A steep drop in the price of uranium has punished uranium miners like industry giant Cameco Corporation (NYSE: CCJ). However, the company's conservative approach has allowed it to weather this difficult stretch in relative stride, with its uranium contracts giving it financial leeway that many peers simply haven't had.
That leeway could end soon, however. And, just as notable, the benefit of contracts on the downside could turn into a headwind as uranium prices move higher. Here's why Cameco Corporation investors should be wary of the miner's uranium contracts.
Contracts are good in a downturn -- mostly
Cameco is conservative by nature, using long-term contracts to lock in uranium sales and prices. Management targets a ratio of 40% fixed prices and 60% market based prices, with uranium costs set at the time of delivery. But even the market based contracts it has in place often contain floor prices to protect the company's downside risks.
That was a huge benefit during the most recent uranium downturn, which started in 2011. The miner managed to remain profitable all the way up to 2016 despite the spot price for uranium falling from over $72 a pound in 2011 to $18 a pound in 2016.
Cameco's contracts were the key. In 2016, when uranium hit its most recent low, Cameco's realized price was $41.12 despite an average spot price of just $25.54 for the year. The miner's contracts allowed it to earn 60% above the spot price for every pound of uranium it sold. That's not a one-year phenomena, either: In 2017, the average price for uranium was $21.78 per pound (even worse than 2016, despite the fact that uranium prices started to recover a little), but Cameco made $36.13 -- 65% more than spot prices.
This has been great news for Cameco and its shareholders, softening the blow of a painful uranium market, but there's a catch. Contracts eventually end.
Although uranium prices have picked up off the lows reached in 2016, they are still very low by historical standards, and customers have been reluctant to ink new contracts since it is still relatively cheap to buy on the spot market. Meanwhile, Cameco's contract book will start to drop off after 2020. The miner doesn't say how many contracts will end or how quickly they will fall away. But 2021 will be an important year to watch, because financial results could be hit hard if contracting activity doesn't pick up.
Contracts can limit an upturn
That said, there's another problem with contracts. When times are flush, Cameco's contracts can actually restrain results. Back in 2011, the miner's realized price for uranium was $49.17 per pound, while the spot price was $56.36. Cameco earned nearly 13% less per pound in that year.
That isn't an unusual situation, either. So while contracts have been a huge help during the downturn, if uranium prices go high enough Cameco's financial results will be held back by the same contracts. It's the other side of the coin, and one that investors will want to keep in mind now that uranium prices are starting to pick up again.
For long-term investors, the trade-off is likely worth it for the downside protection that contracts afford Cameco. However, Wall Street will likely reward miners that are more exposed to spot prices with a premium relative to Cameco if uranium prices go high enough to limit the giant miner's top line. In other words, Cameco's stock may not fully participate in a uranium miner rally. It's something that you'll want to keep in mind so you don't end up surprised by Cameco stock's performance.
Take the good with the bad
Cameco is one of the largest uranium miners in the world, and has long taken a conservative approach with its business. One key piece of that is its contract book, which has been a huge safety valve during the uranium downturn.
But there are risks to this approach that investors need to understand. The biggest concern to watch right now is that those contracts will start to fall off relatively soon. Longer term, assuming uranium prices recover enough, Cameco's contracts could also be a negative, as they will restrain results and make Cameco's conservative approach look like a mistake -- at least for a little while. If you own Cameco or are thinking about owning it, you need to be wary of, and make sure you understand, the costs and benefits of its contracts.
10 stocks we like better than CamecoWhen investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has quadrupled the market.*
David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Cameco wasn't one of them! That's right -- they think these 10 stocks are even better buys.
Click here to learn about these picks!
*Stock Advisor returns as of August 6, 2018