Frac sand producers such as U.S. Silica (NYSE:SLCA), Hi-Crush Partners (NYSE:HCLP), and Emerge Energy Services (NYSE:EMES), experienced incredible growth in 2014, reporting record growth in sales and earnings. However, with oil prices now at six year lows investor fears and uncertainty have sent share prices crashing by as much as 64% in the last six months.
I'd like to take a look at four facts highlighted by US Silica's and Hi-Crush partners managements in their latest quarterly conference call -- a valuable but underutilized investing tool -- so that you can see get a better idea of whether these companies and MLPs now represent great long-term income opportunities or merely value traps.
Better fracking techniques require more sand
"Oil and gas volumes in the quarter, grew to a record 2 million tons, a 79% increase on a year-over-year basis, driven largely by the continued adoption of new completion techniques, which employ more sand per well." --Bryan Shinn, U.S. Silica president and CEO
Shinn is referring to the fact that, over the past four years, the amount of frac sand used per well has more than doubled, from 2,500 tons per well to 5,000 tons with some wells using as much as 8,000 tons. More importantly, according to Schinn, this is a long-term trend that will continue.
Higher sand demand per well might help decrease the coming pain by lowering break even costs of drilling
"Suffice to say that we believe this trend is here to stay, and should offset some of the decline in demand we expect to see as a result of the significant number of rigs that have been already been laid down this year. ... For example, if we see a 30% to 35% reduction in average rig count, we estimate that raw frac sand demand could decline by as much as 15% to 20% from 2014 levels. The difference is attributable to higher rig efficiencies, smaller decline in horizontal drilling where proppant is used and well designs with more proppant per well." --Bryan Schinn
"Based on our analysis of announced and known capacity expansions, there were plans to bring approximately 30% more capacity online throughout 2015 ... we believe it's prudent to continue to plan for significant long-term growth as drilling and completions activity will ultimately rebound ... our 2015 CapEx plan is designed to be extremely flexible allowing us to speedup or slowdown investment as market conditions dictate." --Bryan Shinn
This quote highlights the fact that U.S. Silica remains bullish on the long-term demand for frac sand, however, should oil prices remain low for several years then the entire industry might face an oversupply problem that might send the long-term price of frac sand crashing.
U.S. Silica, Hi-Crush Partners, and Emerge Energy have 70%, 88%, and 87% of their production currently under long-term contracts, which protect their cash flows for up to 4.2 years. However, as those contracts end, lower frac sand prices might result in sales, earnings, and distribution growth greatly slowing or even turning negative in the years to come.
Strong Coverage Ratios and Balance Sheets mean safer payouts and chances for potential opportunistic acquisitions
"Distributable cash flow attributable to the limited partners...generated a coverage ratio of just over 1.3 times of the distribution...We have yet to borrow on our $150 million revolver facility. Our debt to the trailing 12 months EBITDA ratio continues to be conservative at 1.32 times. Our strong balance sheet provides us with flexibility and the ability to be opportunistic in this environment whether taking advantage of a strategic acquisition or organic growth such as through the expansion of our distribution network." -Laura Fulton, CFO Hi-Crush Partners
Hi-Crush and Emerge Energy Services are fast growing MLPs with generous yields of 7.8% and 10.8%, respectively. Given likely deteriorating market conditions income investors probably want to know two things. First, how safe are the current payouts, and second that these MLPs will be able to pay their high yields without sacrificing growth capital that's needed to expand production and transportation capacity.
As this quote indicates, Hi-Crush's distribution is well covered by its distributable cash flow or DCF which is well protected by its long-term, take or pay, contracts. While it's always possible that oil service companies might breech these contracts if oil prices decline or remain suppressed for several years, at least for now the payout appears safe.
Emerge Energy Services, on the other hand, is a variable paying MLP that pays out almost 100% of its DCF each quarter -- likely why market is offering a substantially larger yield relative to Hi-Crush. Thus while Emerge Energy would be the first frac sand MLP to, given its growing capacity and strong contract backlog, I think that the chances of the the distribution amount decreasing are slim, at least for 2015.
Finally, the strong balance sheets and available liquidity US Silica, Hi-Crush, and Emerge Energy have available means that, should the frac sand industry experience severe distress these three giants of the industry would be the best positioned to step in and acquire additional assets at fire sale prices. This would likely mean larger market share in the long-term, and faster distribution growth when oil prices finally recovered to sustainable levels.
Takeaway: 2015 may see earnings fall but oil crash is likely to create great long-term buying opportunity
Frac sand suppliers such as U.S. Silica, Hi-Crush Partners, and Emerge Energy Services are unlikely to grow sales and earnings in 2015 due to the oil crash. However, their long-term contracts and the fact that greater use of frac sand is one way for oil and gas companies to maximize productivity from each well means that demand declines might prove smaller than those of other oil services companies. Thus I would advise potential and current income investors to look at any sharp share price declines in 2015 as a potential long-term buying opportunity. However, due to the uncertainty about how long oil prices may remain suppressed, any such investments should only be made as part of a well diversified portfolio.