Covia Sheds Light On The New-Look Frac Sand Industry

Summary

• Pricing is at unsustainable levels, according to CVIA. Since they are one of the lowest-cost producers, they will survive while others are forced to idle mines.
• CVIA reiterated that unit-rail, quality, and proximity (even for trucking) matter down to the last penny.
• More information on decline rates was given, proving that Northern White will continue to play an integral role in fracking.
• As a result, investors should remain long CVIA, as a potential double is in the cards from current share prices.

Summary of Investment Thesis:

Frac sand producers have been punished for lower frac sand pricing and threats of debundling by E&Ps. Pricing has even reached unsustainable levels, according to CVIA. But CVIA is providing an opportunity to investors in that they expect pricing to rebound in 2019. This is due to various catalysts such as a resumption in E&P activity, reloaded budgets, and added pipeline capacity. CVIA also believes that debundling is not affecting them. Actually, it is helping, as E&Ps prefer to bundle with someone like CVIA who can offer a full suite of services (Pioneer even showed why debundling won't work for E&Ps on a large scale, which we will discuss further). The most important takeaway, however, is that since pricing has reached unsustainable levels, and CVIA is one of the lowest-cost producers in the market, this means an inflection point has been reached and a bottom may be in for the stock, which represents over 50% upside from current share prices.

Covia (NYSE:CVIA) announced third quarter earnings recently and shed much needed light on the sector. While the company reported a net loss mainly due to goodwill impairments and one-time costs associated with its recent merger, volumes did decline 19% and revenues declined 27% quarter over quarter.

So, the business did, in fact, see a slowdown last quarter from exhausted budgets and lack of pipeline availability and is expected to see continued weakness in the fourth quarter due to bad weather and lower pricing. This, in turn, will be followed by the inevitable bounce in 2019, as that is when E&Ps, with reloaded budgets and improved takeaway capacity, will resume completions activity again.

For the record, CVIA's industrial business also remains strong. It is even growing internationally in places like Mexico and maybe seeing price increases soon as a result. This confirms that CVIA's industrial sand segment, as well as U.S. Silica's (SLCA), should not be affected by added Northern White supply that has been displaced from the Permian.

Put more bluntly, CVIA's industrial customers need a certain quality of sand with precision timing and location, which most smaller sand miners cannot provide, and this assuaged investors' fears of Northern White frac sand oversupply affecting the pricing of industrial frac sand. This is another big value gap missed in Covia's typical coverage, as their industrial business makes up for their energy segment, and does so in a major way. Fairmount Santrol and Unimin's industrial businesses are no longer "insignificant" with their recent merger together. Industrial revenues of $199 million for the third quarter and more than $56 million in gross profit is nothing to slouch at.

But, these points have been widely discussed. The bigger idea Covia shed light on were the three key points that lowest-cost mining, transportation, and quality of sand matter, significantly. So significantly, in fact, that the other nugget CVIA threw out was pricing was at unsustainable levels for frac sand, and decline rate studies are showing that brown sand is leading to less cost savings in the end than Northern White sand. This should have been the nail in the coffin for bears who shamefully believe that Northern White is dead.

Anyway, this signals that a bottom may be close at hand for the lowest-cost producers like CVIA who can operate at these lower pricing levels and that more pain may be in store for the higher-cost sand producers that don't have the three keys mentioned above.

Consequently, I remain long frac sand players like Covia, and investors like me who have endured the fight this long should do so as well since a potential double is in store from current levels of around $6.00 per share.

Pricing Is Unsustainable At Current Levels

As investors may be aware of, demand for frac sand fell to about 85 million tons in the third quarter from the originally estimated 115 million forecast, dragging frac sand pricing through the mud (minus $9 per ton to be exact). Demand should fall even further to 70 million tons in the fourth quarter from bad weather and seasonal slowdowns. So, how could this be a good thing for CVIA in any way possible? It's simple, pricing cannot go much lower.

Covia reported that their margins were around $13.60 per ton. So, if pricing falls to the low-mid teens, then that shows pricing is reaching unsustainable levels. Management has even confirmed this by stating:

For now and the near term, the market remains oversupplied, and it will require additional capacity reductions in order to rebalance. To date, we estimate that at least 15 million tons of capacity have been taken out of the market. However, we believe more is likely to come as today's pricing has reached unsustainable levels for the market.

Therefore, more idling of not only Northern White tons, but now local sand, has to occur. Covia did their part, idling 1.6 million tons at their regional mine in Voca, Texas. Now, it is up to other brave, local sand producers to do the same.

Even an E&P in Pioneer Natural Resources (PXD) showed some leadership and idled their brown mine in Texas, choosing to go with closer sand producers like SLCA who have superior, low-cost sand services. The bundling bears of the frac sand industry should be put on notice with this startling announcement made by Pioneer.

Pioneer has now proven that even vertically integrated E&Ps can lose money if their sand mine is not efficient enough through the closing of their local mine recently. This point was covered in my article on WildHorse Resources Development's (WRD) vertical integration investment into sand, just before their buyout.

This is why continuous vertical integration into sand in-basin is unsustainable. Because it takes a perfect storm to find a low-cost mine near your drilling acreage for one; and two, if continuous vertical integration were so easy, then this would cause sand pricing and margins to drop with the new additions of supply. The alternative to go with someone who can do it cheaper, like SLCA will arise. Hence, the Pioneer mine closing an opting to go with SLCA instead.

While their mine might have even been low-cost enough, the ability to move it efficiently, with adequate last-mile services, may have been the key to the closing for Pioneer. This same trend should benefit Covia and other lower-cost frac sand producers.

New Look Production Model For CVIA Going Forward

In order for Covia to operate at these near unsustainable levels until completions activities resume, idling of higher-cost mines had to occur.

This means that they will now have 8 million tons of low cost in-basin sands and 19 million tons of Northern White sand that has, you guessed it, unit train-capable facilities.

Notice CVIA didn't necessarily say that they had low-cost Northern White mines, but that those mines had unit-train ability. Maybe they do have low-cost Northern White mines, which would only be a plus. Regardless, this silver bullet in bear's hearts on unit-trains being needed to move sand effectively was discussed in our last article on Smart Sand (SND).

CVIA will also have 4 million tons of remaining Northern White capacity at their hybrid plant, which is more efficient, apparently, as it can respond to changes in market demand quicker.

They are even officially adding last-mile abilities now with silo-based systems to encourage customers to bundle with them. CVIA is going to stay with an asset-light strategy through third-party alliances, which benefits them in slower times like these. Also, the last-mile space continues to grow with new entrants and solutions they remarked, and so CVIA wants to achieve the highest payload per ton possible. Adding "payload per ton" to my repertoire helps me understand sand margins easier.

Here is what management had to say about their unit-train ability, lower-cost operating model, and last-mile solutions going forward:

I think what's unique about Covia is the sheer amount of unit train capable capacity that we have for Northern White sand, which provides us with a distinct cost advantage. Obviously, volume is a really important element to managing cost. And so, we're focused on really maximizing our volume as much as possible in this environment.

This restructured footprint further strengthens our cost competitive position and it allows us to supply our customers with Northern White pricing covering at unsustainably low levels for the market. We've also initiated strategic alliances with select partners in order to give our customer base the option of an integrated mine-to-well-site solution, utilizing today's leading last mile technologies.

In general, this model affords our customers with the highest optionality, so that we can tailor our solution that is best suited to each of our customer's specific needs. More specifically, we've chosen to align with providers who will enable us to offer solutions which emphasize technology and that is in both assets and administration, high payload transport, overall efficiencies, and importantly, safety.

Now, as sand prices weaken, the sustainability of CVIA should be less of a question since they are one of the lowest-cost producers in North America with last-mile capability now (debundling by some E&Ps is no longer a threat because of last-mile services being added by CVIA).

Covia's Sustainability At $55 WTI

With oil prices falling below $55 a barrel, this could cause another set of problems for Covia and major frac sand players, especially those with contracts indexed to the price of oil. However, I don't expect E&P activity to slow around the $55 dollar area since they are lowering breakevens with new drilling and completions technology that is coming out, seemingly, on a daily basis.

To put things in perspective, Emerge Energy (EMES) said they can operate comfortably at $50 oil prices, and that was over six months ago. I believe breakevens are falling even further for E&Ps as IRRs continue to rise. The industry breakeven for fracking was at $45 a year ago. I expect that number to be more like $35 to $40 now since efficiencies continue to be captured a year later, and that may even prove to be too conservative.

EOG Resources (EOG), for example, plans their budgets at $40 oil, and makes a 30% return on wells even then, implying some of their breakevens are under $30. Many operators data trade as well, so I expect some of these strategies by EOG to be shared with competitors.

Another reason E&Ps have to keep fracking in a sub-$55 WTI environment is not only to keep their lights on and bills paid, but also to incentivize bonuses (due to short cycle investing vs. longer cycle investing offshore). On top of this, CO2 emissions and political alliances with the U.S. should keep demand steady for cleaner shale oil, and damage competitors of the U.S. like Russia and Iran, instead.

Decline Rates A Bigger Issue Than Previously Expected

Not only is the manufacturing and transport of sand without low-cost solutions a problem for newer entrants who can't achieve those same payloads per ton, but quality is another important issue that bears are underestimating.

Bears seem to understand that there is a quality issue all right, but that it is apparently just not an issue to an E&Ps and pressure pumpers who are going with full brown sand operations. The skeptics are right about those E&Ps who want the upfront savings of $400,000 to $500,000 per well using brown, which should displace white.

But, there are thousands of smaller-private E&Ps that may feel differently since CVIA proved decline rates are so significant, that cost savings erode after certain timeframes. The company would not give those timeframes for declines or exact specifics on local brown conductivity, but they did say:

In the near-term, local sand is likely to continue to gain share from Northern White, solely on the basis of cost, as operators incorporate local sand into their well design. The ultimate adoption rate of local sand, however, still remains to be seen. However, our own extensive testing along with third party verification continues to illustrate a substantial and consistent differential in both mines generation and conductivity between local and Northern White sands even when the testing is well within the specified limits of both products.

To put the potential impact of this into perspective, the cost savings differential to complete a well using local sand versus Northern White sand can be lost in a matter of a few months with only a very small percentage in well production decline.

While this does not suggest that local sand will not have a future, as it is fit for purpose for many well environments, these findings support our continued confidence that proppant demand will continue to be a mix of both local and Northern White sand, and Covia is well positioned to be the leading supplier of a comprehensive proppant solutions to meet the very broad needs of our customers.

To prove Northern White is not only dead but also growing, one needs to look no further than Covia's contracts inked in the third quarter. A few were for Northern White sand (that's all the company would say on the call).

Analysts' Consensus

Analysts price targets are not as bullish as mine. But, then again, analysts have never been too accurate in the frac sand space. Old articles I wrote on frac sand companies just six months ago had high targets in excess of 100%. My, have times changed.

Source: E*TRADE

Now, the high target of $10.000 represents over a 50% gain, but the average price target by the analyst community is just $7.64. This means that on average, analysts believe the stock has little upside left. But, if they were wrong in being too optimistic six months ago, I'd be willing to bet they are wrong again in being too conservative now.

My thesis on the price target not being bullish enough stems from the fact that while pricing for frac sand contracts was in the $70s just six months ago, even reaching over $100 on spot pricing, that was before new supply came online in tandem with exhausted E&P budgets.

Fast forward to the present day, and you have Northern White prices reaching the teens in the Permian, and local brown pricing holding up in the $60s (according to SLCA). I have heard quotes actually for $40 local brown sand pricing recently, showing that oversupply problems are worsening for Covia since smaller players appear to be slashing prices to compete.

While this may seem like an uphill battle for frac sand pricing going forward, analysts should factor in a pricing recovery for 2019 since completions are expected to resume "immediately" by E&Ps with larger production goals. Budgets just need to be reset.

This event, alone, should drive local brown sand pricing back up at least $10 dollars, in my opinion, since more Northern White will be displaced by new local sand mines, and more brown will be idled.

Remember, CVIA and PDX already idled some of their higher-cost brown volumes. They expect more local brown to come offline, in addition to the 12-15 million tons of Northern White that has already been idled.

I also believe that analysts are severely underestimating Covia's industrial segment, which should add more EPS for CVIA in the coming quarters since they are still growing that segment. This diversification, in addition to higher pricing and volumes for 2019, should cause CVIA's share price to be back in the low to mid teens.

If frac sand pricing made a full recovery, shares should be back at $30 where the initial public offering occurred at. Pricing is not expected to reach former highs again, according to some skeptics. But, again pricing is expected to return to healthy levels in 2019 (according to Hi-Crush), and larger volumes and industrial price increases are expected, too.

Risks

The risks to Covia's story, besides the obvious in the temporary oversupply of sand, are that completion activities could stop from various issues such as lower oil prices, limited takeaway capacity, and poor weather at any given time. This, in turn, has a dramatic effect on frac sand prices and margins, and will definitely cause challenges short term for frac sand producers like CVIA.

However, many of those issues are transitory and are priced into the stock now anyway. Many companies are saying the problems are transitory, in fact, and that their stock prices are at unrealistically low levels, and this is why buybacks are occurring. Even Smart Sand is doing a buyback program now. Hi-Crush Partners (HCLP) and U.S. Silica are already buying back their stock for the same reasons.

Covia also has integration risks related to the merger, but no problems have arisen that I am aware of in the new marriage. In fact, Covia says their synergy program is on track, especially with their supply chain integration, where half of the synergies of the program are meant to be captured by re-pairing origin/destination points of both companies. This reworking of the supply chain, in addition to their SG&A costs being consolidated, are helping to eliminate redundancies and keep the synergy program on track to meet its goals.

CVIA's debt is also coming down. Net debt stood at $1.48 billion, but it was reduced by $22 million since the second quarter. I expect this trend to continue, especially if volumes ramp and synergies continue to be captured. Their Term Loan B debt doesn't mature for quite some time either (until 2025), and doesn't have harsh covenants like a similar competitor in Emerge Energy has.

Conclusion

Pricing is holding up in-basin for Covia, as the $9 drop was only related to Northern White pricing. Therefore, averaged out, the pricing drop was actually $6. This means CVIA should see higher revenues in the short term due to heavy exposure of their in-basin mines ramping. Longer term, in the second half of 2019, completions are expected to resume. So, this should allow Northern White pricing to return as well, further bolstering CVIA's margins and revenues.

Even if the second half of 2019 gets pushed back for the added takeaway capacity, which would be contrary to the timeframes of most in the oil & gas industry, this would have to be expected nonetheless, since Murphy's Law rules the energy sector at the moment.

In that case, Covia's behemoth of an industrial business, low-cost mining of quality sand, and logistics network with unit-train and last-mile capabilities should see them through the fight. Combine this with the fact that pricing has reached unsustainable levels, and you have only the low cost players like CVIA standing in the end.

With activity expected to resume as soon as budgets are reloaded in 2019, which will then accelerate into the back half of 2019, I believe investors who are long CVIA here around $6.00 per share should position themselves accordingly for the next up-swing to $10.

Disclosure: I am/we are long CVIA HCLP EMES SLCA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.