In my coverage of U.S. Silica Holdings (NYSE:SLCA), as well as the frac sand industry in general, I've explained to readers the long-term growth potential these investments represent. However, recently the market has not been kind to shares of proppant suppliers, such as Emerge Energy Services LP (NYSE:EMES), Hi-Crush Partners LP (NYSE:HCLP), Eagle Materials Inc (NYSE:EXP), and Carbo Ceramics Inc (NYSE:CRR).
As this chart shows, in the past few months proppant suppliers have seen their share prices plunge between 13.5% and a painful 64% for Carbo Ceramics, the leading ceramic proppant manufacturer.
Just as I explored the three biggest reasons that U.S. Silica and its peers might soar in the long run, I think it's important to examine the risks, those things that could drive the price lower. In so doing we can see if the recent price drop represents a long-term buying opportunity or a warning from the markets to stay away from an industry in trouble.
Global economic weakness resulting in declining energy prices
Recently the prices of both natural gas and oil have begun heading lower as increased production from America's historic shale boom has met with concerns over a slowdown in the global economy, which would hurt demand for oil and gas and drive their prices even lower. This in turn would likely force oil and gas producers, which have been purchasing frac sand in record quantities, to slow new purchases, driving down the price of frac sand and hurting producers' margins.
How big a threat is this to U.S. Silica, Emerge Energy, and Hi-Crush? Well, if the decline in energy services is short-lived then not much, as the megatrend of increasing U.S. oil and gas production is likely to provide a strong long-term growth catalyst for the industry. However, should the world economy slow or even fall into recession for a prolonged period of time, then energy prices could become depressed for several years, which could alter the fundamental investing thesis of these companies. How likely is that?
Well, on Oct. 7 the IMF released its World Economic Outlook for 2015 and cut its growth targets for global economic growth from 4% to 3.8% for 2015, and 3.7% to 3.3% for 2014. The report highlighted an increased risk of recession in Europe, which the IMF estimates at a 38% probability (double that of April), as well as a 24% chance of a Japanese recession.
Fortunately, there was good news about the U.S. economy, which the IMF estimates has just a 14% chance of a recession due to our recovery being:
[U]nderpinned by an improving labor market, better household balance sheets, favorable financial conditions, a healthier housing market as household formation gradually returns to levels that are more closely aligned with demographic factors, higher nonresidential investment as firms finally upgrade aging capital stock, and a smaller fiscal drag.
However, the risk of a global recession must always be considered, especially with rising concerns about China's slowing growth and inflating debt bubble. For example, since 2008 China's total debt has surged from 147% of GDP to 251%, as the Chinese government turned to debt to stimulate economic growth through its many state-owned banking institutions.
However, now China's total bank debt stands at $25 trillion ($11 trillion more than in 2008), with many U.S. economists (52% in a recent survey) concerned that China will experience a debt crisis within the next few years.
Already signs of slowing growth in China have begun affecting commodity prices, and though the Chinese government is officially predicting 7.5% economic growth this year (down from 10%-plus in recent years), many analysts believe that number will be closer to 5%.
Even if China's debt and real estate bubbles don't pop, resulting in a global recession, slowing economic growth from China could have a detrimental effect on long-term energy prices and result in prolonged weakness in the entire energy sector, including oil services suppliers such as U.S. Silica.
Market correction is overdue
Another risk factor for proppant suppliers like U.S. Silica is that the stock market is now in the sixth year of a fantastic bull market, and perhaps overdue for a correction (10%-plus decline from recent highs). The S&P 500 usually suffers such a decline about once per year and a 20% decline every couple of years. It's now been 28 months since the S&P 500's last correction.
Now a market correction is by no means certain. However, it's important to realize that the risk of a downturn is real. Such a market decline could be terrible in the short term because of how fast share prices of companies such as U.S. Silica, Emerge Energy Services, and Hi-Crush Partners have risen the last two years.
Another factor to consider is that volatility is a major reason for the massive market outperformance of these companies. For example, Hi-Crush Partners and U.S. Silica Holdings have betas of 2.34, and 3.68, respectively. While that's great when the market is booming, it can make things a lot more painful during a correction.
Overproduction of frac sand is a risk
Demand for frac sand has been growing at 28.3% annually and is expected to continue growing at over 10% through 2022.
In fact, U.S. Silica has seen such a surge in demand that it was able to raise prices by an average of 20% this year, and recently announced that it sold out of production through mid-2018.
This kind of surging demand has resulted in major production expansion throughout the industry. For example here are the growth plans for U.S. Silica, Emerge Energy Services, and Hi-Crush Partners, the three largest suppliers in the industry.
- U.S. Silica: 102% planned capacity growth over next two years
- Emerge Energy Services: 68% increased capacity by the end of 2015
- Hi-Crush Partners: 325% capacity growth in just one year
The long-term contracts these companies have secured for this increased production means that a short-term decline in energy prices, and thus demand for frac sand, isn't a major concern. However, should slowing global economic growth or recession result in a long-term reduction (three to five years) in energy prices, then U.S. Silica and its peers will face the prospect of their current lucrative contracts expiring and themselves sitting atop literal mountains of frac sand, while demand may have fallen off a cliff. This might result in frac sand prices crashing and could eviscerate these companies' margins and share prices in the long term.
I view the recent price collapse of U.S. Silica and its peers as a result of overvaluation due to their fantastic recent run-ups, combined with the recent decline in energy prices. I continue to believe that U.S. Silica, Emerge Energy Services, and Hi-Crush Partners remain three of the best long-term ways to profit from America's shale energy boom.
Thus I view the recent corrections in the share prices of these companies as a great long-term buying opportunity, one that may make exceptional long-term capital gains and income generating potential possible. That being said, all investors must take the time to examine all sides of an investment thesis, the potential gains, as well as the potential risks.
As long as investors in frac sand suppliers are aware of the risks of that prolonged depressed energy prices, an overdue market correction, and industry overcapacity pose, then they can adjust their holdings accordingly as part of a diversified portfolio that can minimize the risks of devastating, permanent losses.
Adam Galas has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.