Carbo Ceramics navigates the shifting sands of the fracking world

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It's a drama. It's a mystery. It's unfolding as we speak.

It's about proppants. Proppants? If you're not a geologist, you can be forgiven for not knowing the word. Proppants are small solids – grains of sand or pieces of ceramic materials – that are placed in hydraulic fracturing fluid to "prop up" shale rock as oil and gas are extracted.

The North American fracking boom has been a boon for proppant companies, perhaps most of all for Carbo Ceramics Inc. Carbo is the only publicly traded North American company to focus on ceramic proppants, which are smoother and stronger than sand and have been widely believed to improve well performance.

Carbo shares have generally moved in tandem with the overall outlook for drilling activity. But in 2014, something different has happened: Carbo has tumbled while the stocks of sand sellers have zoomed. There's a growing belief that exploration companies are abandoning ceramic proppants in favour of sand because their performance doesn't justify their 10-times higher price.

It creates a fascinating dilemma for investors: Is the market overreacting to Carbo's challenges, making the stock, currently trading at one-third its 52-week high, a bargain? Or is there still more bad news in Carbo's future, making its shares still too expensive compared to the sand sellers?

Here's a brief history of Carbo and the proppant industry, courtesy of analyst James Wicklund of Credit Suisse. Carbo rose to prominence when its products were used extensively in the Haynesville shale basin in Louisiana. The Haynesville is a "high-pressure gradient reservoir" where ceramics are necessary because the shale rock will crush ordinary sand. Carbo shares ran to $180 (U.S.) in 2011 at the height of Haynesville drilling.

"The problem was, the Haynesville shale was so prolific, we crushed natural gas prices," Mr. Wicklund said. Gas prices went from more than $5 per million BTU in 2011 to below $2 in early 2012. "All of a sudden, Carbo lost its best market." Its shares fell by two-thirds.

However, drillers continued to use ceramics in other, lower-pressure plays where sand may have been a suitable substitute. And as activity rebounded in places other than Haynesville, so did Carbo's shares.

Now, energy companies need to cut costs, particularly in lower-pressure, liquid-based reservoirs. "The easiest thing for me to do is go from ceramic to sand and save $750,000 in one fell swoop on a $10-million well," Mr. Wicklund said.

Adds Brandon Dobell, an analyst for William Blair & Co.: "The producers have engineers who recognize that over the life of the well, ceramics are probably better, but on a shorter time frame – one year, three years, five years – you may not be able to tell the difference in production rates with a bunch of ceramic in it, versus a whole bunch of sand. And yet the cost to that producer, and the [value] of that well, is going to look better when you use sands because ceramics are a lot more expensive."

It's not a theoretical concept: Carbo was struck a blow in August when Rosetta Resources Inc., a major customer whose former CEO sits on Carbo's board, told investors it was planning to save $500,000 per well by switching from ceramics to sand in the South Texas Eagle Ford play.

The mystery, then, is just how many players will make the ceramics-to-sand shift. Now, speculation is rampant that Carbo will lose another customer in Kodiak Oil & Gas, a user of ceramics in North Dakota's Bakken play. Whiting Petroleum Corp., a sand user, is buying Kodiak.

"The expectation of the market is that Whiting's going to get in there when they have control of Kodiak and change all their completions to sand from ceramics," says analyst Marc Bianchi of Cowen & Co., who adds Whiting's comments about the deal make this proposition "debatable."

Mr. Bianchi is neutral on Carbo shares, but not because of the sand issue, which he says "investors are incorrectly placing too much emphasis on." Instead, he sees Carbo's near-term problem as a glut of ceramics imports, with potential downside to the stock if the company has to keep cutting prices.

But once that market settles, he says, Carbo becomes "pretty interesting" because of its new-product pipeline, which includes its Kryptosphere product, a new ceramic that will supposedly be the strongest yet, suitable for improving offshore wells. The technology behind Kryptosphere may also allow Carbo to strengthen the ceramics it now makes from kaolin clay.

Mr. Bianchi's optimism is atypical, however. There are just two "buy" ratings among the 14 analysts covering Carbo, with seven "holds" and five "sells," according to Bloomberg.

Of the four New York Stock Exchange-traded sand proppant companies, William Blair's Mr. Dobell likes U.S. Silica because of its diversified revenue base and better transportation and storage infrastructure. He also likes Emerge Energy Services LP, because it's increasing its capacity quickly and "has most possibility of upside earnings surprises."

There's a twist in the ending, however: Sand bulls and ceramic bears were surprised by Carbo's earnings report Thursday, in which revenues were stronger than many expected, and management expressed confidence in the future use of ceramics. While Carbo's shares didn't jump, the sand companies all showed high single-digit declines – making them even more appealing for those who think the end of ceramics dominance is near.

Globe app users click here for charts comparing Carbo Ceramics with other sand sellers.