CRC - California Resources Corporation: More Bad News Out Of California

Summary

• New setback rules went into effect on January 1, pushing drilling in California to more rural areas.
• Now, the Appeals Court has suspended new oil and gas permits in Kern County temporarily, removing another area for drilling.
• California Resources faces declining opportunities to put capital to work, particularly in the first half of the year.
• Regulatory headaches like this can really pressure theoretical fair values. To me, it's worth avoiding because of it.

The saga at California Resources (CRC), and as per usual, there is no shortage of regulatory headaches to talk about for the beleaguered producer. Late last year, I wrote a research note talking about the potential changes from SB 1137, a new regulatory rule that codified a 3,200 foot setback rule that went into place in January of this year. At the time, this did not seem like that big of a deal. The setback rules would mostly impact California Resources urban assets within the Los Angeles Basin, and while those carry much higher oil cuts and low breakevens than their other assets, they are not necessarily where the bulk of net present value of California Resources lie.

Its San Joaquin assets, particularly those in Kern County, is where California Resources looked prime to really invest in 2023. But, investors can count on regulators to throw a wrench into the best laid plans. The California Fifth District Court of Appeals recently set a stay into place, effectively killing the permitting of new oil and gas permits in Kern County. This is a reversal of fortune, as there was a prior positive ruling on this issue (King and Gardiner Farm vs. Kern County) in 2022. While the stay is temporary and could be lifted at any time, the court could also decide to pause all new oil and gas drilling for the duration of the judicial appeals process.

This is a big deal, as more than two thirds of California oil production - and production at California Resources Corporation - comes out of Kern County. During 2022, 106 wells were drilled in the San Joaquin compared to just 41 in the Los Angeles Basin, with all of that Los Angeles Basin activity being waterfloods of existing wells versus new conventional drilling (which almost always yields higher production rates). The majority of those San Joaquin wells were in Kern.

Momentum has been trending that way, and when coupled with the new setback rule, a disproportionate amount of the 2023 drilling program was likely to take place within Kern as well. Given the recent news, much of this now will likely have to be pivoted elsewhere until there is some sort of resolution. See the below from the late January 8-K filed with the SEC on this issue:

We are disappointed with this preliminary order and will await the appellate court's final decision on whether Kern County can rely on the EIR during the pendency of the appeal. If Kern County permitting remains paused during the appellate process for an extended period of time, we intend to reduce our rig count and capital program in 2023, and focus our drilling in areas outside of Kern County, as well as increase our workover activity. In the meantime, we will continue to focus on delivering strong cash flow from our low decline assets.

In general, a quick reversal won't be the end of the world. Fresh permitting was only reinstated back in November and was proceeding quite slowly before this ruling anyway, so most everyone was expecting a rather soft production rate out of Kern County in early 2023. This does risk the outlook for the back half of the year though, and this could bring overall production levels down much more than what is implied in recently issued guidance that came alongside the Q4 2022 earnings release.

Takeaways

While I and many analysts don't expect the stay to be permanent, that is a risk. At the minimum, this will cause some slippage in the earnings potential of the business - even with California Resources owning conventional, low decline rate assets. While the firm looks cheap based on earnings multiples and the potential of other aspects of its business (e.g., carbon capture), I've learned long ago that the market (and myself) tend to underestimate negative risks stemming from harsh regulation. Given that, I'm staying away from being long.

For further details see: