CRC - California Resources: The Future Of Oil Is In California

2023-11-07 06:25:52 ET

Summary

• There is polarization and heated debate surrounding the future of oil.
• Here is the opportunity for financial gain by capitalizing on the unreasonable positions of others.
• Understanding the biases and false beliefs of competitors is critical while seeking alpha in the market.
• California Resources is significantly undervalued under key DCF measures supported by the viability of its unique energy strategy.

"The truth is sometimes a poor competitor in the marketplace of ideas - complicated, unsatisfying, full of dilemmas, always vulnerable to misinterpretation and abuse." ? George F. Kennan

The future of oil in California? Golly, I should stop reading right now. Yes, I know I've chosen a somewhat provocative title in one of the most rhetorically heated and hotly debated sectors in the market. But there is a reason that California Resources Corporation (CRC) is so unique and why the firm is likely paving the road for many in the energy industry in the future. Like a plant that evolved in a harsh environment, it should provide survival lessons for companies with weaker constitutions.

It was spun off from Occidental Petroleum ( OXY ) in 2014 to deal with the challenging California regulatory environment. A firm operating in one of the harshest regulatory environments in the country has a higher beak-even cost. So, in the price plunge of 2020, the firm went bankrupt, somewhat understandably. However, the firm retained some of the Golden State's premier oil assets.

Since emerging from bankruptcy with a superior financial position, the firm has been taking an interesting strategy, and its exciting strategy is something the entire American Energy industry will be learning from. That's right, California Resources Corporation may be giving Texans some lessons in black gold. What I mean by that is that this company has become an industry leader in low-carbon oil drilling and natural gas extraction.

This was coupled with decades of operating expertise in California and enviable oil assets even with the regulatory albatross. But like some very tough creatures from harsh environments, I suspect California Resources Corporation will reward shareholders far more than first-order thinking based on flawed assumptions would suggest. For example, while California may seem a weakness to you, it is also the 5th largest economy on earth. I live here. It is not the socialist, crime-infested nightmare portrayed on television.

While the state government may seem activist and overbearing, it is also potent, and if it's in your corner, well, you sure can get a lot done in the Golden State. And to be frank, one hand washes the other here. California's climate goals are on the national stage for judgment, and CRC's assets and capabilities will probably be vital in avoiding humiliation. California imports a lot of energy, and energy price volatility is a particularly loaded issue in the state with a history of taking out governors with recalls. One way Mr. Newsom can hope to avoid this fate is by consuming energy produced in the state.

Polarization is Obnoxious, But it Can Also Be An Opportunity to Outmaneuver the Crowd

This company is very polarizing in a very polarizing industry. I used to work in politics. So, while you guys have only recently enjoyed being criticized by others with irrational political views, I was sitting in the Senate Office phone room getting yelled at and threatened by people when I was 21 years old. The polarization on environmental issues was already high, and it was reflected in how members of Congress were voting long before our modern era of polarization.

Once, folks even chased me during the high-stakes passage of the Affordable Care Act when I forgot to remove my ID card after exiting the Senate Office where I worked (Bill Nelson, now head of NASA). You guys may find many political discussions in the current climate as unpleasant as most do, but just be glad you didn't have to walk briskly away from a bunch of protesters screaming that you want to kill their grandma as a college student. Luckily, they weren't so fast-still not cool.

Anyway, my point is that I am no stranger to polarization. I had a front-row seat to its unfortunate rise. Yet, the only time I have been accused by both sides of supporting mass human genocide is when I write about Energy companies. The pro-energy folks say that if I'm giving anyone kudos for achieving ESG goals, I'm a pinko communist who doesn't understand humanity has only been elevated out of poverty because of the beautiful energy-rich bounty that God put in the ground.

The activists and climate-focused folks think I should be throwing blood on the fur coats of oil executives' wives instead of telling people to buy their stocks. Both these fervent constituencies miss that I'm writing for the humble shareholder, whatever their persuasion.

Some big guys might read my stuff, but my core constituency is Americans of any political persuasion who want to cut through the BS and make money for their families. All these concerns from fervent whipped-up interests trouble me very little from that perspective, although both positions should be duly considered, fervency and gauche presentation aside.

Folks seem to get particularly testy. Their egos get particularly disturbed, and zeal often replaces measured, reasonable debate. This is unfortunate since measured reason is a prerequisite for productively discussing such a complicated subject as the world's energy consumption and efforts to make it less dependent on carbon-emitting fuels.

But even if you're the most aggressive Energy activist out there, there's no way you're not getting into net zero without a lot of natural gas use and lowering the carbon intensity of both natural gas and oil in how they are used and extracted are also crucial to the realization of those goals.

While growth options are limited in California due to the onerous regulatory environment on new wells and drilling, the opportunities for new Natural Gas extraction that the firm has begun moving forward on are particularly enticing.

So, it's fair to say the debate is a little heated. But here lies our opportunity for alpha. The heated debate sometimes means a lot of unreasonable people making unfortunate decisions for themselves. While you may be unable to shake them and make them see reason, it is sometimes possible to financially benefit from their folly.

I suspect California Resources Corporation is one such instance where alpha can be found on the backs of flawed assumptions. The firm's low-carbon production is worth something and will continue to be. And there's potentially a lot of upside in the expertise being gained at this firm.

There are certainly some natural reasons for this reality. The valuation decline in the energy sector has been precipitous as the industry's externalities have occupied public consciousness. Energy has become a hot-button issue, and climate change itself seems to have become a key battleground in the culture wars. It's natural to expect an industry looking down the barrel of a .44 to engage in some perfectly legal obfuscation and misdirection to give management time to respond to changing realities and perceptions.

And, of course, the activists themselves engage in the same. The result is a highly emotional subject where you can sometimes upset people by stating mere facts. And as obnoxious as this polarized reality can be, it is simultaneously a significant opportunity for outmaneuvering other investors whose judgment is affected by it. To me, this is always one of the easiest and least resource-intensive ways to achieve alpha.

There's another positive in this approach, too. Much has changed since modern markets began in the Low Countries in the 17th century. Human psychology is not one of them. When you're seeking alpha, your performance compared to others, the false beliefs and biases of your competition are crucial information. When it's a highly polarized subject like Energy where many people may have their judgment compromised by emotionality, there's the chance to get ahead of the crowd, whatever their beliefs.

Risks and Where I Could be Wrong

One of the most significant risks for this company is the high production cost compared to other producers. This Achilles heel is what led to the bankruptcy in 2020. While the company has taken great pains to improve its financial condition and resilience, as well as to introduce new growth opportunities, it is still a major vulnerability that investors should be crystal clear about. And despite the cornucopia of bullish data from around the economy, there is always the chance that the aggressive Fed hiking cross-checks the economy and knocks some of the bull's teeth out.

In addition to a lot of positive data, there is no shortage of data for the bears to hang their hats on. Above, the Conference Board's widely followed Leading Economic Indicators suggest a recession is ahead. This is where a critical risk in this company lies. Many oil companies, significantly larger ones like Exxon ( XOM ) and Chevron ( CVX ), have significantly curtailed their break-even cost for oil production. Given the regulatory constraints that CRC faces, this is not the case for them.

Low oil prices could cause the price of this stock to drop very quickly, mainly since the same catalyst put them out of business three years ago. This risk is somewhat mitigated by the company's dedication to best hedging practices after the bankruptcy. However, while these are helpful, they can never fully protect against the impact of a sudden and unexpected drop in the oil price. You can assume that because of the company's higher break-even cost, adverse price action will be more significant than an oil producer with lower break-even costs. This should not be considered a low-risk investment. It is not. But that fact in itself provides an opportunity for alpha.

Conclusion: California Resources Corporation is Potentially the Kelly Slater of Energy

Surfing is challenging, especially when competing at a competitive level. If the waves were excellent and consistent, it would be much easier. But surf competition hosts have yet to be able to learn to control the waves to give participants a more even and easy playing field. If they could, I'm sure they would. But anyway, when you think of surfing, you probably think about the enormous waves, fearlessly facing a wall of water that would make the rest of us wet ourselves.

Professional surfers certainly do this, and while it is one of the more glamorous and inspiring features of their profession, it is being able to catch waves in diverse environments. Surfer Kelly Slater grew up in Florida, which is known for small and poor waves. Yet, this supposed weakness made him a fierce competitor against Surfers who had grown up on the tremendous, easy waves of places like San Clemente, California. Consistency is vital in surfing. Consistency in capital return is also essential for long-term investors.

This company could potentially be the Kelly Slater of the Energy Industry. The future seems to entail a reality similar to CRC's than yesteryear. And since it is at the vanguard of low-carbon production within an onerous framework, its knowledge will be advantageous. In terms of Carbon storage, its current efforts have a lot of relative credibility to those who embrace the new world order out of cleverness instead of self-preservation.

This is a round-about metaphor for the value I see in CRC. It will potentially have a semi-protected Energy monopoly in one of the world's largest economies. My previous experience in politics makes me highly suspect that Governor Newsom will be forced to buy what CRC is selling in more ways than one.

Of course, one of the primary things that gives me confidence, though, is that there is a large margin of safety for this stock. With such a limited dividend history since bankruptcy, this is very important to me. And despite a good run over the last year, the company is clearly undervalued. Is it possible the firm becomes a defacto "California Aramco?" This is a low-probability scenario, but it could occur. What I like about this company is that there are a lot of scenarios that happen short of that where you will still likely be rewarded for being a patient shareholder.

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