After The Q4 Disappointment, California Resources Remains A Buy If You Believe In Higher Oil Prices
- CRC continues to be a buy only if you believe oil prices will be higher going forward.
- We break down the bear, base, and bull case price targets.
- While the quarter was a disappointment with the lack of clarity on production guidance, we estimate that more than 85% of the future value creation will come from higher oil.
- CRC continues to be a high risk, high reward play on oil prices.
After California Resources' (CRC) Q4 earnings announcement, our big takeaway was that production guidance came in below what analysts expected. The 120k to 125k boe/d production guidance for Q1 was much lower than what everyone expected, and while given multiple opportunities to explain on the conference call, CEO Todd Stevens did a terrible job explaining why the guidance was so low.
We followed up our Q4 analysis with an article titled, "Everyone Has A Plan 'Till They Get Punched In The Mouth." The CEO could have said these 19 words, and the market might not have punished the stock as much:
We will increase production in the second half, we just want to be more comfortable with where prices are.
But things that are obvious to us may not be obvious to many, and while the lesson cost CRC $270 million in loss of market cap, we think the underlying fundamentals and premise for why we bought CRC have not changed.
CRC remains a highly levered bet on oil prices
The key thesis for why we bought CRC is our thesis that oil prices will move higher. And like all energy stocks, there's an inflection point where CRC shifts from bankruptcy to stable to thriving.
For equity investors, the bulk of the gains do not come in the "stable" phase. For debt investors, the bulk of the gains come from the stable phase.
Buying CRC's stock then is akin to having a call option on the "thriving" phase. For us, $25 per share, where CRC traded a month ago, was still in the stable phase. The ramp up in share price from $7 (when we wrote about it in September) to $25 was the inflection shift from bankruptcy to stable.
We said in our original write-up that Brent needs to be above $55 to $57/bbl for CRC to reach its corporate breakeven (the cost of replacing production, paying debt interest, and keeping production flat). We have only had Brent average above that for one quarter so far (CRC's Q4), and Q1 2018 is also seeing price improvements quarter over quarter.
So, what are the odds?
Here are the probabilistic layouts of the payoff in owning CRC.
If you are a believer that oil prices (Brent, in this case) will trend higher and average at $70/bbl over the next five years, then our implied share price value is $76 to $83 per share by 2022-2023.
If you are a believer that Brent will average $60/bbl over the next five years, then our implied share price value is $4 to $6 per share by 2022 to 2023.
If you are a believer that Brent will average $75/bbl in 2018, followed by an incremental increase of $5/bbl every year to 2023, then our implied share price value is $212 to $259 per share by 2022 to 2023.
Taking those three scenarios laid out, we get an expected value of $93 per share using 40% probability for the base case, 35% for bear case, and 25% for bull case.
As you can see, base case assumption shows CRC to still rise materially to $80, but it's the bull case that is the standout winner with a PT of $236 and a probability adjusted contribution of more than half of the expected value.
For those of you that are invested in CRC, this scenario analysis should be ingrained in you as the underlying stock is a quintessential call option on higher oil prices for longer. We have now included this probability chart in the CRC excel model (only available to HFI Research subscribers), so you may pick and choose the probability payoffs yourself. You can also adjust the oil prices in the different scenarios (there are three), and see for yourself what the payoff is.
It all comes down to your assessment of oil prices
CRC is not an investment where you can make the assumption that oil prices will stay lower for longer, and the equity portion would thrive. As you can see in the probability tree, the bear case is not good for equity holders but good for debt holders. This has been the case since we first invested in CRC, and nothing has changed since.
Going forward, then, whether to buy or sell CRC really comes down to your assessment of the oil market environment. If you believe that oil prices will be higher than $70/bbl average (or even if Brent is at $65/bbl - it's a $43 per share target), then CRC is a buy today. But if your view or conservatism says that oil prices could remain around $60/bbl for the next five years, then CRC is far from a buy as you can see from the $5 price target downside.
While in the short term, investors can pile in and out of CRC based on a few thousand barrels per day of production miss, the material long-term driver for equity holders remains in the hands of where oil prices are in the future. If we were to break down the potential attribution for CRC equity holders in the future, this is how we would look at it:
- Value added by management - 10%
- Value added by higher oil prices - 85%
- Better operational results - 5%
We think over 85% of the value that ultimately drives CRC's stock price higher will be in the form of higher oil prices. Given our assessment that oil prices will keep moving higher from here, we remain bullish on CRC. But the payoff is not without its potential risks, so make sure you understand the oil thesis fully.
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This article was written by
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Analyst’s Disclosure: I am/we are long CRC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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