It’s been quiet the past few days, thus we are heading back out on the road this week. Before we leave, however, we wish to impart a few quick thoughts on news from the week as well as offer some initial thoughts on the fluid end market.
- HCR Q1 earnings release – files for bankruptcy protection.
- Calfrac Q1 earnings call – company confirms fleet reactivations.
- U.S. land rig count down only one rig on Friday. Now at 254 rigs.
- COVID Observations. The Double Tree Midland notified us via email on Saturday afternoon that it is suspending operations due to the COVID. Our reservation was cancelled by them, thus prompting our call to inquire why. According to the hotel front desk, this will not be a permanent closing – most likely a ~30 day shutdown as the hotel will purportedly do a deep cleaning and possibly some renovation. We suggest new bath towels while they are at it.
- Driving to Midland tomorrow. Have a few openings for Tuesday if you are free. Anyone up for KD’s on either Tuesday or Wednesday?
Fluid Ends: Last week we conducted several updates with both frac companies and OEMs as we are assessing the state of the fluid end market. During this round of calls, we did not expect to hear any good news and that proved to be the case. According to multiple contacts, fluid end pricing is in the tank as stainless-steel fluid ends are pricing in the ~$40,000 range with lower prices available if purchases are made in bulk. Chinese fluid ends are purportedly being sold closer to ~$30,000 if procured in volume (let’s instead support our U.S. friends, please). To put the competitive dynamic into perspective, one frac company reports fluid end builders will not only sell the fluid end for cheap, but many will deliver it for free. These issues, by the way, are not new. Access to fluid ends hasn’t been a problem in some time as many companies stepped into this market while several large frac companies make their own. According to one contact, a large frac player opened its first U.S. fluid end manufacturing facility having previously manufactured a portion of its fluid ends overseas. As for the pricing collapse, it’s a combination of new entrants who joined the market at very low prices while the current downturn, coupled with a need by some fluid end OEMs to unload inventory for cash, is a key reason for the recent price concessions. And, it’s not just fluid end pricing which is moving lower, so too is the price for valve and seats.
Key issues facing the market: (1) fluid-end life lasting longer than expected, function of better designs (including longer-lasting valves/seats) and smarter preventative maintenance practices; and (2) changes in operating practices as frac companies are focusing on less cycle time on the equipment. Further complicating matters is the fact that some frac companies ordered fluid ends assuming a shorter-life, thus the companies over ordered (i.e. result of longer actual lives and the Q2’20 industry collapse which no one expected). In those instances, the frac companies have months of inventory on hand. In other cases, frac companies keep no inventory given market challenges. They don’t need too because the fluid end OEMs are so stuffed with inventory that just-in-time deliveries when needed are not an issue. Another consideration, some frac companies regularly refurb fluid ends. The average cost is about $15,000 to repair and generally an additional 500-600 hours can be attained (i.e. reduces need to buy new when you can refurb). Finally, some frac companies admit the obvious. They will rob idle frac units of their fluid ends in order to eliminate the need to buy a new fluid end. All these trends collectively mean some companies are not likely to buy fluid ends anytime soon.
Visiting with fluid end OEMs, some claim they won’t need to order steel blocks until Q1 and possibly Q2 as they not only have months-worth of finished goods in stock, but also plenty of forgings too. What could change this? A sharp increase in activity. The current inventory overhang is something, we believe, which will simply take time to work through.
Hi-Crush Q1 Earnings: Delayed earnings, thus the company’s Q1 results, which were reported on Thursday, are somewhat irrelevant. The most consequential observation is the company’s announced expectation to file for bankruptcy protection. Like many OFS enterprises, HCR is burdened by too much debt, thus the current downturn necessitates a restructuring. For sand loyalists, this announcement is not terribly surprising and it follows a pattern of other sand restructurings. If memory serves correct, since 2016 we’ve seen several restructurings including Chieftain Sand, Completion Industrial Minerals, Emerge Energy Services, and Shale Support. More recently, Carbo Ceramics and Vista Sands announced the need to restructure. So the HCR news isn’t shocking. Moreover, there will be more sand restructurings, we suspect, as profitability within the frac sand space is anemic and many companies are burdened with growth-fueled debt obligations. Nevertheless, HCR has lots of good people, so we wish them well.
As for balance sheet metrics, at March 31, 2020, the company’s total debt was roughly $472M. Q1 Adjusted EBITDA was $9M or $36M annualized. That’s before the Q2 industry slowdown, so presumably the Q2 numbers will be worse. To HCR’s credit, it is taking steps to lower costs as 60% of its workforce has been reduced since mid-March; capex guidance was lowered 40% while three production and three terminal facilities have been idled. Working production capacity is currently 5.7M tons/year which compares to its nameplate capacity of 17.3M tons. As a reminder, SLCA also reduced its production capacity to 6M tons vs. its 24M nameplate capacity. Numerous other facilities across the U.S. are either idled or running at bare minimum levels, but the name plate is still there.
HCR’s Q1 volumes moved higher to 2.5M vs. 2.1M in Q4’19 while contribution margins nudged lower to $8.48/ton from $9.02/ton. Like most other companies this year, HCR incurred significant impairment charges due to the current industry woes. Specifically, HCR wrote-down $146M of certain production and terminal facilities. No consequential forward-looking commentary was provided in the release.
For any sand enthusiast, we do our best to stay up to speed on this space, but a great analyst on the sand sector is the team at Infill Thinking.
Calfrac Q1 Earnings. Delayed earnings, thus Q1 results are also somewhat irrelevant, but what matters most is company commentary which points to higher activity. Specifically, Calfrac noted it will soon deploy its fourth fleet in the U.S. which we suspect will go to work in the Rockies/Bakken. We believe CFW bottomed at ~2 fleets, thus a respectable jump from the bottom In Canada, Calfrac will deploy two large spreads to the Montney/Duvernay and potentially 1-2 small fleets to the Viking.
As with many other service companies, Calfrac also faces a balance sheet dilemma as total debt at 3/31 stands at nearly C$960M. Q1 EBITDA adjusted EBITDA was roughly $7M. We don’t have a formal Calfrac model, but consensus estimates have the company generating slightly negative EBITDA in 2020 with potentially $30-$35M in 2021. Not sufficient cash flow generation given the current debt load, thus presumably why Calfrac announced in mid-June its intent to consider alternatives to address its capital structure.
With respect to fleet profitability, Calfrac’s U.S. operations generated Q1 EBITDA of $5.2M. We estimate an average of ~9 working fleets which would imply annualized EBITDA/fleet in the vicinity of $2M-$3M per year – this excludes maintenance capex burden. From the 30,000 foot perspective and applying this profitability across the U.S. frac market, the Q1 profitability metrics once again reaffirm what we already know. That is, the industry is working at unsustainable levels and a clear need for upward pricing momentum is necessary. Barring a meteoric rise in commodity prices, the answer is consolidation. Yes, some companies will close their doors or suspend operations, but in multiple cases, those assets are then being liquidated and falling into the hands of others. Case in point are the old frac assets of BAS which are now in the hands of three other frac companies. Meanwhile, the old Oasis assets are being sold and we believe there are two buyers for this equipment. More frac equipment, meanwhile, is on the auction block so rinse, wash and repeat.
Sunday afternoon news. CHK files for bankruptcy. This was expected, but it hit the tape as we are writing this note. According to a Bloomberg article, CHK entered into an agreement to eliminate about $7 billion in debt.
Other Items. Pro Petro filed its 2019 10-K earlier this week. In our prior life we had opined the filing would likely happen in March/April. Just goes to show you what we know. That said, the company is approaching being current with its SEC filings. One would assume the Q1 10-Q filing should be finalized sometime in the next month or so. We suspect the stress levels on Midkiff have gone down, so kudo’s to the team for getting the 10-K finished. Also, an interesting move by U.S. Well Services this week as it displayed an ability to think outside the box. On Monday, it announced it will lease a turbine to a customer in Mexico. This turbine will provide power generation and should be placed into service in Q3. No idea what the financial contribution will be, but we suspect it’s much better than margins being generated in the U.S. frac market.
Not trying to sound like our dear departed mother-in-law with our persistent reminders/pestering, but these notes are not and never should be considered investment advice.