By the numbers
- Stocks, total demand, use per well, and price all increased over the course of 2016
- The hyper share price appreciation of 2016 is unlikely to be seen again in 2017 because the use of sand per well will hit diminishing marginal returns and because there is more “low-cost” capacity than industry experts originally estimated
- Current valuations are critical in this volatile market
Transportation most significant cost: The U.S. is the largest producer and consumer of frac sand in the world. Nearly 70 percent of domestic production in 2016 came from the Great Lakes region, but most fracking takes place elsewhere in the country; thus, sand must be shipped to shale basins up to 1,000 miles away or more. Moving sand from mines to transload facilities located near oil and gas plays is the most significant expense of production, accounting for upwards of 75 percent of the final cost for some producers. Further, mines that lack direct access to a railroad spur are forced to truck the sand to rail yards where it can be loaded onto railcars; therefore, it is advantageous for frac sand mines to have a railroad spur on site.
Contract terms important in appraisals: Frac sand is typically mined only to fulfill existing contracts, which often state the tons of frac sand that are to be shipped to customers over a specific period of time. When the oil industry was healthier, Gordon Brothers’ appraisers valued frac sand inventories off of these contract commitments as they would typically be fulfilled. But in the current depressed marketplace, while contracts are still taken into consideration for pricing, appraisers no longer assume that customers will purchase the amount of inventory stipulated in contracts (tons sold) as customers are no longer taking delivery at that volume. Rather, in order to estimate the amounts customers are likely to purchase, Gordon Brothers analyzes the most recent shipment data to determine sell through volume.
Wet sand warrants special appraisal considerations: To produce frac sand, raw sand is removed from the ground and then run through a wet plant that separates it into different grades (typical mesh sizes include: 20/40, 30/50, 40/70, and 100). Once sorted, the wet sand is run through a dry plant to reduce moisture prior to transport. Wet sand, therefore, is considered “in-process.” Lenders considering lending against wet sand inventories should request a conversion be conducted in an appraisal that would assume a portion of the wet sand would be dried so it can be sold through to customers. In the current marketplace, wet sand has little to no value.
Liquidation period: The liquidation period for frac sand inventories is primarily dependent on three factors: the volume customers are taking, how much wet sand is on hand, and how long it will take the company to convert the wet sand to dry sand. Oftentimes, bottlenecks in the production process constrain companies’ ability to convert and ship product. Considering the above, Gordon Brothers’ appraisers typically assume a four- to six-month liquidation period for the inventory.
Seasonality impacts inventory levels: In high producing regions, such as those around the Great Lakes, long, cold winters impact the ways frac sand mines operate. Wet sand can only be processed when the weather is warm enough, typically April through November, with the exception of companies that have moved their wet plant operations into temperature-controlled buildings and can process wet sand during the winter months. To keep dry mills running throughout the winter, processors build inventories of wet sand throughout the summer, typically peaking in November. Lenders should be aware of these fluctuations when analyzing collateral. Lenders should further note that dry sand inventory does not fluctuate in the same manner as wet sand. Most plants store dry sand in silos or covered rail cars and maintain capacity near or at the maximum for those containers.
Oil’s effect: As of September 2016, per Baker Hughes, the U.S. drill rig count had decreased by over 30 percent over the previous year. As a result, industry analysts noted that demand for frac sand had fallen as much as 20 to 40 percent in the same period. However, while 2017 might not be a stellar year for oilfield services in general, the sand proppant those companies use in hydraulic fracturing may enjoy its best time yet. With crude oil prices appearing stable at more than $50 per barrel, exploration and production companies are gaining confidence and spending more money on capital expenditures. Increasingly, analysts and investors are bullish on sand proppant’s prospects as rig counts climb and exploration and production companies pour ever more sand downhole to accelerate production. This phenomenon has been the single biggest driver of improved well production in the U.S. While the U.S. rig count plummeted almost 75 percent over the last two years, sand demand dropped approximately 40 percent. In 2017, however, proppant use in the U.S. alone will reach above 2014 peak levels despite the diminished activity of 60 percent fewer rigs. Furthermore, following the expectations that the U.S. oil rig count will rise over the next few years, U.S. sand demand in 2018 should be at least 150 percent higher than in 2016.
Industry forecast: Industry experts predict sand demand to be approximately 59.9 million tons in 2017 and 74.4 million tons in 2018 (up from 50.7 million tons and 66.9 million tons in 2015 and 2016, respectively). Forecasters remain bullish on sand demand based on a number of secular trends, including longer laterals, more stages per well, and more sand per foot/stage. The latter of these trends has started to become a concern, at least in some basins. At some point, there is likely to be a point of diminishing production return relative to how much sand is pumped downhole. Additionally, rising sand prices will likely inhibit ever-increasing sand use per well. Similar to the focus on expense savings that drove the shift to regional sand, higher-cost sand will likely force operators to be more creative with how sand is used in an effort to reduce costs. All in all, industry experts predict sand use per well will begin to slow down some time in the next 18 months.