Cameco (CCO) is our top pick in the mining sector because of its leverage to rising uranium prices, which we expect to rise to US$65 per pound by 2019 from US$26 per pound currently. The shares are trading at a wide discount to our fair value estimate of $23.
Uranium demand is driven primarily by government policy and the economics of nuclear reactors. While European electricity demand would be affected if economic growth slows because of the contagion of other countries besides Britain exiting the European Union, nuclear power generation should remain fairly resilient because it provides baseload power with lower operating costs than other forms of generation. Once turned on, nuclear reactors run continuously for one to two years before requiring refueling.
Brexit is unlikely to have meaningful consequences for the uranium industry. The United Kingdom represents just 2% to 3% of global demand. Europe as a whole makes up 30% of global uranium demand, with about half coming from France. Our projections do not include meaningful growth expectations in Europe. In fact, we expect Germany and Belgium (4% of global demand) will shut down all of their existing reactors. As we had not forecast much growth from Europe, any further impact from Brexit should be limited.
Our long-term thesis continues to play out, as 10 nuclear reactors came on line in 2015 (8 from China). With just over 400 reactors operating today, we see 86 under construction or restarting over the next five years, with a further 172 planned over the coming decade. We continue to expect the bulk of the growth to come from China, with support from South Korea, India, Russia, and restarts in Japan. Together, these five countries make up 30% to 40% of global uranium demand and should account for 70% of the demand growth over the coming decade.
We see higher demand, low-cost production
We expect Cameco's annual uranium production, which was 27.2 million pounds in 2015, to rise more than 30% by 2019. The new volume will be low cost, with the majority coming from one of the highest-grade deposits in the world. Fulfillment of Cameco's growth plans will hinge foremost on the successful delivery of Cigar Lake (50% ownership stake), a greenfield project near Cameco's McArthur River mine in Saskatchewan. Cigar Lake shares McArthur's attributes: a stellar ore grade, large scale, long life and an attractive operating cost profile. Production began in 2014, with annual output ramping up to target capacity by 2018.
Uranium prices remained weak in 2015, owing to the current supply glut caused by delayed Japanese reactor restarts. This situation won't last much longer. We expect new reactor capacity to drive the strongest uranium demand growth in decades, rising 40% by 2025. Annual growth of 2.8% might not sound like a lot, but it is massive for a commodity that has seen precious little demand growth since the 1980s.
The mined supply of uranium will struggle to keep pace amid rising demand and falling secondary supplies. Low uranium prices since Fukushima have left the project cupboard bare, and we expect a cumulative supply deficit to emerge by 2021. These shortfalls should begin to affect price negotiations in 2017, since utilities tend to secure supplies three to four years before actual use. We estimate contract market prices must rise from the mid-US$40s to US$65 a pound to encourage enough new supply.
Cameco has dug a narrow economic moat
Production costs are the primary litmus test for measuring competitive advantage in the highly cyclical mining industry. All producers can generate fat returns on capital when commodity prices are high, but only the lowest-cost producers can be expected to generate excess returns on capital through the cycle. Measured by cash cost of production, Cameco ranks among the lower-cost uranium miners at $21 per pound in 2015 (before royalties) by virtue of an enviable asset base anchored by the extremely high-grade McArthur River mine. Generally, this is a recipe for strong returns on capital.
However, owing to long-term contracts struck with utilities before the post-2003 surge in uranium prices, Cameco has been unable to fully capture the economic benefits due its cost profile. As a result, by our measurements, the company hasn't consistently generated returns in excess of its capital cost (about 10% in our model) over the past several years.
We expect this to change in the coming years. We expect Cameco's price realizations will naturally improve as contracts struck in periods of weaker uranium prices continue to roll off its books. A concurrent improvement in contract prices (toward our US$65 midcycle estimate) and new low-cost production from Cigar Lake should help Cameco clear its cost of capital over the long term.
Uranium price is primary uncertainty
The uranium price is the biggest uncertainty for Cameco. Over the past five years, prices in the contract market have been as high as US$72 per pound (in 2011, immediately before Fukushima) and as low as US$44 per pound (summer 2014)--volatile, but not especially so by commodity standards. We expect a combination of robust demand and weak supply to push prices to US$65 per pound (real 2015 dollars) by 2019, although there is considerable uncertainty around that forecast. For instance, Japanese reactor restarts could be less numerous and slower than we anticipate, or China could stumble in its ambitious reactor buildout efforts. On the supply side, Kazakh production, always tough to project, could prove stronger than we anticipate.
