The state of the frac-sand industry
I recently published a write-up of Select Sands Corp., a frac-sand producer trading over the counter that makes up a large percentage holding in Greystone’s portfolio.
The full write-up is lengthy, and can be viewed here, but for the sake of reader’s attention spans, I shortened considerably the analysis for the previous post, and tried to focus on the key aspects of what will drive the investment thesis forward.
One section I left out for the sake of brevity was the due diligence I conducted surrounding Select’s competitors. While reading competitor annual reports and conference call transcripts, I was able to gain a very clear understanding of the state of the frac-sand industry, and where incumbents find themselves in terms of the demand picture, pricing environment, and outlook for the next few years. Since commodity-related businesses depend so much on favorable supply/demand dynamics, it was incredibly important to get a sense of where we currently stand on both of those fronts as it relates to frac-sand. As a result, I wanted to include my findings in a separate post as what I found is incredibly relevant to the investment opportunity.
According to Select’s competitors, it appears as though additional capacity is needed for both Northern White and in-basin brown sand, pricing increases should continue at a minimum of mid-single digits, demand is high across all of the major basins, and the 2-3 year outlook is favorable given supply constraints and the increased amount of proppant being used per well. Select’s competitors are spending on capex, capacity build-outs, and acquisitions, gearing up to meet continued demand for their product. Eventually we will reach a point in the cycle where all of this additional supply will lead to a drop in prices, but it appears that we are years away from that scenario and the favorable dynamics should benefit Select over the next 12-18 months.
Select competes with a variety of publicly traded frac-sand companies, in addition to private companies, new sand ventures, and companies that mine/ship frac sand as one of their business segments (non-pure play). My focus for this section pertains mostly to Select’s publicly traded peers consisting of US Silica, Hi-Crush Partners, Smart Sand and newly formed Covia (Fairmount Santrol and Unimin). My goal for this section is to try and paint a picture of Select Sands peer valuations, what other management teams are seeing throughout the industry (commentary) and what the environment looks like in terms of pricing. Of note, Select is the smallest of all of the other businesses, and has the shortest operating history.
The frac sand industry is represented by several public companies: Smart Sand (SND), Hi-Crush Partners (HCLP), U.S. Silica (SLCA), Covia (CVIA) and Emerge Energy Services (EMES). Also, there are new entrants into the market, including emerging companies like Select Sands.
Wisconsin, has traditionally been considered the dominant market for the production of frac-sand. Wisconsin’s 44 active mines account for nearly half the nation’s total installed frac sand capacity, according to Thomas P. Jacob, a senior research analyst in IHS Markit’s upstream research division. In the realm of frac sand mining, the Badger State is undisputed king. The quartz-rich northern white sand sourced within its borders–and to a much lesser degree, neighboring Minnesota and Illinois–has long demanded a premium price in shale plays. It’s physical properties make northern white ideal for mining.
At any point in time, odds are that unit trains being loaded with Northern White at central Wisconsin mining facilities are destined to ride the rails for the long haul south to the Permian Basin, which is far and away the biggest frac sand consuming market.
Recently there has been an explosion in the mining and use of what’s known as ‘in-basin’ brown sand, coming directly from the major oil and gas basins in Texas, due to the superior geographical location (although inferior quality). There has been much talk about, and research devoted to the use of cheaper, more convenient Texas sand that is being used as a cheap replacement for northern white and other types of higher quality product.
To streamline supply-side logistics and reduce delivered costs, a long list of companies are working to make West Texas a new frac sand supply epicenter by opening mines right in the backyard of North America’s hottest horizontal resource plays. IHS Markit counts 17 active brown sand mines in operation across Texas (mostly in East and South Texas), but has identified a roughly equal number of new in-basin mines that have been announced within the greater Permian’s central basin platform that separates the Delaware and Midland sub-basins.
In an excellent article arguing against the ‘short frac sand’ thesis, SA author Paul Santos describes many of the key quality differences between brown ‘in-basin’ sand and northern white. While I won’t repeat what was already researched and written, the quality and characteristics of Northern White remain far superior to any other sand found around the US. Investors can read the article and learn more by visiting the link above, as well as going through some of Select’s competitor conference calls, where major differences between the two types of sand are outlined. These differences include things like crush strength, solubility, the presence of dirt, mud and rocks, over-estimation of capacity, and various other critical differences.
I also wanted to include a snapshot of industry data made up of hours per mine for various Select competitors, as well as some Q1 2018 EBITDA and tonnage estimates to give an idea of what’s taking place across the industry as it relates to each specific mine, and where each company fares in terms of capacity.
As mentioned above, in-basin production has seen significant increases in capacity, greenfield expansion, hours worked and sand mined.
Hours for certain in basin mines improved significantly, however it remains unclear whether the majority of mines produced consequential volumes during Q1, and again, the quality of sand is far inferior to Northern White supply.
There has been enough written research about Select Sand’s competitors including the frac-sand players that I’m covering in this section, so I won’t dive too deep into each business, as many have done a much better job than I could. Instead, I’ll try to cover a few key aspects including industry commentary from each, info about pricing, the demand outlook, and any relevant Q1 conference call highlights from each company.
I’m not a huge fan of EBITDA multiples (given different capital structures and capex needs from company to company) but they can provide an ‘equal footing’ to examine cash flows across Select’s competitors. However it’s important to note that one thing we don’t see with Select that nearly all of their competitors are facing include high amounts of capex, high cost of production, transportation bottlenecks, high debt levels, and acquisitions to streamline operations and build out more capacity. The high capital expenditures per year make a meaningful difference when evaluating free cash flow and earnings between each business. In going through the quotes below, a few things were made very clear:
Pricing is strong and increasing across the board
Demand continues to escalate given more proppant being used per well and some logistics constraints
Outlook appears favorable for 2018 and 2019
Many Northern White producers are sold out, or can’t fill demand fast enough
Hi-Crush Partners (HCLP)
Given the energy industry’s outlook for 2018 activity levels, we expect well completion activity to continue to improve over the next several quarters, which, coupled with higher usage of frac sand per well, should result in an increased positive influence on demand for raw frac sand. Supply of frac sand is expected to increase in 2018 as development of new Permian Basin production facilities are completed and ramp up operations. However, we believe this new supply will lag further increases in demand, presenting continued positive impact on supply and demand dynamics, and therefore potentially preserving a constructive environment for pricing stability or improvement.
Over the last few months, differing strategies have been evident in the frac sand sector. This includes a series of transactions that indicate a diversification away from the energy industry, a diminished focus on the proppant market, sales of terminal assets and varying degrees of participation in the last mile. In contrast, this is where we’re firmly committed and investing. We are confident in and proud of our position as a dedicated provider of frac sand supply and logistics. And this is for good reason. The fundamentals of our industry remain strong and continue to strengthen, including further increases in demand for both Northern White and in-basin Permian sand. These strong fundamentals, attributable to longer laterals, more proppant per lateral foot and continued emphasis on slickwater completions, among other factors, indicate healthy demand growth for frac sand over the next several years.
In 2017, several new and existing suppliers announced planned capacity additions of frac sand supply, particularly in the Permian Basin. We expect frac sand supply to lag growth in demand over the coming months and quarters. While planned capacity may exceed the expectations for frac sand demand, the collectively available industry capacity is constrained due to 1) availability of the grades of sand that are currently in demand, 2) general operating conditions and normal downtime and 3) logistics constraints. The industry is expected to add capacity over the next 12 to 18 months, particularly in the Permian Basin; however, we do not expect such supply to be available in the volume grades or timeframe needed to efficiently meet the increasing demand. The advent of “In-Basin” sand supply available closer to the wellsite in the Permian Basin may cause a shift in supply over time from Northern White sand to In-Basin sand supply. However, we believe this shift will be specific to finer mesh sizes of sand, particularly 100 mesh which is the principal grade produced in-basin. Northern White supply of 100 mesh is likely to shift to meet the demand for sand in other basins, with other grades of Northern White continuing to find a market in the Permian Basin. While these shifts may cause periodic mismatches of supply and demand in particular basins, we do not believe there will be a long-term oversupply of sand given the projections of increasing demand.
Today, Northern White sand remains in high demand across the U.S., including the Permian, which is expected to account for 45% to 50% of total U.S. demand in 2018. In response, the industry has been developing in-basin Permian facilities, which has introduced concerns regarding potential Northern White displacement in the Permian. With the few additional, yet telling months of visibility into these evolving dynamics, we’re more confident than ever in the resiliency of Northern White supply. We reiterate three main factors that support the ongoing near-term and long-term strength in demand for Northern White.
The first factor relates to quality. Operators across the industry still demand large quantities of Northern White for its quality, uniformity of characteristics, and the simple fact that its production effects are well-known and well-documented. We have long been aware of and continue to follow the in-basin sand developments in regions outside the Permian. Based on our own due diligence performed on these deposits, we do not believe many of these reserves meet the quality standards our customers require. We’ve recently heard others in the industry echo this sentiment. This focus on quality will continue to influence adoption and development of in-basin sand and we believe the quality requirements support a strong base load of demand for Northern White.
From the Hi-Crush 10K: No reliable publicized pricing information for raw sand exists.
Moving to pricing, despite the decline in volumes quarter over quarter, pricing at all points of sale increased in the first quarter. The shift to the most profitable points of sale, tightening supply of frac sand, along with improving demand supported this price increase. Average sales price per ton, excluding services revenues, increased to $73 per ton in the first quarter of 2018, compared to $71 per ton in the fourth quarter of 2017 and $60 per ton in the first quarter of 2017. Price increases in the first quarter of 2018 followed the pattern we have been experiencing since late in 2017.
We continue to see negotiated price increases in our market-based Northern White contracts as fundamentals for the industry improve.
Excluding our fixed price contracts for our Kermit production and comparing apples to apples by mesh and location, we saw increased prices in the first quarter of 8% on average over prices realized in the fourth quarter, and in many instances, saw a 10% improvement or better.
…I think around 80% of our Northern White sand, is long term under contract. We have evolved over time to more market-based pricing in those contracts and so we’re able to adjust the pricing as the market is moving.
Q1 2018 Call Highlights
We estimate the reduction in unit train shipments led directly to lost volumes of approximately 450,000 tons to 500,000 tons of frac sand for us during the first quarter. This impacts not just volumes, but also cost efficiencies, as unit train utilization drives delivered cost absorption due to higher volumes per train and lower rail rates as compared to manifest trains. And, of course, the lost volumes increased our production cost per ton.
During the first quarter, our terminal network served as the backbone of our operations. For more than a year, you’ve heard us discuss extensively the importance of our owned and operated terminal network, and the first quarter demonstrated what we’ve long believed to be the significant benefits of this model. Having full control over and flexibility around logistics is a critical component in providing value in any environment, but particularly in the face of operational challenges.
In the second quarter, we expect supply from in-basin Permian mines to total 4 million tons to 6 million tons, including contributions from our Kermit facility. Meanwhile, demand so far this year has exceeded our prior forecast and we now expect realized demand in 2018 to be 110 million tons or more, exiting the year at a higher annualized run rate of 120 million tons as we move into 2019.
In our view, the growth in frac sand demand over the next couple of years will be limited only by factors that govern completions activity: the availability of frac crews, logistics constraints, and hydrocarbon take-away capacity. In the context of this significant increase in demand, Northern White will be essential in meeting the industry’s growing needs.
That was referenced to, really, the demand that we had from our customers for the sand. We certainly had many, many more orders for sand than we could fulfill given the rail issues that we experienced.
Covia (CVIA) is a low-cost provider of sand to Energy (frack sand) and industrial end markets. CVIA is the result of the combination of Fairmount Santrol and Unmin (previously private). The combination put together the first and second largest sand companies to create a behemoth in the space. On the proppant side, once Unimin’s Utica plant expansion has been complete and the company’s two West Texas mines (legacy FMSA Kermit mine and legacy Unimin Crane County mine) and the recently announced Oklahoma mine are up and running, we estimate nameplate capacity at ~37Mtpa (proppant only) with ~2Mtpa tons of coating capacity
The combination of Fairmount and Unimin has brought together the two largest frac-sand companies, with reported capacity on the proppant side of their business at 37mm tons/year with their West Texas and Oklahoma mines up and running. The combined company generates $181 million in gross profit with a broad, geographically diverse asset base.
I don’t yet have information for Covia’s Q1 in terms of management commentary, and will provide any updates in the comments section below. There is a great piece of sell side research initiated by Credit Suisse on Covia, from which I pulled a lot of data.
Smart Sand Inc. (SND)
Yeah, one other thing I would add is that we are essentially are almost doubling our capacity and we have the people in place to run the two new plants. And as we can see of how this sands being made in the Permian it’s just not as easy to gear up and get started for from the ground stop on new plants and you have to bring these people in and train them so. So we’ve done that and the first quarter reflects that cost, but we have to do that because we had to be ready for the plants 4 and 5 which are already making sand.
We’re all analyzing what sand costumers want. We find that many [indiscernible] [0:00:35]want a company that not only provide high quality sand, but can efficiently and cost effectively deliver that sand all the way into the blender at the well site.
Looking back, it was a busy quarter but a good one and a good start to the year. Looking ahead, I continue to see positive trends for our industry. They include increasing demand for frac sand and positive momentum in pricing.
We had our highest quarterly sales volume ever, pricing trends continue to be positive, our average selling price increases by 16% compared to last quarter, demand was up in fact it exceeded supply, and we further expanded our logistics footprint.
We’re gearing up to meet the continually increasing demand especially for Northern White.
As Chuck discussed, we are starting to we’re starting up our expanded capacity as we speak. As with any startup of new facilities, it will take some time to get this capacity fully operational and to start getting the full benefit of the expanded production levels. So while we do anticipate increased sales volumes in the second quarter, we do not expect to start getting the full benefit of our expansion until the third quarter, assuming market conditions and the demand for fracking continue remain at current levels or better.
Average sales price per ton in the first quarter increased 16% to $39.98 per ton versus $34.49 per ton last quarter. The increase an average selling price sequentially was primarily due to higher contracted sales prices which increased partially due to pricing adjustments in our contracted prices for changes in the price of oil and partially due to one contract with invasion pricing, which ramped up sales volumes in the core.
Q1 2018 Call Highlights
As announced previously, we signed 20 year leases on two locations in the Permian basin. These long term leases give us a very economical access to desirable acreage. The upfront cost was low less than $5 million and the minimum royalties are also low. These leases position us to provide sand directly to customers in the Permian in the future.
US Silica (SLCA)
During the quarter, we also announced the sale of three trans-loads located in the Permian, Eagle Ford and Appalachian basins for $75 million in cash. Of the 57 trans-loads that we utilized today, these were the only facilities that we actually owned. Some speculated that this sale was a referendum on the future of Northern White Sand, but nothing could be further from the truth. This was an opportunistic transaction with one of our best logistics partners and a logical extension of our asset-light trans-load strategy, where third party partners invest in infrastructure, thereby allowing us to focus capital on other higher return alternatives.
Labor is certainly an issue out there right now. We’re hiring people as fast as we can, but it seems like for every 10 people we hire, one resigns to go work somewhere else. Unemployment is really low in the Permian.
Look – if you think about this industry, no matter what it is, it seems like there’s a wide spectrum of opinions, and there’s frequently disagreement on almost everything from a technical nature in terms of completion, so I guess we shouldn’t be surprised that there will be disagreement around which types of proppant to use as well.
Based on significant customer interest, we expect continued substantial growth in this business (Sandbox).
Finally, let me provide a market outlook for both our operating segments. In oil and gas, we continue to see strong demand for Northern White, regional and local frac sand. More rigs, longer laterals, more sand pump per foot, and greater rig efficiencies from pad drilling are driving sand volumes per well up and to the right. We estimate that the total frac sand demand run rate today is greater than 100 million tons per year, and we expect demand to ramp throughout the year at a faster pace than capacity additions. Accordingly, we expect the market to remain extremely tight throughout 2018 and into 2019.
As far as the sand supply itself, we’re completely sold out right now. We’re literally selling everything that we can make, and we have had a number of good contracts that we’ve signed over the last several quarters. We’re now, I think, over 30 contracts that we have in oil and gas. As I said in my prepared remarks, we signed a few more in Q1. The thing I really like about our latest generation of contracts is that, as you mentioned in your question, that most of them involve a prepayment from our customers, so I think that gives us a lot more security in that we can take a prorated portion of those prepayments to earnings on a quarterly basis, whether customers buy their volumes or not.
I think generally the market is extremely strong. I would say just looking back over the last eight or nine years that I’ve been in this industry, save for some points in 2014, this is probably the strongest that I’ve seen in terms of demand, and the market is as tight as I’ve seen it in my several years in the industry.
We’re just completely sold out right now, so there really isn’t any more Northern White volume. We’re obviously trying to squeeze everything we can out of mines right now, and sometimes as the weather warms up we can get a few more tons through our facilities; but save for that, we’re already at capacity for Northern White and pushing just absolutely as hard as we can.
…given the projected tight market into the future, several customers have recently approached us about extending and upsizing some of the contracts that we’ve just signed, as well as adding Sandbox delivery services to ensure uninterrupted sand supply. Given these dynamics, we anticipate that our spot pricing will continue to increase in the second quarter at mid-single digit rates, and that some of our contract volumes which are indexed to horizontal rig count will reset to higher pricing as well. Based on customer feedback, we also expect that Northern White sand demand will remain strong through the end of the year.
I would say that most of the contracts that we’ve signed recently are relatively fixed in price. We do have some, maybe 25% I would guess, that are leveraged to rig count, so if we see rig counts go up, we’ll see increases there, and I actually mentioned that in my prepared remarks we expect that most of the contracts that we have that have that type of clause in it will actually move up to the next price tier in the contract, so that should give us a bit of tailwind there.
Q1 2018 Call Highlights and Outlook
We sold a record 3.3 million tons in oil and gas during the quarter despite some extreme winter weather conditions and a sluggish start by some of our oil and gas customers. I’m also pleased to report that due to the breadth and depth of our mine and trans-load network, we were not adversely impacted by the widespread rail disruptions that many in our industry experienced in the first quarter.
On challenges of building out an in-basin mine:
I would say the other thing that is challenging for all of us who are bringing up mines in the his environment is that the deposits are somewhat more difficult. They contain clays and muds and a lot of other things that are difficult to properly process, especially in a low water environment like most of us are running in, in West Texas…
…a very large customer came to us just in the last couple of weeks and said, look, we thought we wanted to use the Permian sand, but the quality there even is not good enough, so they asked if we could sign–or they could sign with us a large Northern White contract. This is a very sophisticated large customer.
A lot of opinions out there. I feel like, though, that as you picked up in your question, generally the quality–as you get further and further afield from the Permian, the quality gets even worse, which is going to limit adoption of those products
Emerge Energy Services (EMES)
In an environment where our peers are experiencing significant new plant construction delays and cost overruns, we have delivered on our word.
We believe that following through is an important competitive advantage, one that has earned us credibility in the eyes of our customers. In turn, customers are rewarding us with new take-or-pay contracts that we expect to cover the entire 2.4 million ton per year of current capacity. While some of the contracts are signed, we’re in the final stages of executing a number of contracts where we have already verbal commitments. Demand for our San Antonio frac sand is so strong that we are targeting a contracted rate of more than 80% of the entire 4 million tons per year capacity under the new NSR permit we expect to receive.
Now, I want to turn to a few key market dynamics that we are witnessing in our industry. Sand demand in the market remains very positive, and demand continues to outstrip supply. We are turning down Northern White orders due to ongoing constraints from the railroads, and customers have been patiently awaiting the start of our new San Antonio plant. Prices, increases materialized in the first quarter as expected, but we sold a higher mix of lower priced coarse grades compared to the fourth quarter. Overall, our average selling price increased by 1%, but if our Northern mix had held constant between quarters, the price increases on the fine grades would have translated into an overall increase of 3% or more.
We and our peers have consistently declared that Northern White sand is not dead, and the evidence to support this view continues to mount. While some operators find in-basin sand acceptable in certain applications or for certain grades, others see the value that high-quality sand brings in their complex well designs.
Because of these longer laterals and the increase in rig count, we think the industry frac sand demand for 2018 will exceed 100 million tons, and several customers are bullish on 2019 industry activity levels, with 15% plus growth projections.
On Northern White demand:
I think we’re certainly sold out, as we said in our prepared remarks. All the Northern White that we can produce and the in-basin sand as well is spoken for. We really are starting to see an uptick in Northern White demand for several reasons. One of them though is the coarse fraction particularly now the increased demand for 30/50 that we’ve seen of late just increases both the potential on pricing as well as the demand for Northern White. There’s been some reports that indicate people are really at the transition point now having looked at in-basin sand and compared it to Northern White. Some are actually going back to Northern White. I’m not saying that’s a widespread trend, but that is happening. And many are looking for a combination of in-based for, say, 100 mesh, and then Northern White for the coarser sand.
For the second quarter, we implemented Northern White price increases for our contracted and spot customers in the range of 3% to 5%. We do not see the tightness in the market slowing down, as many of the in-basin plants continue to fall behind schedule, and the railroads have not fully corrected the service shortfalls. With these challenges, and the record market demand for sand, we are essentially sold out of Northern White and in-basin sand for the remainder of this year and beyond.
That’s very interesting and very helpful insightful color. Maybe one last follow-up, to what extent do the market dynamics that you just mentioned translate into maybe a different contracting strategy. And more broadly, how many tons are currently contracted out committed for 2018-2019. If you could give us a refresher on how you go about contracting your business both in terms of volume commitments, but then also prices. That would be extremely helpful. Thank you.
Well, our Northern White contracts have been in place for a while. We’re continuing to sign contracts for Northern White sand, but those are longer term, anywhere from three to five or six years even in place. Some of those contracts are take-or-pay contracts for Northern White. And we have in the range of 65% to 70% of our Northern White contracted out long-term.
We don’t have a firm projection right now, John. I think a lot of it will depend on what happens. We’re watching West Texas to see what other capacity develops. But I think where we were in a positing thinking that prices will flatten out, now we’re starting to question that. I’m not saying that prices won’t flatten out in the second-half. But with the increased demand that we’ve seen of late for Northern White, and the increased for 30-50 in particular, that’s going to buoy our pricing, and there’s some thought now that we may do a little better in the second-half and simply leave the pricing flat.
Taking a look at Select’s publicly traded competitors, from an PE and EV/EBITDA standpoint, Select trades on the lower end of median multiples for both 2018 and 2019, providing investors with a nice discount to peers on a multiples basis. Covia estimates were the most difficult as I don’t yet know how the company’s cost structure will shake out following the combination of Fairmount and Unimin.
Source: Author Data
It makes sense to apply the usual small company discount to Select given their size and volumes compared to their peers, but I’d argue because of their clean balance sheet, growth profile, margin structure and quality product, applying at least the median multiples for 2019 makes sense (although I still believe they are too conservative). I’d be ok with – and I do so below – applying a multiple to my estimates of Select’s 2019 EBITDA somewhere in the range of 8-10x. Although Select is the smallest of all of the businesses, and has the shortest operating history, I feel Select has one of the best management teams in the business, and a group who is certainly up to the task of delivering shareholder value and seizing the opportunity in front of them. I always place an incredible amount of weight on the abilities, alignment and experience of management teams, but with a commodity-driven, capital-intensive business such as frac-sand mining, being able to get behind a solid management team is paramount to the thesis playing out favorably.
In a commodity-driven business, it’s no secret that the low-cost producer usually wins out, or sets themselves up to earn a majority of the returns or most favorable returns on capital among industry participants. While it’s too early to crown Select the ‘low cost provider’ of frac sand given their reduced volumes versus peers, in modeling each competitors’ cost on a per ton basis, Select appears to win out.
Despite limited tonnage, Select is able to ship product at lower costs than their competitors (and in line with management’s comments during my site visit), which I’m assuming is a function of their geographic location, as well as easily mined sand deposits (don’t have to dig too deep). Of note, the other thing you’ll notice in the above chart is the price at which Select commands for their sand – much lower than peers. From what I understand, Select does not include in their price the cost of shipping/transport while their competitors do. Select’s customers pay the transport costs. In addition, Select is expecting to save around $4 ton in transport costs following the move to their new Independence facility which is closer to the quarry, will combine wet and dry processing equipment, and cut down on miles driven.
Select seems to have a group of very unique assets, a great management team, and is in a great position to capture a chunk of the industry demand moving forward.