My Investment Strategy to Add Fracking to My Portfolio

Three months ago I used my favorite investment strategy, writing puts, in an attempt to add units of Hi-Crush Partners  to my portfolio. In one sense, that strategy was a failure as units of Hi-Crush stayed well above my strike price, meaning I won't be purchasing units when the puts expire next week. However, I was able to keep the full put premium which equated to a very nice 12% return for my capital at risk. Because I still want to add Hi-Crush to my portfolio, I'm going back to the well and writing puts again.

My trade
Last time I was able to write puts striking at $17.50 each. Because of the company's recent run-up, this time I'm forced to move up the ladder and write puts striking at $20. Those puts currently yield about 5% for the capital at risk, but are 10% below the current price of the units. Because I view $20 a unit as a fair price to pay I think that this trade offers a pretty good risk and reward ratio, even though I won't be paid as much to write puts this time.

The advantage of using puts as an investment strategy is that it allows the investor to buy stocks for much lower than the current price or at least earn income while trying. In this case, I will either buy Hi-Crush for a price that's 15% lower than it's currently trading, or earn 5% in income for trying. That's a pretty big difference for this income stock. For example, if I bought today my forward yield would be about 8.64%; however, with patience I could lock in a yield of about 10%.


Why Hi-Crush?
I like that Hi-Crush is a pure-play, low-cost proppant producer as well as its choice to be structured as an income-friendly MLP. That income is secured by long-term, take-or-pay contracts from leading oil-field service companies which give its profits stability. Further, the company has long-term visibility in the fact its frac sand is used to enhance the recovery rates of oil and gas, making it a critical component in the process of increasing production. As you can see on the following chart, demand will almost double over the coming years: 

Source: Hi-Crush Partners 

Hi-Crush is well positioned to capture this growth. Not only does it have the logistical capabilities to reach all of the major shale plays, but it has the financial flexibility to pursue industry consolidation. The company recently added a major Marcellus- and Utica-based distributor to its platform, which should also enhance its ability to grow. Overall, Hi-Crush has a multitude of potential acquisition opportunities ranging from drop-down deals with its parent to additional consolidation transactions which should enable it to grow its distribution payout in the future.

Risks
An investment in Hi-Crush is not without risks. It's not as diversified as rival U.S. Silica Holdings , which has pursued a strategy that has it boasting over 200 products and 1,400 customers. Hi-Crush has just a handful of customers and one main product. Meanwhile, U.S. Silica is much more geographically diverse with 15 facilities compared to just two for Hi-Crush. I like the fact Hi-Crush is a pure play; however, being concentrated is a big risk, which is one reason why I'm writing puts to buy units much cheaper. 

The other risk that can't be overlooked is the threat from ceramic proppants, like those made by CARBO Ceramics , which could take a greater market share than is currently projected. Referring to the demand chart, frac sand is projected to remain 75% of the proppant market as that market grows. However, some shale plays like the Bakken are forcing producers to turn to higher-cost ceramic proppants because the returns are better. Halcon Resources , for example, pointed out that its strategy to use ceramic proppants was one of the driving forces behind its improved returns in the Bakken. The company saw much higher initial production rates, while expecting better estimated ultimate recovery rates from its investment in ceramic proppants. If ceramics do end up taking market share, it could crush my investment in Hi-Crush.

Final Foolish thoughts
Despite the risks, I think I'll be well rewarded by investing in Hi-Crush. By writing puts, I can strategically purchase units lower, or at least earn some additional income for my troubles. I like the risk and reward balance of this trade, which is why I'll be making it as soon as our trading rules allow. 

While Hi-Crush is a stock I want in  my portfolio, it might not be the top stock for you. Instead, you might want to take a look at the stock that The Motley Fool's chief investment officer has selected as his No. 1 stock for this year. Find out which stock it is in the special free report: "The Motley Fool's Top Stock for 2013." Just click here to access the report and find out the name of this under-the-radar company.

The article My Investment Strategy to Add Fracking to My Portfolio originally appeared on Fool.com.

Fool contributor Matt DiLallo has no position in any stocks mentioned. The Motley Fool owns shares of HI-CRUSH PARTNERS LP UNIT LTD PARTNER INTS and U S SILICA HLDGS INC COM USD0.01. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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