Fracking Can't Happen Without These Companies

With all the attention paid recently to fracking – and oil and gas sectors generally – many want to know where the good investment opportunities are. Is a company that does fracking to find oil or natural gas a good bet?

First, a bit about what fracking is. Fracking is short for hydraulic fracturing. A well is drilled, and part of that well is designed to go horizontally through the rock. Then water is pumped into the well, mixed with a substance called a "proppant," which is usually sand. A trace of other chemicals is often added to increase the viscosity of the fluid – usually guar gum.

The pressure fractures the rock, allowing whatever hydrocarbons are in it to flow more freely and exit through the well. The proppant helps keep those cracks open, and the result is more natural gas and oil. Hydraulic fracture is generally used on rock that ordinarily wouldn't be permeable enough to allow oil and gas out fast enough to be profitable.

It's an old technique, but it was only the twin pressures of higher oil prices and improved technology for digging that made it what it is today: the source of nearly two-thirds of the natural gas production in the U.S. (For more, see "With Fracking, It's All About Water Management.")

The companies that do the fracking are a varied lot. There are some big, familiar energy giants in that group – Chevron Corp. (CVX), ExxonMobil Corp. (XOM) and ConocoPhillips Co. (COP), all of which have delivered healthy returns over the last five years (81%, 41%, and 81%, respectively). However, the big petroleum companies have more often been on the trailing edge of the boom that fracking has produced; only Conoco is primarily a natural gas company and it has shifted away from that recently. More often the traditional oil producers own the leases to the land on which fracking is done, and contract the work out to oilfield services companies. (For more, see "How Fracking Affects Natural Gas Prices.")

Marc Bianchi, an analyst at Cowen and Company, notes that the pressure pumping and drilling are businesses that don't have high barriers to entry, as getting the pumping equipment is relatively easy to do. At the same time, that also puts a cap on profit margin growth, as competition holds prices down. And big players, like Halliburton Co. (HAL) are still in the industry as well. "It ends up with some pretty severe booms and busts in that business," he says. (For more, see "An Oil and Gas Industry Primer.")

The bust, though, might still be some years away. The demand for energy – and natural gas – has been increasing steadily. It is, after all, a big reason why hydraulic fracking is worth doing to begin with. In 2016, the United States used 27.49 trillion cubic feet of natural gas, up from 21.69 trillion a decade earlier and 22.6 million in 1993.

Then there are the companies that provide the equipment to do the fracking, and the sand that goes into the water used to fracture the rock. Bianchi says one area that's interesting are the proppant providers. U.S. Silica Holdings Inc. (SLCA) and Emerge Energy Services LP (EMES) are two examples and they've both benefited from the increased activity in both oil and gas extraction. It's actually more difficult to add supply in this market, Bianchi says, so the proppant providers tend to be more insulated from competition. The stocks of both U.S. Silica and Emerge have produced five-year returns measured in the hundreds of percentage points.

For anyone wanting to play in the fracking space, oil prices are going to be a factor. Natural gas and oil are different markets, in the sense that oil is basically global and natural gas is more localized. The extraction of natural gas, though, tends to track oil production because the types of rock that produce natural gas also happen to be the ones that carry oil. Historically, a lot of natural gas production is a byproduct of oil production.

Areas such as the Marcellus Shale, in the eastern U.S., produce primarily natural gas and they are in the news because hydrocarbon production isn't something we associate with upstate New York. However, a sizable portion of the new production are in Texas or North Dakota, says Bianchi. (For more on this topic, see "Alternative Ways to Play the Marcellus Shale.")

That's changing – in the future there are likely to be more "pure" gas plays as the technology develops for getting gas out where oil isn't worth it. But for now, it's a good rule of thumb that as oil production rises, so does natural gas. The converse is also true. (For related reading, see "Key Ratios for Analyzing Oil and Gas Stocks.")

Another factor is exporting natural gas. The U.S. actually exported some 2.3 trillion cubic feet of natural gas in 2016, according to the EIA (the latest figure available). That's a more than the 1.7 trillion cubic feet for 2015; in fact, the trendline has been steeply rising since 2000, when the U.S. sent out 243 billion cubic feet. Almost all of it leaves the country via pipeline to Canada and Mexico. (For more, see: "The Next Energy Debate: Should The U.S. Pass Gas?")

The wild card in this is Europe and Japan. To be sent to either place natural gas has to be liquefied and that cost a not insignificant sum. to make economic sense, the price of natural gas has to stay relatively high in europe and asia, while staying low enough in the domestic market that it isn&/#39;t simply more profitable to sell it here.

It's possible the European Union may want to reduce its dependence on Russian natural gas, but as Russia already has the infrastructure in place to deliver it, prices would have to be high in order for imported gas to be competitive – or there is a political decision to stop importing Russian gas. (For related reading, see "The Next Hottest Shale Play Is Down Under.")

With a low barrier to entry, the amount of competition to drill for and extract oil and gas via fracking tends to keep profits down – not to mention the relatively low price for gas. Assuming that, the companies that provide the implements and services to frackers could be the better bet. (For related reading, see "Why Schlumberger Is a Name You Should Know.")