Whether or not to use ceramics in fracking has been a debate that has raged for years. Michael Filloon, who has covered primarily the Bakken, has a great article summarizing the latest trends towards sand. The bottom line from the article is that other issues have led to increases in initial production and resource recoveries from the wells. Well designs in particular have led to fantastic, previously unimaginable gains, and those gains are continuing.
It seems reasonable to assume that with the giant collapse in energy pricing, sand, which is far cheaper, would be the first choice, as long as the wells are sufficiently profitable. Plus, if the wells show resource recovery improvement and flow rate improvement, the argument for ceramic proppant superiority may be - in fact, it is - hard to prove.
So ceramic proppant, which costs more than sand or even resin-coated sand, has had to wait until all other avenues of improvement were exhausted before it could clearly demonstrate its superiority. From the Q1 earnings call transcript:
If in fact the industry is reaching its limits on increasing reservoir contact, the next logical area for improvement is through increasing conductivity throughout the reservoir.
Increased conductivity is achieved by placing more durable proppant such a ceramic proppant that can withstand the closure stresses or sand based proppants fail, thus we remain steadfast in our efforts to highlight our ceramic proppant be a normalized production studies which show the value of optimizing both the reservoir contact and the conductivity within the fracking reservoir.
We estimate that over 50% of the wells drilled in the US will have closure stress greater than 6000 psi, a point at which even the best white sand will start to crush. Using sand in these wells means the production and recovery of these reservoirs will be compromised.
On the other side of this argument is Gary Kolstad, CEO and chairman of the board of CARBO Ceramics (NYSE:CRR). Two board members are now backing up their belief in him with cash loans (discussed further below). However, it currently is very hard for him and the board to prove the advantages of using this relatively expensive product when significant operational improvement is being shown using much cheaper sand.
There have been some clear-cut wins, such as when CONSOL Energy (NYSE:CNX) used KRYPTOSPHERE LD in a 13,500 foot deep well and the well flowed initially at 61.9 MMCFD. But operators in general remain far from sold on the role CARBO Ceramics' product played in this result. Kolstad appears to realize this.
Management has now specialized the ceramic products into a family of products consisting of several different types, each suited to specific well circumstances. However, all of this product differentiation has undoubtedly led to higher-than-wanted inventory levels of more than $100 million. Plus, now the company has to prove that not only is ceramic proppant superior, but also the focus on specialty ceramic proppant is better still. The company is ramping up supplies of the new products while the severe downturn has limited the ability of the company to liquidate previous generation products.
Filloon's article had wondered if CARBO Ceramics was all but gone. The company has lost quite a bit of money and was projecting to lose more (a lot more). The volume for the sand producers was holding up reasonably well as operators moved to use more sand at the expense of proppant and other materials. All of the increasing volume of proppant was going to cheap materials such as sand. CARBO Ceramics, on the other hand saw its volume drop as much as the percentage drop in activity, and the company found it hard to contract fast enough. So the patents and the specialization do not appear to be worth much at this time.
"KRYPTOSPHERE technology adoption is moving forward with both KRYPTOSPHERE HD, the high density and LD, the low density being utilized in some of today's highest profile wells over the last few quarters. Going toward KRYPTOSPHERE LD is being incorporated into a number of new completion designs in the US and internationally.
KRYPTOSPHERE HD opportunities are typically associated with large scale complex projects for deep wells with ultra high stress conditions. The timing of that work is often times hard to pinpoint as the planning and execution of those projects are long term and can vary. We do however expect more opportunities to materialize for KH, our KRYPTOSPHERE HD in 2016.
Another growth area of technology we have surrounds our proppant delivered technology suite of products. Within the production assurance platform, the GUARD family of products protect sour wells built -- our clients' wells from build-up of scale salt, paraffin et cetera that choke up production and result in costly remediation work. We have some of our clients that now have wells on line for almost 700 days that you SCALEGUARD without any workovers needed to treat scale build-up. This breakthrough technology delivers tremendous value to our clients in lowering their LOE and increasing production.
We also continue to build out our fracture evaluation services products suite with Quantum. Quantum is an innovative propped reservoir volume or PRB imaging service has seen significant interest from E&Ps. As a result, field testing has been accelerated and multiple jobs are in planning stages for the remainder of 2016.
Quantum fracs will allow E&P operators to visualize the location of the proppant in frac and thereby be able to measure PRB for the first time ever. This will improve decision making in well spacing, perforation cluster spacing, fluid selection and proppant selection. It really enables E&Ps to maximize their EURs and develop the reserves more economically.
One of our most recent commercialized technologies, FUSION is also seeing very strong interest and we have additional work planned in the coming quarters. FUSION's development dates back a few years to address the requests of two super majors to create a new mobile proppant pack for injection and producing wells. While initially the technology was designed and targeted for wells in the Gulf of Mexico, there are other industry provinces this technology could also address." Source: Q1 earnings call transcript
But CARBO Ceramics is clearly moving into other lines with new products designed to challenge the current market leaders in their respective sectors. These new products should decrease the company's reliance on proppant for profitability. However, introducing new products and new technologies in the current industry environment will be much more challenging than usual. In earlier conference calls, Kolstad was extremely honest and upfront that introducing new products was going to be brutal in the current industry settings. In fact, the company budgeted no sales for the fourth quarter as the industry literally shut down towards the end of the year, from lack of cash flow, until the new year started. The company has a much more positive attitude about increasing sales of these new product lines although no specific guidance has yet been given, and it does not report its product lines separately. Still there is reason to hope for a far better future than the present without the dependence solely on ceramic proppant. The GUARD product line in particular targets some very large markets that could prove to be larger than the various ceramic proppant markets.
However, first the company has to get to that bright future. Management had stated in the conference call that the second quarter would be cash flow positive because a tax refund check was received. However, the company would still run a cash flow deficit from operations and financing the new products of $25 million in the second quarter. That deficit would use over half of the tax refund. There has always been a danger that the company would run out of cash before the new products were successful. The drilling levels still appeared to be contracting until the latest commodity price rally took hold and appeared to provide some relief from the very fast decrease in activity.
Plus the lenders got nervous and saddled the company with restrictive terms, mandatory loan paybacks, and a decrease in the credit line amount which mandated CRR pay back $23 million of badly needed cash. This made the negative cash flow situation much worse.
Then two members of the board of directors came to the rescue with a $25 million 7% subordinated loan that will mature in 2019. Those terms are much better than the company was able to get from its traditional lenders and will give CRR some much needed breathing room. A show of management faith like this will always reassure future investors somewhat, and lenders quite a bit. If the new products show significant growth, then the company could well find financing from other sources. The latest oil price rallies have stopped the activity downturn for the time being and given the company time to rationalize its operations to decrease the cash losses. Suddenly the ability of the company to successfully finance all the new products looks a whole lot brighter.
The balance sheet shows more than $500 million in assets in excess of the long-term debt. So, if management is given some time, it may be able to sell some assets, weather the cheap proppant inventory liquidation to liquidate some company inventory, and sell some unneeded capacity to raise cash. A recent shelf filing will provide another possible to finance the new products once it becomes effective. Plus, maybe there will be a more favorable financing offer in the future as the industry continues to turn the corner towards (hopefully) a rebound. The current ratio looks ok, but there is too much inventory, and it will take a while to decrease inventory levels. In fact, inventory may have to increase first (requiring more cash) to facilitate new product introductions.
As long as activity remains steady or even grows a little, the company has time to idle facilities, liquidate inventory and otherwise raise cash and decrease costs. This was a company that in years past generated a fair amount of cash and had no debt. With the emphasis on developing these products at the request of noted industry partners, the emphasis on patents, and product differentiation, this company could be a significant cash flow generator again in the future.
But that future depends upon new product penetration and industry awareness of the superiority of these new products. Plus, the company needs to convincingly demonstrate that superiority. Many of these products are now undergoing field testing and the results are posted on the company website, as well as suitable press releases, and articles in industry journals. Even so, the market penetration will take time. But with the shelf registration and the financial backing of the board of directors, the company took a giant step in the right direction. Now, let's see how well the company executes with that money and the new product lines.
If management is successful, this company could be worth many times what the stock is selling for now even if the market does not improve much. This company could be selling for less than one times its cash flow in five years if these products become fairly successful. Of course, management could also fail miserably in its execution of bringing these new products to market. The GUARD line, for example, is an improvement over existing processes and could well replace those processes in the very near future.
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