Carbo Ceramics (NYSE:CRR) is a favorite of short sellers. With share prices down some 80% from a 52 week high of $156, short interest still stands at 39.2%.
Carbo manufactures and sells ceramic proppants used in fracking. They also market sand as a low cost proppant, and provide consultant services directed at achieving superior EUR (expected ultimate recovery) from fracking. As such, the company stands squarely in the middle of the controversy surrounding the long term role of shale oil in the global energy economy.
Production and consumption walk hand in hand in a fairly straight line up and to the right. Not shown, the price of oil varies substantially more than seems intuitively reasonable, given the stable pattern exhibited by supply and demand. I attribute the difference to speculation and manipulation.
The rapid growth of shale oil production has been driven by easy access to capital, in the form of borrowed money. This will play out the same way the housing bubble played out. Various naïve and ill-informed investors will find themselves holding, directly or indirectly, assets that were created and marketed with a complete disregard for the accuracy of statements made to promote and sell them.
Unlike excess housing, which can take decades to deteriorate into uselessness, many of the excess oil wells created by this binge will peter out quickly, due to the nature of shale oil, combined with short-sighted production methods.
Meanwhile futures volume grossly exceeds what is required for natural longs and shorts to hedge their positions. There has been a lot of money change hands in this market over the past six months, and very little news or discussion about who the winners and losers have been. I’m investing on the basis that speculation and manipulation created the multi-year high in 2008, and the multi-year low now in evidence. I do not expect the authorities to intervene: however, I do expect the law of supply and demand to prevail over the long-term.
Carbo’s forward seven year average EPS is $3.56. Taking six years of actual earnings, I add analyst consensus for the coming year at $2.04 and divide by seven. Note two cyclical lows are included in the computation. Multiplying by a PE7 of 12.5 for a cyclical, the indicated value is $44, to which I add $11 for the excess of current assets over the 2:1 ratio required to run the business in a prudent and orderly manner. So…I see a stock worth $55 trading in the low $30s.
The high short interest is a debatable factor. I see a large number of negative-minded speculators who are convinced that they are both smarter and more agile than long term investors. Those who held similar beliefs in 2009 suffered serious losses.
CEO Gary Kolstad makes a cogent case for the use of ceramic proppants over sand. The company was making a similar case in 2009, and investors who relied on it were amply rewarded. Here’s a link to a recent 40 slide presentation, from which the following was taken.
Logically, oil wells should be drilled with an eye on EUR (expected ultimate recovery). Many of the more aggressive producers have opted for a strategy of filling the thing up with cheap sand, recovering enough in the first year to cover the capital, and going on to the next one.
That business model has proven to be unsustainable, and another will need to developed. Kolstad believes he has a better way, which involves the use of ceramic proppants. I made money on that premise in 2009, and expect to do so again this year.
Strategy and Tactics
Implied volatility is high, and options premiums are generous. As developed above, a credible argument can be made that the shares are seriously undervalued. Further, the downside is limited by the strength of the balance sheet, specifically the $11 of excess current assets.
Under the circumstances, I’ve been expressing bullish opinions by means of options spreads, always selling more time value than I am buying. The point is, I believe shares will eventually trade up toward the $60 area. In the mean time, I’m being paid to leave my money on the table, so it’s easy to be patient.
The dividend yields 3.94% at a recent price of $32.57, and a patient long term investor is likely to be rewarded by simply buying the shares and holding for a price recovery. Rather than attempt to call a bottom, it is normally more productive to take a starter position and average in while monitoring earnings, conference calls, and the price of oil.