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Friday, March 03, 2006

Supply/demand imbalances and intrinsic value

Strathmore Minerals is an investment based on a supply/demand imbalance of uranium. I'm hesitant to make investments on this basis mostly because it's difficult to predict what will happen in a complex world and even more difficult to predict when. It's good to see the price of uranium on a constant upward climb for years. It's also good to see UxC explaining that the price increases of 2005 can't be attributed (at least not entirely) to speculation. [no permalink so it won't last]
There has been much discussion over the past year on how investors/hedge funds became active players in the uranium market. In fact, this buying group accounted for just over 25% of the total 2005 spot volume (as shown in the chart at right). However, even without this group's participation, activity last year would have set a 10-year volume record adding upward pressure on the spot price.
Warren Buffett's reason for buying silver years ago was based on a large imbalance between supply and demand which would be extremely difficult to correct, except through market forces with higher prices. With this sort of thing, the difficult part is knowing when the imbalance will result in higher prices as unknown amounts of stockpiles are depleted. And you have no idea at what prices each stockpile will be willingly sold.

When I looked at silver a few years ago, the size of the stockpiles were reportedly very large and it could take a decade or so for a significant enough portion of them to be depleted. I never even got to the point of whether or not demand was significantly dropping due to a shift from photographic film to digital storage.

But in the case of this sort of imbalance, there is an intrinsic value when you can find a lower bound on the price silver would need to reach in order to restore an equilibrium to the market and an upper bound on the time it would take for that equilibrium to be sufficiently established. You then take the price difference and compute the present value from the latest possible equilibrium time.

The constant danger of this sort of thing is due to civilization's frightening resourcefulness. We have a long history of either switching to unexpected alternatives (such as with energy in Western Europe when firewood became scarce and they switched to coal and then switched to oil) or else making far better use of resources. At one time, most people thought we would run out of space at garbage dumps as they were filling up and it was almost impossible to open new ones. But the industry got very good at stuffing more garbage into less area so that capacity has actually increased substantially over time. Likewise, it's important to know what unexpected things could happen to silver demand as the price increases toward the anticipated higher equilibrium.

professionally spellchecked, pro bono, by Pat J. Lo. C'est une question d'equilibre

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