Like a torrent of mud hurtling through a well casing thousands of feet below ground, the oil price crash will have obvious ramifications of unpredictable magnitude. For fracking sand suppliers responsible for the key ingredient in that mud, the slump is sure to dampen a recent boom.

The rapid growth of the past several years was based not just on the increased pace of drilling but on new drilling techniques using far more sand than usual to realize impressive and cost-effective production boosts.

Shares of the fracking sand providers have dropped dramatically from the summer’s highs, and are now cheap assuming crude returns to $75 a barrel in a year or two. But if it doesn’t, cheap could get much cheaper as the backlog of lucrative supply contracts secured during the recent frenzy gradually runs out.

Because we believe crude is now closer to a bottom than to a sustainable long-term equilibrium price, we’re recommending what we believe to be the least risky of the publicly traded sand miners. Just know that Hi-Crush Partners (NYSE: HCLP) is still risky enough to make its 7.3% current yield a fair deal rather than a giveaway.

The master limited partnership has just increased its payout 8% from the prior quarter and 32% year-over-year, and plans to keep up this pace based on the growth built into its current contracts. These account for the bulk of production and have an average remaining life of 4.2 years, long enough, we believe, for the current glut of crude to dissolve.

Should it do so, wider adoption of the pioneering sand-heavy techniques still being refined by the leading drillers should support continued demand growth. We’re adding HCLP to the Aggressive Portfolio; buy below $40.  

HCLP and its two best-known publicly traded competitors, U.S. Silica Holdings (NYSE: SLCA) and Emerge Energy Services (NYSE: EMES), supply the sand that, once shot through the perforations in the well casing at high speed, holds open rock fractures, allowing the oil (or natural gas) to flow to the well bore.

The consumption of fracking sand has grown rapidly over the past five years. Not only did the number of wells drilled increase, but the laterals (the horizontal distance drilled) have gotten longer, leading producers to increase the number of stages (separately fractured intervals) per well. At the same time, field tests kept showing that wells fractured with more sand per stage tended to deliver better flow rates, further stimulating driller demand.  

As a result, demand is expected to continue to grow even as rig counts fall. PacWest Consulting Partners recently predicted it would increase at an average annual rate of 24% through 2016, approaching 145 billion pounds annually.


Source: PacWest Consulting Partners presentation

Of course, with recently rising prices dangling the prospect of recouping the entire investment in a new sand mine within two years fracking sand supply has been rising as well, and though it hasn’t outstripped demand so far there’s certainly a risk that it might catch up soon, especially if crude prices stay depressed.

But in addition to the buffer of their long-term contracts the larger suppliers do retain first-mover advantage in the logistical infrastructure needed to deliver sand from the mine to the drilling pad. This has become especially important of late as railroad snags and railcar shortages have made life at least a little bit more difficult for new competitors.

As we have just seen with oil, in an era of ultra-low interest rates the mere hint of rich returns can quickly flood any commodity niche with enough capital to turn a shortage into a glut before too long. Fracking sand is certainly vulnerable to the same dynamic, so the securities associated with its production, yield and all, must be seen as speculative trades rather than long-term investments.

But after the gut-wrenching losses of recent month, sentiment now seems grim enough for this trade to work, and the increasing intensity of sand use in fracking is likely to persist at any oil price so long as there’s shale drilling. 

One of the most popular types of sand used, thanks to its favorable physical characteristics, is Northern White sand (also known as “Tier One”), found predominantly in Wisconsin and the upper Midwest. There are few publicly traded players in this space, and the top 10 producers hold more than 75% of the total capacity.
 

Source: Hi-Crush Partners presentation

Hi-Crush Partners has 7.5 million tons of annual sand production capacity in Wisconsin and over 30 years of reserves. In 2014, 3.8 million tons of frac sand were contracted, and for 2015 6.6 million tons — 88% of production capacity — is already under contract.

The partnership also has onsite rail capacity for unit trains, and 6,000 railcars under management for handling the logistics of transporting sand to customers. Hi-Crush has access to all major U.S. oil and gas basins with direct loading and unloading of unit trains and in-basin terminals across the Marcellus and Utica shales, as well as a new terminal in the Permian Basin.

The partnership went public with little fanfare in 2012, pricing its units at $17, well below the anticipated range of $19 to $21. But in 2013 the public awoke to the improving sand demand and prices and made Hi-Crush the year’s best-performing energy MLP with a gain of 142%. On Aug. 29, 2014 the unit price closed at a record high above $69, marking a gain of 246% since the IPO two years earlier.

But it’s been almost all downhill ever since as the oil price crashed. By the end of 2014 units were down 55% since the summer peak — but still up 66% from the IPO price.

For the most recently reported quarter (Q3 2014), HCLP set records for revenues, sales volumes, EBITDA and earnings. Revenue for the quarter came in at $102 million, versus $53 million in the same quarter in 2013. The partnership sold 1.2 million tons of fracking sand, a 62% increase over the same period last year and a 15% increase over the previous quarter’s volume. The average sales price was $71 per ton. The average production cost was $13.89 per ton during the quarter, lower than $14.20 per ton three months earlier.

HCLP reported earnings before interest, taxes and depreciation and amortization (EBITDA) of $43.9 million for the third quarter of 2014, versus $19.5 million in Q3 2013.  Distributable cash flow of $32.3 million for Q3 2014 corresponded to distribution coverage of 1.40x. HCLP was also added to the Alerian MLP Index during the third quarter.

Approximately 91% of the volumes sold were under long-term fixed price contracts.

On Jan. 15 HCLP announced a quarterly cash payout of $0.675 per unit, for a 7.8% annualized yield at the current price. “We remain focused on growth, and on delivering value to our Hi-Crush unit holders,” the CFO noted via press release. “Our financial position is solid.  Year over year, we have increased our quarterly distribution by 32%.  We remain committed to delivering double digit annual growth in our distributions to our unit holders through similar quarterly increases.”


Source: Hi-Crush Partners presentation

HCLP has an Enterprise Value (EV) of $1.4 billion, an Enterprise Value/EBITDA of 12.3, Total Debt/Equity (mrq) of 120.6, and a current ratio of 2.7. The debt/EBITDA ratio is at a conservative 1.3. Despite the decline in oil prices, HCLP projected growth of 25% in 2015 during the 3rd quarter conference call (albeit with oil at that time trading at $75/bbl.)

The partnership’s contracts specify annual cost and price escalators, largely shielding it from any immediate pricing pressure.

The other fracking sand MLP is Emerge Energy Services (NYSE: EMES), formed by Texas-based Insight Equity in 2012.  In 2013, Emerge Energy Services was combined with Superior Silica Sands, Allied Energy Company and Direct Fuels in a series of transactions that culminated with the initial public offering of Emerge. EMES went public in May 2013, and rose an astounding 771% by Aug. 29, 2014. By the end of 2014 units were down 63% since that August 29th peak — but still up 226% from the IPO price.

Emerge Energy Services’ steeper rise and fall may be because it is a variable distribution MLP, which has no minimum quarterly distribution and no implied promise to keep the payout steady or growing. The distributions vary with the cash flow of the MLP.

EMES has sand facilities in New Auburn, WI, Barron County, WI, and Kosse, TX, and 8.2 million tons of sand under contract (representing 87% of pro forma capacity of 9.4 million tons per year) with an average remaining term of 4.2 years. Emerge currently has 13 transload locations positioned in six key North American shale plays, more than 5,400 customer and leased railcars, and 5,000 more railcars scheduled for delivery over next several quarters.

For the three months ended September 30, 2014 EMES reported revenues of $296 million, adjusted EBITDA of $37.4 million, Distributable Cash Flow of $34.6 million — and declared a distribution of $1.38 per unit for the third quarter of 2014 (an 18% increase over the previous quarter). Its sand segment sold over 1.1 million tons (versus 1.2 million tons for HCLP for the same quarter), at an average gross margin of $31.24 per ton.

EMES has an Enterprise Value (EV) of $1.4 billion, an Enterprise Value/EBITDA of 13.4, Total Debt/Equity (mrq) of 193.0, and a current ratio of 2.1.

EMES has issued preliminary guidance of $8/unit in distributions next year, which would represent an annualized yield of 14.3% at the current price.

EMES also operates a fuel business processing transmix, refining biodiesel and providing related logistical services. But fracking sand has accounted for the vast bulk of recent profits.

U.S. Silica Holdings is the largest fracking sand supplier. The company went public in early 2012 and its share price had risen nearly 350% by the end of August 2014. Like HCLP and EMES, SLCA was then victimized by the drop in oil prices, its share price plunging nearly 65% from peak by year end.

U.S. Silica’s facilities are located in 13 states, and it also operates an office in China. The company is more diversified than EMES or HCLP, selling its sand into many different end-use markets. In the third quarter of 2014 SLCA sold 3 million tons of sand, a 42% improvement over the same period last year. Oil and gas volumes accounted for 1.9 million tons, an 80% increase on a year-over-year basis and a 26% improvement sequentially over the second quarter of 2014.

At year end the company had some 70% of its total oil and gas volumes under long-term supply agreements.

SLCA has an Enterprise Value (EV) of $1.5 billion, an Enterprise Value/EBITDA of 7.2, Total Debt/Equity (mrq) of 95.7, and a current ratio of 3.3. The company expects to have over 9,000 railcars in service this year, and was still expecting 20% volume growth in 2015 if oil prices were $70/bbl.

The partnership pays a modest dividend currently yielding 1.8%.

Another major supplier, FMSA Holdings (NYSE: FMSA), accounted for 12% of total industry capacity and a third of the total resin-coated sand capacity, according to filings ahead of its October IPO. FMSA’s private equity sponsor had hoped to raise as much as $1 billion in the offering, which took place just as crude sank below $90/bbl.

Even at that oil price, the IPO raised only $400 million at a reduced valuation amid faltering demand. Those who took the plunge three months ago already have plenty to regret with the share price down from $16 to less than $6.

FMSA’s operating subsidiary, Fairmount Santrol, operates 11 fracking sand processing facilities with 12.3 million tons of annual capacity, and 11 coating facilities with 2.4 million tons of capacity. Fairmount has been producing proppant for three decades, and is an industry leader in the higher-value resin-coated sand that’s more effective in high-pressure reservoirs. Resin-coated sand made up just 11% of the total market last year according to FMSA, yet fetched four times as much per ton as raw sand.

FMSA has an Enterprise Value of $2.2 billion, an EV/EBITDA of 6.2. Debt now exceeds the $943 million market cap, and the small float representing 22% of the total market cap probably didn’t help matters during the recent sell-off.

FMSA reported a 41% revenue increase to $374 million in the third quarter. It’s projected nearly $400 million in adjusted EBITDA for 2014, and is expected to issue a forecast for 2015 when it reports the fourth-quarter results next month.

In November, Smart Sand Partners (SSLP) filed to raise up to $100 million in an IPO. Like the two established fracking sand MLPs, SSLP produces Northern White frac sand from sand mines and a processing facility in Wisconsin. Its integrated facility has on-site rail infrastructure and wet and dry sand processing facilities, enabling the delivery of approximately 2.2 million tons of frac sand per year. As of June 30, SSLP had approximately 217 million tons of proven recoverable sand reserves and 64 million tons of probable recoverable sand reserves.

SSLP has contracted 96% of its production capacity under fixed price contracts with weighted average remaining contract life of 2.7 years. For the 12 months ended Sept. 30, the partnership had revenue of $52 million and estimated distributable cash flow of $16 million that would have been available to investors. For the 12 months ending September 2015 the partnership projects that distributable cash flow will explode to $71 million. This increase is primarily attributable to the anticipated sale of 2.4 million tons of frac sand, up from just 500,000 tons sold in 2013.

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