerging markets appears sound, the payoff from these investments won’t be immediate. At this time, Babcock & Wilcox rates a hold, though I will continue to monitor its prospects in my Energy Watch List.
Extract Resources (ASX: EXT, TSX: EXT) is an Australian exploration company whose principal asset is the Husab project in Namibia, which contains two known uranium deposits, Rossing South and the Ida Dome.At present, the firm is focused on Rossing South, the fifth-largest known primary uranium development in the world. According to company estimates, the deposit contains “indicated resources” of 257 million pounds of uranium and “inferred resources” of 110 million pounds. The current resource grade is about 43 percent higher than the output of Rio Tinto’s Rossing mine.
Management expects Rossing South to generate 15 million pounds of uranium each year, with production beginning at the end of 2013.
Located 5 kilometers from Rio Tinto’s Rossing operations and 20 kilometers west of Paladin Energy’s Langer Heinrich field, Rossing South should benefit from nearby infrastructure. It doesn’t hurt that Rio Tinto owns a roughly 20 percent stake in the company.
In the near term, the stock could receive a bump from several catalysts. Not only has management reportedly been in talks with potential partners to develop the resource, but the company is also expected to release a definitive feasibility study in the fourth quarter.
At this point, Extract Resources is a speculative play suitable for the most aggressive investors. Although Itochu Corp’s (Tokyo: 8001) recent acquisition of a roughly 10 percent equity stake in Extract Resources is a positive, it also further muddies the ownership picture, which raises concerns about execution. That being said, Rio Tinto and Itochu’s ownership stakes and presence on the board suggest that the firm could be a takeover target.
The stocks recommended in the three model Portfolios represent my favorite picks. The three Portfolios are designed to target different levels of risk: Proven Reserves is the most conservative list; the Wildcatters names entail a bit more volatility; and Gushers are the riskier plays but have the most potential upside.
I realize that this long list of stocks can be confusing; subscribers often ask what they should buy now or where they should start. To answer that question, I’ve compiled a list of 15 Fresh Money Buys that including 13 names and two hedges.
I’ve classified each recommendation by risk level–high, low or moderate–and included a brief rationale for buying each stock. Conservative investors should focus the majority of their assets in low- and moderate-risk plays, while more aggressive investors should layer in exposure to my riskier and higher-potential plays. Hedges are appropriate for investors looking to offset some of their portfolio’s broader exposure to energy stocks.
Also note that stocks that exceed my buy target for more than two consecutive issues will either be removed from the list or the buy target will be increased. Here’s the list followed by a short update on each pick.
Source: The Energy Strategist
Seadrill (NYSE: SDRL) offers a high dividend yield that’s likely to grow considerably over the next 12 months. In addition, the company has the most modern fleet of deepwater rigs and little exposure to the Gulf of Mexico. It remains a top play on an end-of-year rally in oil prices. Seadrill is now a buy up to 31.
Cameco Corp (TSX: CCO, NYSE: CCJ) is the must-own name in the uranium industry. Buy Cameco Corp up to 30.
Peabody Energy Corp (NYSE: BTU) is the only US miner with substantial exposure to Australian coal. I expect management to offer more bullish comments regarding Asian coal demand when it reports third-quarter earnings. Buy Peabody Energy Corp under 54.
Suncor Energy (TSX: SU, NYSE: SU) is a Canadian producer that focuses on oil sands. The firm should benefit from its exposure to oil and has ample opportunity to increase production. Buy Suncor Energy under USD43.
Chevron (NYSE: CVX) is the integrated oil giant with the best production growth prospects. Buy Chevron up to 90.
Penn Virginia Resource Partners LP (NYSE: PVR) is a high-yielding master limited partnership (MLP) with leverage to growing gas and natural gas liquids (NGL) production from the Marcellus Shale. The MLP’s coal royalty business also gives Penn-Virginia solid exposure to a recovery in US coal markets. Buy Penn Virginia Resource Partners LP under 26.
Schlumberger (NYSE: SLB) is the technological leader in oil services wand benefit from new product introductions over the next four quarters. Buy Schlumberger under 85.
Weatherford International (NYSE: WFT) is the cheapest oil services stock in my coverage universe. In its third-quarter conference call, we should see further indication that operational issues that plagued the stock in 2009 are now firmly in the rear-view mirror. Buy Weatherford International under 26.
Afren (LSE: AFR) is an Africa-focused oil producer that should post impressive production growth over the next few quarters. I’m raising my buy target on Afren to 130 pence, or GBP1.30.
MacMahon Holdings (ASX: MAH) handles basic mine preparation and services work in Australia. It’s a major beneficiary of the coal-mining boom.
Investors have massively overreacted to the Knightsbridge Tankers’ (NSDQ: VLCCF) decision to issue 4.25 million new shares in a secondary offering. When a company issues new shares, it dilutes the value of shares held by existing holders, so the knee-jerk reaction is to sell.
But that’s the wrong take. Knightsbridge Tankers is deploying the proceeds to acquire new ships that will generate additional revenue and, ultimately, higher dividends for shareholders. New share issues aren’t truly dilutive if the cash is used to generate additional revenue streams.
Secondary offerings of shares have proved a great buying opportunity for dozens of Portfolio recommendations over the past 18 months, including Linn Energy LLC (NSDQ: LINE) and Enterprise Products Partners LP (NYSE: EPD). I suspect this pattern will hold once again. Buy Knightsbridge Tankers under 22.
Nabors Industries (NYSE: NBR) is a land-focused contract driller with exposure to demand for advanced rigs needed to produce shale plays. A relatively low-risk play on a potential year-end recovery in gas prices, Nabors Industries rates a buy under 28.
Hedges:
First Solar (NSDQ: FSLR) has underperformed in recent weeks. Prospects for growth in the solar power industry are dimming thanks to declining European subsidies. Sell First Solar short above 110.
Diamond Offshore Drilling (NYSE: DO) has been dragged higher in recent weeks by improving sentiment surrounding oil. An aging fleet and heavy exposure to the US Gulf of Mexico make the stock a bad long-term play. Short Diamond Offshore Drilling above 60.
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