After several quarters in a row of heavy losses and an overall feeling that the frack sand industry was a bust, U.S. Silica Holdings (NYSE:SLCA) finally turned things around last quarter with its first profitable quarter in a long time. That's great news for investors now, but U.S. Silica's management thinks there is much more in store for the rest of the year.
Here are several quotes from the company's most recent conference call that explain the fantastic opportunity in front of these frack sand producers, the challenges they will face to meet that opportunity, and what investors should be watching in the coming quarters from U.S. Silica and the industry in general
Demand growth coming down the pipe
I don't think I'm the only one who has thought this, but the rebound in shale drilling in the U.S. has been nothing short of spectacular. This time last year was the nadir for total active rigs at less than 400. Since then, Baker Hughes' weekly total active rig count has more than doubled to just over 900. For U.S. Silica and other frack sand producers, that has translated into incredible demand growth.
According to CEO Bryan Shinn, though, we're still in the early innings of shale's post-crash growth.
We believe our industry will remain tight in the near future due to 3 main factors: First, our industry must add capacity to meet customers' needs. Our internal estimates and current sell side reports estimate industry sand proppant demand to be about 75 million tons here in 2017, growing to over 100 million tons in 2018, with some estimates as high as 147 million tons. Our industry will be short capacity and we cannot let sand become the bottleneck for the completions industry.
We're short on capacity
The frack sand business isn't as simple as it sounds. Sure, it's selling a rather raw commodity, but you can't just scoop up sand with an excavator and dump it in a rail car. One thing that producers are particular about today, for example, is mesh size -- a measure of sand grain size. The higher the number, the finer the sand. According to Shinn, demand for more smaller grains means that the overall production capacity of the industry doesn't reflect the amount of sand that can be delivered to customers, and that means the industry is well short on supply.
[O]il sand is not fungible within that 100-million-plus tons of projected 2018 demand. Unlike many industrial products, there is a lot of friction in the sand market for a variety of reasons, including logistics, quality differences and mesh sizes. Therefore, we're on average to see 20% to 25% more total supply than demand before our markets come into balance. So for example, if 2018 demand is 110 million tons, that implies that supply and demand balance around 135 million tons of effective capacity. Today, even after estimated reactivations of idle capacity, our industry will only have approximately 90 million tons of effective capacity, thus leaving a 45-million-ton shortfall versus projected 2018 needs.
[E]ven all the likely capacity additions that are being talked about are not enough. We think there could be an additional 10 million to 15 million tons of brownfield capacity added in the next 12 to 18 months, including our own expansions and perhaps as much as 20 million to 25 million tons of greenfield capacity being added locally in the Permian. All of which will be needed, if current demand estimates prove accurate. Even if our estimated 35 million tons of potential brownfield and greenfield additions come online, the market will still be short.
There is one reason why investors should care about this supply issue: price. If effective capacity is still below total demand, then sand suppliers should have strong pricing power over oil and gas producers.
Changing our customer relationships
Oil and gas producers aren't naive. They see this effective capacity vs. total capacity dynamic playing out and the consequences for prices down the road. So U.S. Silica is taking advantage of this situation by changing its contract structure with customers. Here's Shinn on the changes.
[C]ustomers do come in to us to lock in sand supply for the next 3 to 5 years. We're using these discussions to form deeper relationships with the companies that we expect to be the long-term winners. We're also working on the next generation of agreements that can better weather the cycle, both for our customers and for U.S. Silica. And... rapid growth in proppant demand represents a massive opportunity for [U.S. Silica's logistics service] Sandbox. Keep in mind that this new local sand phenomenon is not just an opportunity for U.S. Silica to substantially increase sand sales. All this new capacity has to get to the wellhead and we believe that Sandbox is the ideal delivery solution with an unmatched combination of flexibility, efficiency, and scalability.
While U.S. Silica's Sandbox logistics service can increase margins on per ton sold. Investors should be most pleased with the idea that customers are lining up to sign 3 to 5 year supply contracts. The idea of having volumes and prices locked in for several years should make U.S. Silica a much more stable company over the long haul.
New investment paying off
U.S. Silica's management believes that the future of its business is supplying both the sand and the transportation & logistics associated with that sand. That's why it bought logistics specialist Sandbox during the downturn and is investing heavily in expanding that business today. According to Shinn, management is already quite pleased with the results and plans to spend even more on this service throughout the year.
We also saw very strong growth in both volumes and profitability at Sandbox. In Q1, loads shipped were up 84% sequentially. We now have almost 40 active crews across the major basins and are well on our way to doubling that number by the end of this year.
A bottleneck coming for the North American oil industry?
For all the good news in the American oil and gas business today, Shinn did give a word of caution. Growth rates this high can be great, but eventually, they start to expose cracks in the value chain.
It seems like there are just not enough frac crew horsepower and other services out there right now. And so I think that it's a great opportunity for our service company customers as things starts to catch up a bit here, where we've -- as we've seen the ducts go up, there could be a surge coming. And I think that's the good news. The bad news is it's going to stress everybody's supply chains again, and I think that could lead us into another round of substantial pricing increase as well. So we'll see how that plays out.
Exploration & production at the $50 a barrel range is the equivalent of walking a tightrope for producers. Many can grow production at today's prices, but that is predicated on lower prices for oil services and commodities like sand. If the industry grows too fast and puts pricing pressure on one component, then well economics could take a turn for the worst rather quickly. Investors should keep an eye on this dynamic in the coming quarters. If we see a quick rise in sand prices or a logistics bottleneck, the industry could be headed for a rapid deceleration.
What a Fool believes
I could be wrong, but it's looking more and more that frack sand is the current pressure point in the North American oil and gas market today. Many oil services companies still have lots of idle drilling rigs and pressure pumping equipment to put into the field, but frack sand suppliers are bringing unused production capacity back online at a breakneck pace. It will take a monumental amount of effort from U.S. Silica and its peers to expand capacity beyond its idle capacity and some brownfield expansion projects.
Investors in U.S. Silica will want to watch two things in the coming quarters: New production capacity and margins. The company's Sandbox service revenue is baked into its sand pricing, so higher margins is a sign that it is making headway with these logistics investments. New production capacity is all about keeping up with what has the potential to be a booming industry for the next year or two.