Saturday, July 14, 2007
yet another post about uranium
Charlie Munger argues that investors should always be looking for mental models that apply to businesses and markets and situations in general. Mental models are models of real systems which are accurate for key parts of those systems. I've mentioned before about how I viewed the stock market of the late 1990s to be like the physics of the inside of a thundercloud when people started viewing an "overpriced stock" as a main criteria for a good investment.
One danger in mental models is that people tend to take them too literally or not recognize what parts of the model are similar between the two systems and which parts are not. It's very difficult to separate out the relevant part of the model and figure out whether or not the model is actually valid for the other system in question. You need to forget about the orignal complex system and understand the model of it, why it behaves the way it does, whether the new system in question meets enough of the criteria, and how it differs from the model.
For uranium at this particular point in time, the analogy that strikes me as being most interesting is that of a tsunami from the perspective of someone standing on the beach. But don't read too much into that.
A tsunami has an extremely long wavelength and the very long destructive peak of the wave is preceded by a very long trough. If you ignore the bigger picture and just focus on the area from the beach going out a few miles out to sea, what happens first is that the water level drops by say 10 feet as the trough of the wave reaches the shore*. It's common for people to go wandering out toward the receding water due to curiosity to look at what had been the ocean floor just a few minutes prior. But anyone who is thinking in terms of physics will see the danger immediately. It takes an enormous amount of force to "push" the water level down by 10 feet (imagine carrying even a narrow 10 foot tall barrel of water). Because water moves around very freely, when the water stops being pushed down by 10 feet, it won't simply return to its previous level. All that energy that went into pushing the water down (caused by the unseen wave approaching) is going to cause the water to be pushed up above the normal level by probably 10 feet. And if the water was 10 feet low for 15 minutes time, then the water is likely to be 10 feet higher than normal for roughly 15 minutes.
What makes the tsunami so destructive is the length of time that the water remains at a high level. Even a very large wind-driven wave has a short wavelength and the water goes up for just a matter of seconds at any given spot as the wave travels forward. The wave breaks and rolls back. With a 10 foot tsunami, it's like sea level rises by 10 feet for a very long time and all that insanely heavy water flows very fast, carrying all sorts of dangerous objects with it.
Now let's take a look at the uranium situation. For nearly twenty years, the price of uranium has been very low. For all that time there has been almost no exploration, almost no new investment, almost no new mines, and very little activity beyond simply maintaining the mining of low cost sources of uranium. An enormous amount of attrition and "industry decay" has taken place in the supply chains, organizational knowledge, etc. Compared to the actual demand for uranium, there is only a small core of people remaining who know all the complexities of uranium mining, the "stories around the campfire", the trade knowledge that doesn't show up in books. You have this tiny industry right now that's only a fraction of how big it needs to be.
It took a great deal of "force" to keep the prices so low for so long and to keep the supply industry undersized. A huge amount of excess uranium was mined in earlier years (much of it went into nuclear weapons) and it was dumped back into the market during the long price slump. Meanwhile, the actual usage steadily increased over these years and all indicators are pointing to a huge acceleration of demand going forward. If you don't think it's possible, just look at the demand curve in that chart from 1970 to 1988.
In addition to the force that had kept the prices low, there are very big new forces driving up demand. China is sick of all the pollution. The Chinese people will only tolerate so much and the leaders know it. India is sick of both pollution and a lack of electricity. All over the world, countries are moving toward nuclear power. The industry has matured enormously since Three Mile Island (and even a big accident today is unlikely to deter countries like China). Of course the nuclear reactor supply industry also has limits to how much it can ramp up. But I suspect it's easier to scale that up than to create new uranium supplies.
These are enormous forces at play in the uranium industry and they're going to be pushing up against a number of things that are slow to react, regardless of the forces against them. New mines take a very long time to get from exploration to productivity. It takes a long time for industry workers to gain sufficient industry knowledge to be competitive with those who already have it.
And an interesting thing to consider is this: uranium buyers are showing a great unwillingness to pay high prices for uranium. Basic economics tells us that when supply and demand out totally out of whack, prices will rise to bring them back into equalibrium. But if the prices are kept down for whatever reason, the signal going out into industry to increase supply is muted. So the weaker players who might eventually gain enough industry capability to succeed fall by the wayside. Stock prices drop and it gets harder to raise the huge amount of capital needed to increase the supply. So interestingly enough, the investment case for uranium is only increased by lower uranium prices. It merely pushes out the inevitable and increases the resulting impact.
With a tsunami, the longer the water remains at a low level, the worse the oncoming wave is going to be. With uranium, the longer the slump, the more the industry has atrophied. And that makes the imbalance far worse because the demand shows every sign of accelerating going forward. If the currently-incompetent WildEyedExploring Inc. is not supported by a sustained stock market "bubble" in uranium stocks to allow them (or at least some of their workers) to reach competence, then the industry expansion is going to be slowed down and the demand/supply imbalance will be worse and longer.
What I'm really trying to say here is that there are very large forces operating on a slow time scale that dwarf the monthly happenings in the industry. It's those longer term forces that I believe are easier to predict and to rely on as an investor. Yet most investors usually don't look at the bigger picture either because they're impatient or else they just don't see it.
* Actually, it's not as simple as that, as smaller peaks and troughs typically arrive beforehand in a very complex pattern depending on shoreline geography and water depths. But typically there ends up being a big trough followed by a big peak.
UPDATE Monday July 16: Speak of a nuclear accident and one happens.
The media will play this up regardless of how serious it is. Well, at least we'll get to see who screams how loud about nuclear power.
UPDATE Friday July 20, 2007:
I think the story right now with uranium might be that hedge funds are loaning it out to utilities in large quantities, which has removed the panic buying pressure, but definitely would do nothing to ease the supply/demand situation. I could be wrong.
One danger in mental models is that people tend to take them too literally or not recognize what parts of the model are similar between the two systems and which parts are not. It's very difficult to separate out the relevant part of the model and figure out whether or not the model is actually valid for the other system in question. You need to forget about the orignal complex system and understand the model of it, why it behaves the way it does, whether the new system in question meets enough of the criteria, and how it differs from the model.
For uranium at this particular point in time, the analogy that strikes me as being most interesting is that of a tsunami from the perspective of someone standing on the beach. But don't read too much into that.
A tsunami has an extremely long wavelength and the very long destructive peak of the wave is preceded by a very long trough. If you ignore the bigger picture and just focus on the area from the beach going out a few miles out to sea, what happens first is that the water level drops by say 10 feet as the trough of the wave reaches the shore*. It's common for people to go wandering out toward the receding water due to curiosity to look at what had been the ocean floor just a few minutes prior. But anyone who is thinking in terms of physics will see the danger immediately. It takes an enormous amount of force to "push" the water level down by 10 feet (imagine carrying even a narrow 10 foot tall barrel of water). Because water moves around very freely, when the water stops being pushed down by 10 feet, it won't simply return to its previous level. All that energy that went into pushing the water down (caused by the unseen wave approaching) is going to cause the water to be pushed up above the normal level by probably 10 feet. And if the water was 10 feet low for 15 minutes time, then the water is likely to be 10 feet higher than normal for roughly 15 minutes.
What makes the tsunami so destructive is the length of time that the water remains at a high level. Even a very large wind-driven wave has a short wavelength and the water goes up for just a matter of seconds at any given spot as the wave travels forward. The wave breaks and rolls back. With a 10 foot tsunami, it's like sea level rises by 10 feet for a very long time and all that insanely heavy water flows very fast, carrying all sorts of dangerous objects with it.
Now let's take a look at the uranium situation. For nearly twenty years, the price of uranium has been very low. For all that time there has been almost no exploration, almost no new investment, almost no new mines, and very little activity beyond simply maintaining the mining of low cost sources of uranium. An enormous amount of attrition and "industry decay" has taken place in the supply chains, organizational knowledge, etc. Compared to the actual demand for uranium, there is only a small core of people remaining who know all the complexities of uranium mining, the "stories around the campfire", the trade knowledge that doesn't show up in books. You have this tiny industry right now that's only a fraction of how big it needs to be.
It took a great deal of "force" to keep the prices so low for so long and to keep the supply industry undersized. A huge amount of excess uranium was mined in earlier years (much of it went into nuclear weapons) and it was dumped back into the market during the long price slump. Meanwhile, the actual usage steadily increased over these years and all indicators are pointing to a huge acceleration of demand going forward. If you don't think it's possible, just look at the demand curve in that chart from 1970 to 1988.
In addition to the force that had kept the prices low, there are very big new forces driving up demand. China is sick of all the pollution. The Chinese people will only tolerate so much and the leaders know it. India is sick of both pollution and a lack of electricity. All over the world, countries are moving toward nuclear power. The industry has matured enormously since Three Mile Island (and even a big accident today is unlikely to deter countries like China). Of course the nuclear reactor supply industry also has limits to how much it can ramp up. But I suspect it's easier to scale that up than to create new uranium supplies.
These are enormous forces at play in the uranium industry and they're going to be pushing up against a number of things that are slow to react, regardless of the forces against them. New mines take a very long time to get from exploration to productivity. It takes a long time for industry workers to gain sufficient industry knowledge to be competitive with those who already have it.
And an interesting thing to consider is this: uranium buyers are showing a great unwillingness to pay high prices for uranium. Basic economics tells us that when supply and demand out totally out of whack, prices will rise to bring them back into equalibrium. But if the prices are kept down for whatever reason, the signal going out into industry to increase supply is muted. So the weaker players who might eventually gain enough industry capability to succeed fall by the wayside. Stock prices drop and it gets harder to raise the huge amount of capital needed to increase the supply. So interestingly enough, the investment case for uranium is only increased by lower uranium prices. It merely pushes out the inevitable and increases the resulting impact.
With a tsunami, the longer the water remains at a low level, the worse the oncoming wave is going to be. With uranium, the longer the slump, the more the industry has atrophied. And that makes the imbalance far worse because the demand shows every sign of accelerating going forward. If the currently-incompetent WildEyedExploring Inc. is not supported by a sustained stock market "bubble" in uranium stocks to allow them (or at least some of their workers) to reach competence, then the industry expansion is going to be slowed down and the demand/supply imbalance will be worse and longer.
CONCLUSION
What I'm really trying to say here is that there are very large forces operating on a slow time scale that dwarf the monthly happenings in the industry. It's those longer term forces that I believe are easier to predict and to rely on as an investor. Yet most investors usually don't look at the bigger picture either because they're impatient or else they just don't see it.
* Actually, it's not as simple as that, as smaller peaks and troughs typically arrive beforehand in a very complex pattern depending on shoreline geography and water depths. But typically there ends up being a big trough followed by a big peak.
UPDATE Monday July 16: Speak of a nuclear accident and one happens.
About 1.5 liters of slightly radioactive water spilled out of the cooling pool for spent fuel rods, leaked into another supply of water, and 315 gallons of that water were pumped into the sea, said Hiro Hasegawa, the manager of corporate communications at Tokyo Electric Power....They didn't report the event until hours after it happened. If this is all that happened, then that would seem normal (but I don't know their procedures which are probably fairly convoluted about how much information you need before reporting the event).
The media will play this up regardless of how serious it is. Well, at least we'll get to see who screams how loud about nuclear power.
UPDATE Friday July 20, 2007:
I think the story right now with uranium might be that hedge funds are loaning it out to utilities in large quantities, which has removed the panic buying pressure, but definitely would do nothing to ease the supply/demand situation. I could be wrong.
// posted by Bruce @ 10:27 AM 
