Smart Sand (SND) reported strong Q4 earnings despite the weakness that the overall frac sand sector faced during 2018. The company was able to surprise investors with a lower-than-expected loss, mainly due to higher sales and greater contribution margin. These events, of course, were made possible by SND's recently increased logistics capabilities.
Moving sand in-basin, which is where trends are shifting to as opposed to selling FOB, also allows for better pricing for SND. This is because SND is now able to capture incremental value by delivering sand closer to wells in-basin rather than selling freight on board from its mine facility.
These developments show why SND is a legitimate frac sand services provider that's built to last, and can withstand the shocks from a dramatic oil & gas downturn.
As a result, I continue to stay long the frac sand sector, as the main services providers like SND are the only companies that have the transport network necessary to move sand efficiently and affordably for E&Ps.
Smart Sand Says Proppant Demand Is Improving
SND reported that 2018 saw a 32% increase in proppant demand over 2017, and 2019 is expected to be slightly higher than 2018, assuming oil & gas prices remain at current levels.
These numbers must have been for the Permian, or Southern U.S., since SND also reported that Eastern U.S. demand is expected to grow by 13% in 2019 and 2020, and Bakken production is expected to grow 8% annually over the next five years.
These numbers point to a strong oil & gas market for years to come, and imply that cost-effective sand will be needed in a major way to support E&P's ambitious drilling programs.
More importantly, no in-basin sand of significant amount exists in Northern basins, and this bodes well for Northern White pricing in those regions.
If one just thinks that more in-basin sand will be developed in Northern basins next, then he/she is not understanding the nature of moving a bulky product like sand via trucks.
Sand needs to be moved by rail, or it loses the savings from trucks when moved out beyond 50 miles from the mine site, and this has been a major talking point for the CEO of Smart Sand on his latest conference calls.
Northern White Is Also Making A Steady Comeback
In fact, SND management continues to grill analysts for not only misunderstanding the logistics of moving sand through unit trains, but also for not understanding the decline rates of E&Ps that will need to use higher-quality NW sand to offset steep decline losses seen from using brown sand.
E&Ps also need to spend responsibly, within cash flow, in order to stay in good standing with their lenders. This means that maximization of capital is required, and that more NW will be sought out by E&Ps in order to stem losses from the steep production declines they are seeing.
SND explicitly said on its Q4 call to analysts that:
We think you guys need to dive deep into the E&Ps that use the Northern White and how their wells are standing up in regards to the E&Ps that have gone to regional because, we think they're all under a lot of pressure on cash flow and long-term cash flow. And we think once you start looking at that a little closer, you start seeing that Northern White makes sense, move properly with big unit trains.
And went on to say that:
Sustainable profit in logistics starts at the mine. They require large reserves, massive rail yards, and willing rail partners. Such logistics must have complementary large rail infrastructure on the receiving end, preferably right on the producing acreage to minimize trucking distance to the wellhead. When combined with the reduced well performance of regional sand, Northern White delivered an efficient bulk commodity movement makes sense.
Northern White usage is also increasing in the Permian, especially 100 mesh white and 40/70, due to these steeper decline rates found with using brown sand (less crush strength and higher turbidity). This issue with decline rates for brown will undoubtedly lead to higher pricing and margins for SND in the coming quarters, since NW is its primary product.
Another important caveat from SND's calls is that 40/70 and 100 mesh NW is also in tight supply because most NW mines produce coarser grades, like 20/40, which is not what E&Ps need anymore. Gel fracking designs have since switched to slick water, and these use finer mesh grades (100 mesh) with a 40/70 tail in (which is in shortest supply).
U.S. Silica (SLCA) mentioned this point about 40/70 in its recent conference call, saying that the available 40/70 local sand is in tight supply (80/20 rule), and that most 40/70 brown is even inferior quality.
So, this development with the inferiority of local brown 40/70, combined with steeper decline rates, and a tightness of NW 40/70 up north, means that NW pricing could make a comeback in a major way. These events would also cause more brown to be idled, which improves overall frac sand pricing for the sector.
Even newer basins like Oklahoma and the Eagle Ford are experiencing problems with their local sand, according to SND. So, analysts should expect this theme to play out in 2019, and could possibly have to revise estimates higher if more brown sand is deemed inferior to use, or becomes idled by rival NW competition.
Financials Strong
Smart Sand generated EBITDA of $66 million for the year, which was up 116% from 2017 levels. However, the company still reported a net loss of $4.4 million in the fourth quarter, but this was less than feared considering how low NW pricing dropped during the winter.
Again, SND has a clear advantage selling its NW sand in-basin because pricing is more attractive. Plus, its last mile solution and transload terminals in Northern basins are all providing compelling value to E&P customers, which is most likely allowing SND to take market share from smaller sand mining peers focused in the same basins.
For the fourth quarter 2018, contribution margin per ton was also $37.34 compared to $32.95 per ton from the previous quarter, and this was due to higher transportation revenue, lower costs from right-sizing labor, and lower volumes (which incurred less manufacturing costs).
Risks
We have already discussed some of the prevailing risks for frac sand producers above, and have shown that threats of more in-basin sand crushing the sector are highly flawed. This is mainly due to logistics problems and production issues that are not understood by analysts.
However, SND is expecting EBITDA to decrease from the previous quarter, even though sales should be about the same as the fourth quarter. This is due to lower contract pricing that is indexed to WTI prices.
Therefore, investors should not take a downturn in oil & gas pricing lightly. While some E&Ps can operate uninterrupted, regardless of oil price volatility, contract pricing for sand will still fluctuate via WTI escalators, and could potentially affect SND's bottom line in an adverse way.
Conclusion
Smart Sand continues to impress. The company has minimal debt, and is seeing higher pricing in the $30s. Even Covia (CVIA) recently stated that it was seeing price increases on NW.
SND also lives up to its name as the "smarter" way to move sand. It was the only company not to jump into the brown frenzy sweepstakes and was the first to highlight the issues of moving sand without unit rail. This caveat has put fears of more in-basin sand decimating pricing in the rear-view mirror for serious investors.
Other frac sand producers like U.S. Silica, Hi-Crush Partners (HCLP), and Emerge Energy (EMES) have also highlighted numerous times that the decline rates for local brown sand are causing E&Ps to revisit NW sand usage. This data point also bodes well for frac sand pricing in 2019.
As a result, I continue to believe in frac sand providers like Smart Sand, and am staying long the sector despite the misinformation that continues to unfairly knock their stock prices down.
One day, analysts will see how global petroleum consumption, plus our national security of being energy independent, depends on the success of E&Ps that, ultimately, depend on frac sand as one of their biggest sources of EUR uplift.
Disclosure: I am/we are long HCLP EMES. 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.
