Fracking: Playing in the Sandbox

The world of investing is filled with regrets about missed opportunities, such as not buying Apple in 1996, and relief at not stampeding toward what’s hyped, like Facebook.  Yet, despite that experience many mistakes are still made. The current U.S. energy boom is a classic example of regrets and relief.  Many investors do not ask the right questions or consider the right risks.  So, let’s look at some fundamentals about playing in that sandbox.

What we know is that the technology of hydraulic fracturing or “fracking” has been making available more natural gas and oil than the experts anticipated.  Although there are constraints, none are likely to change the game. For example, because the activity is primarily regulated on the state level, who’s in the White House in 2013 is not a factor. Also, in the short term, the public outcry about environmental impacts will remain more rhetoric than regulation. We know as well that some of the dangers we have seen happen, such as earthquakes, can be managed by restricting fracking to isolated areas in less vulnerable locations.  

Here is the question: Is this fracking technology producing, like the social network platform of Facebook, a fad that will soon peak, not a trend which will endure?  Energy is a needed commodity and fracking provides it in abundance, therefore, the process will continue and likely not maximize its growth any time in the near future.  

In terms of specific sectors, we know natural gas prices are lower than they have been in years, at least here in the U.S. So those companies which only deal in natural gas presently are not promising as investments as increase in supply lowers price and these companies have the legal exposure of the dangers fracking can cause. Exporting the natural gas could be the way to profits as the markets in Europe and Asia pay premium prices, but that can’t happen until there is a cost-effective, safe way to ship it.  

Given these current realities, the best bets are with the ancillary services, that is some of those companies which are suppliers to the fracking project owners.  My choice is with the companies that produce sand. Two of them are pure play producers  Hi-Crush Partners (NYSE: HCLP) and U.S. Silica Holdings (NYSE: SLCA) which recently had IPOs.  Another is EOG Resources (NYSE: EOG) which is a diversified energy company which recently added its own sand capacity. EOG’s chief executive officer Mark Papa told the Sanford Bernstein Strategic Decisions Conference last May that sand self-sufficiency will save $0.5 million a well or $300 million this year.  Since other diversified energy companies may make this kind of move, they could become more profitable as well.  

In essence, sand is a necessary proppant to the fracking process, as it is an entity which enhances the release rate of both natural gas and oil. Whether used for natural gas or oil, presently the demand for sand is very high and, therefore, so is its price. The kind of sand used in fracking costs between $20 and $30 a ton to mine.  On the spot market this year it has been selling for $100 or more a ton. Better still since fracking is used almost globally the market is just that, almost global and, given the premium pricing possible, shipping expense becomes irrelevant. Note, France has banned fracking and a state in Germany has called a moratorium to study its impacts, though worldwide radical banning measures or game-changing restrictions are not expected. After all, even after the nuclear problems in Japan, post-tsunami nuclear is still a major source of energy there and around the world.  Mankind needs energy and more of it as the economy recovers.

 

A threat with sand is that, because of the high profits, too much supply can be put on the market. This could bring down the price to the point that some playing in this sand box become bankrupt. It could also sour investors on companies that paid a premium price to acquire sand mines.  An anonymous small-cap focused long-short hedge fund going by the code name “BottomsUpAnalysis” warns that this is probable . Mining sand, it emphasizes, is hardly a complex process and there is plenty of sand around, this means low barriers to entry.

Back to EOG, because they are diversified, the risk it has taken getting into sand is lowered. The stock price, at $112+, with a 52-week range of $66.81 to $119.97, reflects that.  For Q2 it beat expectations and its projection for Q3 has been just as good. Motley Fool analyst Joel South says it’s “positioned to soar” . South, along with other EOG watchers, attributes EOG’s success to both its decision to shift into oil and that they keep the lid on debt. At the September 4 Barclays Energy/Power Conference, Papa confirmed that with the depressed pricing of natural gas he was not going to increase the volume of production of dry natural gas. However, he felt confident that eventually the portfolio of low-cost natural gas leases the company holds would pay off and when that time comes he has all the sand he needs.

Hi-Crush Partners held up its stock price after its mid August IPO. It was recently at $20.52, with a range of $17 to $20.69.  Its strengths include its low-cost operations made possible by shallow sand reserves located near rail transportation, which provides cheaper shipping than trucking.  Post-IPO it has no debt. There are long-term fixed priced contracts.  Although that locked-in pricing could be a disadvantage, satisfied customers could be receptive to higher prices when the contracts are up for renegotiation.

 

U.S. Silica hasn’t fared as well as Hi-Crush Partners after its own IPO last January. Its stock price is at $12.37, with a range of $9.02 to $22.14. Although the Q2 revenue growth was a little better than expectations, its guidance for Q3 was below those.  There have been rumors that it could be taken over and the low stock price increases that possibility and as stock price of such targets rise, this kind of possibility could be an incentive to buy. In addition to the possibility of an acquisition, U.S. Silica has a major strength which is its diverse customer base. Their customer base goes beyond the energy sector and include Sherwin-Williams and PPG.

This is a good sandbox to play in given that sand is a “prop” both with natural gas and oil fracking globally the demand is there. Pricing will probably level off but still allow for healthy profits. The danger of overcapacity is real however, in any worst-case scenario all three of these companies will likely survive. Sand isn’t EOG’s main line of business. Hi-Crush has its competitive advantages of easier-to-get-out reserves and cheaper transportation.  U.S. Silica serves sectors outside energy.