Global Markets – 4th quarter 2006 : Uranium or oil – which will dominate as the primary energy source in the 21st century?

I recently read an interesting article about the development of nuclear energy in China and India, which I have tried to summarise in this report for your interest. Currently the energy consumption of each of these countries is about 1/30th of that of the Americans and about 1/20th of that of Europe, per capita. However, based on increasing urbanisation and the constant improvement in living standards, projections are that by 2050 the populations in these regions could reach 1.5 billion. In light of these forecasts, it is not unreasonable to estimate that the per capita energy consumption in these regions could increase by up to ten times.

Although China has an abundant supply of coal and oil, the Chinese government recognised that they could not rely exclusively on thermoelectricity (oil, natural gas and coal) and that other sources of energy had to be found. The Three Gorges Dam project was established and it is expected that "by 2008 the dam will produce the equivalent of 20 nuclear reactors or 50 million tons of coal each year." However, this will still not meet the increasing energy demands. The Chinese government have been proactive in working towards a solution. At the beginning of last year, they implemented a nuclear plant-building program which aims to establish 30 nuclear power reactors by 2020. While nuclear energy currently represents about 2% (8.7 GW) of China's overall electricity production (from 9 reactors), within the next 15 years China would like to increase this level to 40 GW – and by 2050 to 160 GW.

To reach these targets, China will require two things – "uranium, and help". The sourcing of uranium doesn't seem to be posing any problems as China has already implemented agreements with Australia and Mongolia. They are currently also courting other uranium rich countries like Kazakhstan, Niger and Namibia. The real difficulties have come about in relation to "help". There was speculation that China would either engage the help of the French (Areva), the Russians or the Americans (Westinghouse, now owned by Toshiba) with this project. The dilemma, however, was that China wanted "technology transfers", while the foreign corporations wanted the contracts "but are not keen on the technology transfers (for they know that those transfers will help build a competitor that will, one day, potentially run circles around them)." Surprising everyone, China has elected to concentrate on creating expertise at home rather than relying on assistance from elsewhere. This is a very brave approach, in light of the fact that China has never undertaken a nuclear project without assistance from foreign engineers. "Given China's energy needs, it seems unlikely that China would have decided to go it alone unless it felt confident in its own domestic ability to deliver."

India faces similar challenges to China (a growing demand for energy, increasing urbanisation, etc), but the solutions available to India are very different. Importantly, because India has not signed the non – proliferation treaty, they have had to develop their own nuclear solutions using their own scientists. "India has done a tremendous job in terms of research as the country now stands as one of the greatest players in the nuclear research field." This has lead to a very interesting development – India is one of the top four countries in the world producing the highest number of PhD's in nuclear fusion - the other three countries are the USA, Australia and Israel. In addition, more than half of these American and Australian students are Indian or Israeli nationals. However, while India has some of the top nuclear fusion expertise in the world, they lack another very important ingredient – uranium. By not having signed the non – proliferation treaty, no country will sell India uranium. In July last year America very cleverly signed a nuclear cooperation treaty with India – throwing them a potential lifeline. However, before this treaty can be enforced, it must to be sanctioned by each member of the Nuclear Supplier Group – which will take time. Countries like China and Japan "will veto the proposal until India decides to put a formal cap on its military program. And India is still apparently not willing to do so. Until then, no material and no uranium can enter into India."

All is not lost for India, though, because "India today has one of the largest reserves of thorium (second only to Australia's)." Thorium "is a small cousin of uranium (two protons less) that actually works like uranium as soon as it is irradiated in a reactor." This process is more expensive than using uranium, but it is still a very viable option and "the first prototype of thorium based reactors are already at work" in India. In fact, for India, thorium may well turn out to be a better answer than uranium itself in the long run, especially if one notes the sharp increase in the price of uranium over the past four years.

Source: GaveKal Asset Allocation and Economic Research. Author: Vincent Gorgues.

REGIONAL COMMENTARY UNITED STATES OF AMERICA

Interest rates remained unchanged at 5.25% during the quarter. This is the third consecutive month that rates have remained on hold, following a two year period of gradual rate hikes. Commenting at a recent awards ceremony, Sandra Pianalto (Cleveland Federal Reserve President and a voting member of the Federal Reserve committee for 2006) stated "I expect some slowing in the rate of inflation as recent energy price changes and the effects of the monetary policy actions work through the economy. But some risks remain that inflation will not recede into a range consistent with the FOMC's price stability objective. In that event, it is possible that some additional monetary policy restraint would be required."

Speculation on the future direction of US interest rates remains very mixed. One view is that, based on the recent weakness shown by the housing market (a recent report by the National Association of Realtors indicated that "house prices posted a record drop from a year earlier in September"), the Federal Reserve would be unlikely to consider a rate hike at this stage. Another view was that "the Fed appears to be putting the economy ahead of inflation, it is trying to assure the market that inflation is under control. In terms of the next move, I am confident enough to predict the next move will be a cut." However, the third school of thought on the matter is that, while rates aren't expected to rise further any time soon, they are ruling out any hope of a rate cut in the near future.

GDP in 2006 is expected to come in at 3.1% (compared to the initial forecast of 3.6%), while 2007 GDP has been revised down to 2.9% from 3.3%. On a more positive note, CPI is expected to average 2.3% for the year, which is better than the 3% forecast earlier this year. October jobless figures were better than expected at 4.4%, compared to 4.6% in September.

EUROPE

The European Central Bank (ECB) increased interest rates by 0.25% to 3.25% at their meeting in October, but elected to keep rates on hold at their November meeting. Analysts were not surprised by the decision taken at the November meeting, but they are still expecting a possible 0.25% increase at the December meeting. This view is fuelled by the fact that, although the October inflation numbers were better than expected (at 1.6%, which is below the 2% inflation target) continued hints of "strong vigilance" by the ECB make another rate rise before year end a real possibility. According to the President of the ECB, Jean-Claude Trichet, "acting in a firm and timely manner to contain risks to price stability remains essential to ensue that inflation expectations are kept solidly anchored."
Annualised growth fell to 2.6% in the third quarter from 2.7% in the first quarter. According to Astrid Schilo, an economist at HSBC "overall, the eurozone's growth momentum has slowed in the third quarter, but was still at a respectable rate."

UNITED KINGDOM

In line with expectations, the Bank of England (BoE) raised interest rates to 5% during the quarter under review. The main driver for this move was inflation, which remained above the target level of 2% (currently at 2.4%). Commenting on the 0.25% increase in November, Milan Khatri (chief economist at the Royal Institution of Chartered Surveyors) said that "by acting in a timely manner, the modest rise in interest rates will help to cool the housing market but at the same time promote wider economic stability and prevent inflation pressures building." Despite the consensus view being that interest rates are likely to rise again in the new year, the chief economic advisor at the Confederation of British Industry, Ian McCafferty, is of the opinion that hopefully "…a further increase should not be needed." Interest rates are currently at their highest level in five years.

The Office for National Statistics reported that GDP growth in the third quarter came in ahead of expectations at 0.7% or an annualised 2.8%. Forecasters were expecting GDP growth of 0.60%. Phllip Shaw, chief economist at Investec Securities, London, is expecting UK economic growth to "exceed Chancellor Gordon Brown's range of 2% to 2.5% for this year, but to fall a little short of his range for next year of 2.75% to 3.25%."

JAPAN

The Bank of Japan (BoJ) kept interest rates on hold at 0.25% during the quarter under review, but hinted that rates are likely to increase soon, once inflation pressures increase. At a recent meeting of business leaders, BoJ Governor Toshihiko Fukui stated "we must not take a long time to adjust policy interest rates. Our task is to carefully take action before these conditions [inflation] appear in order to achieve price stability and keep future economic swings gradual." This news was well received as it created "optimism that the economy was growing strongly enough to boost corporate earnings despite higher interest rates". Annualised growth for the period July to September came in at 2%.

Evidence, however, that the Japanese economy remains fragile, came in the form of the unemployment figures for September, which rose to 4.2% from 4.1% in August. Further disappointing news "showed average monthly household spending down by 6% in September compared with a year ago, the biggest fall in five years."

At the end of September, Shinzo Abe of the Liberal Democratic Partly replaced Junichiro Koizumi as the prime minister of Japan. Shinzo Abe, who is 52 years old, is the youngest prime minister Japan has had since the Second World War. He is known for his campaigning "for policies including a tight alliance with the US, the revision of Japan's pacifist constitution and a more assertive foreign policy."

SOUTH AFRICA

In line with market expectations, the SA Reserve Bank (SARB) increased domestic interest rates by 0.50% at their October meeting. The Prime Lending Rate is currently 12%, while the Repo Rate is 8.5%. The market is forecasting at least another 0.50% interest rate increase in December, with the possibility of a further rate increase in February 2007. This view is driven, in part, by the depreciation of the Rand this year as well as the volatility of the oil price. The interest rate outlook (more specifically the increase expected in February) could improve due to the fact that the Rand and the oil price have show signs of improvement in recent weeks.

Producer Price Inflation (PPI) has moved up sharply in recent months, resulting in inflation (CPIX) currently being at its highest level in three years. Recent trends suggest that PPI may well break through the 10% level, which will not be good news for inflation or interest rates. Inflation is expected to breach the top of the target band (of 6%) in early 2007, but is expected to stabilise by mid year. In addition to the currency and oil price movements, other risks to the inflation outlook include rising food prices and strong household expenditure.

Commenting recently on the Current Account deficit, Reserve Bank Governor Tito Mboweni said that "while the deficit is currently more than adequately financed by capital inflows, investor fears relating to the sustainability of the deficit increase the risks of exchange rate adjustments which would threaten the longer term attainment of the inflation target. The policy challenge is to maintain low inflation within the context of a growing economy and a sustainable external balance."

In the recent Medium Term Budget Policy Statement, the Minister of Finance revised the 2006 and 2007 growth (GDP) forecasts down to 4.4% (real) in respect of each year from 4.9% and 4.7%, respectively. Growth is expected to increase to 5.3% in 2009 ahead of the Soccer World Cup in 2010.

It is concerning to note that, despite a climate of rising interest rates, a recent article commenting on the Reserve Bank Quarterly Bulletin stated that "household debt to disposable income is almost at 70%, which is the highest level ever recorded, while household savings as a percentage of disposable income is effectively zero; the lowest level ever recorded in SA."

GENERAL – OIL AND GOLD
The oil price declined during the quarter under review, from $68.69 per barrel at the end of August to $62.86 per barrel. This is despite OPEC reducing output at the beginning of November and continued disruption to supply in Nigeria. OPEC president, Edmund Daukoru, believes that there may well be an oversupply at present and has therefore not ruled out a further cut in output. The oil price has declined by some 20% since the highs reached in July this year (reaching approximately $78 per barrel), due to reduced tensions in the Middle East and a stock surplus mainly as a result of reduced demand.

The gold price exhibited periods of volatility during the quarter under review and ended the period at $641.90 an ounce, compared to $624.90 at the end of August. In a recent article in the Fortis Metals Monthly newsletter, investors were cited as being the main drivers of the price. According to this publication "while there is always the chance that gold might recover ground lost in recent months and revisit the highs of 2006 before the end of the year, the chances of this are in the hands of investors, watching the performance of the US currency."

CONCLUSION
With this being our last report for 2006, we would like to take this opportunity to wish you and your family a peaceful and happy festive season. Please take note that our offices will be closed from midday on Friday 22nd December 2006 and will reopen at 08h00 on Wednesday, the 3rd January 2007.