3 Plays in Fracking’s Secret Ingredient

by Aaron Levitt | September 28, 2012 11:19 am

The hydraulic fracturing and advanced drilling revolution has completely changed the energy landscape across North America. As the exploration and production (E&P) industry has embraced this technology, a virtual ocean of natural gas, oil and natural gas liquids have been unlocked from the continent’s shale rock. At the same time, previously dry or dying fields have been given new life. All told, “fracking” is suddenly moving the U.S. ever-closer to energy independence[1].

But clearly, tapping these formations isn’t as simple as drilling a hole deep into the ground. From 1,000-horsepower pumps and special carbide drilling bits to the correct slurry of fracking liquids based on the type of rock being drilled, it takes a lot of industrial know-how and some pretty high-tech equipment to frack a well properly.

It also takes one really really low low-tech component as well: sand.

As the main ingredient in “proppant” — which is injected into the well along with fluid to hold open the fractures so hydrocarbons can flow properly — the demand for both natural and synthetic sand is exploding.

For investors, there’s plenty of potential in this boring world as the drilling boom continues to evolve.

It’s a Sand Rush!

While it may not seem like a big deal, sand is quickly becoming the commodity du jour in the energy sector. Fracking a single well consumes up to 1,600 tons of sand, and the industry’s demand reached nearly 28.7 million tons in 2011[2]. That’s up from 6 million tons in 2007, according to independent laboratory PropTester and consultancy group Kelrik.

This rising demand has set off a virtual Sand Rush across Midwestern states like Wisconsin and Minnesota because fracking requires a specialized quartz sand — not any old playground sand will do.

Geological conditions across the Great Lake states were right hundreds of millions of years ago to form sand hard enough to withstand the pressures of deep drilling[3], while also having round particles. That’s key because that spherical shape leaves space so the oil and gas can escape. Depending on the quality (the best stuff is called Northern White or Ottawa Sand), fracking sand can fetch upwards of $65 a ton.

Like the E&P firms looking for hydrocarbon deposits[4], sand miners have been offering hundreds of thousands of dollars to Midwestern residents for the mineral rights to their land, plus royalties between $1.50 and $3 per ton — simply for their sand beds. While that may seem crazy for something so basic, even including royalty payments it costs only $18 a ton to mine the easily accessible material. Net profit margins for most firms are in the neighborhood of 65% to 70%.

Overall, fracking’s long-term trajectory makes the proppant miners quite an interesting proposition for investors. Here are three picks to help your portfolio play in the energy sector’s sandbox.

Hi-Crush Partners

Fresh off its recent IPO[5], Wisconsin miner Hi-Crush Partners (NASDAQ:HCLP[6]) could be one of the best picks in the sector. The firm operates a 600-acre sand-mining facility in Wisconsin that produces top-of-the-line Northern White monocrystalline sand. This facility can produce roughly 1.6 million tons of sand per year and has a reserve of 33 years.

Almost all of that production is accounted for because Hi-Crush is currently contracted[7] to produce nearly 1.5 million tons annually under four long-term contracts with oil-field service firms Baker Hughes (NYSE:BHI[8]), Halliburton (NYSE:HAL[9]) and Weatherford (NYSE:WFT[10]).

The kicker for investors — aside from the fact Hi-Crush has zero debt — is that it’s structured as a master limited partnership. That will provide investors with big dividend distributions given the firm’s low-cost advantage and steady cash flows. Hi-Crush’s management intends to pay a minimum distribution of $1.90 per year, which could rise as sand prices go higher. That gives investors a very juicy yield of 8.7% at the current share price.

U.S. Silica

Another new IPO that investors may want to try is U.S. Silica (NASDAQ:SLCA[11]). The 112-year-old firm owns more than 140 million tons of worth of American Petroleum Institute-certified reserves. That’s roughly 40 to 45 years worth of fracking sand, and it’s on par to produce 3 million tons this year.

The firm’s oil and gas focus has been strictly on U.S. fields[12] such as the Utica, Marcellus and Bakken. However, SLCA has recently been involved in supplying sand for oil and gas operations in South America[13]. That could provide another avenue for growth,

The rising demand for fracking sand was one of the reasons the company floated its IPO back in January. However, as natural gas prices fell, investors sold the shares, and U.S. Silica has dropped roughly 18% since its debut to sit around $14. Now could be a great time to buy, given its long-term growth projections.

CARBO Ceramics

Falling natural gas and natural gas liquids prices[14] haven’t been good to shareholders of CARBO Ceramics (NYSE:CRR[15]), either. Shares have tumbled from a 52-week high of $162 all the way down to just $65. That’s somewhat due to its product base. CARBO doesn’t just mine sand but also manufactures two categories of proppant: synthetic ceramic and resin-coated.

While more expensive that regular sand, these “better” proppants can help E&P firms realize up to 20% greater rates of returns from their wells and often lead to quicker recovery times. However, given that fact that most wells are still below marginal costs of production, the additional cost for CARBO’s products aren’t worth it.

Yet, in the long run as drillers go deeper, CARBO will be in unique position to profit from the need for more high-tech fracking products. Shares can be had for P/E of just 11.28, with a dividend yield of 1.7%.

Sand may be boring, the profits you can find in it sure aren’t.

As of this writing, Aaron Levitt didn’t own any securities mentioned here.

Endnotes:
  1. U.S. ever-closer to energy independence: http://investorplace.com/hot-topics/energy-independence/
  2. nearly 28.7 million tons in 2011: http://online.wsj.com/article/SB10001424052702303877604577383923263429292.html
  3. deep drilling: http://www.investorplace.com/2012/09/transoceans-promising-deep-water-future/
  4. looking for hydrocarbon deposits: http://investorplace.com/2012/09/three-big-ep-buys-outside-the-majors/
  5. IPO: http://investorplace.com/ipo-playbook/3q-ipos-few-but-still-notable/
  6. HCLP: http://studio-5.financialcontent.com/investplace/quote?Symbol=HCLP
  7. Hi-Crush is currently contracted: http://www.hicrushpartners.com/
  8. BHI: http://studio-5.financialcontent.com/investplace/quote?Symbol=BHI
  9. HAL: http://studio-5.financialcontent.com/investplace/quote?Symbol=HAL
  10. WFT: http://studio-5.financialcontent.com/investplace/quote?Symbol=WFT
  11. SLCA: http://studio-5.financialcontent.com/investplace/quote?Symbol=SLCA
  12. strictly on U.S. fields: http://www.ussilica.com/business-segments/oil-gas
  13. South America: http://www.investorplace.com/2012/05/latin-america-still-offers-energy-plays/
  14. natural gas liquids prices: http://investorplace.com/2012/09/now-natural-gas-liquids-are-overflowing/
  15. CRR: http://studio-5.financialcontent.com/investplace/quote?Symbol=CRR

Source URL: http://investorplace.com/2012/09/3-plays-in-frackings-secret-ingredient/
Short URL: http://invstplc.com/1nxHavN