You don't think of a silica miner as somehow at the heart of the new oil and gas boom, but it's actually the case...and this one is in prime position to make a big move in coming years, writes Elliott Gue of The Energy Strategist.
With development in liquids-rich shale plays expected to continue apace, the market for proppant—sand or ceramic material that props open the fracture reservoir rock—will tighten even further.
US Silica (SLCA) is the second-largest producer of commercial-grade silica (quartz sand) in the US. The company produces its silica by extracting quartz from open-pit mines and crushing and processing the mineral into sand.
The primary end markets for commercial silica include the oil and gas production industry, glassmaking, building products, and the metal foundry industry. In many of these end markets, there are few, if any, substitutes for commercial-grade silica because of its resistance to crushing and other difficult-to-replicate qualities.
The dynamics of silica demand have changed dramatically in recent years. As recently as 2004, industrial processes such as the manufacture of glass, building materials, and metal castings accounted for almost 88% of silica demand. Today, the energy industry is the largest single end market for silica, and this growth trend should continue in coming years.
This paradigm shift in silica demand stems from the rapid development of shale oil and gas plays. Producers mix either silica sand, resin-coated sand, or ceramic material into the fracturing fluid to act serve as a proppant. The material enters the fissures created during the hydraulic fracturing process and literally props them open so that these cracks don’t close up once the pressure is removed.
Producers must use sand that meets certain standards set by the American Petroleum Institute (API) for shape, size, and resistance to crushing. The most common proppant used in the oil and gas industry is API-grade silica sand, which accounts for about 80% of the market.
Meanwhile, resin-coated sand—silica sand coated with a resin to makes it smoother and more crush-resistant—accounts for another 10% of the market. Ceramic proppant manufactured by firms such as CARBO Ceramics (CRR) is more expensive, and accounts for the remaining 10% of the market.
The US horizontal rig count serves as a good gauge of demand for commercial-grade silica. Horizontal drilling is one of the key innovations that enable producers to unlock the hydrocarbons trapped in low-permeability formations. By drilling laterally off a vertical shaft, producers expose the well to more of the productive layers.
Over the past three years, the US horizontal rig count has soared to more than 1,150 units in early 2012, from a low of 372 rigs, a trend that reflects the frenzied development of shale oil and gas plays.
Shares of US Silica have slumped from a high of almost $22 to less than their IPO price because of concerns that drilling activity will diminish this year. We expect the US rig count to hold steady or increase by 5% in 2012, as producers shift their emphasis from dry-gas fields to liquids-rich plays.
But the rig count alone isn’t the only driver of proppant demand. As operators gain experience in the major shale plays and better understand the geology, they grow more efficient and can drill more wells with the same or fewer rigs. Even with a flat rig count, producers may drill more wells.
Producers now drill longer horizontal segments for their wells. A few years ago, a producer might have drilled a 5,000-foot horizontal well; today, lateral segments often exceed 10,000 feet.
Longer wells involve more fracturing stages, which translates into more proppant per well. The industry has also found that increasing the amount of proppant used to complete each fracturing stage yields superior initial production rates and overall productivity.
In addition to rising demand, US Silica benefits from certain company-specific advantages.
First, the company has a total of 316 million tons of silica sand reserves, about 148 million tons of which should qualify as API grade. In addition, the firm benefits from some of the lowest production costs in the US.
The company’s reserves are located near key rail links, which reduces transportation time and costs—a distinct advantage and a major cost center for some competitors. US Silica believes it’s the only proppant producer capable of delivering its product to all the major shale fields in the US.
Moreover, investors must consider the type of proppant the company can produce. As a rule of thumb, dry natural gas fields are located further underground, where temperatures and geologic pressures are intense. (That’s why exploration and production companies sometimes refer to a field being “too cooked” to produce oil). Oil- and liquids-rich plays, on the other hand, are often located at shallower depths and under less extreme pressures and temperatures.
Ceramic proppant resists crushing better than sand, but it’s also more expensive. Historically, producers have opted for ceramic proppant in deep-lying gas formations that contain little or no natural gas liquids (NGL).
However, with natural gas prices at depressed levels, many producers have decided not to pay up for ceramic proppant even if it leads to better production rates. These trends, coupled with a shift in drilling activity from dry-gas fields to liquids-rich plays, explains why shares of CARBO Ceramics have lagged over the past year.
Since US Silica produces silica sand proppant and will launch a resin-coated variety, the company stands to benefits from the shift away from dry-gas fields and ceramic proppant.
In addition, not all sand is identical. US Silica’s coarse, white Ottawa sand is best-suited for formations that contain oil and NGLs, while finer, brown sands are the proppant of choice for budget-minded producers targeting natural gas. As drilling activity in liquids-rich plays continues to accelerate, demand for US Silica’s wares should grow significantly.
The supply side of the equation should also support higher prices for US Silica’s output. During the financial crisis and Great Recession, traditional industrial demand for silica sand contracted to 19.1 million tons in 2009 from 28.8 million tons in 2006.
Although the oil and gas industry’s demand for silica sand increased over this period, the market remained oversupplied. As a result of the decline in overall demand, producers curtailed investments in new supply.
It’s not a simple matter to increase silica sand production. It can take 12 months or longer to find an appropriate deposit, one to three years to obtain the necessary permitting from the government, and two to three years to site and build mining, processing, and transportation infrastructure. Two to three years would be the minimum time frame to bring a greenfield silica project online.
As demand surged in 2011 and into early 2012, supply growth has remained sluggish because of a lack of investment. However, US Silica has expanded its capacity to produce silica sand significantly. In 2011, the firm completed a project that increased the annual production capacity of its Ottawa, Ill., operation by 1.2 million tons, and expanded a plant in Michigan.
To fund these endeavors, the company signed take-or-pay contracts with customers that guarantee minimum cash payments regardless of whether the silica sand is used. As both facilities produce the coarse, white sand used in liquids-rich fields, this material will likely be in high demand.
US Silica will launch a line of resin-coated sand once the firm completes a plant in Illinois that’s capable of producing about 200,000 tons of the proppant. Management expects this facility to be up and running in 2013. The company has also identified additional brownfield expansion projects at its existing facilities that could add incremental capacity.
Longer-term production growth could come from reserves acquired in Wisconsin. The company expects to complete construction on a production plant by the end of 2013 and to start churning out silica sand in 2014. Management expects this facility to produce about 500,000 tons of proppant per annum.
In 2009, the oil and gas industry accounted for only 19% of the company’s sales, compared to about 36% in 2011. Management estimates that energy companies will generate two-thirds of the firm’s sales by the end of 2013. Spot silica sand prices have surged over the past two years, and with demand expected to increase at an annualized rate of 15% through 2014, prices have room to grow.
And even if spot prices remain flat, US Silica will reap the rewards as supply contracts signed in 2008-2009 roll off and are replaced with deals that feature more lucrative terms.
Shares of US Silica trade at roughly 11 times projected 2012 earnings, while CARBO Ceramics’ stock fetches more than 13 times forward earnings—a huge disparity when you consider US Silica’s superior growth prospects and that the company has the potential to grow its earnings at an average annualized rate of 30% to 40%.
With North America-focused services firms struggling to secure sufficient proppant to meet demand and drilling in liquids-rich shale plays accelerating, US Silica’s growing production makes the stock a buy up to $19.50.
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