Thursday, October 4, 2012

Carbo Ceramics ( NYSE - CRR ) -- China Retreats

Carbo Ceramics (CRR $63.00) appears on track to report unexceptional Q3 results.  The company has been under pressure for the past year from a combination of declining demand and rising competition.  Carbo is the leading producer of ceramic proppants used to keep the rocks open during oil and gas fracking operations.  The company has been expanding into the lower priced ceramic covered sand market, as well.  A lot of wells don't require the strength of a 100% ceramic product.  The proppants are manufactured to a round shape, which maximizes the flow rate of the oil and gas being recovered.  The industry originally boomed in the natural gas segment.  A tremendous surge in drilling activity ensued, much of it in Pennsylvania and surrounding areas.  Carbo was unable to supply the entire market.  So a number of drilling companies found alternative sources, most of which were based in China.

Natural gas prices subsequently collapsed.  Once a fracking operation starts there's no way to turn it off, without turning it off forever.  Many mid-level exploration companies had to worry about lease expirations, too.  They also had shareholders and lenders to satisfy.  So the drilling continued even though losses were incurred on a full cost basis.  Once natural gas prices dipped to $2.00 per Bcf the marginal cost began to exceed revenue.  At that point new activity died.

Amazingly, the market shifted to oil.  A midsized oil company (Mitchell Energy) had been working on oil fracking for years.  It showed everybody how to do it.  And the equipment build-up in Pennsylvania rushed to North Dakota where massive oil deposits were identified.  Carbo followed the industry.  But the company was slowed down by a lack of rail lines and warehouse facilities.  It also continued to face tremendous Chinese competition.

Many operators still have contracts to purchase Chinese proppants.  With experience they've discovered that Carbo's products deliver a much  higher rate of return.  But they remain obligated to work off their existing contracts.  Distributor inventories of Chinese proppants still are elevated, moreover.  So the lower quality lower price competition is likely to remain a factor over the next 2-3 quarters.

But Chinese products now are entering the U.S. at a diminshed rate.  Many China based producers have exited the business.  Others are supplying the Chinese fracking market, which itself is booming.  The overhang of low priced Chinese goods is wearing down.  And awareness among customers about the superior performance of Carbo's products is rising.

Natural gas prices have rebounded to $3.00 per Mcf.  The combination of declining production and rising utility consumption has reduced the amount of gas in storage.  That combination almost certainly will force prices back into the $4.00-$5.00 per Bcf range.  Which is where it once again becomes economical to drill.

Once that happens Carbo will enjoy excellent fundamentals both in the oil and gas segments.  Competition will continue, for sure.  But the company likely will be able to sustain margins at lofty levels. Carbo has largely completed its infrastructure build-out in North Dakota to capitalize on the oil segment.  That should be reflected in upcoming periods.  A pick-up in natural gas combined with reduced Chinese competition promises to amplify the forthcoming improvement.  In 2-3 years income could reach $9.00 a share.  International expansion could provide further leverage.

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