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FABRICE TAYLOR

Hi-Crush: A very profitable sandbox for the fracking industry Add to ...

Fabrice Taylor, CFA, publishes the President’s Club investment letter. His letter and The Globe and Mail have a distribution agreement. You can get a free copy here.

At first glance, it looks like the income statement of a very successful tech company: net profit margins of about 65 per cent, return on equity of about 70 per cent and a torrent of free cash to fund lavish dividends.

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But this company doesn’t sell iPhones or software. It sells sand – lots of it. And unlike tech companies, it uses its free cash flow for dividends. Investors should take a look because the company – Hi-Crush Partners LP – has the makings of a very promising niche investment.

Hi-Crush doesn’t produce sand for playgrounds or gardeners. It furnishes aggregate for the biggest industry in the world: oil and gas. The product is known as frac sand, or proppant, and is used in the fast-growing technique of multistage fracking.

New drilling techniques that have opened up huge new reserves of oil and especially gas involve drilling deeply into very hard rock, then drilling horizontally to access new sources of hydrocarbons.

Because the rock is so hard, hydrocarbons can’t flow through it toward the well bore. So drillers create artificial channels in the rock by fracturing it. They do this by pumping chemicals, water and sand at extremely high pressure into the hole. The high-pressure fluid eventually creates fractures in the rock, that allow for flow.

But the rock understandably wants to close in on itself. That’s what the sand is for, to prop it open (I presume that’s why they call it proppant).

Putting sand in the fracture keeps it open but allows the hydrocarbons to flow toward the surface.

The trouble is that it’s pretty hostile down there. It’s very hot several thousand feet below surface, and then of course there’s the pressure. Ordinary sand won’t do.

The best sand in the world is called Northern White, or Ottawa, sand. (It’s not named after our capital but rather Ottawa, Ill. This sand tends to be found in Wyoming and Illinois.)

Quality frac sand is relatively scarce, but what makes Hi-Crush’s especially valuable is that it’s near a rail line. The price of sand, like all aggregates (gravel, etc.), includes a lot of transportation costs. The less it costs to ship, the more valuable it is. Since Hi-Crush’s plant in Monroe Country, Wisc., is essentially on the rail line, the product is in high demand and very profitable.

How profitable? It sells at an average contracted price this year for $65 (U.S.) a ton (that’s the revenue to Hi-Crush; the customer pays more because of the shipping). It costs only about $18 a ton to produce the sand. So the margins are generous.

So is the return on capital. Hi-Crush can produce 1.6 million tons of sand annually, for revenues of more than $100-million. The reserve life is a little better than 30 years. The equipment and plant cost about $70-million. That explains the astronomical return on equity, which is achieved without debt.

And for added security, the bulk of production over the next few years is already contracted at higher and higher average prices to big customers like Weatherford, Halliburton and Baker Hughes. And if these customers don’t take up their contracted amounts, they have to pay a “make-whole” price that effectively locks in the same profit. Clearly, the suppliers have the upper hand in frac sand right now.

Hi-Crush intends to pay a minimum distribution of $1.90 a unit per year, which could rise. That gives investors a roughly 8.5 per cent yield.

But besides company-specific reasons to like the investment, there are two bigger themes that recommend the idea. The first is a world of essentially zero interest rates, which will be the norm for a long time in my view (and in Ben Bernanke’s). That means high and reliable yields will attract lots of buyers in time, creating capital gains for those in early.

The second is the United States’ goal of weaning itself off OPEC by revitalizing its energy industry. Washington has vowed to do this before and failed, but I think political and economic realities combined with technology will make it happen this time. The job creation alone is attractive to Washington. The industry is entering a long boom.

There are two wrinkles with this idea: One is that it’s in U.S. dollars and the loonie seems headed higher. The other is the tax treatment of the distributions, which you should investigate. But I think it’s still an attractive idea (I own some). Sand is looking very solid right now.

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