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Wall Street's latest fad is built on sand—the fracking kind

Gas is flared as waste from the Monterey Shale formation where gas and oil extraction using hydraulic fracturing, or fracking, is on the verge of a boom on March 22, 2014 near Buttonwillow, Calif.
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Gas is flared as waste from the Monterey Shale formation where gas and oil extraction using hydraulic fracturing, or fracking, is on the verge of a boom on March 22, 2014 near Buttonwillow, Calif.

Super-sized hydraulic fracturing jobs, which use vast amounts of sand to coax more oil and gas from shale, have led to astronomical returns for investors in companies that mine the tiny particles.

The question is whether those super-sized gains can continue.

Demand has jumped for the sand used in hydraulic fracturing, which blasts it, along with water, chemicals, into wells to crack rock and release crude oil and natural gas. The increasing practice of "superfracking" requires much more sand, and investors have taken notice.

Emerge Energy Services, a master limited partnership that produces sand for use in hydraulic fracturing, began trading a little more than one year ago at $17 per unit. Today the units trade at about $109. Shares of two other sand miners, U.S. Silica Holdings and Hi Crush Partners, have more than doubled in the past year.

Read MoreRelax: Monterey downgrade won't dent US shale boom—yet

And Fairmount Minerals, one of the largest providers of sand to the oil and gas industry, is considering a $1 billion initial public offering, according to sources familiar with the situation. Still, investing in these companies carries risks.

A drop in crude prices would slow drilling. And the market for sand itself is opaque, requiring investors to make a leap of faith as contract terms, prices and supply and demand are not fully disclosed.

Also, some oil and gas companies, such as EOG Resources, are cutting out the middleman by buying their own sand mines. At the same time, RBC Capital Markets says U.S. demand for raw frack sand will climb 30 percent from 2013 to 2015.

Houston oil and gas company Rice Energy, which operates wells in the eastern United States, says it has benefited from using at least 7 percent more sand than its competitors.

"It's something that we've found really effective to help stimulate the well" to produce more oil and gas, said Julie Danvers, director of investor relations.

Milk Money

Demand for sand is expected to outpace the number of rigs drilling new wells for the foreseeable future, but valuations for the sand miners are rich. Their enterprise value—market capitalization plus debtis about 10 times expected earnings before interest, taxes, depreciation and amortization.

An investor looking for a way to profit indirectly from the fracking boom could buy shares of Martin Marietta Materials Inc , which provides gravel to build roads at frack sites and whose enterprise value is 11.7 times EBITDA.

Analysts at Baird Equity Research say Emerge has a good growth outlook but rate its units "speculative."

"If you buy (Emerge Energy) here, do not do it with the milk money," Baird cautioned in a June 5 note to clients.

Not every oil and gas producer is convinced that super-sized sand fracks are needed. Chesapeake Energy CEO Doug Lawler said that while the company was tinkering with the amount of sand it used in some areas, greater quantities do not work on all wells.

"With every shale, the reservoir is different," Lawler told a shareholder who asked about sand at the company's annual meeting on Friday.

Sand miners also face the risk of an energy glut and corresponding drop in oil and gas prices, which could reduce drilling. While crude prices have gotten a substantial lift from worries over violence in Iraq, there is lingering concern that producing oil from shale will leave the domestic market oversupplied.

In 2013, U.S. crude production climbed to a 24-year high and is forecast to grow more this year with the help of oil pumped from shale, according to government data. Investors in sand miners must also accept the lack of information available to them.

Read MoreCalls for end to crude oil export ban are getting louder

Thomas Dolley, a mineral commodity specialist at the U.S. Geological Survey who tracks the sand market, said the industry was fragmented, and participation in the government's supply and demand surveys was not mandatory, resulting in what may be incomplete data for investors.

Because most sand companies are privately held, Dolley tracks sand mine openings through industry contacts and the media, he said. "I would say we could use a little more transparency," he said.

The U.S. Bureau of Labor Statistics' latest producer price index shows frack sand prices in May reached their highest level in more than two years, according to a report from Cowen and Co.

But Cowen called the government's data for short-term trends "unreliable" because some prices in the sample include transportation costs and others do not.

--By Reuters

Energy

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