Hi-Crush Partners LP (HCLP) is a low cost producer of Northern White sand that is used as a proppant in oil and natural gas wells. Detailed descriptions of the company's business can be found here, here, and here.
The Baker Hughes Issue
On November 13, Hi-Crush reported Q3 2012 earnings, along with announcing the termination of a supply contract that previously provided Baker Hughes (BHI) with sand totaling 18% and 16% of Hi-Crush's contracted sand volume and total annual sand volume, respectively (as reported July 1, 2012). Due to the termination, Hi-Crush lost 25,000 tons of contracted sand sales in October. Although this lost volume could grow as Baker Hughes' volumes potentially remain unsold in future quarters, Hi-Crush management made it clear on their conference call that they believe they will be able to sell the Baker Hughes sand fairly easily through current customers, new customers, or in the spot market. Hi-Crush's units were knocked down 25% that day to ~$15, a level where they continue to trade today.
While the news of a large contract cancellation/termination is alarming, in this case it is overshadowing opportunity. Below I discuss points that I think provide a deep assurance to investing in Hi-Crush units.
Subordination Period Provides Distribution Cushion
Half of the outstanding HCLP units are subordinated units, and the other half are common units purchasable in the open market. Common units are entitled to the minimum quarterly distribution of $.475/unit before the subordinated units are paid any amount, $.475/unit or otherwise. Common units accrue any missed distributions or amounts below $.475 quarterly. Accrued arrearages to common units must be paid before subordinated units receive any subsequent distributions. Subordinated units do not accrue arrearages.
The subordination period ends as early as the first distribution date after June 30, 2015, as long as both common and subordinated units have received at least $1.90 annually for the prior 3 years. While this subordination period may end earlier, as early as the first distribution date after June 30, 2013, it would only occur if both common and subordinated units received an annual distribution exceeding $2.85 (net of any incentive distributions). I would much prefer the subordination period end sooner rather than later, and while this period has been incorrectly explained elsewhere, the provided reduction in distribution risk has seemingly been overlooked.
Rig & Well Efficiencies
60% of Hi-Crush sand production is sent to the Eagle Ford, Permian, and Marcellus plays. On Hi-Crush's Q3 2012 CC, management discussed wells at Eagle Ford experimenting with longer lateral lines and higher sand concentrations. In July of 2011, a 3,500ft lateral would use 5 million pounds of sand. Recently, wells have seen good results with 5,000ft laterals and using as much as 10 million pounds of sand.
Similarly, on their Q3 2012 CC, Cabot Oil & Gas (COG) talked about wells in the Marcellus areas transitioning from 3,500ft laterals with 15 stages, to wells using the same lateral length but with 18 stages and the same amount of sand used per stage. They also discussed using longer lateral lines.
This all comes back to more sand being used in wells. While well numbers and rig counts have softened into the latter part of 2012, some of this is attributable to the above efficiencies, rigs being able to drill more wells, archaic oil/gas rig classification, and possible end of year E&P budget exhaustion and constraints as noted by Halliburton (HAL) in their Q3 2012 CC. Baker Hughes contributes the slowdown to cautious outlooks on natural gas prices into 2013, as discussed in their Q3 2012 CC.
Hi-Crush management has repeatedly said they are looking to bring the Augusta facility into the Hi-Crush MLP structure, and that it will be accretive. During the Q3 2012 CC, they reinforced this plan, and gave notion of this occurring early in 2013. Acquisition costs and related financing to bring in the Augusta facility would not affect operating surplus, on which distributions are based.
Additionally, management confirmed that they could move Augusta volume through Hi-Crush to make up for the lost Baker Hughes volume, but do not need to in order to maintain the common unit distribution through 2013. Baker Hughes is not a customer at the Augusta facility either. I view the Augusta facility as a free call option.
The points above are relatively weightless when viewed in light of Mr. Huff's recent actions. John Huff ran Oceaneering International (OII) for 20 years through 2006, and serves as a current director at Hi-Crush, among many other admirable positions. He purchased $1.23 million worth of Hi-Crush units early last week at an average price of $16.41. This occurred a week after Hi-Crush announced the Baker Hughes cancellation, and a month after Hi-Crush initially became aware of the cancellation. In light of recent investor questions, I view this purchase as a silent response by Mr. Huff: "Baker Hughes issue. What issue?" Otherwise, this is a potentially expensive PR blunder by a pretty bright guy.
Hi-Crush units have been hit hard in recent weeks, and could no doubt see selling pressure through the end of 2012 as sellers look to take tax losses. This is the largest near term downside pressure, but is a welcome buying opportunity for longer term investors.
Fiscal cliff worries leading to tax reform are often brought up as risks against MLP's in general. The estimated annual cost to the US Treasury from MLP tax breaks is only $300 million, barely a drop in the bucket in the grand scheme of tax reform, and not enough to counter the massive domestic energy and infrastructure gains brought by MLP's.
In late 2011, EOG Resources (EOG) began shipping sand that they mined themselves, for use in their wells. The CEO pegged the savings at 20%, or roughly $1 million on a typical $5 million onshore well. While moves like this are a potential threat to Hi-Crush's proppant demand, the increasingly stringent government regulations, logistical issues, and local resistance to mining should dampen any future threat.
Although there are many more details that may be pertinent to an investment in Hi-Crush, I have addressed the recent issues that I believe are discounting Hi-Crush units far too much. Longer term, I expect Hi-Crush to perform as management has lain out, and the units to experience above average price appreciation as the distribution risks are reassessed by the market over the next quarters. Ultimately, the timing of John Huff's purchase should be all that is needed to comfortably move past Baker Hughes.