Crude oil prices are less than 50% of their 2014 levels but the US shale oil drillers continue to add oil rigs and increase their production. As a result, the Energy Information Administration expects the US crude oil production to reach 10 million barrels per day in 2018. We want to be a part of this shale oil boom.
- We want to take part in the shale oil boom through FMSA
- Frac sand use per well has more than tripled in the last few years
- US oil producers are adding rigs at a fast pace, which is good news for frac sand companies
- The demand is expected to grow further until 2022
- FMSA is a turnaround story and is highly rated by the analysts
- We believe that the selling is overdone and the stock is ripe for a sharp rebound
- In the medium-term, FMSA can turn into a multibagger
A direct shale oil play might not be the best way because crude oil prices are stuck between the range of $40 per barrel on the lower end and $55 per barrel on the upper end.
If price drops below $40 per barrel, OPEC jawbones prices higher announcing various measures to curtail supply. On the other hand, as soon as prices cross above $50 per barrel, the US shale oil drillers start drilling at a frantic pace, keeping prices under check.
The producers are therefore unlikely to make a hefty profit. Hence, we shall look for companies that supply items to the shale oil drillers. In this group, we like Fairmount Santrol (FMSA). At the current levels, the stock is a good buy with low downside risk and a huge upside potential. FMSA can turn into a multibagger in the medium-term.
FMSA mainly supplies high-performance sand and sand based products that are used in the oil and gas exploration industry. They also cater to foundry, building products, glass and sports and a few other markets. However, their main income comes from their sand business.
What is frac sand and why is it used by the shale oil drillers
Frac sand is a high-purity quartz sand that has uniform round grains. It is a tough material, hence, is used by the petroleum industry in the fracking process while producing oil and natural gas from rock formations.
In order to free the oil and gas trapped inside the shale formations, frac sand is pumped into the wells along with water mixed with chemicals and thickening agents. This creates fractures in the rocks through which oil and gas flow into the well.
In this article, we shall also use the term proppant for frac sand.
How much frac sand is used in each well
In 2014, in the Bakken, producers used about 400 pounds of proppant per foot of completed hole. However, in 2017, the proppant use is expected to skyrocket to 1,500 pounds per foot of completed hole. Similarly, in the Permian, in 2014, operators used 800 pounds of proppant per foot, which has increased to 1,900 pounds of proppant per foot in 2017.
As technology advanced, the producers observed that by increasing the proppants, they were able to increase the access to the reservoir resulting in higher oil and gas production.
As a result, the overall consumption of proppant has increased over the past four years and is likely to grow further till 2020. The chart above confirms that the demand for frac sand is here to stay and is only likely to increase further. But, with crude oil prices ruling at less than half of 2014 levels, is the demand sustainable?
US shale oil producers are adding oil rigs
The US shale oil drillers have been undeterred by the range bound crude oil markets. In fact, they have more than doubled the oil rig count to 765 in the week ended August 4, 2017, from the lows of 316 hit in end-May 2016. However, this is still way below the peak oil rig count of 1609, in October 2014.
Nonetheless, due to increased use of proppants per well, the total consumption of sand in 2017 is likely to overtake the peak consumption of sand in 2014, when oil prices were above $100 per barrel. Expectations are for the consumption to continue its uptrend for the next five years, though analysts don’t expect crude oil prices to reach $100 per barrel anytime soon.
Therefore, the visibility for demand is clear. But why do we like FMSA?
FMSA is a turnaround story?
We like the company because it is turning around for good. It has got its act together, reduced its debt and is likely to strengthen further as the year progresses.
In Q2 2017, the company had a net income of $0.05 per diluted share, compared to a net loss of $0.05 per diluted share in Q1 2017 and a net loss of $0.54 per diluted share in Q2 2016.
The company had a huge total long-term debt of $1 251.5 million as of September 30, 2014. However, after reducing its total long-term debt to $845.1 million in Q1 2017, FMSA has further reduced its long-term debt to $796.1 million in the latest quarter. Considering the cash and cash equivalents of $178.5 million, the total net debt of the company is $617.6 million as of June 30, 2017. The company wants to further reduce the net debt to $500 million to $550 million by the end of 2018. This is a positive sign confirming that the company is serious about strengthening its balance sheet.
In the latest quarter, the company has posted impressive growth on all fronts. When compared to the previous year’s quarter, the growth numbers are even more impressive. In Q2 2016, the company had a revenue of $114.2 million and a net loss of $87.8 million.
The company’s performance is improving every quarter.
Expectations of the company for the third quarter and beyond
The company expects to increase raw frac sand prices by $5 to $7 per ton in the third quarter of this year, assuming a constant mix. FMSA expects proppant demand to increase in 2018 to 100 million tons as the producers complete the drilled but uncompleted wells.
In order to capitalize on the increasing demand, the company will launch a capacity expansion at Kermit, Texas to cater to the Permian. They have also reactivated the Shakopee facility, which should begin full production by the end of Q3 2017. With these two facilities coming on line, FMSA’s annual frac sand capacity will increase from 11.9 million tons to a nameplate 15.6 million tons.
What do the analysts think about FMSA?
The consensus 12-month price estimate on the stock is $7.5, with forecasts ranging from $3.7 to $17. Even if the stock reaches the most conservative estimate, it will be a rise of 34% from the current levels.
What are the risks to our investment
No investment is without its risks. Here, the risk is on two fronts. If OPEC and allies don’t extend the production cuts beyond March 2018, crude oil prices can again fall to $40 per barrel. Sustained low prices will affect the drilling activity of the US shale oil producers.
Another concern is overcapacity. With the boom in frac sand demand, many companies are expanding their operations. Therefore, analysts expect the supply to overshoot demand, which will affect the pricing power of the companies.
What do the charts forecast?
The stock is in a free fall, since reaching a high of $13.12 in end-January. From its highs of the year, the stock is down a whopping 80%. We believe that the market has been too harsh and has priced in a very bearish scenario, which is unlikely to play out.
At the current levels, though the stock is in a water fall decline, we expect some sort of support to kick in soon. However, we would prefer to go for a staggered investment approach in this stock. We shall buy 50% of the allocation at the current levels and buy the remaining 50% over the next few weeks, once the stock stops falling and changes its trend from down to up.
This is a medium-term play; therefore, the investors should be ready to hold this stock for more than a year to realize strong gains in it.