There's no sugar-coating it: Cheap oil has hit the market like a whirlwind, and investors everywhere are looking at their energy stocks really hard right now. The biggest question most people want answered is whether shale drillers are going to be able to keep on drilling, which could have a large impact on whether or not Emerge Energy Services (NYSE: EMES) will be able to maintain its sizable distribution payments for the foreseeable future. Let's take a look at why Emerge Energy Services' distribution is different from many others in the space, and if you can expect those distribution payments to keep on growing.
A different kind of dividend risk
Traditionally, when looking at a master limited partnership, a major metric you need to look at is distribution coverage, because it shows whether the amount of cash coming in the door from continuing operations is sufficient to pay for the distributions management has set. The funny thing about Emerge Energy Services is that the distribution coverage is always 1.0, or break-even.
The reason this happens is because Emerge has a variable rate distribution, which means it only pays out as much cash as it brought in that quarter, and management has little say in the matter. The benefit of this kind of investment is that it ensures the company doesn't get in financial trouble when a string of bad quarters can't cover the distribution payment -- especially for smaller operations with only one or two cash-producing assets. The drawback, though, is that your quarterly distribution checks will vary from quarter to quarter based on the performance of the company in that 90-day period.
Emerge's slightly misunderstood relationship with shale
With this in mind, it's pretty easy to make the connection between oil prices and the distribution payment for Emerge. A majority of its distributable cash comes from the sale of sand used in hydraulic fracturing, and if oil prices were to keep sliding or stay at these lower prices, there is the risk that drilling activity slows and demand for frac sand diminishes. This will inevitably reduce overall demand for the product and send volumes delivered and prices down.
While this logic makes sense, there are few holes in that argument. One thing to consider is that Emerge, like most of its peers in this space, sell their sand on long-term contracts rather than on the spot market. According to management on its last earnings call, 87% of the company's production is sold on fixed-price contracts through the rest of this year, and all the way through 2015. This also includes the expanded production it has brought on and expects to bring on during this time frame.
The other aspect to take into account here is that despite the lower costs today, the amount of activity from land-based oil and gas producers is still staying relatively strong. According to Baker Hughes Rig Count data, total onshore drilling rigs in operation is 10% higher at the end of November than it was during the same time last year. On the flip side, we are actually seeing rig counts and drilling activity in the offshore regions starting to slow. The reason for this is that the cost per barrel for offshore can sometimes be much more expensive than American-based shale drilling, as seen in this chart from Chevron.
Source: Chevron Investor Presentation.
With oil prices in the $55 per barrel range, companies across the space are all making a lot less money. However, there are sources of oil out there that have a higher break-even cost than onshore-based oil production in the U.S. It's likely these higher-cost barrels -- known as the marginal cost barrels -- will be the first ones to see dwindling production. For Emerge Energy's sake, the hope is that winding down these marginal cost barrels will have enough of an impact on the supply side of the oil markets to keep shale/tight oil production growth in the black.
What a Fool believes
It's too difficult to speculate on oil prices and where they go from here, so avoid making any rash investment decisions regarding Emerge Energy Services simply on an oil price theory. With a vast majority of Emerge's frac sand production secured with fixed price contracts for quite some time, there is not much fear that the company's distribution will be affected in the short term. Also, with other, more expensive sources of oil out there, the chances of U.S.-based shale drilling taking a huge hit doesn't seem as big of a threat as some media pundits are suggesting. This seems to suggest that investors in Emerge can sleep relatively sound knowing that the company's distribution doesn't appear to be at risk for a major drop any time soon.
