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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management Biweekly Asset Allocation report for April 15, 2024. I'm Phil Adler. The recent rally in the price of uranium appears to be more than just a flash in the pan. Confluence Investment Management chief market strategist Patrick Ferron Hernandez joins us today to focus on a major reason for this. It's a reason that might be somewhat overlooked.
Phil Adler:Patrick, we've discussed uranium recently, after confluence added uranium and uranium miners into its Asset Allocation strategies. An obvious reason is that utilities around the world are looking to add modernized nuclear plants to their power generation mix. Today we look at what might be a less recognized reason, at least so far, and that is demand for nuclear weapons. Where is this demand coming from?
Patrick Fearon-Hernandez:Well, hi, Phil, and thanks for having me on the program. To answer your question, we see the increasing military demand for uranium is coming from 2 major sources. First, the ongoing modernization programs among some current nuclear weapon states, and secondly, the outright arsenal expansions that we see happening or potentially happening in others. We've looked at a number of different scenarios for the coming decade or 2, but in all the scenarios, China's ongoing arsenal expansion looks like it will be the key driver of military uranium demand going forward.
Phil Adler:Well, how quickly is China's demand growing?
Patrick Fearon-Hernandez:Well, it's really an interesting story. After decades of keeping only a minimal nuclear deterrent of about 200 warheads, China has recently begun a dramatic expansion that western analysts believe will lift its arsenal to at least 1770 warheads by 2,035. That number would match the number of weapons that the US and Russia each have deployed today. To give you a sense of what that means in terms of an annual production schedule, Western analysts believe China has built an average of about 42 new warheads each year since 20 20, including a big surge of 90 warheads over the last year. To reach the expected 1770 warheads by 2035, China would probably have to boost its production rate to an average of a 115 warheads per year until then.
Phil Adler:Do you think, Patrick, these statistics are trustworthy?
Patrick Fearon-Hernandez:Well, that brings up an important caveat for this particular topic. Information on nuclear weapons inventories, production methods, technological breakthroughs, and the like is extremely sensitive for any country, so it tends to be highly classified. For our analysis, we've relied on unclassified government data and private sector estimates from recognized authorities such as the Federation of American Scientists along with our own educated guesses. Our estimates could well be off the mark, but we think they're reasonable. In fact, as we've modeled out this analysis, we've tried to be conservative in our estimates of weapons production and incremental uranium needs.
Phil Adler:Now you say China wants to match the number of US warheads by 2035. Well, do you expect US demand will accelerate to stay ahead of.
Patrick Fearon-Hernandez:China? Well, that's certainly possible. Our estimate that China will build a 115 new warheads per year is a ceteris paribus number. In other words, it assumes that all other numbers are static. But if the US responds to China's build up by boosting its own arsenal, we could end up in an arms race in which the US, China, and probably Russia are all building new weapons and spurring increased production by the rivals so that the world's nuclear weapons arsenal overall takes on a life of its own and grows dramatically.
Patrick Fearon-Hernandez:Again, we're trying to be conservative for our estimates. So in this analysis, we didn't even try to model out the increased weapons production
Phil Adler:What about other countries around the world, which seem likely to join the race for nuclear weaponry?
Patrick Fearon-Hernandez:Well, precisely. Given the increasing geopolitical tensions we see today and given the way the US allies are becoming increasingly concerned that the US won't stand shoulder to shoulder with them in time of war, we see some chance that many of today's non nuclear states might eventually decide to go nuclear for their own national security purposes. It's actually fairly easy to come up with a hypothetical scenario in which the hypothetical scenario in which the number of countries with recognized nuclear arsenals doubles from today's 9 to 18 or more in the next decade or 2. Obvious candidates would include South Korea, where some 70% of the population already supports going nuclear, but also countries like Japan, Germany and Poland. If we see this kind of nuclear proliferation, the growth in military uranium would be even greater than I talk about in my analysis here.
Phil Adler:It might be useful at this point to ask an elementary question. What exactly is the role of uranium in the manufacture of nuclear warheads?
Patrick Fearon-Hernandez:Well, to keep it as basic as possible, certain isotopes of uranium and plutonium are fissile, meaning their atoms are susceptible to being split in a sudden chain reaction, which releases enormous amounts of energy. When controlled, both uranium and plutonium chain reactions can be used to turn water into steam, to turn generators, and create electricity. But uranium and plutonium chain reactions can also be set off in an uncontrolled way to create a bomb blast. They can also be used to set off a fusion reaction in which different isotopes of hydrogen are fused, which also releases enormous amounts of energy in a hydrogen bomb. So uranium itself can be used in a nuclear weapon.
Patrick Fearon-Hernandez:Plutonium can also be used, but very little plutonium occurs naturally on Earth, so it's generally produced from uranium. So in other words, uranium is the key ingredient that generates the blast in a nuclear weapon, whether it's based on uranium or on plutonium.
Phil Adler:Can we say that the plutonium necessary for nuclear weapons, the production of plutonium, demands a significant amount of uranium?
Patrick Fearon-Hernandez:It certainly looks that way. But remember, a lot of information about nuclear weapons and their production is highly classified. So we can't be sure our numbers are absolutely accurate. And and, of course, even if we did know that they were accurate, we couldn't reveal that. Nevertheless, we have found information from a US government site that's unclassified and that suggests that a modern hydrogen bomb might require about 15 kilograms of Plutonium.
Patrick Fearon-Hernandez:And that it takes about 4,000 kilograms of uranium to produce 1 kilogram of Plutonium. So in other words, one bomb probably requires the equivalent of about 60 metric tons of uranium. Now if China really does boost its nuclear weapons production to a 115 weapons per year, that implies that its military uranium demand alone would be at least 6,900 metric tons per year. And that doesn't even take into account the increased need that you would see for higher levels of purity or to account for production losses or to build reserves or reserve stockpiles of weapons.
Phil Adler:Well, what about global supplies of uranium? Will the present production rate be able to keep up with this demand?
Patrick Fearon-Hernandez:Well, put it this way. In 2023, the world's uranium mines produced only about 65,000 metric tons of yellowcake, which is an unpurified form of triuranium oxide. China's basic military demand of 6,900 tons would account for about 11.5% of that. And keep in mind that today's mine output only covers about 75% of the uranium needed to generate electricity with the rest being brought out of inventory. So big increases in military uranium demand are therefore likely to have a significant impact on uranium prices going forward.
Phil Adler:What do mining companies say about prospects for major new discoveries?
Patrick Fearon-Hernandez:Well, without doubt, new uranium reserves are likely to be discovered in the coming years. But the reality is that uranium reserves are already known to exist in many regions and countries around the world. The key question is how much it cost to exploit the various reserves. The very lowest cost reserves are in Kazakhstan, Uzbekistan, and Russia. And we suspect that's where China is getting the bulk of its uranium right now.
Patrick Fearon-Hernandez:As China uses more and more of that low cost metal, prices will go up and more costly reserves in other countries should become more economically viable.
Phil Adler:Patrick, it seems to me that the demand for uranium might keep growing for a very long time based on the reasons we've discussed, the need for nuclear power and the drive to manufacture nuclear weapons. And the only real uncertainty is how high might uranium prices go. Do you agree?
Patrick Fearon-Hernandez:Well, yeah. It's certainly starting to look that way to us. Again, investors probably aren't paying enough attention to the possible incremental demand for uranium from weapons. As that becomes clearer to investors, it could push uranium prices even higher than they already are.
Phil Adler:Do you lean toward investing
Patrick Fearon-Hernandez:In our asset allocation strategies, we use exchange traded funds and our main uranium vehicle to date has been an ETF that invests mostly in uranium miners, but also has about 10% of its assets in the miners but also has about 10% of its assets in the metal itself. In our global hard assets fund, we focus more on the uranium miners.
Phil Adler:What would have to happen for Confluence Investment Management to increase exposure to uranium in its asset allocation portfolio recommendations?
Patrick Fearon-Hernandez:Well, that's really a question of our process. Our asset allocation committee meets every quarter to develop our total return, volatility, and yield estimates for various asset classes over the coming 3 years. Based on those projections, we use a linear programming approach and our own judgment to set the percentage allocation for each asset class for each of our strategies for that quarter. At that point, we decide on the specific investments to make in each asset class. Now, we currently use our uranium ETF for part of our allocation to mid cap stocks.
Patrick Fearon-Hernandez:Within this process, our allocation to the uranium ETF could fluctuate based on our overall exposure to mid caps and to our specific outlook for uranium prices. So it's really a more complex process that takes into account opportunities and risks across a number of different asset classes.
Phil Adler:Finally, Patrick, do you consider uranium more suitable for aggressive portfolios?
Patrick Fearon-Hernandez:Generally, yes. Although it's important to remember that our allocation to one asset class in particular or in a particular portfolio could be impacted by our desired allocation to other asset classes. For example, our growth strategy currently has a slightly higher allocation to mid cap stocks than our aggressive growth strategy. In large part because our aggressive growth strategy has a much higher allocation to small cap stocks, leaving less available for mid caps. But nevertheless, we do see uranium exposure as potentially more volatile and therefore more appropriate for more aggressive portfolios.
Phil Adler:Thank you, Patrick. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice, and this information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stoll. I'm Phil Adler.