Monday, August 22, 2011

Carbo Ceramics (NYSE — CRR) -- Bridging the Gap

There is a sizeable gap between current energy and the renewable sources that aim to one day replace them. Wind and solar power don’t produce harmful byproducts, but the cost is much higher than fossil fuels, even with government incentives in some countries. Natural gas is a cheaper, cleaner alternative to oil and coal, respectively. Huge deposits found in shale rock around the world have led many to believe that natural gas can bridge the energy gap.

Carbo Ceramics (NYSE: CRR $130.00) is the leading provider of ceramic proppants used in hydraulic fracturing (“fracking”), the technique used in shale rock gas and oil drilling. Wells are typically drilled 8,000 feet down, and then another 6,000 feet horizontally. Charges are used to break apart the rock. Then water, chemicals and proppant are pumped in under high pressure to further break apart the rock and release the gas or oil. As the water is pumped out, the proppant remains to keep the shale open and allow the raw fuel to escape back up the pipe.

The company offers three primary types of proppant: sand, ceramic and resin-coated versions the two. Sand is the cheapest and most commonly used; ceramic is more expensive up front, but used in the right situation it yields more gas and thus more cash flow. The resin-coated proppant is used in scenarios that risk proppants flowing back up the well and interfering with machinery.

Since demand for Carbo’s products depends on demand for gas and oil, we’ll take a look at that first, concentrating on gas. George Mitchell, CEO of Mitchell Energy, developed hydraulic fracturing during the 1980s and 1990s, and it has become the standard for shale rock drilling. Shale gas deposits have been found in the United States from New York to Texas, and large caches of natural gas are presumed to exist in China, Australia, India and in parts of Europe. One reserve, in the Marcellus shale below New York, Pennsylvania and West Virginia, is thought to contain 262 trillion cubic feet (TCF) of natural gas – the U.S. uses 20TCF annually. Natural gas deposits in the U.S. could satiate our current usage rate for the next 30-40 years. This would give renewable energy solutions more R&D time while curbing American dependency on foreign fuel.

Natural gas prices have fallen 69% since July 2008. The fuel traded at $13.69 per million British thermal units (MMBtu) then, and now goes for $4.18 per MMBtu. Prices sunk as low as $2.41 per MMBtu in September 2009. Prices for natural gas heating have decreased as well, far below oil and propane.

Increased natural gas mining, production and use could reduce political leverage now held by OPEC members. Disputes led Russia to cut off natural gas supplies to Ukraine in 2006 and 2007, which also stopped supply to parts of Western Europe in the middle of winter. Ukraine, in turn, altered its foreign policy to placate the Russians enough to open the gas line again. Since then, Europe has stepped in to purchase Qatari liquid natural gas in an effort to rid its dependency on strong-arming nations like Russia and Iran.

Prices for drillable land are skyrocketing. Indian company Reliance paid $14,000 per acre for drilling rights outside of Pittsburgh, a price some say is a bargain. Range Resources CEO John Pinkerton said he wouldn’t have sold for anything less than four times that amount. Royalties paid to private land owners are also surging – some see as much as $1,750 a day. While many relish the added income, others fret over the environmental repercussions of fracking.

Shale drilling runs the risk of contaminating water supplies. This risk led former New York Governor David Paterson to sign a bill last December banning shale drilling statewide until July 1. A bill from the state legislature that would have halted fracking altogether was vetoed by Paterson. New York City Mayor Michael Bloomberg helped push the bill through. The entire city’s water supply comes from a watershed in the Marcellus Shale – contamination would have a chaotic effect and it’s not worth the risk, Bloomberg argued. The moratorium has been lifted for most of the shale (excluding around the NYC supply), though a regulatory review must be completed before drilling resumes.

The wells are reinforced by concrete to prevent seepage into the water table, but this measure has not proved failsafe. Eighty-two tons of chemicals are used on average for each well in the fracturing process. Outside of Dish, Texas, levels of a labeled carcinogen, benzene, were found at 10,700 times the safe long-term exposure level because a valve was left open.

In November 2009, 32 Dimock, Pennsylvania residents filed suit against Cabot Corp. for negligence in its drilling operations after methane and other pollutants entered the water supply. New York Attorney General Eric Schneiderman subpoenaed three drilling companies (believed to be Cabot, Range and Goodrich Petroleum) on August 8 to investigate whether the companies truthfully reported the life spans and profitability of their wells. The subpoenas were issued under New York’s Martin Act, meaning intent is not necessary to prosecute fraud. But there may be too much on the line for shale gas to get shut down entirely. The harvesting of other fossil fuels has similar dangers to the environment. Sooner or later, New York will likely hop on board.

Carbo’s results have surged over the past two years along with the industry’s expansion. Revenue for 2011 is estimated at $575m-$600m, with an EPS of $5.50-$5.75. A new plant opening in the fourth quarter is expected to boost revenue about $25m per quarter. Next year, revenue could rise to $750-$800m as additional production facilities come on line. The company held $53.3m in cash at the end of the last period, and no outstanding debt.

The short term outlook for the company is filled with risk. Carbo’s fortunes will follow the drilling industry’s over the next several years. If environmental concerns continue to crop up, short term sales could be adversely affected. The current low price of gas makes drilling uneconomical for many companies too. Coal is still the primary source of power in the U.S., so switching to natural gas will take yet more time and money for those companies. The current economic conditions could also dampen natural gas demand. Natural gas may be a cheaper, cleaner alternative as is, but new plants need to be built to fully utilize it.

Two buyers accounted for 53% of Carbo’s revenues last year. These companies then sell to a far greater number of end users. If these customers become dissatisfied with Carbo’s products, or if a competitor develops a superior product, sales would likely suffer. There are several direct competitors worldwide, most notably French company Saint-Gobain Proppants and Mineracao Curimbaba in Brazil. Several of Carbo’s key patents expired recently, allowing more opposition to enter this increasingly cutthroat market.

The long term outlook is more promising. There is too much money on the line for shale gas to fail. Eventually, today’s environmental concerns are likely to be satisfied. But that could be years away. In the meantime the stock is priced for perfection. Any bumps in the road could provoke painful selloffs. Still, the stock offers worthwhile performance for investors who can tolerate the risks. Income could achieve $12.50 a share within 2-3 years. Applying a P/E multiple of 20x to those earnings suggests a target price of $250 a share, potential appreciation of 93% from the current quote. Carbo is located in Houston, TX.

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