3 Reasons CARBO Ceramics is Likely to Under Perform its ...

3 Reasons CARBO Ceramics is Likely to Under Perform its ...

Learn three reasons investors should avoid CARBO Ceramics in favor of its competitors, even if oil prices recover.

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It's no secret that the oil crash has been brutal on proppant suppliers such as CARBO Ceramics (CRR) with shares for Carbo and most of its peers plunging 70% or more in the past year alone.

However, three key reasons complicate the investment case for CARBO Ceramics, even when compared to its frac sand peers. In my opinion, its business model is quickly losing relevance. Even with shares trading at their lowest levels in almost 12 years, CARBO’s growth prospects seem frail against its competitors.

Based on CARBO's business model, I am convinced the company will grow much slower than its competitors, even if oil prices recover sharply in the coming years.

CARBO's products are world class, but...
CARBO sells high-tech proppant solutions to oil and gas producers that can greatly increase the production of their wells and thus lower their overall per-barrel-equivalent production costs.

For example, its flagship Kryptosphere HD ceramic proppant is designed to withstand extreme pressures found in very deep oil wells, such as those used in offshore drilling, able to prop open cracks in shale at pressures of 30,000 PSI. As a point of comparison, traditional frac sand crushes at between 1,000 and 7,000 PSI, while resin-coated sand can manage only up to 12,000 PSI.

Even among ceramic proppants, CARBO has an edge. At 20,000 PSI, Kryptosphere HD offers four times better oil and gas flow conductivity than the lower-cost ceramic products from its competitors, mostly Chinese and Brazilian producers. However, as cutting-edge as CARBO's technology is, there's a major flaw that threatens to stymie its big growth plans, no matter what price oil trades at.

Extremely expensive and losing market share

As this table of CARBO's product sales illustrates, its advanced ceramics have been losing market share to regular frac sand. In its last quarter, regular frac sand made up 56% of CARBO's proppant sales volume—a trend continuing for several years even when oil was around $100 per barrel. Sand is significantly cheaper than competing proppant technology—5 to 10 times cheaper than resin-coated sand and ceramics, respectively.

Falling ceramic market share means falling margins

CARBO's EBITDA margin has been in decline since 2012. The oil crash decimated its margins far worse than its competitors such as US Silica, Emerge Energy, and Hi-Crush Partners, which are focused on lower-cost sand sales. In fact, in its last quarter, sales volumes of CARBO's high-margin ceramics and resin-coated sand plunged 58% and 77% year over year, respectively, compared with just a 5% reduction in sand volume.

My concern is that, even when oil prices recover, CARBO's higher-margin products will fail to gain market share, especially since ceramics are much harder to scale than sand.

Ceramics production capacity is harder to increase
Ceramic proppants are generally made in a factory through a more expensive and harder to grow process compared to sand. This means that as demand for proppants has exploded in recent years, CARBO's ceramic products have faced falling market share not only because of their higher costs but also because the company hasn't been able to build out its capacity fast enough.

As CARBO's sales volumes have had to shift more toward lower-cost frac sand, its sales have stalled—even before the oil crash—while those of its competitors have surged as they brought new sand mines online.

The simple fact is that, when it comes to frac sand, CARBO is a very weak player, with neither the sand reserves nor the transportation logistics capacity to compete with its far larger competitors. For instance, this past quarter its sand sales were as follows:

• CARBO: 129,000 tons
• US Silica: 1.2 million tons
• Emerge Energy: 861,000 tons
• Hi-Crush: 1.2 million tons

Takeaway: CARBO's business model is inferior
In my opinion, ceramic proppants will remain a niche market increasingly dominated by much cheaper frac sand, except for the minority of oil wells where pressure conditions are extreme enough to justify the higher cost. While CARBO may survive the oil crash, I believe long-term growth investors will ultimately benefit more by buying CARBO's commodity sand-focused competitors, many of which pay generous dividend yields while you wait for the industry to recover.

Ceramic proppant outlook: trying to build a market on sand

The phrase “building on sand” has an unfortunate ring of reality to those ceramic proppant suppliers striving to gain traction in the North American hydraulic fracturing market today.

Proppant producers and oilfield service companies are enjoying a most buoyant recovery period from the oil price decline doldrums of 2015/16, driven not only by a moderate recovery in oil prices but by impressively increased proppant loading levels, longer laterals, and more frac stages per lateral.

Evidence from first-quarter performances of proppant suppliers and users indicates a strengthening trend that began in Q4 2016. The increasing fracking and proppant use is expected to continue through 2017 and into 2018. For more information, please visit AnYiCheng.

Early estimates of US proppant consumption for the year suggested around 55m short tons, which was expected to rise to 80m tons in 2018. However, more recent figures exceeded expectations, with 75m tons for 2017 and over 100m tons projected for 2018.

However, this soaring demand is primarily for frac sand. Ceramic proppants simply do not see much use. Proppant and fracturing expert Pickard Trepess, Managing Director of FRAC PT FZE, will explain why silica sand successfully substitutes ceramic proppant in some shale fracs at the Oilfield Minerals & Markets Forum Houston, 21-23 May, The Houstonian Hotel.

During the last golden period (2010-12), the proppant market share was around 80% frac sand, with 10% each for ceramic proppants (CP) and resin-coated sand (RCS). Due to E&P companies implementing innovative and low-cost fracturing treatments using sand, this ratio has shifted to around 95% frac sand, with the remaining 5% shared by CP and RCS.

80% US capacity idled

The market downturn and continuing trend of using more volumes of frac sand instead of CP have prolonged the early 2015 idling of most USA’s CP production capacity, including plants from Carbo Ceramics, Saint-Gobain, and Imerys. Few of these idled plants are expected to return to production soon.

As a result, around 80% of US CP production capacity is not operational, leaving potential active capacity at approximately 680m lbs/yr, though some of this may be underutilized. During 2016, Carbo’s overall CP plant utilization was as low as 18% of stated capacity (total capacity 1,900m lbs/yr, including the Kopeysk, Russian plant at 100m lbs/yr). Carbo does not expect significant improvements in capacity utilization in 2017.

The Millen plant remains mothballed, a majority of production at New Iberia is idled, the Toomsboro plant is idled, and there is very limited production at the McIntyre plant, initially mothballed in 2015. The majority of Carbo’s CP production now comes from Eufaula, Alabama, and Kopeysk, Russia.

Carbo has suspended completion of the second production line at Millen, Georgia, and the second phase of the retrofit at New Iberia with KRYPTOSPHERE® technology. Operations at its Luoyang, China plant ceased in early 2015, and the company does not intend to resume operations in China.

Carbo’s drive for diversification; less reliance on ceramic proppants

In its Q1 statement, CP world leader Carbo Ceramics admitted that the oil price recovery had still not encouraged companies to move away from low-cost completions. Their existing or targeted customers continue to use more third-party raw frac sand than CP or RCS as a percentage of total proppant consumption. Carbo expects this trend to continue.

This ongoing trend, combined with an oversupplied CP market liquidating imported inventory, directly impacted Carbo’s Q1 2017 sales volumes. North American CP sales volume decreased by 35% compared to the same period in 2016, while international CP sales volumes decreased by 23%. The average selling price per pound of all proppant sold by Carbo was $0.06, down from $0.14 for the same period in 2016, reflecting the drop in higher-value CP sales.

Notably, while CP sales volumes dropped significantly, the company experienced an almost 400% increase in frac sand sales to 370m lbs during Q1 2017. Carbo’s Marshfield, Wisconsin frac sand plant was idled in early 2016, but by the fourth quarter, sand volumes sold more than tripled sequentially from 46m lbs to 149m lbs. Carbo is in the process of bringing the plant to full utilization during 2017 (1,500m lbs/year or 750,000 tpa).

Overall, Carbo put on a brave face with a 19% sequential increase in revenue in the first quarter of 2017, driven by increased technology product sales, frac sand sales, and environmental product sales. Carbo is clearly adapting to the current situation by not only enhancing frac sand production but also diversifying into new product markets, such as ceramic grinding media, mineral processing, and foundry markets, partly utilizing its idled CP plant assets.

Gary Kolstad, President and CEO of Carbo Ceramics, said: “Our strategy is to reduce our reliance on base ceramic proppant. We believe the worst of the industry down cycle is behind us. While imports of low-quality Chinese ceramic have been virtually zero over the last eight quarters, it appears some competitors are still pricing below cost. However, this is not a sustainable strategy over the long term.”

“We are focusing on the foundry, the grinding, and the mineral processing industrial market segments because they are very large, they are less cyclical than the oilfield, and they fit our technology, people, and asset base very well.”

“We expect to see continued expansion of our technology products, industrial ceramic media, frac sand, and environmental businesses. We believe our 2017 revenue will show strong double-digit growth of at least 40% over 2016”, said Kolstad.

Carbo is expanding its ceramic media product portfolio. Regarding mineral processing, the company is entering into agreements with other companies to produce products for them.

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