Looking At Uranium - What a hedge.

As an investor uranium has made me very uncomfortable. There is no question that there is a huge gap in supply and demand and that uranium mines take longer to get the approval process to build them than other mines, so there should continue to be a gap for some time, but it has all the appearance of a bubble.

So, I've been looking deeper into uranium because the spot is very, very, very high, and any one in a position to take advantage of that spot price is going to make a lot of money. The question is, have investors fairly valued the potential, under valued or over valued it?

So, I've been reading Cameco's management an analysis. Cameco has 513 million pounds of uranium reserves. At that spot price of $113/lb, well that's $58 billion dollars!!! And their market cap is only $17.8 billion US, fully diluted. And heck, they also have 100 million pounds of resource and another 316 million pounds of inferred resource. They also have 3.6 million ounces of gold reserves. And then they have the electrical part of the business.

Actually, the numbers do not excite me. Certainly if they were able to sell their uranium at those prices they would make so much money because the profit margin would be incredible.

But, these are things that I found. Much uranium is bought and sold through long term contracts. In 2006 the cost per kWh for energy produced from nuclear power was 1.66 cents, from coal was 2.28 cents, 6.60 for gas and 9.64 cents from petroleum.

So nuclear energy costs only 1.66c/kWh (average 2006) when spot prices are $49.60 (average 2006), right?

Wrong, time to choke, Cameco's average price was $20.62/lb, about 41% of the actual spot price. The industry tends to make contracts 2-4 years prior to delivery and have those contracts in place for 4-6 years. Cameco has 60% of its uranium hedged. Looking back to just 2003, well that was the first year the average spot price exceeded $11 US, that's the price range for 60% of it uranium. That's only about 90% short of the current spot price...

At $20.62 that 513 million pound uranium reserve is worth about $10.6 billion.

Currently their production volume is about 21 million pounds per year, and they have a fully integrated business in converting the uranium from what's pull from the ground to what nuclear reactors actually use. They actually ended up selling 32 million pounds, but they purchase other uranium concentrate, process it and then sell it. They do not gain from the bull run on uranium for those 11 million pounds.

It seems Cigar Lake had production commitments for 2007. It seems like these contracts at low prices are being extended for 5-7 years.

I didn't find guidance on the price of the hedged uranium, but it seems only an inflation increase is in order.

It sure changes the dynamics of what a stock might be when they are only getting about 10% of the current spot price for 60% of their production.

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Imperial Metals - The Right Hedge

Imperial Metals is a primarily copper mining company with other metal by-products. Like Quadra, in 2006 they hedged their copper, only Imperial hedged the right way, protecting earning and minimizing losses.

The company did have derivative losses from hedging, about $27 million for 2006, relative to production, that's about 1/5th the loss that Quadra had. In one hedge they protected themselves from copper going below $1.80, but participated in price increases to $2.60. Later they had a hedge that had protection from going below $2.90/lb, but price participation up to $3.68/lb, and another hedge had price protection for $2.50/lb and price participation to $3.06/lb. Sure the hedge cost them money, but this is the right way to hedge, keeping 75-80% of the gain. Quadra hedged at $1.60.

The change in their financial position from 2005 to 2006 is stellar, short term assets up $27 million, all assets up $78 million and none of those fiat intangible assets like "Goodwill" listed on their balance sheet. Additionally, their liabilities are down by $21 million for a total change in financial postion of $99 million. Not bad for a company with a fully diluted market cap of $433 million. Earnings per share for 2006 was $2.69, or 22% of today's earlier share price of $12.12.

Imperial currently has two sources of income, their Mount Polley mine which provided net revenue sales of $210 million for 2006 and their equity income from their share in the Huckleberry mine, which provided them with $34 million. Guidance for 2007 is 98 million lbs copper, 58,800 oz gold, 596,000 oz silver, and 210,000 lbs molybdenum. And again they have hedge for 2007, 3/4rd of their copper is hedged to between $2.97 and $3.47/lb.

The company recently purchased bcMetals for $68 million, from cash and a $40 million loan. According to Management Discussion and Analysis:

The Red Chris project has received Federal and Provincial environomental approvals for mine development. A bcMetals feasibility study on the Red Chris property indicates a 25 year mine life at 30,000 tons per day with reserves of 276 million tonnes grading 0.349% copper and 0.266 g/t gold.

Working through the numbers, 276 million tonnes of 0.349% copper is a contained resource of 2.1 billion pounds of copper, which they bought for a take-over price of about 1/3 of a penny per pound, making the gold free. That price is well under the 1c/lb of copper resource guideline of my previous post.

The production rate indicates 84 million pounds of copper/year and 94,000 oz of gold. With recovery rates taken into consideration it would be more in the range of 75 million pounds of copper and 50,000 oz gold (my rough estimate).

Other exploration holding include their Bear property which has molybdenum and copper. The best drill results were 296 meters of 0.059 molybdenum and 0.27% copper. Some pure moly plays for open pit have just 0.06 molybdenum.

Their Sterling property is gold and so far has defined a resource of 46,000 ounces of gold with 7.41 g/t. There are more exploration opportunities on this property.

Their Nak property has rich chalcopyrite veins which grab samples returned grades as high as 5.11% copper and has drill results with 0.1 to 1.1% copper.

Their Giant Copper property, located 220 km east of Vancouver, had a 1989 feasibility study that calculated a reserve of 3.7 million tonnes of 1.08% copper, 0.47 g/t gold, 19.18 g/t silver and 0.01 molybdenum. These results are before NI43-101, so they are not compliant.

Their Porcher Island property is also a gold property with before NI43-101 estimated mining reserve of 623,000 tonnes of 6.9 g/t gold.

By doing the hedge the right way Imperial Metals is in a very, very strong position for 2007 earnings. They will be able to pay off debt and be in a strong financial position to further develop and explore their properties.

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The Leverage of Earnings

"Around 2000 I left my job and cashed out my pension and put it into commodities," was what a colleague was saying. "I had $14,000 and it is now a quarter of a million."

The commodities bull run created an enormous leverage of earnings. Take Northern Orion, a junior start-up company around the beginning of the bull run and now it has $230 million in the bank. The big players have reported billions of dollars of earning.

Eastern Platinum has gone from a junior start-up to a company with a $1.5 billion dollar market cap. Its earnings are a little on the low side for the market right now, but with 700% expansion of mining production over 5 year planned, high grades of platinum resources and demand for platinum as both an industrial metal and a precious metal, they will have good growth in earning..

Roca is a new start-up that if moly prices remain where they are should make in the range of 25-30c/share in either Q3 or Q4 this year.

Blue Note is also building a new mine and should have earnings of 2-4c by Q3 or Q4 this year. Blue Note will perform nicely this year.

Aur Resources has gone from a $2 stock in 2000 to $23 today with 2006 earnings of $3.23 per share, and 60-70% growth in production planned over the next 2 or so years.

To have been there at the beginning of the bull run, at the period when earnings exploded.

There is one stock I've recently looked at that an unfortunate hedge decision reduced its earnings to about 20-25% of what they would have had without the hedge. The company's earnings were 87c/share for 2006, and with only 40 million shares, taking a $144 million dollar loss and still making money is amazing. $144 million is about $3.60/share of cash flow that they didn't have to put to earnings. There is a thing called taxes that they would have to pay on that, so it isn't quite that good, but it is very sweet overall.

The stock is Quadra and this stock is in a position to see a leverage of earnings much like the early bull run days, indeed, 2007 will be Quadra's bull run.

Quadra's hedge which limited them to an average of $1.72/lb of copper for 2006 hit them at both end, earnings and costs. There is a thing called "price participation" where as the price of a commodity increases, smelter companies get a cut of that increasing price. Quadra had hedged at $1.60 and copper went as high as $3.99/lb on the LME. So, not only did Quadra forfeit 60% of the potential income, they had to pay smelter costs as if they were getting $3.99/lb. So Quadra paid the full costs of the bull run, but had none of the benefits. The average LME price for copper for 2006 was $3.05/lb. Quadra didn't get an average of $1.32/lb of "free" money.

Quadra has even more leverage of earning to come. They ran into a few problems with production and produced 117 million pounds of copper. They believe they've worked out those issues, certainly towards the end of Q4 their recovery rates improved considerably, and they've given guidance of $125 million pounds, an small increase of 7%. But, they are in the process of building a second mine which is planned to start producing late 2008 and will add 75 million pounds of production per year, so a two year growth in production rate of 67%. There are a couple downsides, increased debt to pay for building the new mine, but that is highly preferable over dilution that would limit earning potential forever.

2007 is going to be Quadra's year for stellar performance.

QUA Toronto, QADMF.PK in the US.

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Quadra - When the hedge is over

Quadra is a $350 million, fully diluted, market cap mining company with a producing mine with 2007 production guidance:

• 125 million pounds of copper,
• 60,000 ounces of gold,
• no guidance on molybdenum, 260,000 lb in 2006.

They have just obtained financing to build a second mine for start-up in 2008, guidance 28 million pounds, increasing to 75 million pounds in 2009, bringing the fully diluted number of shares up to 42.7 million. Additionally they have plans to develop a third mine in Chile which will produce 300 million pounds.

Last year copper prices peaked at $3.99/lb and they have come down, slaughtering the earnings for most copper mines. Take Goldcorp, market cap 19.7 billion, earnings crumbled to 11c/share in Q2 from 50c/share in Q4 -- in Q2 Goldcorp's copper earnings accounted for 65% of their total earnings, and enabled them to claim -$123/oz production costs on gold, all from a mere 46,700 lbs of copper sales.

For 2006 Quadra's eps was a mere $0.87, indeed, while Goldcorp was producing its record earnings, Quadra was losing money. Quadra made a hedge, and the hedge ended up costing Quadra $143.9 million in derivative expenses. The average LME price for copper in 2006 was $3.05, but Quadra's average price was $1.32/lb less, $1.73/lb, because of the hedge. $143.9 million in lost income amounts to $3.53/share. After taxes it means that $2.18/share of earning potential was lost to a bad hedge. Without the bad hedge, eps for 2006 would have been in the $3+/share range.

Quadra has shipped the last of its hedged copper and will clear the last of its hedge loss this quarter.

Think of the end of the hedge as an enormous cut to costs. Their income for 2006 was $393 million, and out of that came this enormous $144 million hedge cost, or 37% of their revenue.

Another problem that Quadra had was lower than expected recovery rates, a mere 61% on copper until the last two weeks of December, where it increased back to the 70-80% recovery rate. This problem appears to have resolved now, but it also lowered overall production for 2006.

So, Quadra is going into 2007 with a double leverage potential on earnings, an enormous reduction in expenses, and improved production rates. At $3/lb for copper, $375 million, at $650 for gold, $39 million, and perhap $5 million for their molybdenum, for 2007 revenue of about $419 million, and no $144 million hedge expense.

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