The last few months haven't been kind to frac sand suppliers U.S. Silica Holdings, (NYSE:SLCA), Emerge Energy Services LP (NYSE:EMES), or Hi-Crush Partners LP (NYSE:HCLP). The plunging of oil prices, combined with the overvaluation that was a result of a truly phenomenal run over the last 18 months, has resulted in a brutal correction in the share/unit prices of these companies/MLPs.
Long-time Motley Fool investors know that major corrections like this often make the best long-term opportunities. I'd like to illustrate why U.S. Silica has the potential to be one of America's best growth stocks over the next 10 years by turning to five quotes from the company's conference call.
Amazing growth in sales
"The step change in demand that we continue to see from our blue chip oil and gas customers drove record volumes for the company of approximately 3 million tons, a 42% improvement over the same period last year. Oil and gas volumes in the quarter grew to a record 1.9 million tons, an 80% increase on a year-over-year basis." --Bryan Shinn, president and CEO, U.S. Silica Holdings
This growth in frac sand volumes is due to several factors. For example, the number of wells in key gas formations, such as the hyperprolific Marcellus and Utica shale, is booming, but also new wells are being drilled deeper, longer, and with more stages.
In fact, thanks to these new drilling techniques the volume of sand consumed by the average well has doubled from 2,500 tons to 5,000 tons, with some wells using as much as 8,000 tons of sand.
Plunging oil prices haven't slackened demand
"We're seeing strong demand for our products across all of the major basins, and we expect to remain sold-out of all grades of frac sand for the foreseeable future." --Bryan Schinn
Energy investors have been very nervous recently, as evidenced by plunging prices of energy stocks. Thus far, though, the shale oil and gas boom hasn't been affected much and there is reason to believe that lower energy prices may not derail America's energy renaissance as much as some fear.
For example, as The Wall Street Journal's Mark Mills recently explained, there are two reasons to believe that lower oil prices won't have too detrimental an effect on oil and gas production.
First, the fracking revolution first took off in 2008 and 2009, when oil prices were as low as $50, indicating that production costs for much of America's shale oil is low enough to weather the current oil price correction.
Second, newer technologies have greatly increased the efficiency of newer wells. For example, according to the Energy Information Administration, the average production per well has quadrupled over the last four years.
These kinds of efficiency gains can help lift margins even when energy prices are down and keeps high-growth demand from American energy producers for frac sand.
Strong pricing power causing record earnings
"Higher volumes and stronger pricing drove record revenues for the company in the quarter of over $241 million, an increase of 67% over the same period last year. ... Adjusted EBITDA for the quarter was a record $77.5 million, a 72% increase on a year-over-year basis." --Bryan Shinn
This year U.S. Silica has been able to exhibit strong pricing power by raising prices twice, for a total of 20%.
There is good reason to believe that this pricing power may continue. For example, analysts at Morgan Stanley project that frac sand demand will increase 96% by 2016 (compared to 2013), while supply will increase only 76%.
Long-term contracts protect against dropping oil prices
"We're currently in discussions with existing customers about extending and expanding contracts and with new top tier customers to establish contracts. Based on this, we expect to enter 2015 with more than 70% of our oil and gas capacity under long-term contract in anticipation of the start up of new capacity at our Fairchild and Pacific sites in the second half of the year." --Bryan Shinn
Long-term contracts are a great way for frac sand suppliers to ensure consistent cash flows and profit margins. Because increasing the volume of frac sand used is one of the best ways to increase production, oil and gas companies are willing to sign increasingly longer contracts to ensure a steady supply.
For example, during its second quarter conference call, U.S. Silica reported that its contracted sand supply was sold out through mid-2018. This should give current and prospective investors confidence that today's low oil prices don't pose an immediate threat to the profitability of the industry.
Margins continue to improve
"Pricing continued to strengthen in both operating segments, driving enterprise contribution margin per ton to a record $31.33." --Bryan Shinn
The immense demand for frac sand, which thus far shows no sign of letting up, is driving the margins and operating efficiencies of U.S. Silica, Hi-Crush Partners, and Emerge Energy Services to industry leading levels.
|Company/MLP||Net Margin||Return on Assets||Return on Equity|
|Emerge Energy Services||8.20%||23.90%||54.40%|
|Industry Average (Oil & Gas services)||7.60%||5.80%||10.80%|
Bottom line: frac sand is one of market's secret growth opportunities
While it's possible that prolonged low oil prices may end up hurting demand for frac sand, in the short-medium term it's also possible that energy producers may resort to using more frac sand to boost production per well, thus lowering their costs in order to preserve margins. While only time will tell if this comes to pass, thus far the pricing power and profitability of frac sand producers indicates that this market niche is a potentially great place for investors to target in order to cash in on America's shale energy bonanza. With share prices of market leaders U.S. Silica, Hi-Crush Partners, and Emerge Energy Services getting clobbered recently, long-term investors should consider adding these companies/MLPs to their diversified growth portfolios.