Friday, October 28, 2011

Carbo Ceramics ( NYSE - CRR ) -- Shrugs Off Competitive Threat

Carbo Ceramics (CRR $140) reported excellent on target Q3 results.  Sales advanced 41% to $167.1 million.  Earnings climbed 81% to $1.61 a share (excluding stock option expense).  Carbo is one of the two leading manufacturers of ceramic proppant used by oil and gas producers in shale production.  The tiny spheres are inserted into the rock after it's been fractured to let the oil or gas flow to the surface.  Most wells are drilled horizontally and typically are 10x longer than straight up and down wells.  So more material is required.  The proppant is injected into the well with a mixture of water and a jello like material.  The water drives it in.  The jello keeps it in place until everything settles.  Then it disolves.  Since the proppants are round plenty of area remains for the oil or gas to flow back up the well bore. 

Most wells are 8,000 feet or more below the surface, far below the water table.  Occasionally natural gas escapes towards the surface during the fracturing process.  When that happens it can mix into the water supply.  Technically speaking the jello material is made from chemicals, though it isn't much different than actual Jell-O.  That gets loose once in a while, too.  The Environmental Protection Agency has moved aggressively against those contamination issues, blocking natural gas development in large sections of the country.  The EPA additionally has blocked Carbo from building new production facilities in some areas.  For all the hoopla the amount of actual damage is negligible in relation to the volume of energy produced.  So while expensive remediation efforts might be required the industry appears likely to keep growing at a brisk pace well into the future.

Growth is accelerating in the oil shale segment.  Carbo got its start in shale gas.  Its ceramic proppants worked better than conventional sand at keeping those new age wells open.  Sand continues to be used in straightfoward applications because it's less expensive.  But operators increasingly are switching to manufactured proppants to maximize the flow rate.  In the shale oil segment, that conductivity advantage is even more pronounced.  Drilling activity is surging because the market price of petroleum is 5x greater than natural gas on a Btu equivalent basis.  The potential profit is much greater.  In 2011 an estimated 32,500 oil wells will be drilled in the U.S., up 75% from the year before.  The entire increase is coming from the shale oil segment.  Natural gas wells are seen coming in at 19,500, up 5%.  At this point Carbo is sold out and can't keep up with demand.  New capacity is being brought on line, the EPA notwithstanding.  But the tight supply situation has caused drillers to seek alternative sources.  The resulting advent of new competitors has created some question marks about Carbo's long term outlook.

Saint Gobain, the other leading producer of ceramic proppant, is expanding capacity.  More ominous is a build-up in Chinese production.  The Chinese have entered the market with lower quality products but they've offered lower prices, as well.  The surge in industry demand has allowed Carbo to maintain margins and keep expanding to date.  And that trend could continue if the international market begins to adopt shale drilling.  For now the technology remains a North American specialty.  At some point the number of drilling rigs could max out, or energy prices might skid and cause some rigs to go out of service.  If proppant capacity keeps jumping an oversupply situation could develop.

Today, performance remains vibrant.  We have lifted our 2011 earnings estimate by $.15 a share to $5.65 a share.  A stronger showing is possible if the customary Q4 industry slowdown fails to develop.  Next year $6.60 a share (+17%) is a realistic target, in light of the economy and the Administration's efforts to promote green energy at the expense of fossil fuels.  New manufacturing capacity is in the pipeline.  If prices and margins aren't disrupted earnings could keep advancing at a 20%-30% rate well into the decade.

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