Hi-Crush Is Misunderstood and Neglected

We think

Hi-Crush will continue to be the lowest-cost producer of Northern White frac sand in the industry, a fact that has been obscured by the U.S. shale downturn as well as the shift in mix through the downturn from Northern White to Texas-based “regional” sands. Regional sands notwithstanding, over 70% of the frac sand market will need to be supplied by Northern White sands in our midcycle forecast, and Hi-Crush stands at the bottom of this cost curve.

In our view, 77 million tons of annual proppant supply, or about 37% above the 56 million tons of peak demand in 2014, is adequate to fulfill the call on U.S. shale production in 2020 and afterward. We expect just over 18,000 North American horizontal wells completed in 2020 (11% below 2014) but average proppant per well to be 7.7 million pounds (about one third higher). These increased proppant loads have led to increased well productivity, which correspondingly reduces the number of wells required to fulfill U.S. shale production needs. Thus, while this number represents a strong recovery from the 2016 trough of about 35 million tons, it falls below more bullish demand estimates of 80 million-90 million tons.

Hi-Crush is one of the top four public proppant suppliers, which we expect to collectively supply 54% of all proppant demanded in 2020, up from 40% in 2014. This increase can largely be attributed to organic greenfield and brownfield capacity expansion from these lower-cost producers. We expect Hi-Crush to increase its Northern White proppant tons supplied to 7.2 million tons in 2020 from 4.5 million in 2014.

Unfortunately for the lower-cost producers, there is a strong downside to capacity expansion. Northern White producers outside the top four public companies will only produce at about 70% capacity in 2020. These smaller producers constitute the steeply upward sloping portion of the supply curve. Thus, lower supply from this batch of producers means that the marginal ton of supply will come from a lower-cost producer compared with the 2014 peak. Accordingly, we see mine-gate Northern White sand selling at about $38/ton in 2019-20, above the approximately $30/ton price in 2016 but well below the $55/ton price in 2014.

Sole Business Segment Has Narrow Moat Frac sand suppliers with ample reserves and positioning on the bottom half of the cost curve for high-quality frac sand can earn excess returns on capital on average throughout the cycle, in our view. Hi-Crush fits these criteria. The company's average production cost of $15/ton in 2014-15 compares favorably with IHS' estimated median Northern White cost of $25/ton and our estimate of marginal Northern White production cost of $30/ton in 2020. Additionally, the company has at least 20 years of reserves at its chief locations.

Frac sand has a steep cost curve. The fundamental scarcity of frac sand is a necessary, although not alone sufficient, cause for the steepness of this cost curve. This scarcity is because only a small portion of all available sand has the strength necessary to prop open hydraulic fractures, and thus serve as a suitable proppant for North American shale oil and gas development. Impurities in the sand, with other lower-strength minerals mixed in with silica, make the majority of available sand ineligible as a proppant. Thus, frac sand is found only in a narrow belt of sedimentary rock formations 450 million-500 million years old, which are present near the surface in economic quantities in only a handful of places in North America.

Within this small range of frac sand production opportunities, several factors contribute to some producers’ ability to produce at lower costs versus marginal producers. First, there are economies of scale associated with larger mine and plant size. Whereas Hi-Crush and most of its peers produce chiefly from locations with at least 1 million tons in annual capacity, we expect the marginal unit of supply to come from locations with capacity of 500,000 tons per year or less. Next, sand that is closer to or at the surface can reduce excavation costs by several dollars per ton. Hi-Crush engages in largely surface mining or mining with very shallow overburden. Finally, the proximity of both the mine and plant to rail is crucial. Assuming trucking costs of $0.25/ton-mile, deposits even 20 miles from a rail line would cost an additional $5/ton. Most of Hi-Crush’s production is directly adjacent to a rail line. 2020 marginal tons of supply, however, will come from producers with substantially higher sand trucking costs.

Given our narrow moat rating, why has Hi-Crush exhibited poor returns in 2015-16? Beyond the cyclicality of the company’s moatworthy frac sand production business, the company has also been affected by its entry into the nonmoatworthy frac sand transportation business. It increased its percentage of sand delivered in basin from 0% to 33% over 2012-14 and acquired a logistics company via which it provided in-basin transload services for other frac sand companies. However, the cyclical fall in proppant tons shipped has left much of its fixed-cost transportation base unused. While this factor is currently weighing heavily on Hi-Crush’s performance, we expect it to reverse by 2019-20. Additionally, the spread between mine-gate and in-basin pricing should widen as utilization of fixed-cost resources tightens. Thus, this transportation operating leverage should not obscure Hi-Crush’s ability to generate economic profits via its production advantages.

The reduction in supply over this period has been disproportionately shouldered by higher-cost Northern White producers (chiefly those other than the big four public companies: U.S. Silica SLCA, Fairmount FMSA, Hi-Crush, and Emerge Energy Services EMES). We expect these higher-cost producers to return to supplying the marginal ton of sand by 2019-20. We project Northern White utilization to reach 67% by 2020, which places the production cost of the marginal ton at $30/ton, according to IHS’ cost curve, up from about $17/ton today. Given that nearly all of their production costs are variable in the medium term, the high-cost nature of their production will not fail to enter their required price to restart operations. Thus, Northern White mine-gate pricing should recover substantially from about $30/ton currently to $38/ton in 2020, although still well below the $55/ton peak of 2014. These 2020 projections represent midcycle levels of proppant supply and demand and hence pricing as well.

Our reasoning for assigning Hi-Crush a narrow rather than wide moat rating lies in the volatility of the oil and gas industry and the fact that frac sand prices and profitability are captive to that volatility. We are confident that midcycle conditions will yield economic profits to frac sand producers of Hi-Crush’s caliber, but cyclical lows could bring years of mediocre or low returns on capital, as has been the case in the aftermath of the oil price collapse of 2014.

Energy Prices Are Key Hi-Crush has high downside risk with respect to downward shocks to energy prices. The firm is part of a North American shale value chain that is competing with various offshore producers to supply the marginal volumes of oil or gas. If the cost advantages of the former were to diminish compared with the latter, Hi-Crush would suffer.

Two notable sources of enterprise risk face frac sand producers in particular. First, a change in the federal or state environmental regulatory climate could make frac sand mining much more onerous. Frac sand mining has a high environmental impact, including surface mining and high water consumption. Operating a sand mine requires the approval and periodic renewal of numerous permits. Thus, there is ample opportunity to place stumbling blocks to frac sand mining, should the political will to do so emerge. Second, there is legal and regulatory risk associated with silicosis, a lung disease caused by exposure to silica dust. It is quite possible that frac sand producers will be legally liable even where silicosis is found among well site workers, should such cases arise.

As expected for a company that has exhibited prudent capital allocation along with strong excess returns on capital, Hi-Crush exhibits robust financial health. Some future equity issuances are likely, as the company has negotiated an “equity cure” via which it can fulfill the gap in its covenant provisions in its term loan facility through new equity issuances. However, we do not believe these will destroy value for existing unitholders. Management wisely opted to cut distributions to zero, despite the negative reaction this generated among the company’s MLP-focused investor following. This saved about $100 million in cumulative cash flow in 2016.

The company’s notable recent acquisitions include its purchase of frac sand logistics company D&I in 2013 at an apparently cheap 7 times multiple to D&I 2012 earnings. However, this acquisition has turned out to drag heavily on Hi-Crush’s current performance, as the operations acquired from D&I are centered on the challenged Marcellus and Utica plays.

Although the company’s MLP structure invites the potential for abuse of the interest of the limited partners, we believe that management has acted very fairly. All of the transactions between Hi-Crush and its sponsor parent have been equitable, in our view. The sponsor’s decision to allow the interruption of a supply agreement that was very costly for Hi-Crush demonstrates a strong alignment of interests.