CRC - California Resources: A Counterintuitive Play In A State Planning To Eliminate Fossil Fuels

2023-10-11 14:14:39 ET

Summary

• California Resources operates in an environment of limited new drilling due to regulatory and permitting challenges, forcing it to return money to shareholders and diversify its portfolio.
• CRC owns valuable land in California and has drilling expertise, which could potentially boost its value through royalty securitizations and deep geothermal energy projects.
• The company is managing its oil and gas assets for cash flow, and developing carbon capture initiatives and renewable-driven electrical generating programs to meet California's climate goals.

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Investment Thesis

California Resources (CRC), an oil and gas company, is one of the largest oil producers in California. On the face of it, this might seem to be a huge negative since CRC’s market likely has the most aggressive climate policies of any large economy (if California were a country it’s GDP would rank 5 ^th among nations) in the world. And, indeed, investors have shied from the company in part because of its regulatory and permitting headwinds. However, the very factors that limit new drilling relieve the company of the need for growth capex, and allow the company to return that saved money to shareholders through dividends and share buybacks, while also helping fund the company’s move to diversify its portfolio away from fossil fuels through programs such as an ambitious carbon capture initiative. Moreover, California is an “oil island,” not connected by oil pipeline to any other state. This means that California must import about 2/3 of the oil it consumes, which in turn means that as the state moves away from fossil fuels, imports, not local production, will likely bear the brunt of reductions for years to come (because Californian oil provides jobs, taxes, and spending while imports do not). CRC may account for 17% of California’s oil production ( 53,000 divided by 311,000 ), but it only provides 3% of California’s oil consumption (53K bbl/day divided by 1.66 million bbl/day). In sum, CRC is trying to make a virtue of necessity, and the very factors that limit the company’s growth could turn out to be a positive for shareholders through the maintenance of a strong balance sheet, dividends, and stock buybacks.

Company Overview

CRC is one of the largest oil companies operating in California. Its original assets formed the core of Occidental Petroleum, which was founded in 1920. As noted, the state is an “oil island,” unconnected by oil pipelines to the rest of the nation, which means that most of the oil California uses comes in by tanker, and thus California’s oil is priced to Brent rather than West Texas Intermediate.

Because it produces oil in a state that imports about 2/3 of its oil, and because CRC owns about 1.3 million acres of the land on which it drills (as listed in the most recent 10-K), the company has certain advantages. With greatly reduced transportation costs, the company’s realized revenue from oil is very close to index price. Because it owns most of the acreage where it produces oil, CRC does not have to pay the 12.5% royalty that is typically charged for oil production on leased land. Among its holdings are some of the most productive oil fields in the U.S. (Elk Hills in Kern County), and about 14,000 valuable acres in the Los Angeles Basin.

CRC was spun off Occidental Petroleum in 2014. In 2020 it filed for bankruptcy, groaning under a $5 billion debt load. It emerged from bankruptcy in Nov. 2020, just three months after filing. As of June 30, 2023, the company had one $600 million senior note outstanding, and only $152 million of net debt after cash. Freed from crushing debt service, it has been something of a cash machine, generating $1.1 billion of free cash flow since Q4, 2020, and returning $697 million of that cash to shareholders through a fixed dividend and share buybacks. The buybacks have reduced the share count from 83 million to 69 million as of June 30 (same slide deck as above, page 10).

As of June 30, the trailing twelve month revenue was about $3.4 billion and TTM EBITDA was about $1.5 billion . At about $55 a share, the EV to EBITDA multiple was about 2.75, below the oil industry average of between 3 and 5 times. On the other hand, CRC trades above 4 times the multiple based on expected EBITDA in 2024.

CRC produces about 86,000 barrels of net oil equivalent a day, with 61% of that oil, 20% gas, and 13% natural gas liquids (the gas percentage has temporarily grown to 27% because CRC has been having difficulty getting permitting for maintenance drilling in oil-rich Kern County after an appeals court stayed new permitting for drilling).

As might be expected, CRC’s performance is highly sensitive to oil and gas prices. Just how sensitive was revealed in the company’s Q1 ’23 performance. It had guided to free cash flow of $151 million to $180 million. As it turned out, all of the variables CRC listed, such as total production, operating costs, G&A, etc., were within guidance . Free cash flow, however, blew past expectations, coming in at $263 million. This was in part because of interrupted service in a key pipeline carrying natural gas to California, forcing the state to rely more on local production.

CRC prices its natural gas to Henry Hub. Most natural gas companies have a negative differential to Henry Hub prices because of transportation costs. EQT, for instance, one of the largest natural gas producers in the U.S., estimates about $0.50 negative differential per million BTU to Henry Hub. Because it is producing gas in its home state, CRC usually has very little negative differential and sometimes the differential turns to positive.

Because of drilling restrictions, particularly in Kern County, California’s richest oil fields (accounting for 75% of the state’s onshore oil production), CRC is not even meeting its spending projections for maintenance. The company has been operating for over 100 years in California, and it knows its fields, which means that what drilling the company does yields highly predictable results. This in turn means that CRC’s fields have a very shallow decline curve, on the order of 10% (7%-13% for various fields) annually. By contrast shale oil fields often see declines of 25-30% a year (and OilPrice recently pegged the typical decline at 40%).

Carbon capture has become a centerpiece of CRC’s move to diversify away from fossil fuels and help California meet its climate goals. To that end, it has formed a joint venture with Brookfield, called the Carbon Terravault , to develop the infrastructure for sequestering CO2 underground. The joint venture allows the company to offload some of the capital costs (according to a company presentation, CRC’s share of the first five years of capital costs will be $ 637 million . In that same presentation, CRC estimates EBITDA generated by the joint venture will be between $225 million and $675 million by year end 2028.

The Value Proposition

For investors, the biggest question marks lie in the gauntlet of regulatory hurdles and restrictions on drill permitting that oil companies must deal with in California. Together with operating costs, this makes CRC a relatively high-cost producer at about $47-$48 a barrel. Using various estimates of ’24 EBITDA given futures strip prices at various levels, we can arrive at a rough sensitivity of a $20 million change in EBITDA for every $1 change in futures strip price. And therein lies the rub because Brent prices have varied wildly over the past few years. If the price of oil remains at $90, EBITDA might even rise a bit in ’24 because the company has plans to lower production costs. If, as the street expects, the price averages in the low 80s next year, EBITDA will drop, probably by about $100 million, but the company will still be generating sold free cash flow. If stock buybacks continue, that should provide natural upward pressure on stock prices even with stable EBITDA.

Because the biggest variables that will impact CRC's performance are external and out of the company's control -- e.g. the price of Brent, a new or renewed pandemic, actions by OPEC, Russian sanctions, and all types of geopolitical turmoil, including the new war between Israel and Hamas -- any projections of future earnings should be taken with a very large grain of salt. What can be said is that because CRC is spending virtually nothing on exploration or expansion, its production should be maintained (or decline slowly), its expenses should be quite stable, and that being the case, barring external events, revenues will remain stable (using strip pricing), but CRC should steadily build cash and move from tiny net debt to rather large negative net debt. In fact, by the end of 2026, in such circumstances, cash might build from $448 million at the end of Q2, to close to $1.8 billion, enough to pay off its $600 million in debt at maturity with plenty of cushion.

That's the virtue of CRC; in an unpredictable world, its future is relatively predictable. Brent pricing - currently at $88 - is well above CRC's guidance of about $75 for the second half of 2023. If Brent retreats to an average of $80, the market could still justify a share price of around $61 using 69 million shares, a terminal multiple of 5, and Henry Hub of $3.50. On the other hand, the uncertainties of when/if Kern County will allow resumed drilling, and California's hostility to oil might cause investors to use a lower multiple, in which case, a fair valuation at $80 Brent might be in the $49 a share range. Regardless of how far Brent rises, investors are unlikely to reward CRC with a soaring price simply because it's operating in increasingly hostile waters.

CRC's dividend, which costs the company about $78 million a year is safe so long as Brent doesn't not spend a very protracted period in the low to mid $40s.

There are a couple of positive outliers that could boost CRC’s multiples and value. They have to do with the land that the company owns and its drilling expertise. With regard to CRC’s land owned in fee, while the company does not have to pay a royalty on this land, CRC could collect that royalty itself and use it to fund a securitization. Royalty securitizations typically trade at 12-15 multiples or nearly twice the multiple of an E&P company, and could provide a lift to the stock.

CRC not only has lots of land, but it also has drilling expertise and equipment. One possibility for zero-carbon, cheap electrical generation comes from a promising new form of renewable energy called deep geothermal. Deep geothermal involves drilling through the basalt or granite that lies roughly 8 km. or more below the surface. Rock this hard defeats conventional drills, but a number of startups are using millimeter wave technology developed in plasma labs to vaporize the rock and permit access to virtually unlimited reservoirs of 1,000 degree F heat that could produce steam and power most gas or coal-fired electrical generation plants. Estimated costs for such electricity, including capital costs, run between 1 cent and 3 cents per kilowatt hour – as cheap as any electricity on the planet. CRC hasn’t explored this possibility, but if deep geothermal gains traction (pilot projects are already in process), it might do well to consider a joint venture.

CRC is not alone in managing its assets for cash flow rather than growth. That’s true of most E&P companies. As one analyst told me, “’Drill baby drill’ has left the building.” One differentiating factor for CRC is that given California’s regulatory and permitting hurdles, and also the state’s plan to drive fossil fuel use close to zero, it couldn’t pursue growth exploration even if it wanted to.

Management realizes this, and is also trying to make a virtue of necessity. Rather than fight California’s attempts to reduce carbon emissions, it’s trying to make them a profit center through its ambitious carbon sequestration program, and also through renewable-driven electrical generating programs. If it’s estimates of future EBITDA for Carbon Terravault come to pass by 2028 year-end, that program alone could contribute up to $8 a share in value. Looking at this another way, if the carbon sequestration joint venture produces $675 million in EBITDA by YE 2028, it could cushion a $16 drop in oil prices (as CRC will take half the benefit).

The company makes a strong argument that as California reduces its reliance on fossil fuels it should do so by decreasing imports, not domestic production. In part it’s an economic argument: the company argues that it’s spent $16.8 billion in the state since 2014 and provided $2.9 billion in revenues and taxes (as well as thousands of jobs), and that to the degree the state continues to consume oil it’s better if that oil comes from California rather than Alaska, Ecuador or Saudi Arabia. From an environmental and climate standpoint, it’s better for oil to come from a company that is abiding by strict environmental laws, than to come from sources where governments often turn a blind eye to pollution, methane releases, and other climate-related issues. CRC also argues that it has some of the lowest carbon intensity of any producing company in the U.S., meaning that it uses relatively little energy to get the oil out of the ground.

As someone who has long argued that human-caused climate change poses a dire threat to society, the economy, and the biosphere; and also as someone who believes that we are not nearly doing enough to transition away from fossil fuels, I also realize that we still need to produce oil and gas during that transition. The jury is still out on whether CRC will be able to meet its goals for diversification away from fossil fuels, but it is to be applauded for its efforts to meet the needs of the various stakeholders, while abiding by the stringent rules of a large economy that has the most aggressive decarbonization program in the world. As such, it could someday provide a model for other fossil fuel companies facing the transition to climate-friendly energy.

Risks

A near-term risk is that the appeals court does not lift the stay on drilling permitting in Kern county. And when/if the appeals court lifts the stay, CRC is going to have to spend additional money to make up for lost production. Most observers expect the issue to be resolved, but it’s unclear how long this will take. Another risk is that we’re talking about California after all, so the company also could encounter other road blocks as time goes by and the impacts of climate change intensify. And yet another risk is a black swan disruption to the oil market, as occurred in April, 2020. A free fall drop in oil prices could inflict pain, but the company has no near-term debt maturity, tiny net debt, and - at $900 million plus - plenty of liquidity.

Conclusion

The bottom line is that in its unlevered state, CRC is being managed for cash flow, and it is returning about 60% of its free cash flow to shareholders through dividends and buybacks. The two most important variables are whether California imposes even tougher restrictions, and the price of Brent. As for Brent, if it falls back into the mid-50s, CRC’s EBITDA could take a roughly $600 million hit. If Brent remains in the recent range of $80s to $90s, CRC will do just fine. As for California, if the state manages its decarbonization through a decline in imports, CRC will have a long and profitable runway. At $55 a share, the dividend is about 2%, though shareholders also benefit as buybacks reduce share count. Management seems well-suited to navigating California’s oil-hostile landscape in a responsible way.

I spent 15 years as a strategist at a hedge fund focused on distressed situations. One of the postulates of distress investing is that even in industries headed for oblivion there will be opportunities because technical and emotional factors often cause the markets to price companies as though oblivion will come faster than the facts warrant. Moreover, businesses adapt – e.g., today only about 8% of Apple’s (AAPL) revenues come from the Mac. CRC is in a sector headed for oblivion, but it is broadening its portfolio through various forms of carbon capture, renewables, and greener inputs for agriculture. It also has the best balance sheet in the business, and while the stock may not soar, it will likely produce returns for shareholders for years to come as it gradually shifts to renewables and CO2 storage comes on line.

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