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A Supply Tsunami

The advent of horizontal fracturing in the United States has created immense demand for proppants, which "prop" open fissures that release oil and natural gas into wells drilled deep into carbon-rich shale rock. Several materials, most notably uncoated sand, resin-coated sand, and ceramic, are suitable for this purpose, but uncoated sand, due to its low cost and natural abundance, has become the proppant of choice in all but the deepest wells, which require denser and more crush-resistant ceramic particles.

Our work - based on extensive conversations with county land and permitting officials, among other sources - suggests that a wave of new uncoated sand supply is about to flood the market. Specifically, in Wisconsin alone, we estimate that at least 14.1 million tons of new frac sand capacity (49% of total current production) is currently under construction, with another 11.5 million tons (an additional 40% of current production) permitted and/or proposed in the state. This compares with forecast 12% per annum demand growth.

The chart below summarizes our research; it is not intended to be exhaustive, but rather only represents those new builds that we have come across, and have been able to get clarity on the status of, during our diligence. Those properties listed as "proposed" in the second section are only those planned mines for which production estimates are available. And again, this is just for the single state of Wisconsin:

Under Construction

Owner

County

Production (mm tons)

Comments

Source

Canadian Sand and Proppant

Barron

1.2

To come online spring of 2013, subject to final permits.

Company, county land official.

Chieftain Sand

Barron

1.0-1.2

Came online end of July 2012.

County land broker, county land official.

EOG (EOG)

Barron

1.0

Work proceeding quickly, should come online soon.

County land official.

Great Northern Sand

Barron

1.0

Likely to have come online end of July 2012.

County land broker, county land official.

Midwest Frac

Barron

<1.0

Permitted, but excavating operations have not fully begun.

County land official.

Superior Silica

Barron

1.0

Should be online by the end of the year.

County land official.

Gregory Weber

Buffalo

0.6

100 loads per workday, to come online in August or September 2012.

Buffalo County Zoning Committee minutes.

Kendall Klevgard

Buffalo

0.8

Local mine granted permit in February, currently finalizing state permits. 125 loads out per day, 5-6 days per week.

County land official, Buffalo County Zoning Committee minutes.

Ryan Barth

Buffalo

0.3

Local permits granted, mine to open soon, to process 1000 tons per day.

County land official, Buffalo County Zoning Committee minutes.

Steve Stamm

Buffalo

0.8

Permits granted in January 2012, currently under development. 95 loads per day, every day of the year except holidays.

County land official, Buffalo County Zoning Committee minutes.

Preferred Sands

Chippewa

>1.0

Under development.

County land official.

Preferred Sands

Chippewa

0.75-1.0

Under development.

Company.

Hi-Crush

Eau Claire

1.6

Coming online in Q3 2012.

Company S-1 filing.

Smart Sand

Monroe

>1.0

Facility opened in late June 2012.

Company news release.

U.S. Silica (SLCA)

Monroe

Initially 0.75-0.85, potential to expand over time.

To come online in Q2 2013.

Company Q2 2012 earnings call

Total:

14.1

Percent of Current Production:

48.7%

Proposed

Owner

County

Production

Comments

Source

Premier Silica (Pioneer Natural Resources)

Barron

<=1.0

Plans are "being progressed," mine capacity "up to one million tons."

Company press release.

Superior Silica

Barron

2.4

Rezoning secured, set to discuss specifics.

Barron News-Shield.

Larson / Johnson / Stanton

Buffalo

0.9

Expecting 150 loads per day, 5 days per week.

Buffalo County Zoning Committee minutes.

R & J Rolling Acres

Buffalo

0.9

Mine approved by Board of Assessors, still has not been granted local permit. 126 loads per day, six days per week.

County land official, April 2, 2012 Application for Conditional Use Permit.

Seven Sands

Buffalo

1.1

Expecting 190 loads per day, 5 days per week.

Buffalo County Zoning Committee minutes.

Copper Road Minerals

Monroe

1.2

To produce 100,000 tons per month.

Company.

Wisconsin Industrial Sand

Pierce

1.0

Hearings ongoing.

Pierce County Land Management Committee minutes.

Vista Sand

St. Croix

1.0

10,000 rail cars to leave annually, assuming 100 tons per car.

Company.

10K International

Trempealeau

1.2

Local permit received. 175 trucks per day, 6 days per week.

Trempealeau County Environment and Land Use minutes.

Kraemer Company

Trempealeau

0.5

Local permit received. 80 trucks per day, around 5 days per week.

Trempealeau County Environment and Land Use minutes.

Scott Swanson

Trempealeau

0.5

Local permit received. 80 trucks per day, around 5 days per week.

Trempealeau County Environment and Land Use minutes.

Total:

11.5

Percent of Current Production:

39.7%

100%+ (Annual) Returns on Investment

This surge in supply is being driven by a classic case of boom-and-bust bubble economics. Uncoated frac sand typically costs between $20-$30 a ton to mine. Two years ago, pricing for uncoated sand averaged in the low-to-mid $40s per ton but then spiked to north of $100 per ton earlier this year on an intermittent supply crunch (spot is currently around $80 per ton).

The implied new entrant economics are perhaps best illustrated by recent IPO Hi-Crush Partners LP (HCLP). Hi-Crush acquired acreage in Wisconsin last year and constructed in just six months a fully operational sand mine, processing plant, and unit train load-out facility capable of producing 950,000 tons of uncoated sand per year. The company subsequently expanded capacity to 1,600,000 tons for total invested capital of roughly $57M, and expects to generate approximately $65M of annual EBITDA from that investment.

More generally, frac sand mining is anything but complex: surface sand (or, more rarely, underground sand) is simply hauled away (or blasted out if necessary) with minimal processing. The sand deposits themselves are abundant. Put simply: The tsunami of supply is here to stay, unless pricing collapses to provide ample disincentive.

Customers Becoming Competitors

Making matters worse, the primary consumers of the uncoated frac sand, E&P companies, are increasingly getting wise to the game and constructing their own capacity, with EOG Resources and Pioneer Natural Resources (PXD), among others, nearing completion on, or having purchased, wholly-owned projects. In the words of EOG CEO Mark Papa at the Sanford Bernstein Strategic Decisions Conference in May:

We have our own sand mines, the most recently [sic] we opened in Wisconsin, and the way to look at these sand mines for the self-sourced sand is that we'll be using these mines to essentially service all of our U.S. frac jobs and that's about 600 wells this year at a savings of $0.5 million a well or about $300 million.

The Likely Endgame

Economics 101 dictates that an oversupplied commodity will price to a level that reduces supply enough to balance the market by forcing producers out of business. While we have not come across a frac sand project with cash operating costs north of $35 per ton, we consider that to be a reasonable base-case level for where pricing will return to in the coming quarters. This would represent a decline of more than 50% from current levels.

Source: The Coming Tsunami Of Frac Sand Supply