Hi-Crush Sees Stabilization Of Frac Sand Pricing And New Revenue Model

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About: Hi-Crush Partners LP (HCLP)
by: Todd Akin
Summary

HCLP swung to a loss in the fourth quarter of 2018, citing a perfect storm of temporary events that weighed on frac sand pricing and earnings.

However, pricing has stabilized according to HCLP, for reasons we will discuss below.

New contract structures with E&Ps and destinations for Northern White volumes should also transform HCLP into a more stable company, while still providing strong growth potential to shares.

As a result, I am staying long shares of HCLP.

Hi-Crush Partners (HCLP) reported a loss in the fourth quarter of 2018 as a perfect storm of events, namely lower oil prices, poor weather, budget exhaustions, and slowing completions from inadequate takeaway capacity, all occurred, causing lower frac sand pricing and a reduction in volumes.

All of these issues are transitory, and should be resolved by the end of 2019. However, the fact that Northern White pricing is suffering is not transitory, and should continue to penalize miners who have higher costs and less in-basin supply.

Thankfully for HCLP, the company has a solution to not only combat average frac sand pricing weakness (by using new contract structures with E&Ps through last mile), but it also continues to believe that displaced Northern White sand can find a home again in expanding basins.

Therefore, HCLP has the ability to work through all current headwinds it faces, and its new "value for value" strategy in sacrificing pricing for last mile abilities, as well as its C-Corp conversion, will transform the company.

Consequently, this new revenue model of lower for longer pricing with increased volumes, in turn, will possibly attract institutional investors, and I am staying long for the ride.

Northern White To Finally Make A Comeback?

The theme of in-basin sand being easily found, and displacing Northern White sand, is wreaking havoc on overall frac sand pricing.

In-basin pricing has actually been relatively strong, even in basins like the Bakken, according to Smart Sand (SND), and 40/70 continues to be in high demand, no matter whether it's local, or Northern White.

It seems that certain analysts still aren't aware that many grades of silica sand are used in fracking, judging by the questions asked from Jefferies on the Q4 conference call, and this will always provide a home for 40/70 Northern White, even in the Permian.

The issue is that 100 mesh Northern White continues to see displacement because most local sand is 100 mesh (80/20 rule). This would be a problem for sand suppliers like HCLP, long term, if they couldn't find a home for their stranded 100 mesh.

However, it is rarely mentioned that other basins outside of the Permian are expanding rapidly, and this is not including the Bakken, Eagle Ford, or the Marcellus.

Rather, exciting new growth areas are getting the necessary infrastructure built out to allow E&Ps to move into manufacturing mode in these basins as well, such as the Powder River Basin in Wyoming, the Niobrara Basin in Colorado, and the Anadarko Basin in Oklahoma, to name a few.

In addition, according to Schlumberger (SLB), numerous international basins are opening up such as in Argentina, the Middle East, and China, and these regions would utilize HCLP's last mile containers.

In fact, the Vaca Muerta is already using large blue PropX containers of HCLP's. So, even if HCLP does not sell sand directly to those international basins, they will still be able to play burgeoning international frac sand trends through last mile and PropX.

New Contract Structure To Transform HCLP

We have talked ad nauseum about HCLP's bullish future prospects in prior articles, particularly as it relates to Northern White pricing improving longer term, and last mile generating extra revenues at the wellhead.

However, the talk about contract restructurings, while it has been touched on briefly by me, is not seeing much traction in the investor community. Ironically, this notion about new contract structures was repeated throughout HCLP's Q4 call.

To summarize, HCLP has announced a new foundation to their company through their new contracts with E&Ps, as opposed to oilfield service companies in years past.

This is happening either as a result of the bundling benefits E&Ps receive by going through HCLP for all of their sand and transportation needs (which is cheaper than going through an expensive middle man. E&Ps also need more access to sand because of their switch from wildcatting to full development mode, which has only recently occurred on a wide scale basis) or, the new contract structures could also be occurring simply due to HCLP's superior last mile options, as they are the only frac sand company that owns and offers two last mile options.

Either way, bundling savings, last mile superiority, or both, will revolutionize HCLP, providing them with a stronger foundation and better contracts.

Needless to say, being fully sold out of sand and (80%-90%) contracted in the future will lower costs and increase fixed cost absorption again, even if pricing suffers from the "value for value" exchange theory. Because, as long as HCLP's sand has a home through their last mile and new E&P contracts, these actions will improve their volumes and cost savings.

The question is, can HCLP make enough off of their new contract structures? I believe they can, since last mile should add about $10 to $15 in value to contract pricing, which offsets the $10 to $15 lost from lower sand pricing. This is just a rough guess, as HCLP will not disclose their contracting structures, nor was it mentioned by analysts on the Q4 call.

I have argued numerous times that these new contracts of HCLP's should increase earnings in the way of full utilization and more fixed costs savings, reduce volatility, increase visibility (through longer term contracts), and provide stable cash flow for years to come, even at lower average pricing per ton.

In addition, once more mine idlings occur, and completions resume in a large way (as more pipelines come into service in 2019), frac sand pricing should rise back to the mid $60s or $70s again (where many long term contracts are inked at originally in 2018), allowing HCLP to earn more profit via spot sales or WTI escalators, and gain more leverage on the upcycle.

Financials Strong

HCLP swung to a loss in the fourth quarter of 2018 for reasons mentioned above, as volumes declined and average price per ton fell from $64 to $58.

Consequently, HCLP's revenues were only $162 million, compared to the $214 million in the third quarter of 2018. However, eliminating the dividend and moving to a C-corp structure will improve fundamentals for HCLP.

Debt is also currently manageable at $445.5 million, and HCLP has no balances drawn under their ABL facility. Hopefully these latest initiatives can help attract new investors to HCLP that will, ultimately, provide a stabilization to share prices in the future.

Risks

Risks remain high in the frac sand space as long as completions suffer from a lack of takeaway capacity. Threats of a slowing global economy can also affect oil prices, which affects the rate at which completions occur.

However, as described above, even with lower sand pricing, HCLP should be more insulated from downside volatility as their new contract structures will provide stability and long term visibility for earnings.

Here is a brief, direct quote from management on how their new contracts will help earnings through increased volumes going forward:

The benefits we received in return for lower pricing in the form of extended term, additional volumes and last mile services will accrue over time.

Conclusion

Hi-Crush had a slow fourth quarter, like many other oilfield services companies, but results were better than expected. Average pricing only fell $6, and the company now expects a stabilization of frac sand prices as completions resume and more mine idlings occur.

More importantly, HCLP should see less volatility and increased earnings through their Wal-Mart (WMT) model of lower prices and higher volumes.

This new model can only result from a transformation of contracting structures, which is happening in real-time as E&Ps continue to switch to HCLP from more expensive oilfield services players (or one-trick pony sand miners), either due to bundling incentives, last mile superiority, or both.

I also continue to see frac sand as the backbone to fracking, and as the single-hardest product to move and manage due to its bulk, which raises barriers to entry.

This is because, as soon as a competitor thinks they can move into the frac sand business, which seems easy at times because of the abundancy of sand, they will find that more idlings will have to occur, as no mines are lower cost than HCLP's with their first mover advantage, nor do they have the footprint to move the product to other basins like HCLP.

So, the value of sand, and moving it efficiently, is only increasing as higher cost players get eliminated, and E&Ps move more aggressively into manufacturing mode.

Furthermore, new contracting structures are evolving through last mile and bundling so that E&Ps can viably switch to manufacturing mode, and this will provide increased earnings to HCLP longer term.

As a result, I am staying long shares of HCLP, and counting on its new revenue/contracting model to limit downside risks from weaker frac sand pricing in the future.

The new contract structures should also restore the possibility of aggressive share price appreciation potential for HCLP that investors fell in love with, originally, and had become so accustomed to in years past.

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.