The oil crash has played havoc with high-yield oil investments such as Hi-Crush Energy Partners (NYSE: HCLP), which recently cut its distribution by 30%. With crude prices continuing their painful slide, let's take a look at why management thought this cut was necessary but, more importantly, two factors that will determine if Hi-Crush will have to continue slashing its payout in the future.
Why management cut the payout
The first thing to consider when asking whether more distribution cuts will be needed is to understand why management cut the distribution to its minimum quarterly level in the first place. Not surprisingly that answer lies with the collapsing price of crude and the resulting plunge in the US rig count to a four year low. This has greatly decreased the short-term demand for frac sand.
US Oil Rotary Rigs data by YCharts
According to Laura Fulton, Hi-Crush's CFO, the distribution cut "was prudent as it allows to selectively finance growth projects with internal cash flow at attractive rates of return and preserve capital to continue weathering the downturn, while maintaining liquidity for potential strategic acquisitions."
In other words Hi-Crush didn't slash its payout due to current financial distress, but rather as a conservative measure designed to maximize long-term financial flexibility and growth prospects. In fact, co-CEO Robert Rasmus made a point to declare, "with our strong balance sheet, we could pay the distribution at the previous levels, however, we believe this is the time to preserve capital and invest in the company ... The recovery to previous demand and pricing levels will take longer than previously thought."
How much longer could an oil recovery take? Well there is no way to know for sure, however many oil analysts now believe that low crude prices may remain in effect through 2016. For example, analysts at Raymond James -- citing production growth from Iran, Saudi Arabia, and Iraq -- recently cut their respective 2015 and 2016 average oil price forecasts to $50 per barrel and $55 per barrel, respectively.
Low crude prices have resulted in many oil producers continuing to drill new wells, but not completing them -- which means no fracking occurs. In fact, according to James Whipkey, the other co-CEO of Hi-Crush, "The drilled but uncompleted well count is still estimated at 5,000 or more."
This enormous "frack log" of uncompleted wells means that demand for frac sand isn't necessarily decreasing, but rather being postponed until crude prices recover. However, since short-term oil prices are nearly impossible to predict, management would rather be safe than sorry by conserving cash in case low oil prices become a multi-year event.
More sand intensive drilling techniques: the silver lining propping up long-term demand
US Producer Price Index: Nonmetallic Mineral Products: Hydraulic Fracturing Sand data by YCharts
While true that sand prices have collapsed in recent months -- Hi-Crush's contribution margin per ton of sand fell 30% between Q1 and Q2 -- there is cause to remain optimistic about an eventual long-term recovery in frac sand prices. According to Mr. Whipkey,
Data points continue to accumulate from customers, industry participants, consultants, and experts about the phenomenon of increasing frac and proppant intensity, characterized by longer laterals, more frac stages per lateral and more sand per stage.
A study by PLG Consulting found that oil production per well can be increased 25%-100% -- a great way to minimize production costs per barrel -- through a 100% to 400% increase in pounds of sand per lateral foot.
Since some wells are now using up to 80 lateral fracking stages it's no surprise that Bryan Shinn, CEO of US Silica -- another frac sand producer -- told Reuters back in September of 2014 that his company is seeing oil producers using 10,000 tons of sand per well. What's more, US Silica believes frac sand intensity per well could double or triple by 2017 or 2018.
Of course these optimistic predictions require that oil prices recover so that those 5,000 incomplete wells -- and 50,000 old wells eligible for re-fracking -- start consuming literal mountains of frac sand. Thus the key for Hi-Crush's payout to avoid another cut is to slash expenses to the bone and conserve cash to buy time for crude prices to recover.
Bottom line: Hi-Crush's payout may require further cuts but long-term outlook is bright
In the end Hi-Crush's distribution is at the mercy of commodity prices. While I continue to be bullish on the long-term growth of frac sand demand, and that Hi-Crush is a quality energy investment, investors need to realize that low oil prices could persist for several years. In such a scenario, Hi-Crush might have to further cut or completely suspend its payout due to insufficient cash flows to support its minimum quarterly payment.
Instead of fretting too much over the moves being made today, investors with a five to ten year time horizon should consider such an event -- as well as today's low unit price -- as a buying opportunity to take advantage of America's enormous potential fracking future.
