Hedging Against Falling Uranium Prices using Uranium Futures

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Contents

Hedging Against Falling Uranium Prices using Uranium Futures

Uranium producers can hedge against falling uranium price by taking up a position in the uranium futures market.

Uranium producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of uranium that is only ready for sale sometime in the future.

To implement the short hedge, uranium producers sell (short) enough uranium futures contracts in the futures market to cover the quantity of uranium to be produced.

Uranium Futures Short Hedge Example

An uranium mining company has just entered into a contract to sell 25,000 pounds of uranium, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of uranium on the day of delivery. At the time of signing the agreement, spot price for uranium is USD 53.00/lb while the price of uranium futures for delivery in 3 months’ time is USD 53.00/lb.

To lock in the selling price at USD 53.00/lb, the uranium mining company can enter a short position in an appropriate number of NYMEX Uranium futures contracts. With each NYMEX Uranium futures contract covering 250 pounds of uranium, the uranium mining company will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the uranium mining company will be able to sell the 25,000 pounds of uranium at USD 53.00/lb for a total amount of USD 1,325,000. Let’s see how this is achieved by looking at scenarios in which the price of uranium makes a significant move either upwards or downwards by delivery date.

Scenario #1: Uranium Spot Price Fell by 10% to USD 47.70/lb on Delivery Date

As per the sales contract, the uranium mining company will have to sell the uranium at only USD 47.70/lb, resulting in a net sales proceeds of USD 1,192,500.

By delivery date, the uranium futures price will have converged with the uranium spot price and will be equal to USD 47.70/lb. As the short futures position was entered at USD 53.00/lb, it will have gained USD 53.00 – USD 47.70 = USD 5.3000 per pound. With 100 contracts covering a total of 25000 pounds, the total gain from the short futures position is USD 132,500

Together, the gain in the uranium futures market and the amount realised from the sales contract will total USD 132,500 + USD 1,192,500 = USD 1,325,000. This amount is equivalent to selling 25,000 pounds of uranium at USD 53.00/lb.

Scenario #2: Uranium Spot Price Rose by 10% to USD 58.30/lb on Delivery Date

With the increase in uranium price to USD 58.30/lb, the uranium producer will be able to sell the 25,000 pounds of uranium for a higher net sales proceeds of USD 1,457,500.

However, as the short futures position was entered at a lower price of USD 53.00/lb, it will have lost USD 58.30 – USD 53.00 = USD 5.3000 per pound. With 100 contracts covering a total of 25,000 pounds of uranium, the total loss from the short futures position is USD 132,500.

In the end, the higher sales proceeds is offset by the loss in the uranium futures market, resulting in a net proceeds of USD 1,457,500 – USD 132,500 = USD 1,325,000. Again, this is the same amount that would be received by selling 25,000 pounds of uranium at USD 53.00/lb.

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Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the uranium seller would have been better off without the hedge if the price of the commodity went up.

Learn More About Uranium Futures & Options Trading

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Hedging Against Falling Uranium Prices using Uranium Futures

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. Support for this pricing relationship is based upon the argument that arbitrage opportunities would materialize if there is a divergence between the value of calls and puts. Arbitrageurs would come in to make profitable, riskless trades until the put-call parity is restored.

To begin understanding how the put-call parity is established, let’s first take a look at two portfolios, A and B. Portfolio A consists of a european call option and cash equal to the number of shares covered by the call option multiplied by the call’s striking price. Portfolio B consist of a european put option and the underlying asset. Note that equity options are used in this example.

Portfolio A = Call + Cash, where Cash = Call Strike Price

Portfolio B = Put + Underlying Asset

It can be observed from the diagrams above that the expiration values of the two portfolios are the same.

Call + Cash = Put + Underlying Asset

Eg. JUL 25 Call + $2500 = JUL 25 Put + 100 XYZ Stock

If the two portfolios have the same expiration value, then they must have the same present value. Otherwise, an arbitrage trader can go long on the undervalued portfolio and short the overvalued portfolio to make a riskfree profit on expiration day. Hence, taking into account the need to calculate the present value of the cash component using a suitable risk-free interest rate, we have the following price equality:

Put-Call Parity and American Options

Since American style options allow early exercise, put-call parity will not hold for American options unless they are held to expiration. Early exercise will result in a departure in the present values of the two portfolios.

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The put-call parity provides a simple test of option pricing models. Any pricing model that produces option prices which violate the put-call parity is considered flawed.

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Uranium Prices Set To Double By 2020

With prices set to double by 2020, we’ve seen the bottom of the uranium market, and the negative sentiment that has followed this resource around despite strong fundamentals, is starting to change.

Billionaire investors sense it, and they’re always the first to anticipate change and take advantage of the rally before it becomes a reality. The turning point is where all the money is made, and there are plenty of indications that the uranium recovery is already underway.

It’s been a very tough few years for uranium. But it now looks like we’ve reached the bottom, and the future demand equation says there’s nowhere to go but up—significantly up.

Uranium analyst David Talbot of Dundee Capital Markets is forecasting 6 percent compound annual demand growth through 2020, which is enough, he says, to “kick-start” uranium prices up to and beyond 2007 levels. Morningstar analyst David Wang predicts prices will double within the next two years.

Mining Weekly expects “the period from 2020 to be a landmark period for the nuclear sector and uranium stocks, as the global operating nuclear reactor fleet expands.”

“It’s impossible to find another natural resource that is so fundamentally necessary and yet has carried such negative sentiment as uranium. The market has been skewed by negative sentiments that ignore the supply and demand fundamentals,” says Paul D. Gray, President and CEO of Zadar Ventures Ltd., a North American uranium and lithium explorer.

But the toxicity levels have dissipated, and nuclear energy is rebounding as a cleaner power source with next generation safeguards. The fundamentals are again ruling the day, and this will be the key year for uranium,” Gray told Oilprice.com.

Why Sentiment is Changing: Born in Chernobyl, Raised in Japan

The negative sentiment on uranium was largely made in Japan. The 2020 disaster at Fukushima created an irrational disconnect between sentiment and uranium fundamentals.

Now that enough time has passed since Fukushima, this negative sentiment is losing steam as it appears that Japan has succeeded in bringing some of its reactors back online – four of its reactors have already restarted operations. So the world is refocusing on what are arguably brilliant fundamentals, which actually have been there all along.

First and foremost, the world is building more nuclear reactors right now than ever before, despite Fukushima. A total of 65 new reactors are already going up, another 165 are planned and yet another 331 proposed.

Powering all of these developments will require an impressive amount of uranium. Right now, existing nuclear reactors use 174 million pounds of uranium every year. That will increase by a dramatic one-fifth with the new reactors under construction. But in the meantime, uranium producers have reduced output due to market prices and put caps on expansion. As a result, supplies are dwindling.

Currently, the world is increasingly recognizing nuclear energy as the cheaper, cleaner, and greener option—as indicated by the number of reactors being built.

As the specter of nuclear accidents wanes in the aftermath of Fukushima and climate change fears move to the top of the chain, uranium is set for a global sentiment transformation.

As Scientific American opines, “Nuclear energy’s clean bona fides may be its saving grace in a wobbling global energy market that is trying to balance climate change ambitions, skittish economies and low prices for oil and natural gas.”

According to Bloomberg, in Asia alone, approximately $800 billion in new reactors are being developed. Related: After 350,000 Layoffs Oil Companies Now Face Worker Shortages

The market hasn’t quite caught on yet to what this massive nuclear development means for uranium because it’s still stuck in the Fukushima sentiment–but the cracks are showing and it’s about to break free.

At the same time, the uranium industry is not producing the uranium needed to feed the hundreds of new reactors slated to come online. Not even close. The uranium is not being produced because producers can’t turn a profit at today’s spot prices.

The minute the market catches on to the massive amount of reactors coming online combined with the pending uranium supply shortage, uranium will experience a price surge like no other commodity before it.

Up to 20 percent of the uranium supply needed to operate the world’s existing 437 nuclear reactors for the rest of this year and next is not covered, according to uranium market analyst David Talbot.

The market has recognized the pending lithium boom, for instance, as heralded by the electric vehicle (EV), battery storage and powerwall push. But the market is sleeping when it comes to uranium, which has even more obviously bullish fundamentals. That’s why when this sleeping giant awakens suddenly with the start-up of new reactors around the world, it will be with a roar that rewards those savvy enough to sneak around the irrational sentiment.

Determining when the break-out will come, exactly, is part and parcel of playing this rally with an eye to massive returns (for which you can thank the negative sentiment if you’re already onto uranium). But all bets are that this year we’ll see the first new reactors come online, and then it will snowball from there, transforming from a buyers’ market into a sellers’ market.

The Billionaires’ Sixth Sense

Billionaire investors are lining up behind uranium with major acquisitions, betting that they are on the edge of a price break-out.

Earlier in June, Hong Kong billionaire investor Li Kashing, though his CK Hutchinson Holdings and CEF holdings, said he would buy $60 million in convertible bonds from NexGen Energy targeting uranium projects in Canada’s Saskatchewan province.

“The current spot prices seem low, but the fundamentals indicate there’s going to be a very large demand and supply gap — that’s what you’re making a call on,” NexGen CEO Leigh Curyer said of the deal. NexGen is slated to start production in the 2020s.

Mr. Li’s $60-million bet on Saskatchewan uranium is near another uranium company, Zadar Ventures Ltd, which has four projects in Saskatchewan and one in Alberta, and stands to benefit from the high-dollar renewed focus on this resource.

The Athabasca Basin is elephant country in terms of uranium deposits. It represents the world’s highest-grade uranium deposits and is the home to all of the major uranium producers, developers and explorers.

If your going to look for the world’s next uranium mine, the Athabasca Basin is the place to do so.

Considering that nearly half of the U.S.’ 57 million pounds of uranium imports last year came from Canada and Kazakhstan, with Canada providing 17 million pounds—these producers are extremely well-positioned for what comes next.

Talbot predicts that the Uranium pound price could reach $65 within two years, and notes that some mines will be extremely profitable at this price—particularly those in the Athabasca Basin and in the western and southwestern U.S., while development of uranium deposits in Africa will require higher prices.

The Athabasca Basin is precisely where Zadar and NexGen operate, along with other promising contenders, including Cameco Corp. (TSX:CCO) and Denison Mines Corp. (DML:TSX).

Last month, billionaire D.E. Shaw let us all know that he’d acquired 1.4 million shares in Cameco, eyeing rising uranium prices, tightening supplies and growing demand—and joining the ranks alongside George Soros. And others have lined up, too, including well-known money managers Ken Griffin, Ray Dalio and Steve Cohen.

Then we have Bill Gates—who has jumped on the uranium bandwagon with great determination. Through his TerraPower company, Gates is developing a Fourth Generation nuclear reactor that would run on depleted uranium, rather than enriched uranium.

Increasingly, this is shaping up to be the the Year of Uranium, but while the market sleeps, big investors don’t: They’ll be all set when uranium experiences a violent upswing, and those operating around the Athabasca Basin are likely to be among the first to benefit from the upward price trend and shrinking supply.

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