Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

For eons, man has used sand to measure time, build castles, and establish alpha-male dominance in social settings on beaches.

More recently, sand has also been used to frack oil and gas wells.

Like most others connected to the fracking business, sand miners such as US Silica Holdings Inc. and Fairmount Santrol Holdings Inc. got a shot in the arm when OPEC and some other countries announced supply cuts to support oil prices. Less than five months later, the effects have worn off already:

Built On Sand
The OPEC accord boosted sand suppliers but the euphoria has disappeared
Source: Bloomberg
Note: Performance indexed to 100.

Again, as with most other oil-related stocks, doubts about the efficacy of that OPEC accord have pushed U.S. crude prices back below $50 a barrel and crushed the rally. It also didn't help that several miners announced plans to expand capacity or that Fairmount missed earnings estimates for the fourth quarter. Adding to the sense of dread was Monday's news that Source Energy Services Inc., a Canadian sand distributor, was apparently cutting its IPO range.

Even so, the case for sand stocks still holds.

Sand is used as a proppant, keeping gaps in shale rock made by fracking open to let oil escape. One reason U.S. oil production has been relatively resilient to low prices is that E&P companies have worked hard to squeeze more out each time they drill. Using more sand per foot in longer wells is a crucial element of this:

Grain Wave
E&P companies have been pushing more sand into wells to yield more oil
Source: Bloomberg Intelligence

As of the third quarter of 2016, the average well in the Permian basin -- so hot right now -- was being drilled to a lateral length of almost 6,600 feet, up from about 5,700 two years previously, when oil was just beginning to slide, according to Bloomberg Intelligence. Meanwhile, the amount of sand used per foot rose from about 1,200 pounds to almost 1,700 pounds. The effect? Sand per well went up, on average, by 59 percent, to just under 5,500 tons.

The bad news is that the number of wells dropped off a cliff, so overall sand demand fell by roughly half in that time, to about 8.2 million tons. As you might expect, mining stocks were almost buried alive; at one point, Fairmount had dropped by more than 90 percent.

Yet the number of oil rigs drilling in the U.S. bottomed out at 316 last May, and the OPEC agreement at the end of November accelerated the recovery. The rig count now stands at 631.

The latest fear to grip the oil market is that OPEC's agreement won't hold, or it will hold but won't work quickly enough. Judging by the latest figures on compliance with supply cuts, as well as Saudi Arabia's need to maintain positive sentiment ahead of an IPO of its national oil company, Saudi Aramco, it seems likely the agreement will hold through much of this year.

The actual level of future compliance is, of course, unknowable. The key point is that OPEC's combination of jawboning and actual action will tend to keep expectations for stable or higher oil prices alive. Indeed, with maintenance season about to end for refineries, bloated U.S. crude oil inventories should draw down further in coming weeks, likely helping this process. And, as I pointed out here, that will also tend to push E&P companies to do what they like doing best: punching holes in U.S. soil and filling them with inordinate amounts of sand.

Sandpit Futures
Even under a bearish scenario, sand demand in 2018 surpasses the previous peak
Source: Bloomberg Intelligence
Note: Demand for sand in horizontal wells on a trailing four-quarter basis.

Bloomberg Intelligence's demand estimates, seen in the chart above, are relatively conservative compared to other analysts. Estimates for 2017 from Tudor, Pickering, Holt & Co., for instance, range between 77 and 98 million tons.

And while the industry's nameplate capacity is estimated to be around 110 million tons per year, effective capacity due to logistical constraints or production losses is likely closer to 80 million. Though announcements of new capacity have spooked the market -- roughly 10 million tons a year, by Barclays' count -- that doesn't look like a game-changer. Planned additions don't always materialize, and not all sand is created equal, so some expansions may not meet the requirements of E&P customers anyway.

Quality counts just as much as quantity, if not more so, when it comes to boosting the productivity of fracked wells. So sand prices have room to move higher, even with E&P companies doing all they can to cut costs.

For example, assume you are drilling and completing a well for $6.5 million with a lateral length of 6,500 feet and 1,700 pounds of sand per foot. At $25 a ton -- last year's average price before transportation fees -- the sand equates to less than 2.5 percent of the cost of the well. At $60 a ton, more in line with 2014 levels, it is still only 5.5 percent.

Sand stocks have been washed out in the tide of money fleeing oil in the past couple of weeks. The currents are still flowing in their favor.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in New York at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net