The Coming Tsunami Of Frac Sand Supply

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%

Click to enlarge

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%

Click to enlarge

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.

Disclosure: I am short SLCA. I may trade in the security in the next 72 hours. 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.

Comments

[TellUsAboutitz]

Please update us on your SLCA short. Thanks!

[BottomsUpAnalysis]

Thanks for all of the comments on the article. A couple of you raise the issue that the margins of the large incumbents are protected because of a transportation cost advantage they have from (i) the proximity of their mines to Class I rail and/or (ii) their ownership of load-out facilities.

Regarding (i), you can see from the map at the following link (http://bit.ly/O04cgo) that the majority of the larger new mines are also directly on rail and that literally all of the new mines are within 20 miles of Class I rail. Trucking costs for that distance would be minimal, likely only $5 per ton.

As for the notion of load-out facility ownership as a competitive advantage, check out this video (http://bit.ly/O04cgq) ...any sidetrack can be quickly turned into a load-out facility with less than $100k of equipment.

The bottom line is that the infrastructure needed for the transport of frac sand is not an impediment to new supply, nor is it a cause of meaningfully different marginal costs for that new supply. Like the locating, mining, processing, and selling of the product itself, it's remarkably simple stuff.

[Studium]

There are a lot of well-informed people commenting on this article. I love it and find it extremely useful. I hope you also consider attending the 2012 Frac Sand Supply & Logistics Conference (http://bit.ly/S1AM3a).
Thanks!
Pete Cook

[SeeRightThruU]

SLCA has earnings power in excess of $2/shr in 2013 with growth into 2014. Once again all naysayers will discount any expansion and caught off guard when they once again meet or beat expectations and guidance in Oct. 80% of their frac sand volumes are contracted and not exposed to spot prices in the near or medium term, and what you're missing is that SLCAs customers are focusing on access to volume not pricing. Once again, SLCA has defensible per unit economics driven by volume growth. You are also failing to give credit for the Carmuese aquisition. Shorting SLCA at 11.88 will not yield much fruit I'm afraid. We can revisit at year end

[SeeRightThruU]

The company has been in business, and prospered for over 100 years. Even with lower frac sand pricing there has been no material decline for SLCA per unit. SLCA will easily be able to defend contribution margin per ton of sand in the low 40s due to their contract coverage and solid position as a low cost provider. In addition, and most importantly if we accept your premise, only 30% of SLCA's revenue comes from frac sand sales, and although this may be a driver for future growth, even they lost 80% of the revenue from this segment, they would still survive and most likely take over business from smaller companies of like you suggest will crumble. The current PE ratio to long term EPS growth rate is extremely attractive. A more plausible short based on your thesis would be CRR, would it not?

Long SLCA

2

[Abobwa]

Actually 50% of their sales come from frac sand sales per their most recent 10-Q, but more importantly 70% of the company's gross margin dollars come from frac sand in the most recent quarter. Clearly frac sand is driving all the profitability.

The company has roughly $84mm in annual SGA, D&A and interest expenses. Their entire industrial segment had gross margin of $14mm last quarter, or less than $60mm annualized. So the industrial business alone doesnt support the company's cost structure.

Im also not sure why everyone thinks they are the low cost producer. Hi-Crush produces frac sand for less than $20/ton and SLCA cost/ton is above $30 per their most recent quarter.

[Abobwa]

Some good information is at the website below. For what its worth, it coraborates what the author is saying. if you click on the map, it provides a list of sand mines coming on line.

http://bit.ly/P9Aq2Q

[jrich]

Before anyone gets too excited about this article you need to read it again and make sure you understand the contradictions within. EOG and Pioneer Natural Resources are extremely well managed companies. Both have been very successful through their vertically integrated growth and understand supply/demand economics quite well. If there is going to be "Supply Tsunami" of natural proppant hitting the market as the author suggest, why would EOG and PNR enter Cap-Ex investments to secure their own production? If there is any factual premise to the author's article, smart money would sit on the sidelines and let everyone else (as stated by author) develop production to the point of an over supplied market, then step in and buy from the glut at much lower prices. One more thing to remember...you have to look at all sides of a market prior to predicting its supply/demand situation. Without factoring in U.S. fracing growth in relationship to sand production over the same period of time, it is impossible to predict the overall bullish or bearish sentiments of a market.

[Robin Heiderscheit]

Yep, in 2003-05 there was a boom in building ethanol plants. The smart money knew these plants were cheap and that returns would come down. The smart money waited and bought all the plants out of bankruptcy. Happens on a regular cycle with commodity producers.

[Abobwa]

If what the author says is correct and building a new facility offers a pay back period of less than 1 year, EOG and Pioneer would already earn back their investment before the "tsunami supply" hits the market. And by adding capacity, they help facilitate lower prices, and more importantly secure supply, for a commodity they need and are inherently short. In my opinion, i dont see a contradiction between the author's premise and EOG and Pioneer's actions. They simply chose to capture a year's worth bubble margin for themselves and secure supply during a shortage as opposed to getting locked into contracts at high price levels or worse, finding themselves without sand.

[PhilCA]

This is an interesting strand. I just bought HCLP this week for the dividend yield but what I'm reading here would suggest that the yield's not as safe as I though with abundant supply coming on and possibly lowering price for sand. I'd like to find those vaunted 4.7 take 0r pay year contracts reassuring, but contracts like that often have provisions for price adjustments in them. So HCLP might keep the customer, but at a much lower price. As I decide whether to keep this position or not, I wonder if anyone can point me to: (1) A resource that tracks/publishes the price of fracking sand, or (2) Any evidence that HCLP's long term contracts are for fixed prices.

[glenwpeterson]

Read the S-1 please....don't guess....it's right in there....and yes I'm long the stock....for sure....no question...near 10% yield and 10% is a good way to get rich slowly.....contract pricing is layed out, it is long term, it's not adjustable and it's under the current spot market pricing....

[Robin Heiderscheit]

Hi User:

Well, there is good news and bad news. The good news is that those wonderful take-or-pay contracts should be attached to the S-1 that HCLP filed so you can review to your heart's content. The bad news is that they are probably thirty pages long.

I used to finance projects with take or pay contracts for a living so here is what such contracts GENERALLY provide: (1) the obligation to "take" is pretty fixed, because the project lenders demand this but (2) pricing is variable above a floor . . . usually enough to service debt and (3) there are various "out" clauses that are tough but not impossible to trigger.

I am assuming, based on my limited due diligence, that the next couple of years will be fine in terms of cash flows for HCLP based on the contracts. If, as the author points out, new entrants can earn 100% annual ROIs ,however, there are gonna be a heckuva lot of new entrants. That may or may not affect HCLP's price.

There you go. And I didn't even bill you $500 bucks an hour. Hah.

[Robin Heiderscheit]

Yield up to 12%. We have seen this over and over again in the independent electricity production business where there are "take or pay" contracts that are supposedly ironclad but the taker walks away when they perceive a price collapse in the works.

I have no opinion one way or the other but they parlayed a $57ml spend on equipment into a market cap of 10x that amount . . . tough to sustain in a near commodity biz.

GLTA. No position.

[kevin lemm]

I am by no means an expert on stock evaluation but it seems there is more to the company US Silica Holdings, Inc. than its substantial supply of sand proppants. The Company operates in two segments: oil and gas, and industrial and specialty products. The Company's shipping capabilities include five of the class-one railroads, barge, full truckload, partial truckload and intermodal. The Company's products include proppants, whole grain silica, ground silica, fine ground silica, testing silica, recreational silica, aplite, kaolin, hydrous kaolin and FLORISIL. It also operates as a research and development specialist for customized products and solutions. The Company serves a range of industries and applications, which includes oil and gas, glass, chemicals, foundry, building products, fillers and extenders, recreation, industrial filtration and treatment, and testing and analysis. Second quarter Industrial and Specialty Products segment revenues were $50.1 million, a year-over-year increase of approximately 4%. The ISP segment sold 1,098,000 tons. The ISP business segment represents the heritage of U.S. Silica and provides the Company a balanced portfolio of markets and customers. The ISP segment has more than 1,400 customers, produces over 200 products to such diverse end-markets as glass containers, flat glass, paint, chemicals and electronics. In addition to the Industrial and Specialty Products segment, this century old company is well positioned to address the growing demand for proppants used by the oil industry, both in the inventory of sand but also in the important logistics. This is the type of company that you can invest in and feel confident in buying more shares when the price dips. I like this company and will continue to invest at every opportunity.

[Tony Petroski]

You should have covered your SLCA short at $9.50 unless you can make the case they're heading for fifty cents.

I agree with earlier commenters and sand production is ramping up in Minnesota as well.

On the other hand, "fracking" is replacing "nuclear" (or as Jimmy Carter and George W. used to say, "nuculer") as the latest bell ring for our environmental Pavlovian dogs, so expect protests which will slow supply and add costs.

"Beware of the advice and research given out for free."
-- Yogi Buffett

[glenwpeterson]

SUPPLY TRENDS
HCLP believes that while demand for raw frac sand has increased dramatically in recent years, the supply of raw frac sand has failed to keep pace, resulting in a supply-demand disparity.

While existing and new competitors have announced supply expansions and greenfield projects, HCLP does not expect the magnitude of these expansions to meet expected demand, for several reasons:

Difficulty of finding frac sand reserves that meet API (American Petroleum Institute) specifications;
Difficulty of securing contiguous frac sand reserves large enough to justify the capital investment required to develop a processing facility;
Challenges of identifying reserves with the above characteristics that either are located in close proximity to oil and natural gas reservoirs or have rail access needed for low-cost transportation to major shale basins;
Hurdles of securing mining, production, water, air, refuse and other federal, state and local operating permits from the proper authorities;
Local opposition to development of facilities, especially those that require the use of on-road transportation, including moratoria on raw frac sand facilities in multiple counties in Wisconsin which hold potential sand reserves; and
Long lead time required to design and construct sand processing facilities that can efficiently process large quantities of high quality frac sand

[Robin Heiderscheit]

wow . . . not one or two or three but FOUR comments . . . I'm guessing you are long and in love with your pick!

my main concern were I long would be that something they invested $57ml in was sold for 10x that to the me, the public

[glenwpeterson]

I do give the author credit though for not being short HCLP.....$1.90 divy kind of a big hurdle to wanna overcome with a short position and average contract lengths as far as the eye can see.....I could care less about U.S. Silica.....good luck with that one.....

[glenwpeterson]

Author conveniently forgets to mention that HCLPS contracts are also "take or pay" meaning for the average life of the contract that companies are already 80% locked in for an average of 4.7 years. Only reason it is not 100% is that they keep a 3 month inventory to make sure they can deliver or they also are penalized....does that sound like something that is that easy to mine and process....problems with mining are endless related to equipment .....ah, sand is tough n mining equipment and....here' a news flash, mining equipment breaks....This is a classic hack job by a hedge fund short the stock that is trying to make a quick buck...HCLP rail head also a big advantage over expensive trucking...huge advantage over trucking....These guys calling this research are simply pounding sand if you ask me.....

[glenwpeterson]

Pure self serving crapola.....HCLPs contracts average 4.7 years....and new mines that are permitted are being stopped due to environmental concerns and excessive truck traffic...makes HCLPs mine even more valuable to not have to Truck....magnitude of the growth of the industry is just beginning...12% is just the tip of thei iceberg as more companies look for cheaper proppaants like sand....somebody tried this tactic with STB, publish negative article while short......works for about a day....

[bd4uandu]

I am sad to see Wisconsin getting all of the fracking action. Here in the peoples republic of Minnesota they were mining sand deposits in the southeastern part of the state but the community didn't like all of the disruption of commerce and so it goes. Southeastern Minnesota and southwestern Wisconsin have huge deposits of perfect fracking sand.

[Robin Heiderscheit]

Thanks for the heads up. I was circling HCLP. Those economics you describe are way too good to last very long. Good job.