Submitted by David Stockman via Contra Corner blog [16],
On August 4th the Wall Street Journal [17]carried a breathless tale of how a handful of obscure oilfield suppliers were striking immense riches in the sand dunes of Wisconsin. Owing to the “shale revolution”, the stock price of an outfit that had originated in the stagnating business of supplying sand traps to golf courses, and which had been at death’s door as recently as 2011, had gone parabolic.
Emerge Energy Services (EMES) presently traded at $145 per share, reflecting a red hot gain of 8.5X over its $17 IPO price fifteen months earlier. In a literal sense, silicon valley had come to the silicon dunes of Lake Michigan, as reflected in EMES’ valuation at 43X its LTM earnings.
[18]
EMES [19] data by YCharts [20]
Given the fact that EMES’ share price had most recently risen by $100 or $2.5 billion of market just since January 2014, the “momo” story was self-evidently all about upside growth, not current profits or cash flow. In fact, during its 14 quarters as a public filer, EMES had generated negative $50 million of operating cash flow after CapEx. So at a total enterprise value of $3.7 billion, the punters chasing the stock straight up the parabolic curve would seemingly have anticipated some stupendous growth indeed.
Except……except they had no idea about EMES’ sustainable growth potential and didn’t care because the buyers were robots, day traders and flavor-of-the-month hedge funds. They were piling into the stock of a company selling a form (white sand) of the second most abundant low-value commodity on planet earth for no other reason than Emerge Energy Services was another momo play on steroids. The “price action” was the investment thesis.
Yet this typical momo “rip” had occurred not out of the natural elements of human greed and capitalist enterprise, but because the stock market has been destroyed by the Fed. That is, the combination of ZIRP and wealth effects “puts” have eviscerated all of the checks and balances that contain and modulate speculation in honest free markets.
On the one hand, Fed policy has massively subsidized momo speculators in two powerful ways. First, most of them operate through the options markets or employ other forms of heavy, short-term position leverage.
Accordingly, their “carry” cost is close to zero, and their position leverage can be continuously rolled-over without risk. That’s because the Fed’s foolish commitment to “transparency” in pegging its policy rate means that speculators are in the catbird seat.
In effect, the Fed is committed to sending its interest rate change messages by pony express to speculators who operate in the nano-second based cybersphere of modern trading technology. It’s not even a contest; its a bad joke which showers the 1% with stupendous windfalls.
Secondly, even the friskiest day traders who intend to survive need to take out market insurance against their momo bets. That is, they buy puts on the S&P 500 to protect against a market wide downdraft.
Yet owing to the Fed’s drastic financial repression and market manipulation, this downside insurance is dirt cheap—meaning that the net returns on momo-chasing are inordinately high due to the Fed’s implicit subsidy of their cost of doing business (i.e. hedging). Supernormal returns, in turn, attract ever greater sums of speculative capital, thereby providing even greater buying power to the momo trades.
There is no secret as to why downside insurance is so heavily subsidized by the central banking branch of the state and is therefore so cheaply available to speculators. The absurd doctrine of “wealth effects” and the implicit Greenspan/Bernanke/Yellen “put” has generated a toxic deformation in the risk asset markets. Namely, the “buy-the-dips” reflex which has purged volatility from the broad market index almost entirely.
The pattern below would never occur in a honest free market. Nearly six straight years of continuous vertical lift just wouldn’t happen in a setting where the GDP of the underlying economy—US and Europe—-has grown virtually not at all since 2007 pre-crisis level, and where earnings are facing massive headwinds from global cooling, deflation and the heavy anchor of “peak debt”.
But the worst of the market wrecking deformations attributable to Keynesian central banking is not simply the massive implicit subsidies to financial gamblers. Of even greater significance is the fact that no financial market can be healthy and balanced without an abundance of well-capitalized short-sellers. Yet the impact of financial repression has been the utter destruction of whatever short-sellers remained at the time of the financial crisis or their subsequent conversion to “blue pill” longs during the period since.
That proposition was evident in spades in the case of EMES’ meteoric rise. At its late August peak market capitalization of $3.5 billion, it had sported LTM earnings of just $80 million. Yet it would not take more than 15 minutes of reflection to recognize that even those meager profits represented the whip-of-the-whip-of-the whip.
That is, frenzied credit pumping and construction mania had driven the petroleum use rates of China and its supplier satellites to unsustainable peaks, causing crude oil prices to rebound from their post-crisis low of $35 per bbl. to $110. These credit bubble prices, in turn, had attracted an enormous flow of cheap debt and capital into high cost energy production—–most dramatically the US shale patch where production rose from less than 1.0 million bbls/day prior to the crisis to more than 4.5 million per day by last fall.
In turn, the gusher of oil coming out of the shale wells depended upon a massive prior injection of sand—3 to 6 million pounds per well. This is designed to prop open (hence “proppants”) the pores in the shale rock and keep the oil flowing after fracking.
So “fracking sand” production rose from about 14 billion pounds per year in 2007 to 50 billon pounds by 2011; and then to 73 billion by 2013, with bullish estimates rising to 100 billion pounds by 2015 or shortly thereafter.
Needless to say, in another example of the credit driven commodity price aberration where supply temporarily lags an unnatural explosion of demand, the price for fracking sand soared. From about $30 per ton in 2008, it rose to $45 per ton by 2012 and upwards of $80 per ton by mid-2014, with some trades already above the $100 per ton level.
As a result, by mid-2014 sand dunes had become the equivalent of gold mines. Marginal extraction costs of around $25 per ton had rising only modestly, meaning that variable profits from the fracking sand business had risen from under $5 per ton prior to the shale boom to more than $50 per ton.
Stated differently, the reported $80 million of EMES’ profits was perched way out on the end of a long whip of windfalls. Most of Emerge Energy Services’ modest reported earnings, in fact, were not economic profits at all; they representing transient rents generated by the global credit bubble.
Accordingly, the proposition that EMES was worth 43X earnings had nothing to do with rational calculation or honest price discovery. It was a pure artifact of the gambling casino created by the Fed and the other money printing central banks.
Reviewing the facts above, even a modestly adept short seller could have discovered via the government’s latest Minerals Yearbook (2012) that the bottled air being reported as “profit” by Emerge Energy Services did not have much of a future—even had crude prices not collapsed by 50% since mid-year. In the above publication, the USGS describes the Ordovician St. Peter Sandstone in the Midwest as being “a primary source of silica sand for many end uses, including frac sand”. It is mined in the vast area shown below, and is the opposite of rare.
St Peter Sandstone Formation
And it did not take long to unleash the diggers. In 2010, Wisconsin had only five sand mines and five processing plants [21]. By the end of 2013, according to the Wall Street Journal, it was estimated that 100 sand mines, loading and processing facilities had received permits in that state alone.
Moreover, in another demonstration that high prices are their own best cure, the quest for fracking quality sand spread far and wide. In the rich black earth “corn and soybean” lands of Illinois, for instance, ordinary $10,000 per acre land prices soared to upwards of $20,000 where white sand was buried by mother nature under the black top soil.
Indeed, the same geologic process that had deposited the shale, had also produced its modern day extraction “proppant”. So the same WSJ story also noted that one entrepreneur was heading for the black hills to mine white sand:
As the good sand becomes increasingly difficult to find, one company is turning next door to South Dakota. Pat Galvin is chief executive of South Dakota Proppants LLC, which aims to resurrect a 1950s-era mine on federal lands about 40 miles from Mount Rushmore. Located in the Black Hills National Forest, the abandoned mine is filled with the same type of high-quality sand frackers have come to count on, and it could generate up to one million tons annually, he said.
In short, even by mid-2014 the worm was turning. There is white sand virtually everywhere, and the number of new mining operations was proliferating dramatically. It was only a matter of time before supply would have caught-up, causing prices to weaken and the windfall element in a plentiful commodity to be ground out of profit margins.
But with the global collapse of oil prices, the whip is now recoiling violently. At $50 per barrel, the 1700 rigs in the shale patch will drop to under 1,000 as contracts run off, and tumble lower from there. Since fracking demand is driven by new drilling rather than current production, the fall-off in demand will be equally severe.
It goes without saying that in the face of today’s great oil deflation, EMES’ volumes and margins will collapse and its windfall rent bloated earnings will wither as current contracts run-out. But never mind, the fast money is already out of the stock. At $54/share, its down to less than half of its value on Labor Day because the crude collapse has now triggered an equal and opposite mode of “price action”.
Undoubtedly, the home gamers and slow-witted mutual funds managers who bought at the top are once again being taken to the cleaners. But that’s the least of the ills.
[22]
The larger point is the Emerge Energy Services is a poster boy for the “irrational exuberance” that has become institutionalized throughout the length and breadth of the Wall Street casino.
Today’s Wall Street Journal story coming just five months after last summers potboiler is therefore not simply an update on a speculation gone horribly wrong. It’s actually a template for the deluge to come.
