How One Idea Became Three

I am a big believer in the “teach a man to fish” principle and not just when it comes to charitable endeavors. My role here at Oilprice.com is to help you to profit from the opportunities present in the energy markets and, while individual recommendations are a part of that, in the long term understanding how an idea is formed is often more useful than what that idea is per se.

I am lucky enough to spend my time researching markets and individual companies and, over time, I have found that often the ideas that you stumble on as you research a central theme pan out better than the original idea. I have a theory as to why that is so. We all like to think that we analyze empirical data in a dispassionate way and arrive at a logical conclusion, but in reality we usually start with a preconception. In the modern age of information overload it is easy to find data and arguments that support your original hypothesis and there is a tendency to focus on those. Psychologists have a term for it; they call it confirmation bias. By definition, when the data and research you use to confirm your original opinion suggests another idea, you have arrived at that one without any preconceptions. Little wonder, then, that the secondary idea often works out better

This happened today as I prepared to write this piece. Continental Resources (CLR), a US oil exploration and production company with a focus on the Bakken field has been in the news a little this week and I started to do research for a positive piece on the stock. CLR has had an excellent year (+41%), but has fallen over the last couple of days as crude prices have stalled and questions have been raised about the longevity of the Bakken reserves.

These questions came about because the production per well in the area has begun to decline (down 11% year on year according to the latest figures from the North Dakota Industrial Commission Department of mineral resources.) Overall, production for the area is still rising fast, however, as new wells are being drilled, and I am more inclined to the view of CLR President Rick Bott that there are decades of growth left for companies heavily invested in the North Dakota boom. This is especially true given that the technology being used in extraction is relatively new and continues to advance. With that in mind, I set about writing a piece on how any weakness in CLR represented an opportunity to buy the stock relatively cheaply.

I should say that I still believe this to be the case, and would recommend averaging in to CLR on any continued weakness, but as I looked at the possible risks involved in that investment, another idea was formed. Obviously, the profitability of any company is a function of the revenue they can produce and the cost of production, and CLR faces potential risks in both areas.

From the revenue side, I said a couple of weeks ago that I believe WTI Crude prices are looking a little toppish and that could be seen as a negative for Continental. Given the rapid increases in overall production in the Bakken field that I mentioned above, however, that is not a massive cause for concern. On the cost side, the biggest risk I could find was that many analysts are expecting a spike in the cost of frac sand this year. Again, increased production makes it possible for CLR to continue to grow profits, even if this comes about and that results in reduced margins, but this information set me thinking.

There is an old cliché in investing; during a gold rush the real money is made by those that invest in the manufacture and supply of picks and shovels rather than by those who try to pick a winning prospector. Frac Sand, it seems, is the picks and shovels of the black gold rush. Is there, therefore, a better investment to be found in a “pick and shovel” manufacturer?

US Silica Holdings (SLCA) would seem to be a logical place to start, as they are the largest supplier of frac sand in the US.

As you can see, SLCA has been on a bit of a tear in the last month or so, so it would be reasonable to expect that much of the value has gone, but this is one party I don’t mind being late too. Even with all of that appreciation, SLCA is still trading at below 17 times forward earnings, so it would seem that there is still some meat left on the bone. If sand prices do continue to rise, then those estimates of future earnings will be revised upwards pretty quickly, and SLCA at around $35 will still look cheap by the end of the year.

For those who prefer, or need, some yield from their energy related investments, Hi-Crush Partners (HCLP) may be the answer. HCLP is set up as an MLP and offers a yield of around 5%.

The stock has more than doubled in the past year, but, once again, hardly looks overvalued at a forward P/E of around 14.

I wrote last week about my trader’s tendency to look for a hedged position that offers the possibility of profit both ways, and splitting an investment between CLR, SLCA and HCLP would seem to offer just such an opportunity. If a spike in frac sand prices puts pressure on CLR’s margins, then any weakness would be more than offset by your holdings in SLCA and HCLP. If production continues to increase, then all three stocks could show significant improvement, whatever happens to sand prices.

My original intention wasn’t to write about three companies, but rather just one. I find it interesting, though, that in the course of researching that idea, my view changed somewhat. I guess it shows that in investing, just as in life, an open mind is a wonderful thing.