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posted on 07 June 2017

An Energy Empire ... Built On Sand

by John Persinos, InvestingDaily.com

Article of the Week from Investing Daily

To the keffiyeh-wearing ministers in Saudi Arabia who set energy policy, it's been a successful week - if you measure success in terms of curtailing production of the world's most important commodity.


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OPEC on May 25 extended its existing oil production cut for a further nine months, a pro forma decision that traders already saw coming because the Saudis had been hinting at it for days before the official announcement. Regardless, it was welcome news not just for energy investors but also for the broader markets, which have tended to move in tandem with oil price gyrations.

It's remarkable that the ordinarily fractious cartel reached consensus, but it's even more remarkable that cheating has been kept in check (so far).

Below, I examine a "pick-and-shovel" play on OPEC's move and the overall energy resurgence. Without this company's one product, fracking would be impossible - and that's nice leverage for a producer to wield.

With the world still awash in a crude oil glut, OPEC's goal is to push crude stockpiles in developed nations down to the five-year average. They currently stand roughly 300 million barrels above that level.

Tightening output is buoying prices, which helps OPEC as well as North American shale producers. The price of West Texas Intermediate, the U.S. benchmark, now hovers at $49 a barrel, whereas the international benchmark, Brent North Sea Crude, is roughly $51/bbl. Those levels represent a decline of nearly 55% from a high of more than $110/bbl in the summer of 2014, but a clear improvement from oil's 13-year low of $26/bbl in February 2016.

OPEC's steadfastness seems to ensure that crude at the very least has found a floor at $50/bbl, the level at which many energy companies are able to "break even" on their operations.

Crude calculations...

Robert Rapier, chief investment strategist of The Energy Strategist and one of the world's foremost experts on energy, puts the Saudi-led cartel's latest decision into context:

"I was not at all surprised last week when OPEC, in cooperation with Russia and some other key non-OPEC members, announced it would extend the deal for production cuts by nine months to March 2018. As I have argued many times, I don't believe they had much choice. The only real question in my mind was whether they would make additional cuts.

So how should investors play this story? Over the next few months, we should see global crude oil inventories start to come down in earnest. U.S. crude oil inventories have fallen for seven straight weeks, and oil traders expect that larger declines are in store.

These declines are exactly what U.S. shale oil producers need. Falling inventories will provide support for oil prices, which will be good for the oil producers and the companies they depend upon, like oilfield services and sand providers."

Enter sand man...

I've frequently written in this newsletter about a wide variety of energy plays, but here's a secondary opportunity that I'm covering here for the first time: frac sand producers.

Treated sand is a "proppant" designed to keep an induced hydraulic fracture open, during or following a fracturing treatment.

OPEC's recent (and uncharacteristic) harmony on production cuts is yet another sign that the fracking boom will enjoy long-term staying power. Frac sand is an intrinsic part of the fracking process; as such it's a pick-and-shovel play on energy's continued recovery.

Pick-and-shovel is an old Wall Street euphemism that refers to the 19th century California gold rush, when the few people who got rich were the shopkeepers who sold the picks and shovels to the gold-hunters, not the prospectors themselves.

Our favorite frac sand stock is Smart Sand (NSDQ: SND). The company went public in an IPO last November and Robert Rapier added the stock to The Energy Strategist's aggressive portfolio on April 18.

Linda McDonough, chief investment strategist of Profit Catalyst Alert, also likes Smart Sand. Linda added the stock to her portfolio on March 29. She asserts:

"Although Smart Sand's fortunes aren't tied directly to the price of oil, most of the energy group gets tossed around like puppets with oil volatility. Based on Smart Sand's recent quarterly results, it's obvious its customers aren't basing purchasing decisions on short-term fluctuations in the price of oil."

With a modest market cap of $377.5 million, Smart Sand is large enough to withstand the energy patch's volatility but small enough to offer the outsized gains that the better-known energy behemoths are sometimes hard-pressed to provide.

Rock-solid fundamentals...

Smart Sand's first-quarter fiscal 2017 operating results were encouraging. The company posted revenue of $25 million, a whopping year-over-year increase of 141% and 38% higher than Wall Street's average estimates.

Earnings in the first quarter came in at $1 million for diluted earnings per share (EPS) of 2 cents, compared with earnings of $400,000 for diluted EPS of 1 cent in the same quarter a year ago.

One of the strongest attributes of Smart Sand is its rock-solid balance sheet. Through prudent management the company has remained essentially debt free, a noteworthy achievement in an energy industry that's still plagued by a sea of red ink. Smart Sand ended the first quarter with $73 million in cash and cash equivalents, a $25 million increase over the same year-ago quarter.

Earnings momentum for SND appears to be in the cards. The average analyst expectation is that the company's year-over-year earnings growth will hit an astonishing 1,300% in the next quarter, 31.4% in the current year, and 160.9% next year. My calculations call for earnings growth over the next five years of about 120%, on an annualized basis.

And yet, Smart Sand's trailing 12-month price-to-earnings ratio (P/E) is only 24.7, reasonable compared to the average of 28.9 for its peers. Admittedly, Smart Sand's shares have taken a pounding (pun intended) in recent days, but that's largely because its entire industry group has been unfairly driven lower amid oil price volatility. The company's fundamentals remain sound.

Closed-end energy fund...

While I'm on the topic of energy, here's a question that I received this week from a reader:

"Are there any energy-focused, closed-end funds trading at a discount you could recommend?" - Peter A.

Houston-based Kayne Anderson Energy Total Return Fund (NYSE: KYE) looks appealing. With net assets of $406.2 million, the fund's top holdings include well-positioned energy companies such as Enbridge Energy Management (NYSE: EEQ) and Kinder Morgan (NYSE: KMI).

The fund invests in master limited partnerships, midstream corporations, marine transportation, energy-related debt and Canadian income trusts. KYE has gained more than 10% over the past 12 months and currently trades at a discount to the value of its underlying portfolio.

Got any comments or questions? Drop me a line: mailbag@investingdaily.com - John Persinos

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