Carbo Ceramics: Shiny And Smooth, But Costly

| About: CARBO Ceramics (CRR)

Just a few thoughts as anecdotal evidence seems to point to cost and competition based demand growth and pricing reductions for ceramic proppant. Proppant is used to hold the fractures created by the frac job open and ranges from white sand at the low end to resin coated sand (RCS) to various grades of harder and more expensive ceramic. The ceramic proppant is more crush resistant and more uniform (better porosity and permeability) than sand and is designed to hold the fractures created in higher pressure environment wells open longer and result in higher flow rates and ultimately, greater recoveries of hydrocarbons.

Ceramic Proppant Capacity Rapidly Expanding… Carbo (NYSE:CRR) is the leading U.S. supplier of ceramic proppant (current capacity of 1.75 billion pounds per year and they have been and continue to sell as much as they can make. So they are building additional manufacturing capacity (0.5 B pounds per year in progress now)), and will likely, if history is a guide, get that capacity on faster than expected, at a time when demand growth may be set to slow. Saint-Gobain, another ceramic proppant provider, is also expanding their production capacity, opening a new $100 mm plant in AR by late 2012.

Chinese manufactures are also busily ramping production as well and we’ve been told by sources there are apparently increasing quantities of low cost (and perhaps lower quality) Chinese proppant on ships headed to the U.S. and already ashore. Sources who use proppant either directly in their line of work (completion engineers) and E&P managements are noting “piles” of ceramic proppant in Williston and South Texas. Even non-energy types (who know next to nothing about geology) are hopping on the bandwagon, opening up ceramic proppant import businesses in Texas. This evokes images of a gold rush mentality.

…But Do I Need It? Maybe, maybe not. Completed well costs (CWC) have zoomed this year and ceramic proppant costs can run as high as $1+ mm over a similar sized white sand frac. CRR believes the use of its proppant leads to 20% higher IPs and EURs, but in the minds of some operators, it will take some time to determine the veracity of the EUR claim. In the Eagle Ford Shale that extra strength may be needed in the deeper parts of the play, however, there is talk by operators there about performing refracs (fraccing the well again as the flow rate ebbs) in as little as 3 to 4 years, which would be before the extra cost of using ceramic proppant makes sense.

In the Williston Basin and Eagle Ford Shale plays we have noted with each passing quarter a marked increase in CWC and would note that the majority of the cost of a well comes after it has been drilled - in the completion. Whiting (NYSE:WLL), on their 3Q11 conference call, commented their completed well costs were temporarily higher than usual because they could not get enough white sand for their fracs and they were therefore forced to use ceramic proppant. They stated they have already sourced additional sand capacity and won’t be using ceramic, at least by choice and knowing what they know now, going forward in the Williston.

EOG Resources (NYSE:EOG) seems to agree as they are opening their own white sand mine. Notably, WLL and EOG make some of the bigger wells, in terms of long term performance and not just from an initial production rate, in the Williston Basin. Moreover, these are a pair of well funded, household names in E&P, not some barely scraping buy single-midget-digit types who can’t afford proper proppant. They simply don’t think they need it. Given that both have been pioneers in horizontal drilling in shales, I find that interesting. Not specifically siting proppant costs, but more due to an overall acceleration of costs. Newfield Exploration (NYSE:NFX) announced with its 3Q11 press release that it will be deferring its Williston Basin completions through year end. This speaks to the sensitivity of E&Ps to well costs even in a near $100 oil price environment.

Pricing Break Down: The following table was built with the help of a buyer of proppant (they are not CRR’s price points), but they should be somewhat representative of the cost differential we are talking about. As you can see from the following table, ceramic is running about 5x the cost of using white sand. In a hypothetical $8 mm well this represents 13% of the total well cost. I went on to show what happens if you assume a set budget and drill a well program with white sand or with ceramic. I give the ceramic wells a 20% bump in recoveries as per CRR’s claim and would note that this translates into an aggregate boost in reserves of just 4%, since the ceramic well operator will get far fewer wells drilled than the white sand operator. Just some math for thought.

Focus Shifted From IP to IRR. At this point in the game, at least in the Williston Basin, initial production rates have become less important than long term performance. Brigham Exploration (BEXP), the IP press release king, had even admitted this before they were taken out by Statoil (NYSE:STO), as they recently transitioned from a press release each month mode (with successively higher IPs) to a less frequent operational update that noted key highlights but focused on longer term results vs. costs. This makes the use of ceramic as a marketing point to investors less sexy than it was during the delineation phase of the play.

So the focus now is not on high IPs, but on growing volumes AND reducing costs. Also, costs rise and oil prices trend up but at a flatter slope, the present value of a well shrinks. One of the easy ways to find cost savings is to cut out the potentially unnecessary, higher cost use of ceramic. Meanwhile, it will likely be years before we “know” if the ceramic was necessary. This last point was better said by a completion engineer friend of mine:

When you are starting; the reservoir types and G&G are mostly driving with the who, what, wheres. During development the operations are: this is how (cost, technique …). When revenue can not cure the evil, upper management usually asks operations to figure out how to make it happen. This is when there are no sacred cows and things like proppant get thrown about.

Nutshell: I’m not forecasting anything like the end of ceramic proppant usage nor am I decrying management’s claims of increased conductivity leading to 20% EURs. Growth at CRR has been nothing short of stellar. But capital spending growth is slowing (just ask Barclays who puts North American growth at 8% in 2012 vs 31% in 2011. And CRR’s stock would seem to have discounted quite a bit of strength, trading at 19x current 2012 Street estimates. I’m just looking for slower growth for 2012 as E&Ps attempt to stretch their dollars. Nor am I yelling that the “Chinese are coming”. The Chinese are already involved and CRR management has repeatedly discounted Chinese: 1) proppant quality, 2) ability to deliver to the wellsite, and 3) usability (CRR says the Chinese prop is harder on fraccing equipment).

Besides, CRR says that aside from the capital side of the equation, ceramic is hard to make, and it would be hard to compete with them on the efficiency side of the equation. Hmmm...China...efficiency...Hmmm. But turning back to using ceramic vs not, in the Williston, it’s about the rocks and the frac methodology and I can point to a lot of big wells that use just sand and have massive IPs and estimated EURs, much bigger than the average well in the Basin (wells in Sanish, Parshall/Austin standout). I can also point to other areas where the wells have 40 stages and didn’t flow well, even with a well landed lateral and ceramic prop. It’s the rocks, even surrounded by strong wells in fairly close proximity and the ceramic wasn’t a panacea. And turning back to those Brigham wells, we looked at all of BEXP’s long lateral wells in their Rough Rider area, all of which used ceramic proppant, and compared them to 40 short lateral wells drilled by Slawson, with white sand and the twelve month cumulative production from the two sets of wells was remarkable similar.

I would note that the Slawson IPs were much lower than BEXP wells but who cares if twelve months down the road the two wells, one drilled for over $9 mm and the other drilled for under $6 mm, had similar cumulative production? So again, perhaps a slowing of the growth rate is in order now that IPs aren’t so sexy to the market. Perhaps lower prices per pound are too. After all, high prices will, so to speak, take care of high prices.

Meanwhile, E&Ps will always seek to grow production and that means more wells and that in an “only slightly up capital environment” means intense scrutiny of costs. As more pressure pumping capacity hits the basins, costs should abate some. Pad drilling, zipper fracs, and pre sourcing of OCTG and sand will help as well. But there will still be pushback on a big piece of the cost pie, the proppant. And that’s my point, not that it won’t be used but it won’t be seen as necessarily, well, always necessary. At least, not for the lofty prices it commands today, especially not if there is a lot more of it around.

Disclosure: I am long WLL, EOG, NFX.

Additional disclosure: I have puts in CRR.

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