Can Drilling Growth Prop Up Carbo Ceramics?

By Stephen D. Simpson, CFA | August 05, 2011 AAA

Love it or hate it, hydraulic fracturing (also called fraccing or fracking) is a part of life in the oil and gas business today. The easy oil and gas is largely gone in North America and producers like Exxon Mobil (NYSE:XOM), Chesapeake Energy (NYSE:CHK) and Apache (NYSE:APA) increasingly have to resort to more and more technology like fracking to meet their production targets. That has created a huge market for Carbo Ceramics (NYSE:CRR) and its ceramic proppants, but the question remains whether there is enough growth to fuel still more gains in the stock.

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A Quiet Second Quarter
Carbo Ceramics did more or less what analysts expected it to do this quarter. Revenue was up 34% from last year, but down about 1% from the first quarter. While Carbo Ceramics saw better than 2% price growth from the first quarter, volume fell about 3%. Gross margins picked up a bit (40 basis points), but operating earnings still slid slightly from the first quarter.

More Capacity Coming
Given that companies like Halliburton (NYSE:HAL), Schlumberger (NYSE:SLB) and Baker Hughes (NYSE:BHI), all major service companies that perform fracking, have been reporting strong demand for their services, investors might wonder about the sluggish sequential performance.

Simply put, Carbo Ceramics is selling its proppants (basically ceramic beads that are used to stabilize fractures and allow oil or gas to flow) about as fast as it can make them. CRR actually sold more proppants than its rated capacity to produce in this quarter, but the company is basically up against a ceiling with its volume.

With demand running hot and returns on new capacity so strong, Carbo Ceramics is working to bring more capacity online. Toomsboro 4 should be ready by year-end, and should add more than 16% incremental quarterly capacity, while the New Iberia 2 project will add capacity in resin-coated sand (RCS). A little further out, a plant in Wisconsin slated to go online before the end of 2012 will add still more RCS capacity.

Where's the Competition?
One of the stranger things about the proppant market is the lack of competition for Carbo Ceramics. Apart from France's St. Gobain and a couple of Russian companies, there is very little competition in this market. In fact, about three-quarters of frac jobs still use sand as the proppant.

I'm not a petroleum engineer, nor a ceramics expert, but this absence of competition baffles me. Why can't (or won't?) a company like PPG (NYSE:PPG), Corning (NYSE:GLW) or Kyocera (NYSE:KYO) get into this market? What about "specialty material" companies like OM Group (NYSE:OMG) or Materion (Nasdaq:MTRN)? Would it really be so hard for a company like DuPont (NYSE:DD) to get a plant of its own up and running?

Maybe there are industry experts out there shaking their heads at my naiveté, but I just don't see why this market is so limited. Wouldn't an energy services company like Flotek (NYSE:FTK) or Key Energy (NYSE:KEG) benefit by offering a supply component that is in high demand and capacity constrained?

The Bottom Line
While there have been rumblings about the environmental impact of fracking (and France has gone so far as to ban the procedure), the math remains the same - there is not nearly enough easy-to-reach oil and gas in North America anymore. Odds are, though, that Carbo Ceramic's valuation pretty much encapsulates what is attainable close to home.

The real key for CRR going forward is the overseas market. What is often overlooked in "Peak Oil" discussions is the huge dichotomy in drilling activity (and technology) between North America and most of the rest of the world. Who knows how much more oil and gas is attainable outside the U.S. and Canada if producers start sinking wells and using stimulation technologies at a rate on par with North America.

If this overseas opportunity is real, Carbo Ceramics could yet have room to run. For now, though, it is an expensive wait-and-see proposition. (For additional reading, see A Guide To Investing In Oil Markets.)

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