America's ongoing shale energy boom has disproportionately favored a handful of states over others. Investors could likely identify Texas and North Dakota as leading energy-producing states, which is owed to shale formations such as the Eagle Ford and Permian in the former and the Bakken in the latter. In fact, they're the top two oil-producing states in the country at 3.9 million barrels per day (bpd) and 540,000 bpd, respectively. Shale crude accounts for 75% and 93% of their respective output.
But the third-leading crude oil producer might surprise most energy investors. It's not Oklahoma or Colorado, or even Alaska, but the sparsely populated state of New Mexico. The state's rise into the top three was made possible thanks to it hosting a large swath of the Permian Basin and a simple resource that's often taken for granted: water. Companies operating there will need a lot more to responsibly increase crude oil output as planned.
That creates an intriguing opportunity for an unlikely company that calls the state home: fertilizer producer Intrepid Potash (IPI -2.45%). Here's why investors are hoping it can cash in on the water requirements of shale energy production on, so far, the New Mexico side of the Permian Basin -- and what needs to happen to make the struggling stock a buy.
Can Intrepid Potash boost New Mexico's crude oil output?
While fracking has long been associated with water consumption for all the wrong reasons, the geology of each energy basin is a major determinant of how water is used, and how much. New Mexico's unique rock formations and salt deposits mean shale oil production there comes with some unique regulations, while the general scarcity of water forces local and state government officials to strike a balance between energy riches and water conservation.
The opportunity to supply water to energy companies essentially fell into Intrepid Potash's lap. The fertilizer producer controls mining rights on nearly 138,000 acres of land around Carlsbad, New Mexico. It's not just close to oil-drilling activities -- the company's fertilizer mines are literally part of the Permian Basin (the region's unique salt deposits are mostly potassium salts, otherwise known as potash). In fact, due to government requirements to maintain a buffer zone around oil and gas wells, SEC filings include a risk factor for the potential impairment of potash reserves that may be trapped in the buffer zone, however unlikely.
Where does water come into the picture? Well, Intrepid Potash has relied on solar evaporation ponds to produce potash, and it fully transitioned to the production method in 2017. It works exactly as it sounds: Potash-containing brine is pumped into large surface ponds where the sun evaporates most of the water, leaving behind a concentrate that can be processed into multiple products including fertilizer, industrial salts, and brine. It's an inherently low-cost production method, which helped the company to greatly improve operating margins last year.
Solar evaporation also requires large volumes of water, which pushed the company to secure water rights in New Mexico and nearby Utah. That's now resulting in a nearly too-good-to-be-true opportunity for Intrepid Potash.
The company's core operations have continued to struggle through the prolonged rut in the global fertilizer market. However, the business sharply reduced its operating loss to just $14.4 million in 2017, compared to $57.7 million in 2016. That should continue to improve thanks to increased potash output from low-cost solar evaporation and improving selling prices in early 2018. But water sales alone might come close to delivering profitable operations.
Management thinks the company could generate $20 million to $30 million from water sales to oil companies in 2018. Nearly $15 million of that annual total is already baked in from a recently commenced five-year agreement, while the run rate could increase in future years. Considering water sales are accompanied by 90% margins, just hitting the low end of water revenue guidance could result in $18 million in operating income this year, compared to just $6.3 million in water profits in 2017.
It gets even better. While fracking requires water, fracking in New Mexico requires water and lots of brine. That's because certain portions of well shafts drilled through the Permian Basin's salt formations would collapse if non-salty water was used during the drilling process.
Luckily, Intrepid Potash produces plenty of brine as a byproduct from its solar evaporation methods, which is also being sold to energy companies purchasing water from the fertilizer producer. Not only does that have the potential to provide incremental revenue (recorded as a credit to cost of goods sold in the potash segment) in addition to water sales, but it increases the company's stickiness to oil drilling customers that would rather deal with one supplier for their water and brine needs.
Water is key for Intrepid Potash stock
Intrepid Potash made a lot of progress strengthening its business in 2017. Efforts to clean up the balance sheet, reduce operating expenses, and diversify revenue could finally allow shareholders to enjoy a rising stock price and profitable operations. While last year demonstrated that even the most efficient production systems need fertilizer selling prices to cooperate in order to deliver profits, injecting water sales into the equation could change the calculus for investors.
If Intrepid Potash can meet or exceed its expectations for high-margin water sales beginning in 2018, then it could be enough to provide a comfortable hedge against the volatility of the fertilizer markets. That said, it's important to remember that this is still predominantly a fertilizer stock, and the fertilizer market continues to face sizable headwinds. For now, I think investors need to continue to take a "show me" approach, although that could change depending on how things develop in New Mexico's Permian Basin this year.