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Sunday, February 25, 2007

What is Strathmore Minerals (STHJF) worth... according to Sprott?

Sprott Asset Management owns about 19% of Strathmore Minerals (combined links). On Feb 14, 2007, Sprott Securities (see comment) put out this report on uranium.

Big important points they are are:
1) The basket approach is no longer valid. 2007 is the time to pick specific stocks. Stock gains were big in 2006, but will be less so going forward.
2) They believe the spot price of uranium will go beyond $100 per pound.
3) They believe the good investments will be in three categories: producers, imminent producers, and "development stories with fundamentally solid assets aggressively moving towards production."

They list the stocks that they're following, including their target price. I prefer the term value instead of target price for various reasons, but we'll leave that alone for now. None of the stocks are particularly cheap based on their table in Figure 1.

Short term, they see $100 per pound of uranium. Long term, they believe it will fall to $50 based on fundamental economics principles (makes good sense to use that for the long term). Obviously, it's difficult to predict the short term prices. But they note that the utilities are maintaining inventories at historically low levels.

About 80% of production between 2008 and 2012 is already under contract. So buyers are scrambling to locate supply. The Cigar Lake mine flood adds a lot of uncertainty. Hedge funds have driven up prices, which I believe is a good thing since it causes producers to increase supply (basic economics).

Sprott believes supply will catch up with demand in 5-7 years. At that point, they expect uranium to sell for $45 to $60. Now they obviously they know the industry and I don't. But based on what everyone is saying, including Sprott, it seems like it would take much longer for supply to catch up to demand.

Based on the fact that this is the second mine flood at Cigar Lake, and trying to understand the difficulties in that particular mine, it seems to me that it's very likely for them to have yet another flood after they do whatever it takes to fix this one. Sprott is saying that opinions in the industry range from there being a 1-year delay to being indefinite. The difficulties with the water are "a monumental task." Sprott believes it will eventually be mined, one way or another. They believe a best-case scenario is production in 3 to 4 years.

A lot of utilities are losing contracted uranium due to this flood. I recall that Cameco said a while ago that many of the contracts they have allow them to decrease the amount they sell.

Sprott notes that the spot market is small and volume is actually decreasing, so those utilities that need uranium are in trouble.

In December 2006 there were 435 reactors worldwide, with 28 under construction, 64 planned, and 158 proposed (and this keeps increasing). There are predictions by the World Nuclear Association (WNA) that nuclear power generated will increase 45% by 2030, or maybe a lot more than that. Sprott goes into detail with the predictions.

My own opinion (which is worth very little), is that it seems like supply is going to have a very difficult time catching up with the increasing demand in addition to the huge gap already present.

The current reactors require 180 million pounds of uranium (U3O8). Mining only produces 110 million pounds. The rest is made up by MOX (mixed oxide fuel), various national and utilities inventories, Russian LEU (non-weapons related uranium), recycling, tail assays, DOE sales, and HEU (downblended weapons grade uranium). There are lots of issues and limitations in using MOX. But it can be used in up to 30% of the fuel elements of existing reactors without any modifications. But handling the MOX fuel is a big problem. Right now MOX is a small part of the fuel business. I don't know the details of the limitations, but it seems like this could eventually be trouble for anyone speculating in uranium.

The WNA assumes that all the sources of nuclear fuel will just barely be enough until 2012 when there will be a significant supply shortfall, and that's assume everything goes according to plan. Sprott thinks they're overly optimistic. Utilities and speculators are going to be trying to buy more than the amount needed for production. Sprott's supply-demand scenario is in Figure 6 on page 9. But this conflicts with what they said earlier about the price dropping around this time frame.

Sprott believes that investment funds have taken perhaps 12 to 15 million pounds off the market in the last 2 years (most sourced from inventories).

There's also the initial core effect that I had read about in one of the StockInterview articles (I think). Cameco presented a paper at the recent WNA conference (was that the one in Quebec City?). Starting in 2010, ten new reactors will be coming online each year. To start up a new reactor, you need to fill the entire core plus stockpile a supply of inventory. A typical reactor would need roughly 1 million pounds for the core and perhaps another million for inventory. So this would add roughly 20 million pounds of demand each year. And they don't wait until the plant starts up to buy the uranium. Fuel rods need to be fabricated and tooled and the uranium needs to be purchased, mined, converted, enriched before that. All this might take 2.5 to 3 years. So that means perhaps 20 million pounds of additional demand might start showing up in 2007.

In addition, the top producers have been short by abount 10 million pounds due to many different factors. This could mean that production levels are already stressed.

Sprott believes consolidation will be happening in 2007. They list the various stocks they follow and the expected price appreciation. None of them are drastically cheap in their view. Right now, Strathmore is selling for more than their target price.

Sprott then goes into detail about each company they follow.

Aurora Energy (AXU on TSX, AUEGF on Pink Sheets): aggressive explorer. On the Michelin property, 100% of the drill holes have intersected uranium. The stock has gone from US$4 to around US$16 this year. Sprott's target is around US$20 (C$24).

Cameco (CCJ): Sprott goes into some detail about Cigar Lake and other properties.

Denison Mines, Energy Metals, SXR, etc.

Strathmore Minerals (starts on page 56): This details the stuff that's become well-known about Strathmore (it's good to have it all in one place). Sprott is valuing Strathmore strictly on the near-term projects in New Mexico and Wyoming. Their target price is C$4.70. The stock closed at C$4.94. Based on comparables, Sprott estimates the value of the Canadian spin-off of Strathmore to be worth only 60 to 85 cents (not sure if it's Canadian or US, but does it matter?).

They consider most of the value of the Canadian properties to be in the Waterbury Project's 100K acres. Denison struck it very big nearby and that might extend over to Strathmore's property which essentially nearly surrounds Denison's property. The other properties are very deep, far from needed infrastructure, and/or just plain non-core. Strathmore's Dieter Lake has too little infrastructure.

There are still hurdles for Strathmore in New Mexico due to the Navajo's anti-mining stance.

Overall, there are a lot of opportunities for spin-offs and joint ventures for Strathmore.

For the various properties, Sprott assigns $3.50 to $5.50 of value per pound of uranium in the properties they're looking at. This strikes me as extremely pessimistic, especially since these properties were cherry picked and we know that the early ones will have costs of $20 or so per pound.

So here you have Sprott, which owns about 19% of Strathmore giving a target price that Strathmore has exceeded. Strathmore is a Canadian stock and I don't know the reporting rules: when/if Sprott would need to report on stock sales. If they really mean it, then they should be selling now (roughly 14 million shares?). I really don't know if they are or not, but I'm not.

UPDATE next day:
Seeking Alpha has an interesting brief article about uranium investors by Kevin Chan. Someone whispers in your ear, you-ray-nee-um.

UPDATE April 3, 2007:
senor_blanco wrote an important comment about Sprott Asset Management being separate from Sprott Securities. This analysis is not from the same people who own a big chunk of Strathmore. That makes a lot more sense.

Don't confuse Sprott Asset Management (the money management firm) with Sprott Securities Inc (the investment dealer). They were both founded by Eric Sprott, but he sold his remaining interest in Sprott Securities several years ago. SSI recently renamed itself to Cormark Securities Inc to alleviate the confusion.

The report was put out by SSI, while it's Sprott Asset Management which holds a large stake in Strathmore. Presumably, the SAM team is much more bullish than the analysts at SSI.
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