Pretty much any company connected to oil has fallen sharply in the last six months, including frack sand producers such as US Silica Holdings (NYSE:SLCA), Emerge Energy Services (NYSE:EMES), and Hi-Crush Partners (NYSE:HCLP). I believe severe valuation contraction at all three companies sets them up for potentially excellent returns should the price of oil recover later this year, here's why.
Historically low valuations present generous income opportunities
|Company||Current Dividend Yield||AVG Price/ Operating Cash Flow Over last 2 years||Current Price/Operating Cash Flow|
|Emerge Energy Services||10.90%||15||10.7|
As this table shows, US Silica and Emerge Energy are trading at a discount to historical price/operating cash flow, and both Emerge Energy and Hi-Crush offer generous yields. What's more, those payouts are backed by strong balance sheets, along with extremely high dividend and distribution coverage ratios, making them much safer than most high-yielding energy investments. Note that US Silica is a c-Corp whereas Hi-Crush and Emerge Energy are both MLPs, which can have important tax implications for choosing which ones to own in a tax advantaged retirement account such as an IRA.
Short-to-medium-term cash flow stabilized by attractive and profitable contracts
While demand for frack sand is likely to decline due to the crashing price of oil, there is cause for optimism that the decline in demand might not be as severe as the overall decline in new oil drilling. For example, US Silica CEO Bryan Shinn said during his company's most recent conference call that management expects demand for frack sand to decline by just 15% to 20% in 2015 assuming U.S. rig counts fall by 30%-35%.
While the oil industry waits for the worldwide petroleum glut to decrease -- something the International Energy Agency believes might occur by the end of the year -- frack sand investors can take comfort in the knowledge that 70%, 88%, and 87% of US Silica's, Hi-Crush Partners', and Emerge Energy's respective current and medium-term production is protected by highly profitable contracts.
Risks to be aware of
Oil service companies might be forced to break, cancel, or alter some of these contracts if oil prices remain low for several quarters. Should oil prices remain low for several years, the risks of such occurrences will surely increase. However, the fact that the average quantity of frack sand used per well has more than doubled in recent years -- which has helped lower the breakeven price of U.S. shale oil-- should help insulate the industry from the worst of the oil crash.
In my opinion, the biggest risk to this industry is the potential for a glut of supply as U.S. frack sand makers bring online several new large-scale mining operations over the next few years. For example, US Silica expects total domestic frack sand capacity to increase by 30% in 2015.
Some of this new capacity is already under contract, but if oil prices remain low for several years, expiring contracts might be replaced with new deals for less demand, and at far less favorable prices.
Finally, investors should be aware that Emerge Energy Services is a variable distribution master limited partnership. That means it pays out essentially all of its distributable cash flow each quarter and that can vary.
Massive capacity growth over the previous two years and locking up almost all of its production under high margin contract has allowed Emerge to raise its distributions for the last six consecutive quarters. However, potential and current investors should be aware that capacity growth will slow at some point, and should frack sand prices collapse due to long-term low oil prices and less profitable future contracts, this MLP's payout could decline and take the unit price with it.
Takeaway: recent oil crash creates a long-term income opportunity for brave investors
While it can be hard to buy equities in whatever industry is Wall Street's latest whipping boy, this is precisely the time, when pessimism and uncertainty are near their peak, that the best long-term investments are made. As Warren Buffett famously said, "You pay a high price for a cheery consensus," and I would recommend investors with horizons of five to 10 years consider whether these fast-rising dividend growth stocks deserve a spot in their diversified income portfolios.