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Big Money, Small Uranium Sector
Engineer Your Problems Away
Manufacturing Oil
What Shell Can Teach Uranium Producers
How to Make $3 Trillion Vanish
China "Pranks the Dean"
Petroleum Reserves and South America
Where will the world go to find major new ore deposits? Traditionally the mining sector has replaced reserves through exploration. This week we look at a different approach that's creeping into the industry. Mining companies are taking a page from the petroleum playbook and increasingly turning to engineering to unlock large mineral resources. We'll examine what this means for the mining business and look at some very interesting examples from the uranium sector. Given all of the interest in uranium lately from nuclear fuel buyers in Asia (and around the world), sourcing supply is going to be a very important issue. You'll want to keep the developments discussed today in mind over the coming years.
We'll then veer off in a completely different (although equally intriguing) direction and look at some tricks central banks seem to be up to in the foreign exchange markets. This discussion will answer the riddle, how do you make $3 trillion disappear without anyone noticing? The answer gives us some food for thought on where the U.S. dollar might be heading. A critical issue for almost every investment around the planet. We'll get to that, but first let's begin with something radioactive!
Big Money, Small Uranium Sector
Everyone wants uranium these days. The Chinese government said last month it is looking to buy ownership of Australian uranium-producing companies. Japanese firms have concluded a number of uranium deals recently. In February, a syndicate led by Tokyo Electric Power Company paid C$270 million for a 20% stake in Canadian uranium producer Uranium One.
Other nations see the demand for uranium increasing. And they don't want to "miss the party". This month Korea Electric Power Corp became the latest player to announce intentions of buying uranium production. The company's president Chang Joo Ok told officials at a meeting in Perth, "We are very strongly looking at Australian uranium projects. We are focusing on companies producing uranium because we need to secure stable supplies."
This isn't just talk. Korea Electric already concluded one deal in the uranium sector this past April, agreeing to buy 20% of Canadian uranium producer Denison Mines for C$75 million. Korea is serious about buying uranium. And just like China and Japan, they're looking for more deals to come.
The problem for uranium is: what do you buy? The uranium mining sector is small. Mining radioactive material takes specialized expertise in dealing with health, safety and environmental issues. A significant barrier to entry for new miners. That's why 90% of the world's uranium production comes from just 10 companies.
This poses a difficult situation. We have a growing number of nuclear power companies looking to buy uranium production. And a very limited number of producing companies to choose from. This leaves would-be uranium buyers with a tough choice. Get into a bidding war with their competitors and risk overpaying. (Especially an issue for Korea, badly hit by the financial crisis, in competing with the deep pockets of China and Japan.) Or sit back and look for reasonably-priced deals, at the risk of having all of the decent assets bought by more aggressive buyers. Neither are particularly attractive options.
Engineer Your Problems Away
But there is another, less-obvious possibility. One that could potentially secure large uranium reserves at reasonable prices. Engineering. This is a little complicated, so let's look at some background to set the stage.
Basically, there are two ways for a mineral production company to grow its inventory of mineral reserves in the ground. Exploration and engineering. Exploration is the method we hear about most often. Take the uranium sector for example. Canada's Athabasca Basin is the world's top uranium-producing region. Most of the deposits currently being mined here are "unconformity type" uranium. High-grade uranium ore found where younger sandstones are touching older "basement" rocks. Companies working in the Athabasca Basin have spent time and money studying unconformity deposits. They have a decent understanding of the mineralogy, shape and mechanical properties of these types of ores. Athabasca producers understand these deposits. That understanding helps these companies mine and process the ore effectively.
Having studied unconformity deposits extensively, the next step for an Athabasca uranium producer is clear. Go out and look for more unconformity deposits. If a new deposit can be discovered, the company then simply applies its existing knowledge of unconformity mining and processing to build a new mine relatively cheaply and easily. This is the "factory" approach to mining. Come up with a model that works, and then scale out your expertise over as many mines as possible.
The problem is that in any given spot on Earth, there are only so many large mineral deposits of a given type. A uranium producing company that goes exploring for new unconformity deposits in the Athabasca Basin will find a few. At first. But after more and more discoveries have been made, the potential for new finds in the area decreases. You have to spend more money on exploration, with lower odds of success. Eventually a region like Athabasca becomes "mature", meaning that most of the large deposits have been discovered. At some point, it just isn’t worth spending more money to explore for the few remaining deposits.
The Athabasca Basin isn't tapped out yet. There are enough potential discoveries left here to make it worthwhile for producing companies to keep spending money on exploration. In the first quarter alone, the world's largest uranium producer Cameco drilled 40,000 meters on 10 Athabasca projects. And smaller groups like Hathor Exploration have come up with new Athabasca discoveries in recent years. But as the region "matures", exploration is getting more expensive. Producers are paying more to discover a pound of uranium in the ground.
Manufacturing Oil
This is where engineering comes in. I said that exploration is the "factory" approach to growing mineral reserves. Take your mining knowledge and scale it out to new deposits. Engineering is the opposite. Create new knowledge to fit deposits you already have.
The best examples of "engineering deposits" come from the petroleum sector. We saw a perfect example this month, when the nation of Jordan announced it is signing a deal with Shell to develop oil shales.
A little background. Jordan sits on billions of barrels of oil. The problem is that this crude is locked up in shales. To extract fuel from shale requires an enormous amount of heat. So much that with current technology the cost of heating is often larger than the value of the extracted oil. That's why most oil shale deposits worldwide have been left undeveloped, despite the huge oil resources they hold. Everyone has known for centuries that the oil is there. But no one knows how to get it out at a reasonable cost.
Shell is trying to engineer a solution to the problem of oil shale production. For decades, Shell has invested in research on new technologies and techniques for economically producing oil from shales. The company has focused on "in-situ" production methods. Rather than digging the shale up and heating it in a giant oven, you simply inject heat into the ground and "roast" the shale in place. Shell believes this approach will save money and make production more economic. They want to apply their "in-situ" knowledge on Jordan's large oil shale fields.
Shell's oil shale "science project" is different from the strategy most oil producers are pursuing. Most oil companies grow their reserves by exploration. They know a lot about how to drill and pump oil from conventional oil pools. So they go into new geographic areas and drill exploration wells, hoping to discover new pools. If they find one, it's an easy jump to production and making money. The only question is: will the oil be there?
Shell's approach is opposite. With an oil shale play, there's no question that the oil is there. Exploration risk is zero. If you drill, you will find hydrocarbons. You're not going to waste tens of millions of dollars drilling dry holes in search of a major discovery. So Shell is taking the money it saves on exploration drilling and putting it into research on new methods for profitably extracting oil from shale. They're studying the detailed chemical composition of the rock and the hydrocarbons. Inventing new technologies for injecting heat into the ground. Building pilot projects to study the effects of heating on shale and test their hypotheses about what might work in production.
Eventually this approach will work. If Shell spends enough money, sooner or later they will come up with a viable way to make oil from shale. The key question is: how much money will it take? In Jordan, Shell is committing to spend an initial $540 million. This could ramp up to as much as $20 billion. These are big numbers. But the payoff is huge. If Shell finds a working method for shale oil production, they unlock billions of barrels of reserves in Jordan. Paying $540 million for a few billion barrels of reserves is a pretty good deal. There are only a few conventional oil plays on the planet that offer billion-barrel potential. And most of them are deep-water offshore plays, where wells can cost hundreds of millions of dollars. (Petrobras and its partners paid $240 million for the test well that discovered the giant Tupi field, estimated to contain 5 to 8 billion barrels.)
With conventional exploration becoming so expensive (because big fields are getting harder and harder to find), spending money on "science projects" the way Shell is makes more and more sense. Why pay for expensive exploration wells (that may or may not succeed) when you can, for a similar price, buy knowledge that allows you to tap well-known, easily accessible oil deposits? Engineering becomes more cost-effective than exploration.
Especially when you consider the ongoing benefits. If Shell succeeds in producing shale oil in Jordan, they now have a wealth of knowledge about what works and what doesn't in shale technology. They can "take the show on the road", applying their new-found knowledge at numerous known oil shales around the globe. Multiple billion-barrel fields become accessible with relative ease. This is completely different from exploration, where even a successful drill program doesn’t help you whatsoever in making the next big discovery.
This focus on research and development rather than exploration is the exact strategy that kicked off the shale gas boom in the U.S. For decades shales were known to contain huge amounts of gas. But no one had the technology to extract this unconventional resource. It took almost ten years (and millions of dollars) of trial and error in the Barnett Shale before producers finally got the production technique right. But the payoff was well worth it. Gas producers can now drill thousands of wells over large areas, accessing huge gas reserves with almost no exploration risk. The profits from this "gas manufacturing" more than make up for the up-front research and development expense.
What Shell Can Teach Uranium Producers
I mentioned above that uranium buyers are struggling to find uranium supplies to invest in today. There just aren't enough producing companies to go round for would-be buyers in China, Japan and Korea. At least when it comes to conventional production.
As with Shell's oil shale projects, the solution to uranium buyers' problems may be engineering. Rather than paying big dollars to top each other for conventional uranium supplies, buyers could invest their money in unconventional uranium resources.
China seems to have already chosen this strategy. Earlier this month, Australia's foreign affairs minister accidentally leaked details of high-level meetings with the Chinese government. One of the topics of discussion was increasing uranium exports to China from the Olympic Dam mine in South Australia.
Olympic Dam contains the world's largest uranium resource, and is the world's third-largest uranium producer at 7.5 million pounds yearly. But the deposit is different from most other uranium operations. The uranium resource is extremely low-grade, at about 0.05% U3O8. By itself this ore would likely be uneconomic. Fortunately, the uranium occurs with relatively high-grade copper (1.5%). Producing and selling the copper pays for the cost of the mine. Uranium can then be extracted as a by-product, making uranium production economic. In 2008, Olympic Dam had uranium production costs of just over $10/lb after accounting for copper revenues. That's in the upper quartile of uranium mines worldwide.
But producing copper and uranium from the same deposit requires special processing equipment. Like most copper mines, initial processing of copper ore at Olympic Dam produces a copper concentrate. An intermediate form of copper. The next step is to smelt the concentrate in order to create refined copper that can then be used to make wire, pipe and other end-use products. But building and operating a smelter is expensive. Most copper mines simply produce a concentrate at the mine site. They then sell the concentrate to a third-party smelter, who takes on the task (and expense) of turning the concentrate into refined copper.
The problem for Olympic Dam is that most smelters around the world are not equipped to handle copper concentrate containing uranium. The mine would therefore have a hard time selling its concentrate. The solution when the mine was originally built was to foot the expense for a dedicated smelter at the mine site. One that could be designed specifically to handle uranium-bearing concentrates. This was an expensive but necessary step. The Olympic Dam ore could now be turned into refined copper and processed uranium oxide, unlocking the full value of the deposit.
That was back when the mine was originally built. Olympic Dam's owner BHP Billiton is now preparing to expand the mine. Originally, BHP planned to build a new smelter at the site and carry on with operations as usual. But after reviewing the project, BHP decided that a new smelter would cost too much. The company looked around for other options.
That's where China stepped in. According to leaked Australian government information, the Chinese government is planning to import uranium-bearing copper concentrate from Olympic Dam. The Chinese will cover the bill for building a custom smelter facility capable of separating the uranium from the copper. This is a significant engineering cost. But the up-front investment should easily pay for itself, allowing China to become one of the few nations on earth capable of accessing Olympic Dam's huge unconventional reserves. In effect, China is paying to make itself the "buyer of first resort" for the world's largest uranium deposit.
Better yet for China, the expense of building a uranium-capable smelter could have benefits beyond Olympic Dam. Exploration for Olympic Dam-type deposits has ramped up in Australia and around the world over the past decade. New uranium-bearing copper deposits have been discovered in Canada and Brazil (although none yet have the same uranium grade Olympic Dam does). If this increased exploration does lead to new discoveries, China will be uniquely positioned to purchase the ore. Giving the nation a "leg up" in the competition with other uranium buyers.
How to Make $3 Trillion Vanish
Remember that old college prank where students would disassemble a Volkswagen, sneak the parts into the dean's office, and then re-assemble the vehicle for the surprised office staff to find the next morning? It must have been amazing the first time that stunt was pulled off. Everyone would be wondering how something so large could fit through such a small doorway?
There's growing evidence that China (and other Asian nations) may be pulling a similar prank. And the target of the joke is the dean of all deans, the U.S. government.
Nations like China and Japan have an issue with their foreign currency reserves. For years, they've run large trade surpluses with the U.S. China to the tune of $300 billion yearly. Japan about $100 billion yearly. Usually countries would turn around and convert a large portion of these dollars into their local currency. Exchanging dollars for yuan or yen that could be used in the local economy.
But both China and Japan have a problem. They want their currencies to remain weak against the U.S. dollar. A weak currency makes Chinese and Japanese goods more affordable for Americans. Creating a greater global market share for these nations. Exchanging their trade-won dollars for local currency would do the opposite. Push up the value of the yuan and the yen against the dollar. And discourage American buying.
The solution for both China and Japan has been to avoid the foreign exchange market altogether. They've simply kept their dollars as dollars. They've attempted to earn some interest on these dollar holdings by buying U.S. Treasury bonds. Buying U.S. bonds also helped finance the U.S. trade deficit, propping up American consumers so they could buy more foreign goods. The result being that China and Japan now own a combined $3 trillion in foreign exchange reserves, most of which is in U.S. bonds.
Central bankers in these countries are growing uncomfortable with their massive dollar holdings. China has voiced concerns over the last few months that money creation in the U.S. may erode the dollar's value. It's becoming increasingly obvious that Asia would like to move out of dollars.
But dumping the dollar isn't easy when you own $3 trillion. If China or Japan tried to exchange even a small portion of their dollars for some other currency, they would drive down the dollar's value. Impairing the value of the rest of their substantive dollar holdings. Getting rid of $100 billion would be a very small victory if the transaction shaved the value of the remaining $2.9 trillion by even 5% or 10%!
In fact, Asia probably couldn't even get to the foreign exchange market. To get dollars to sell, China and Japan would first have to cash out some of their U.S. bonds. And if the market ever saw China and Japan cashing out bonds en masse, the dollar would fall in value long before those nations could turn around sell their new-found dollars. It would seem that Asian bond holdings are just too large to whittle down.
China "Pranks the Dean"
But there is one potential "back door" that China and Japan can use (and probably have been) to secretly dismantle their "Volkswagen" dollar reserves, sneak them through the narrow door of the foreign exchange market, and then reassemble them like the auto in the dean's office.
This is a bit of a complicated lesson in central banking, but one that could be crucially important in understand currency markets (and by extension almost every other market on the planet). The main concept is that sometimes, money can be in two places at once. Let's examine this a little deeper.
Governments can create their currencies at will. The U.S. government can create as many dollars as they see fit. If they want to make 100 trillion new dollars, they can. The Bank of Japan can similarly print yen. Same for governments around the world. In practice, money creation is unlimited. The theoretical limiting factor is the value of that money. A unit of national currency represents a claim on the assets of that nation. The more claims outstanding, the less the value per claim. Take a very simplified example. The nation of Daveville has a gross domestic product of $1 million. If we assume that Daveville can keep up this level of productivity for 10 years, we might conclude that the total "value" of the Daveville nation is $10 million (this is very simplified). Now suppose the central bank of Daveville issues 1 million Dave Dollars. The value of each Dave Dollar would be $10 ($10 million in national value divided by 1 million Dave Dollars outstanding).
But what if the government of Daveville runs into trouble and needs money to bailout its banks? The central bank creates 1 million new Dave Dollars, which the government injects into its financial system. We now have a total of 2 million Dave Dollars outstanding. So the value of each Dave Dollar is now $5 ($10 million in national value divided by 2 million Dave Dollars). We've devalued our currency by 50%. If by the end of the financial crisis we end up with 10 million Dave Dollars outstanding, the value falls to $1. A 90% devaluation.
The potential for this kind of devaluation should prevent governments from printing massive amounts of new currency (or at least think twice about it). If Daveville prints too much money, its trading partners will eventually realize that each Dave Dollar is worth less and less. Eventually they will stop accepting this currency altogether.
One way to get around the devaluation problem is to increase the value of the nation. To torture our example just a little more, suppose Daveville does end up with 10 million Dave Dollars outstanding. But at the same time, the nation drastically increases its national value. Maybe by discovering some valuable natural resource like oil. Or by increasing trade with its neighbors and bringing more foreign currency into the nation. Suppose Daveville's value jumps from $10 million to $100 million. Now the value of each Dave Dollar stays at $10 ($100 million in value divided by 10 million Dave Dollars) despite the recent printing of new money.
China and Japan have been increasing their national value in just this way. Remember, the value of a nation depends on that nation's assets. And foreign exchange reserves are an asset. By accumulating $2 trillion in foreign exchange reserves over the last several years, China has upped its "national value" by that same amount, $2 trillion. This gives the Chinese government room to create new yuan without devaluing the currency. The printing presses have the green light!
The problem is, what can they do with this new yuan? The government could circulate the currency within the country, paying for public works, infrastructure projects and social programs. In fact, they are doing this with the recently announced 4 trillion yuan stimulus program. But internal spending of the national currency can be problematic. Japan tried it in the 1990s, leveraging the value of their accumulated dollar holdings to create yen and pay for huge domestic infrastructure projects. The spending however, failed to produce much lasting value. The nation simply ended up with a lot of unneeded concrete and a $5 trillion government debt.
China has learned from this. They're looking to spend their new yuan outside of China, where it can be put to more productive use. We saw the first major example of this "global yuan" policy this past week when China and Brazil announced they will work toward settling trade in their national currencies. Brazil would pay for Chinese goods in real. And China would purchase Brazilian goods using yuan. This deal would allow China to create yuan and put it to good, productive use. Buying foreign goods, particularly Brazilian oil.
This is the critical part. By creating yuan and using it to secure goods like oil, China is effectively monetizing its massive U.S. dollar holdings without actually selling dollars. Not a single dollar has moved out of China's bank accounts in the U.S. By all appearances everything is completely normal. No spooking the foreign exchange market. But China is using the book value of its dollar holdings as collateral against which to print new yuan and purchase valuable goods. This way, they don't have to actually move their dollars in order to make use of them. Brazil knows that China holds $2 trillion in dollars and is therefore willing to accept yuan backed by those dollars. Thus China can slowly and secretly dismantle its "Volkswagen" dollar holdings and sneak them outside the U.S. banking system to be reassembled as a portfolio of Brazilian oil, Australian uranium, African iron ore, and other useful goods. Joke's on you, dean!
Some of my colleagues have pointed out that this is an interesting theory, but one that is difficult to track and to prove. Deals between governments are often done in secret (or at least off the front page), so we have a hard time knowing how much new yuan and/or yen is circulating around the globe. Monetary base statistics give us some clue. China's monetary base was up 26% year-on-year in the first four months of 2009. That means 10 trillion yuan ($1.5 trillion) was created in the past year alone. That's a lot of new yuan that has to be going somewhere!
Other "indirect signs" of Asian money creation are becoming too strong to ignore. Just this morning the Bank of Japan announced that it is making some important changes to its loan policies. Most significantly, the Bank will now accept U.S. government bonds as collateral on yen-denominated loans. This rule change allows for exactly the type of scenario discussed above. Japanese investors holding large U.S dollar reserves (in the form of U.S. bonds) can now "monetize" those dollar holdings by borrowing yen against them. This yen can then be used to purchase goods. Traditionally, the Japanese have shied away from circulating yen outside of Japan (the way China is trying to do with yuan in Brazil). But they have done a few deals with Iran to purchase oil in yen. And today's policy change opens the door for more such operations.
Petroleum Reserves and South America
It's been a hectic week making final travel arrangements for my trip to South America next week. It's amazing how a day or two of total panic can really get a lot accomplished! I head off at the end of next week for some rock-kicking in Panama City and throughout Colombia. Should be an interesting trip both on the petroleum and mining geology fronts.
Before the trip I am making a little time for some prep work, attending the Society of Petroleum Engineers training course on the (relatively) new Petroleum Resources Management System (PRMS). Those of my readers involved in the petroleum sector know that reserves reporting is one of the stickiest issues in evaluating E&P companies. It's just very difficult to tell how much oil or gas is in the ground for any given pool. PRMS offers new guidelines on assessing and reporting reserves. Critical stuff for anyone analyzing oil and gas investments. The Society of Petroleum Engineers have been kind enough to have me as a member even though I'm not an engineer, strictly speaking. The organization is a wealth of knowledge and I expect I will leave this course a lot smarter than when I walked in.
My partner Phil O'Neill and I are working on a number of new projects with Notela Resource Advisors, some of which I hope to be able to tell you about in the coming weeks (after all of this traveling is out of the way!). Thanks to all of you who have been in contact regarding Notela. The organization is shaping up better than we had hoped and in the form we'd always envisioned. A virtual network of resource and investment professionals bringing rocks and money together. This wouldn't have been possible without many of you. I know I may sound like a scratched DVD (I've got a lot of those around, with a two-year-old in the house), but thanks again to all of you who've made this possible.
I've been out all evening visiting some of my favorite spots in Calgary, in preparation for departing the city (thanks Silver Dragon restaurant!). Time to send this letter and catch up on NBA playoff highlights before bed. Have a great weekend!
Here's to unconventional thinking becoming conventional,
Dave Forest
Pierce Points Weekly Newsletter
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Note: The information provided in this newsletter is based on the independent research of Dave Forest and Notela Resource Advisors Ltd. and is intended solely for informative purposes and is not to be construed, under any circumstances, by implication or otherwise, as an offer to sell or a solicitation to buy or trade any securities or commodities named herein. Information contained in this newsletter is obtained from sources believed to be reliable, but is in no way assured. All materials and related graphics provided in this newsletter and any other materials which are referenced herein are provided "as is" without warranty of any kind, either express or implied. No assurance of any kind is implied or possible where projections of future conditions are attempted. Readers using the information contained herein are solely responsible for verifying the accuracy thereof and for their own actions and investment decisions. Neither Dave Forest nor Notela Resource Advisors Ltd., make any representations about the suitability of the information delivered in this newsletter or any other materials that are referenced herein for any purpose whatsoever. The information contained in this newsletter does not constitute investment advice and neither Dave Forest nor Notela Resource Advisors Ltd. are registered with any securities regulatory authority to provide investment advice. Readers are cautioned to consult with a qualified registered securities adviser prior to making any investment decisions.
The information contained in this newsletter has not been reviewed or authorized by any of the companies mentioned herein.
Copyright 2009 Resource Publishers Inc.
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