GasFrac Energy Service (GSFVF.PK) offers non-water based fracing services to shale oil and gas E&Ps. Water-based fracing has become very contentious in many parts of the oil patch. GasFrac uses a proprietary propane injected system to retrieve shale oil and gas. GasFrac is a small cap Canadian-based company that has strong supporters and equally strong skeptics. This is a follow-up to this article written last February.
As all shale energy investors should know, water-based fracing is controversial at best. The Feds have announced a 2-year study of the impact on groundwater of water-based fracing, and the State of New York has a moratorium on water-based fracing until their own environmental studies are completed.
The industry has been working on several alternatives to water-based fracing, and one solution is to inject a propane gel to loosen the shale oil. The propane gasifies during the process and is either flared off or separated and resold. GasFrac has commercialized this approach and is building a nice niche in the fracing services business as an alternative to water-based procedures.
The investment thesis for GasFrac is virtually unchanged from the February article, except the Canadian spring drilling season was hugely disrupted because of Mother Nature. The multi-week “spring thaw” lasted much longer than normal, preventing GasFrac projects from proceeding. In the second quarter, the company completed only 70 jobs, below 1st quarter by about 50%. This shortfall adversely affected not only the quarterly P&L, but also annual production and utilization rates. The company continues to take delivery of additional fracing machines, increasing horsepower capacity and future revenues. By the end of the first quarter 2012, GasFrac should have ten fracing units in the field.
The company exited 2010 with capacity of 52,000hp (three units) and will add fracing units each quarter until 1st qtr 2012. Current capacity is 75,000hp (five units) and is expected to grow to 150,000hp (ten units) in the first few months of next year. In addition, the company is also adding fluid and propellant handling capacity to increase the efficiency of its hp in the field. Ration rates have been around the mid-30% but the increased capacity tied with production restraints due to the weather reduced utilization to a mere 15% during the last quarter. However, with weather returning to a more normal cycle the balance of the year, quarterly utilization rates will improve quickly back to the mid-30%. Overall, 2011 annual utilization rates will be in the mid-20%, down from 31% in 2010 and management’s goal of 40%.
The majority business is in Canada, but the company is expanding and introducing its services in the U.S. Some of the newly acquired additional capacity has been targeted to jobs initially in Texas. The company opened an office recently in Texas and has been active in testing its services with several drillers. The Texas jobs have been both new drilling projects and recompletions. The results have been encouraging, and it seems the propane fracing method is on the verge of being accepted as an alternative to water-based processes. In the second quarter, GasFrac completed ten fracing treatments on seven different well bores. There is currently one unit dedicated to the U.S. market and a second unit will accompany it shortly.
The company will mostly focus on the Southern fields to gain traction in the U.S. market before seriously expanding into the more cantankerous Northeast. Expansion in the U.S. will help offset the seasonal weather issues in Canada going forward, in addition to offering an additional growth platform.
Pricing per job has stayed steady at around $215,000 per job. There is little reason to believe pricing will change substantially in 2012. Although initially more expensive than water-based fracing, the average propane fraced well tends to produce at higher volumes with shorter initial start-ups, and with lower clean-up costs.
Increased capacity and greater acceptance of propane fracing will continue to drive growth in jobs completed. The company exited 2010 having competed 419 jobs, with this year’s new estimate of 776 jobs based on a much-reduced second quarter. When all the capacity is added by early next year, the company could complete a bit over 2,000 jobs annually, based on 35% utilization.
Revenues are expected to increase as capacity expands and utilization rates improve. Revenues in 2010 were $97 million, with this year’s reduced consensus estimates of $180 million and next year of over $400 million. Mainly due to the loss reported in the second quarter, earnings for this year will fall to around $0.08 a share from $0.13 last year. Consensus estimates call for earnings around $1.00 per share in 2012, with a range between $0.85 and $1.15.
Gross margins will suffer for the year as the first half was not pleasant with margins of 16% and -8% for the first two quarters, compared to 2010 margins of 25%. However, with a resumption of activity and an increasing number of jobs, gross margins should return to the 25% range for the balance of the year. With added capacity and more experience, along with higher utilizations, gross margins are expected to expand to 28% next year.
The company carries no debt and the most recent round of capital expenditures has been budgeted. There are 65 million shares outstanding and the company went public about a year ago at $5. GasFrac has a current market capitalization of $535 million.
Share prices ran up to $14 in March of this year, and then collapsed with the horrific quarterly results and the general market malaise. Currently trading at $8.25, GasFrac seems to offer value as it is trading at only about 8 times next year’s consensus earnings.
However, the recent earnings shortfall has jilted investors who thought this was the next NASA rocket ship, and reality of Canadian weather-related risks to GasFrac’s current business model set in. The share price probably got a little ahead of itself. In addition, while the company has the potential of greatly expanding revenues and earnings as its capacity quickly grows to 10 units, further earnings growth over $1.00 per share will require additional capacity unit growth and cap expenditures, which are not yet budgeted.
GasFrac is in the process of testing a propane recovery system that will reduce costs for clients that do not have separation facilities on site. Without a separation facility, the expensive propane fluid is flared off. A recovery system will recycle the propane, reducing costs as the propane is reused. The company expects to have a successful production model tested by the end of this quarter, and has announced several potential clients willing to test the system on upcoming jobs.
The company appears to be gaining in critical mass capacity to where larger drillers may be willing to contract GasFrac services for multiple years. The announcement of a few long-term contracts, especially in the U.S., will help smooth out quarterly earnings and add stability to cash flow. As a small company, fixed costs are currently higher per revenue dollar than its peers, pressuring margins. As GasFrac’s business grows with higher utilization of a growing capacity base, fixed costs will decrease as a percentage, adding to margin expansion.
While the company has struggled so far in 2011 and its growing pains have been obvious, the future looks bright for GasFrac. The pressure to move away from water-based fracing technology will continue to mount, both from the government and from the media. Generically, anti-fracing opinions range from focusing on water-based technology to the entire fracing process. While propane fracing should ease the concerns of water-based opponents, the diehard anti-fracing campaign is unswayed by the environmental advantages of propane fracing. GasFrac is exceptionally well suited to provide a viable alternative to water-based fracing, irregardless of the validity of the opponents' claims.
The latest GasFrac investor presentation can be found here
(.pdf document, pages 8-10 discusses well production enhancement advantages of propane fracing and page 11 discusses environmental advantages).
I have been acquiring shares under $10, as I believe GasFrac has a profitable future and share prices offer compelling value. The company is not without risk and is a speculative selection within the oil services industry, but at its current valuation, the risk to reward over the next 12 months seems quite attractive.
As always, investors should conduct their own due diligence, should develop their own understanding of these potential opportunities, and determine how it may fit their current financial situation.
Disclosure: I am long GSFVF.PK.
Additional disclosure: Author has been a shareholder since 2011