This week, representatives from Canada, Denmark, Norway, Russia and the US are meeting in Ilulissat, Greenland. Their goal: resolve conflicting claims for oil and natural gas under the Arctic Ocean, the world’s last great untapped energy reserve.

Talks have taken on new urgency these days because global energy prices have skyrocketed. And Arctic ice has begun melting at an unprecedented pace, placing once unthinkable resources within reach for the first time. The battle for who will exploit these untapped riches, however, is likely to rage on for years. And, in an environment of rising commodity prices and resource nationalism, the stakes couldn’t be higher.

On a larger scale, the exploration of heretofore frozen wastelands for energy is only the latest example of how vital resource producers are being forced to go further–and deeper–to feed insatiable global demand. And the result is growing pressures on supply, the second great underpinning of the global bull market in vital resources.

The operating rule is, the tighter supplies are stretched, the greater the influence any supply interruptions have on price, for reasons yet unknown. In some cases, the causes are violent acts of nature. Earlier this year, floods in Australia drastically cut global supplies of metallurgical coal, the hard coking variety preferred by steelmakers. The result was a dramatic drawdown in stockpiles and a massive increase in world prices.

Earlier this week, iron ore–another key input for making steel–was in the news. With giant Australian producers Rio Tinto (NYSE: RTP) and BHP Billiton (NYSE: BHP) still jockeying for higher selling prices, the output of Brazil’s Companhia Vale do Rio Doce (NYSE: RIO, CVRD) has become increasingly popular with consumers, particularly in Asia.

As we pointed out in our first issue, CVRD is doing its best to produce to both foreign and domestic demand. The problem is a lack of sufficient infrastructure needed to get its output to market. (See VRI, 4 October 2007, The Definite Bull).

As of May 27, some 155 ships were docked or due to enter the Brazilian ports of Ponta da Madeira, Turbarao and Itaguai. And that backlog is rising, as unseasonably heavy rains caused by a La Nina weather system have extended the normal wet season past the end of April. That, in turn, has pushed freight rates for the Brazil-to-China route to record highs, which has further increased costs to steel producers.

More ominous are the growing political threats to supplies of vital resources, even in countries where governments remain at least nominally friendly to trade. Argentine farmers, for example, have launched their third major protest in two months over export taxes levied by the government to curb inflation and redistribute wealth to poorer regions.

Farmers have halted shipments of newly harvested corn and soybeans, while livestock producers have stopped sending cattle to slaughterhouses. As of now, there’s still plenty in stock to meet domestic demand. But the result is new pressure on prices, as agricultural exports from Argentina–a major global breadbasket–tail off.

As big a problem as natural disasters and resource nationalism pose to global supplies of vital resources, they pale in the face of simple logistics. Even the railways and port facilities servicing today’s active mines and farms have proven inadequate in recent months, as the interruptions in Australian and South African shipments of key resources have shown. And these problems only become more acute as increasing numbers of remote regions of the globe are tapped for their bounty.

Every commodity bull market eventually plays out but only after many years of enormous investment. And today’s woes are just the latest evidence of how severe supply problems have become, how much worse they’re likely to develop and how far we still have to go in this cycle.

On their surface, supply challenges are a major plus for vital resource prices and the profits of producers. But, as we’ve pointed out, not every resource producer is equipped to handle them. Supply disruptions and strained logistics mean ever-escalating costs that–no matter how high finished product prices rise–cut deeply into profit margins.

Rising costs are a major reason why even the world’s largest mining companies continue to try increasing their economies of scale, whether by new development or mergers. And they’re why every major mining company is potentially both an acquirer and a takeover target.

For investors, the key is to focus not only on companies that can profit from higher resource prices. Virtually all will at some level. Rather, it’s to find those that can profit from the rising prices and control costs. That’s the kind of companies we’re relying on in the VRI Portfolio. They’re great either as stand alone plays or as the targets of lucrative takeovers.

Though probably not a takeover candidate, one good example is Russian steel producer Mechel (NYSE: MTL). Steelmakers worldwide are enjoying record demand and rising prices. But all are being squeezed by higher input prices (iron ore, hard coking coal and molybdenum, for example) as well as rising electricity costs.

Mechel, in contrast, is an almost fully integrated operation producing 100 percent of its own coking coal, as well as 80 percent of the iron ore and 50 percent of the electricity it uses. The result is an increasingly competitive cost structure that’s generally insulated from most of the pressures being felt by its industry.

Mechel’s American Depositary Receipts (ADR) split 3-for-1 on May 16. We’ve already more than doubled our money in the stock. Mechel’s stock is volatile but still a buy for those who don’t own it up to 60.

It was four years ago when Wu Yueming, a Chinese businessman, met with the CEO of Fortescue, an iron ore miner in Australia. Mr. Tueming was persuaded to invest USD6.7 million in Fortescue. A few days ago, the company’s stock reached a new high of AUD10, bringing his stake to a cool USD673 million.

We’re not guaranteeing the same crazy returns that Mr. Tueming realized. But we think that today’s VRI recommendation, Paladin Energy (Australia: PDN; OTC: PALAF), has the potential to produce big rewards for patient investors.

Australia-based Paladin is a pure play uranium producer with a strong portfolio of developed assets and developing properties both Down Under and in southern Africa. The company has a mine in production, one that will be starting output early next year and six more that are in various planning stages.

Its relatively new production status is the company’s main advantage: It’s not locked into long-term contracts as its more established peers are, so it can benefit from the stronger uranium prices–especially if our assessment that uranium prices have bottomed out is correct.

As noted here last week, the best bets on uranium’s resurgence are going to be younger companies. See VRI, 22 May 2008, Driving Demand. These have the choice to sell mainly on spot market and/or negotiate longer-term contracts with higher prices than the average USD20 to USD30 per pound that’s been the norm in the past 10 years.

For example, Paladin was able in the second half of last year to get a uranium price of USD73 per pound for the next three to five years. These contracts, according to the company, have a floor price of USD30 per pound and so-called escalating rates that can boost the final price significantly higher. And the above apply to only one of the company’s mines because the rest aren’t operational yet.

If it can’t get the prices it wants from future contracts, Paladin also has the option to utilize more spot prices as more of its mines come into production. Some analysts have calculated that Paladin can achieve 70 percent of its deals in market-related terms. And although this remains to be seen, the company is in a uniquely advantaged position in its industry to achieve the goal.

Paladin has one mine in operation and one in which production is expected to start later this year or in early 2009. The largest is the Langer Heinrich Mine located in Namibia in sub-Saharan Africa, close to the uranium mine of VRI’s portfolio denizen Rio Tinto. See the map below.

Langer Heinrich is the first conventional uranium mining project to be brought into production in more than a decade. The first shipment was made in March of 2007, which allowed Paladin to obtain high prices for its yellowcake.

The second Africa mine is the Kayelekera in Malawi, where Paladin shares 15 percent ownership with the Malawi government. This is also an important project for the Malawi economy, and the company has received reliable help from the local authorities. The project is expected to commence production by early 2009 and will be the company’s third-largest mine in terms of resources.

In Australia, the company has interests in six mines, almost all of which are in early planning stages.

One potentially large project is a joint venture with Cameco Corp in Australia’s Northern Territory, which should be in full production within the next four years. This is a significant project for Paladin because the uranium grade is fairly high.

It also owns three more mines that are undergoing feasibility studies and two more potential projects in Queensland where mining uranium still isn’t permitted. There are legitimate expectations that this ban will eventually be lifted. But these projects should be considered extremely long term because it takes quite some time to get uranium mines up and running.

Source: Paladin Energy

Risks and Opportunities

If our long-term price assessment for uranium is correct, Paladin offers an excellent opportunity to capitalize in the multiyear bull market in nuclear energy as we noted last week. There are some caveats, however.

First, the company could face delays in its project development that would hurt short-term performance. Second, two of the company’s major assets are in Africa, a continent known for potential political risks as nationalistic political agendas can become an obstacle for smooth operations. See VRI, 10 January 2008, Gold, Nationalism and Steel. 

Third, Paladin’s management has been quite open about its desire for future mergers and acquisitions to enhance the company’s resource base. On the plus side, they’ve been prudent and successful in this area in the past, and we expect only more upside to come. The company’s balance sheet is strong with a net debt balance of USD127 million and cash of USD149 million. And it’s been able to easily secure financing for future expansion.

The stock is down 14 percent this year, after bouncing strongly off its April lows, and it represents good long-term value at these levels. Buy Paladin Energy, a new addition to the VRI portfolio, for long-term growth up to AUD10 in Australia and at current prices in the over-the-counter shares.

Source: Bloomberg