Time To Cave And Sell Hi-Crush Partners?

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About: Hi-Crush Partners LP (HCLP), Includes: CPE, CSX, CVIA, EMES, HAL, PXD, SLCA, WRD
by: Todd Akin
Summary

Frac sand players are reaching such depressed levels that buyouts are a very real possibility.

E&Ps taking services in-house are crushing margins for services players, which is unsustainable for the oil & gas industry.

But, the case for stable pricing long term will be made below.

As a result, I am staying long frac sand players like Hi-Crush Partners.

Hi-Crush Partners (HCLP) has seen its share prices plummet along with other frac sand players like Emerge Energy (EMES), U.S. Silica (SLCA), and Covia (CVIA) due to speculation that in-basin sand abundancy will eventually drive frac sand players out of business. Forget delays in completions, poor takeaway capacity, or E&Ps' budgets being exhausted; frac sand players are now falling on fears that frac sand will become an obsolete business.

This article is dedicated to the analysts who are downgrading HCLP and driving frac sand stocks into the ground. While they may have some valid points about pricing being affected, short term, I want to propose another side to the argument, and then give my reasons for why this negative share price action in frac sand players like HCLP cannot be sustained.

First And Foremost, Downgrades Were Late

A great article came out recently on Seeking Alpha by Trent Welsh that poked holes in the recent analyst's downgrade on HCLP. It also broke down the financials for HCLP and presented the worst-case scenario for their business, which concluded that they should have enough cash to pay for their dividend and expansion plans. It is hard to disagree with his analysis.

He is not the only one who is bullish on frac sand. Yesterday, a brief article came out on U.S. Silica, stating that certain investors like John Rogers are still adding to their shares of SLCA on weakness. Negative sentiment is seen as overdone, and shares are offering over 60% upside, according to Rogers.

Yet, an analyst out of Jefferies says earnings estimates should be reduced, when CVIA said over a month ago that volumes and pricing would suffer. Needless to say, this bearish analyst is late to the party and is also failing to factor in positive commentary made by both investors and companies alike.

A Trip Down Memory Lane

Let's go back down memory lane to assess whether the thesis changed for the better or worse.

When the original thesis to frac sand changed in 2016 with the discovery of Texas brown sand, it was hard to swallow at first. But, after closer analysis was done, the bull thesis was actually changed for the better. Since there was not even enough frac sand available for E&Ps then, the brown was seen as necessary and a nice complementary mix to white.

Then, MORE frac sand came online last August, which prompted valid fears of oversupply. Since spot frac sand pricing was in the $90s, one could see prices coming back down to a more reasonable $60s or $70s range once all supply came to fruition. When new supply came online, combined with delays in completions and lack of takeaway capacity, lower frac sand pricing was exacerbated, perhaps even to the low $40s (Just a guess. I've heard rumors of NW frac sand pricing reaching the $20s, while SLCA said brown pricing in the Permian held up well in the $60s to $70s).

However, when completions resume in 2019, I could see pricing reaching the mean between recent highs and lows, which is around $65, where many frac sand players inked their contracts for years out. It's almost as if the larger sand players foresaw all of this, which is why they chose that price point and duration for their contracts.

Idling Of Dry Plant Before Expansions Was Also Planned

I just discussed how the thesis changed for the better in 2016, but, admittedly, when more in-basin sand was overbuilt, the combined triple whammy of delays in completions and overflowing pipelines severely weighed on the bull thesis.

Now, fast forward to just a month or two ago, when times were never better for HCLP in 2018. They announced their expansion of white and brown, increased their dividend, and signed those new contracts at attractive pricing. In fact, the expansion of white was for a super-major in the Permian, not for operations in some outer basins like the Bakken, who have to use white.

So, the first noteworthy point here is that Northern White demand in the Permian isn't dead. Decline rates must be an issue, which many E&Ps like Callon Petroleum (CPE) are confirming.

Secondly, my partners spoke to investor relations at HCLP, and we learned that the idling of their dry plant was actually planned ahead of time and was already accounted for when expansion plans were made. So, obviously HCLP is not expanding their sand reserves in a cavalier fashion. They knew about the slowdown in completions the entire time and were just idling their highest cost asset while ramping other assets with lower costs/more attractive margins. Many companies do this, including CSX Corp. (CSX) recently, and their stock price was rewarded.

Now, there are smaller brown sand players trying to enter the market, but many have no market share to even sell to. I suppose they want to build at all costs and just undercut the larger, public frac sand players with lower pricing. While this may be happening in small quantities, where a smaller brown producer can undercut a major by enticing an E&P to break its existing contracts in order to receive cheaper pricing, this strategy cannot be replicated in bulk.

Lower Pricing & De-Bundling Theme Cannot Be Sustained

The big risk facing all services companies, not just frac sand players, is the de-bundling theme currently taking place in the industry. This paradigm shift is attempting to drive oilfield services companies out of business, while E&Ps strive for dominance and bring all of their services needs under one roof. If an E&P gets its own sand mine, pressure pumping crews, water sourcing, and diesel, to name a few, then services companies like Halliburton (HAL) and Hi-Crush are doomed.

But, let me tell you why this de-bundling theme cannot be sustained. The short answer is, while it can certainly continue, the services sector will go bankrupt, causing the economy to suffer. Services companies employ a lot of people and have a large weighting in many market indexes. So, if services companies go under, it could drag the U.S. economy down with it.

Also, there are always the services needed by E&Ps who can't afford to vertically integrate. These E&Ps who rely on the services of a Hi-Crush, for example, would not be able to put any more wells on production if HCLP goes out of business. So, E&Ps who don't vertically integrate are doomed as well, if HCLP goes out of business since they won't have an adequate proppant supply to frac with.

WildHorse Obtains Own Frac Sand Mine

Let's use WildHorse Resources Development's (WRD) new sand mine as an example to explain why vertical integration is not sustainable on a larger scale.

WRD found a 2 million ton in-field frac sand mine near Austin, Texas, and is planning on selling that sand to other E&Ps. They consume about 500,000 tons of frac sand per year, according to reports I have received, which means they will have 1.5 million tons leftover to sell.

If every small E&P did this, they would flood the market with their own sand, drop pricing, and eventually operate those sand mines at a loss. So, whether sand is their core competency or not, WRD will definitely have cheaper proppant supply, but will lose money on the new mine since there will undoubtedly be sand leftover to sell.

Conclusion

The E&Ps who can't afford to take services in-house will also not be able to enter manufacturing mode if services companies like Hi-Crush go bankrupt. Although they can always obtain their own pressure pumping crews, for example, they can't simply get their own sand mine due to logistics issues, to name a few.

If pressure pumping is taken in-house, like many E&Ps are doing, then that leaves those standalone pressure pumping crews without a home, just like frac sand volumes. Therefore, pricing will drop for the pressure pumpers like pricing dropped for frac sand recently, and margins will be decimated. This cannot last.

I don't mind when a Pioneer Natural Resources (PXD) adds a new mine because it doesn't displace older sand. If PXD adds 10% more sand per lateral foot next year, like many E&Ps are doing, then another mine is required in order to keep fracking uninterrupted.

In other words, new sand mines are needed since sand usage is increasing per well, and this doesn't displace older sand. It's more of a plus one that gets immediately absorbed by a bigger E&P player. So, while the de-bundling theme may be affecting all services players, sand is the most difficult to bring in-house because it is too heavy and expensive to ship in bulk.

While pricing is soft for frac sand, momentarily, once completions resume, pricing should return back to more reasonable levels (where the contracts were inked in the first place). In fact, these numbers may even prove to be conservative.

As a result, more frac sand, both Northern White and local brown, is necessary for E&Ps entering manufacturing mode, and services players like Hi-Crush are representing extreme values, as they are now approaching buyout territory.

Disclosure: I am/we are long HCLP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.