Bakken Update: CARBO Ceramics Has A Good Quarter, But The Same Problems Persist

CARBO Ceramics (CRR) posted a better than expected quarter. This pushed its share price up to its best day in quite some time. Although it beat on the top and bottom lines, there could still be significant problems going forward. CARBO's business has changed significantly since 2009. Early that year, its business began to grow quickly based on increased business from horizontal wells in several basins throughout the United States. This company has several businesses, but ceramic proppant was the basis for its growth, and is still a large part of its business. Demand for ceramic proppant was great, but we have seen a significant decline in market share in years since. It is important to note that ceramic proppant has been needed in wells deeper than 8000 feet. Well pressures increase at these depths, crushing sand and ceramic coated sand. In 2009, there were little by the way of other options, so operators would pay a significant premium in areas like the Bakken. Companies now have other options, which has decreased market share and margins.

In Q2 of 2013, CARBO announced an EPS of $.71/share versus the Street's estimate of $.67. It also beat on the top line with revenues of $153.7 million versus estimates of $146 million. Keep in mind, revenues decreased year over year. In Q2 of 2012, it reported $177.6 million. EPS for the same time frame was $1.38/share. It is not surprising CARBO's proppant business is improving. Many of the biggest unconventional plays in the United States are moving to pad development. What this means is operators have drilled the majority of its acreage, and it is now held by production. "Held by production" is a provision in an oil or natural gas property lease that allows the lessee, generally an energy company, to continue drilling activities on the property as long as it is producing a minimum paying amount of oil or gas. The "held by production" provision thereby extends the lessee's right to operate the property beyond the initial lease term. This provision is also a feature of mineral property leases. This protects a land owner from and oil and gas company indefinitely holding the lease and not providing oil and gas royalty payments. Once the acreage is held by production, the operator can develop as it wants. The shift to pad drilling is mainly done for economic reasons. A rig will drill a large number of wells very close together and these wells can be completed at the same time, which are called zipper fracs. Wells are drilled and completed in a much shorter amount of time, which decreases costs significantly. In Q1 of 2013, many operators started pad drilling. This leaves a very large number of wells to be completed in Q2. This will continue in Q3, with a possible decrease in Q4. The Q4 decrease doesn't have to happen, but some operators will trim capital budgets in the last month of the year leaving a large inventory for Q1 of 2014. What this all means is there were a better number of completions in Q2 which increased demand for ceramic proppant.

Improvements in demand for CARBO's ceramic proppant could be due to several different reasons. As stated above, more wells are being completed. Laterals are getting longer, source rock stimulation is improving requiring more proppant per well. This has decreased inventories of Chinese ceramic proppant that are much cheaper than CARBO's. Chinese proppant continues to steal market share. It is produced and sold cheaply to operators in the United States. Cost savings are substantial, and with focus on well costs, operators continue to use it. Although some believe it has lessor quality, customers continue to buy which tells me operators see value in Chinese ceramic proppant.

CARBO's ceramic proppant sales volumes were down 5% sequentially, but grew 8% in the United States. For the quarter, it sold 378 million pounds of ceramic proppant. This compares to 440 million in Q2 of 2012. It exited Q2 with improving margins, which is one of the biggest variables in the markets run up of CARBO's stock price over the past couple of days. It only increased 1% due to mix. This is important, as pricing pressures have persisted over the last year and a half. Carbo continues to see high inventory levels of ceramic coated sand in the United States. This continues to pressure margins, although it did sell more than in Q1. Year over year, it saw a large increase in sales of resin coated sand. In Q2 of 2013, it sold 68 million pounds, versus just 14 million for the same quarter in 2012.

The most pressing issue I have begun to see in horizontal applications within the United States are a switching to all sand fracs. From 2006 to 2008, operators had started using ceramic proppant leaseholds targeting formation deeper than 8000 feet. Due to the expense, many decided to use a mix of sand and ceramic proppant. In 2010 and 2011, wells were using sixty to seventy percent sand and the remainder in ceramic proppant. Newer frac technologies are beginning to stimulate the source rock with shorter, wider fractures. It was initially thought a well would perform better with long thin fracs. The idea was to reach as deep into the formation as possible trying to connect with natural fracturing increasing the flow of overall resource. The shorter, wider fractures have brought about a different mix of proppant. EOG Resources (EOG) was the first to successfully use this tech. By focusing the hydraulic horsepower closer to the well bore, the shale is pulverized. Greater surface area is fracced, and in turn needs larger volumes of proppant. More importantly, these wells use no ceramic proppant. Below I have listed several wells with a completion design focused within a radius of 300 feet from the well bore. The first table shows how EOG's well design compares to other operators in the Bakken.

As you can see above, EOG uses large volumes of sand per foot. Keep in mind this is all sand, where operators like Kodiak and Triangle use large amounts of ceramic proppant. Other operators like Hess and Whiting use lessor volumes. This data gets better when we break it down in a per foot basis.

The table above shoes EOG uses more than twice the proppant per foot as any other operator. To show the effect on production per foot with respect to the 90-Day IP rate, I have added the table below. This table is of EOG wells only.

In the table above, the top two wells use the new completion design. These wells significantly outproduced its other wells when we take into account lateral length. These production improvements have motivated Whiting to adopt the same type of completions. This means it will use no ceramic proppant, but three to four times the sand by volume.

EOG has had the same type of excellent results in the Eagle Ford. The table below is a list of some of the best wells ever in this play. Most of these wells were in and around Gonzales County.

This has revolutionized the way wells are completed in the Eagle Ford. Production has been off the charts on a per foot basis. As an example, I added the chart below to provide IP rates of wells in this area.

These are some of the best horizontal results in the United States. All of the wells are short laterals with an average choke. As an example, I have provided a table below of Penn Virginia's (PVA) well results in Gonzales County. The acreage is similar and close to EOG's.

The above wells use 4 to 5 million pounds of proppant. These wells are not even comparable from a production standpoint. EOG produces three to four times the oil that Penn Virginia produced including NGLs and natural gas.

These results should be worrisome for CARBO, as it would seem more operators will start moving to this completion style, like Whiting did this last quarter. Costs are relatively close to the same, as Whiting stated within 5%. As the same time, production increases substantially, and this is without any ceramic proppant.

In summary, there are still significant hurdles for CARBO to cross going forward. It continues to sell less ceramic proppant, even as we see more proppant used per well in the United States. Chinese products are getting cheaper. This pressures margins, as operators will not spend more on proppant unless the results warrant it. A few years ago, operators believed CARBO was inflating prices as demand was high and there were few other options. Operators believe CARBO's product is better, but it is difficult to know if the added cost will pay for itself. Operators are also finding it does not need the high end proppant for wells 10,000 feet and below. We are beginning to see companies try different types and gauge effectiveness from those results. Triangle Petroleum had recently made a switch to lighter ceramics, and got close to the same results in a very deep section of McKenzie County, North Dakota. Its stock buyback and dividend increases add upside. It also has a new proppant for ultra-deep reservoir applications. This focuses on depths greater than 30,000 feet. I believe this could be a decent area of growth for the company, given its ability to produce stronger, more consistent proppant for high pressure completion jobs. This was a very good quarter, but I would recommend watching this stock closely as we still do not know if it has found a bottom. This company still has considerable headwinds, and I do not believe we have seen the last of lower margins and market share.

Additional disclosure: This is not a buy recommendation. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, are not guaranteed for accuracy or completeness, do not reflect actual investment results, do not take in consideration commissions, margin interest and other costs, and are not guarantees of future results. All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market or financial product does not guarantee future results or returns. For more articles like this check out our website at shaleexperts.com. Fracwater Solutions L.L.C. engages in industrial water solutions for oil and gas companies in North Dakota. This includes constructing water depots, pipelines and disposal wells. It also provides contracting services for all types of construction at well sites. Other services include soil remediation. Please contact me via email if you are interested in working with us. More of my articles and other pertinent information on the oil and gas sector, go to shaleexperts.com.