MLP IPOs: Subordinated Unit Structure, High Yield Offer Good Value Proposition

by: Elliott Gue

Hi-Crush Partners LP (NYSE:HCLP) went public on August 16, 2012, at a price of $17 per unit, well below the anticipated initial public offering (IPO) range of $19 per unit to $21 per unit. The initial offering was also downsized to 11.25 million units plus 1.6875 million units as an overallotment for the underwriters.

However, the downsized offering and lower price generated demand for the stock in the secondary market; since the IPO, units of Hi-Crush Partners have consistently traded above their initial price.

The master limited partnership produces American Petroleum Institute (API)-grade Northern white sand, or Ottawa white sand, from a mine and processing facility in Wisconsin. The 561-acre mine complex boasts a nameplate capacity of 1.6 million tons of sand per year and connects directly to a rail facility owned by Union Pacific Corp (NYSE: UNP). A third-party assessment of the mine estimated that the site contains 48.4 million tons of API-grade sand and is capable of operating at the current production rate for more than 30 years.

In a conventional oil or gas field, the reservoir rock usually exhibits some permeability-that is, the pores and cracks in the rock are connected, allowing hydrocarbons to flow through the reservoir, impelled by geologic pressure. Although shale plays have pores that contain oil and natural gas, these reservoir rocks lack permeability.

Hydraulic fracturing is a process whereby producers pump a liquid into a shale formation under such tremendous pressure that it cracks the reservoir rock. This creates channels through which hydrocarbons can travel, improving permeability. Over the past several years, US producers have honed this technique in a number of prolific shale oil and gas plays, increasing the number of fracturing "stages" along the lateral portion of a horizontal well.

Producers also mix sand, resin-coated sand or ceramic material into the fracturing fluid. This "proppant" enters the fissures created during the hydraulic fracturing process and literally props them open.

The API-grade sand used by oil and gas companies meets certain standards in terms of shape, size and crush resistance. The most commonly used proppant in the oil and gas industry is API-grade silica sand, which accounts for about 80 percent of the total market. Meanwhile, resin-coated sand-silica sand enveloped in a special resin to make it smoother and more crush-resistant-accounts for another 10 percent of the market. Expensive ceramic proppant that doesn't require silica sand represents the remainder of the market.

As horizontal wells account for virtually all drilling in US unconventional plays, the horizontal rig count-a measure of the number of rigs actively drilling for oil and gas-is a good proxy for demand for hydraulic fracturing and, by extension, proppant. When you consider that the US horizontal rig count has soared from a 2009 low of 372 rigs to about 1,150 units, it's easy to see why demand for sand-based proppant is growing quickly.

Nevertheless, investors have lingering concerns that a growing supply of proppant from private producers, coupled with a slight decline in the overall rig count, could lead to an oversupply of this critical input.

Much of the weakness in the overall US rig count stems from producers scaling back operations in basins that primarily produce natural gas. I discussed this phenomenon at length in my May 11, 2012 article entitled Profiting from the Gas Glut. However, the number of rigs targeting oil remains elevated.

The type of sand that Hi-Crush Partners produces provides a degree of insulation against the decline in gas-focused drilling activity. Often located at greater depths than oil, natural-gas fields involve hotter temperatures and extreme geologic pressure. For this reason, exploration and production companies sometimes talk about a field being "too cooked" to produce oil. In contrast, oil- and liquids-rich plays tend to be located at shallower depths.

Ceramic proppant is more crush-resistant than sand but also costs more. Exploration and production firms have increasingly shifted away from using ceramic proppant outside of the deepest unconventional plays, even if this variety leads to superior initial production rates. Hi-Crush Partners stands to benefit from the great migration out of gas-focused basins and upstream operators' preference for sand-based proppants.

In addition, not all sand is identical. The Ottawa sand that's Hi-Crush Partners' specialty has emerged as the variety of choice for operators in liquids-rich plays, thanks to its coarser grains.

US Silica Holdings (NYSE: SLCA), which also went public somewhat recently, produces Ottawa white sand and competes with Hi-Crush Partners, though the former also sells its output to a handful of industrial markets. Hi-Crush Partners, on the other hand, exclusively targets the oil and gas industry.

The contrasting outlook offered by US Silica Holdings and CARBO Ceramics in the most recent quarter speaks volumes about trends in the proppant market and has important implications for Hi-Crush Partners.

CARBO Ceramics has described the proppant market as oversupplied and noted that an influx of cheaper ceramic proppant manufactured in China has depressed selling prices in the US. The company also indicated that proppant pricing had declined roughly 4 percent sequentially in the second quarter. When asked for additional granularity during the Q&A portion of a conference call to discuss results, management stated that that pricing in the "first part of the quarter was much better than the exit." In other words, proppant prices declined as the quarter wore on.

US Silica Holdings' management team had a much different take on trends in proppant pricing during its conference call to discuss second-quarter results:

Spot prices [for fracturing sand] were down 18 percent sequentially. And if you recall, last quarter, when we talked about what was happening in the market we talked about a lot of the frac crew movements and the rig shifts. And the result of all that, in Q1, there were some very acute, temporary shortages that we saw in many basins around the country. And so, it kind of created almost artificially high spot prices in Q1, if you will. I'd say there continues to be a lot of chop[piness] in the spot pricing market. It tends to be sort of a basin-by-basin, grade-by-grade phenomenon. One of the things that was interesting to watch the prices throughout the second quarter. Actually, for us, spot pricing was higher in June than at any time during the second quarter. With that said, the gaps narrowed a bit since last quarter and I would say, though, as we looked at prices in June, our June spot prices were still above our contract prices.

Proppant producers usually sell their output under long-term contracts and in the spot market, where sand is available for immediate delivery. US Silica Holdings indicated that supply shortages in the first quarter temporarily pushed up spot prices, which have since receded.

Fears that the proppant market is hopelessly glutted appear to be exaggerated. US Silica Holdings' management has emphasized that two of the four grades of sand that the company sells benefited from rising prices in the second quarter, while the other two declined in price. Management also indicated that the rebound in the price of West Texas Intermediate crude oil increased customer demand toward the end of the quarter.

Hi-Crush Partners has yet to report any quarterly results, but comments from US Silica Holdings suggest that the market for Ottawa white sand has held up better than the market for ceramic proppant.

In addition, Hi-Crush Partners has booked 91 percent of its anticipated proppant sales from June 30, 2012, to mid-2014 under fixed-price, take-or-pay contracts with leading oil-field service providers such as Halliburton (NYSE: HAL), Baker Hughes (NYSE: BHI) and Weatherford International (NYSE: WFT). From mid-2014 through the second quarter of 2016, about 71 percent of Hi-Crush Partners' planned 2011 volumes are already under contract.

Regardless of prevailing spot prices, services firms have agreed to purchase proppant from Hi-Crush Partners at an average price of $65 per ton in 2012, $66 per ton in 2013 and $68 per ton in 2014.

If the services companies don't meet their minimum purchase commitments, they must make Hi-Crush Partners whole by paying a fee of $49 per ton in both 2012 and 2013 for any volumes they don't buy. Although this keep-whole price is slightly less than the price for delivered proppant, the MLP can also sell this sand on the sport market; even if prices plummet, these keep-whole contracts should protect the sand producer's cash flow and a prudent quarterly distribution.

Hi-Crush Partners' subordinated-unit structure should also ensure that the distribution meets expectations. The MLP currently has about 13.6 million common units outstanding and 13.6 million subordinated units that are 100 percent-owned by Hi-Crush Proppants LLC, the firm's general partner. Private-equity firm Avista Capital Partners is the leading investor in Hi-Crush Proppants LLC.

The subordinated units won't pay a distribution unless investors who hold the common stock receive the full minimum quarterly distribution of $0.4750 per unit. In other words, if the cash available for distribution fails to hit this threshold, the sponsor will forego its disbursement. Even better, holders of subordinated units aren't entitled to any distributions until common unitholders are paid any arrearage from prior shortfalls.

The subordinated units will convert to common units on the later of June 30, 2015, or after three consecutive four-quarter periods in which the MLP has met its minimum quarterly distribution of $0.4750 per unit.

Given its fixed-price contracts and subordinated unit structure, Hi-Crush Partners should disburse its targeted full-year payout of $1.90 per unit. At current prices, this equates to a distribution yield of 9.8 percent. Note that the MLP's initial, prorated distribution will cover the period from the date of the IPO in mid-August through Sept. 30, 2012 (roughly half a quarter) and will be prorated. Investors can expect to receive about half the minimum quarterly payout when Hi-Crush Partners makes its first disbursement to unitholders.

Drop-down transactions from the MLP's sponsor could fuel future DCF growth. Hi-Crush Partners has the right of first refusal to purchase two additional mining locations in Wisconsin that contain 79.2 million tons of probable API-grade sand reserves. One of these sites is already ramping up to produce about 1.2 million tons of sand annually.

With 13.6 million subordinated units and incentive distribution rights (IDR), the MLP's parent has ample reason to ensure that these transactions occur at prices that are immediately accretive to DCF. The quarterly IDR payments made by Hi-Crush Partners to its general partner are based on the distributions that the MLP pays to holders of the common units.

In this instance, the general partner is compensated only through distributions paid on its subordinated units until the quarterly payout on the common stock exceeds $0.54625 per unit. At that point, the general partner will also receive an IDR payment. This fee increases again when the quarterly distribution on the common stock eclipses $0.59375 per unit and $0.71250 per unit. This structure pushes the general partner to grow the MLP's distribution quickly.

Hi-Crush Partners' business entails more sensitivity to commodity prices than the typical midstream MLP that owns pipelines or oil terminals; this stock is only appropriate for aggressive investors that can stomach the risk. That being said, the company's fixed-fee contracts mitigate immediate exposure to spot proppant prices, and the subordinated unit structure helps ensure that the MLP will disburse its minimum quarterly distribution over the next three-year period.

With an above-average yield to compensate investors for added risk, Hi-Crush Partners LP is an IPO I like. See more of my MLP picks by downloading my free report entitled The Best MLP Investments to Own Now.

Disclosure: I am long UNP, WFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.