California Resources Back In Growth Mode - Our Thoughts On The Acquisition

Summary

• California Resources announced an acquisition to buy the remaining interest of the Elk Hills play from Chevron.
• The acquisition was the least execution risk venue CRC could take, and because of the market's prior concern over potential capital allocation issues, this was a bullish deal.
• CRC also increased capex, which saw us boost production average for 2018 higher.
• This deal ultimately allows CRC to return into growth mode, and with the higher operating leverage now to movements in oil prices, the equity will reflect that.

20-Second Analysis

This boosted free cash flow by ~$60 million in 2018. This new flush production of ~13k boe/d will allow California Resources (CRC) to realize higher Brent pricing than the current hedge price of around ~$60/bbl. The acquisition was the least execution risk venue CRC could take, and because it boosts EBITDA and FCF, the deal increased the base case implied share price from $27.19 to $43.33 using $70/bbl Brent. Overall, the deal was positive.

Breakdown of the Deal

CRC bought ~13k boe/d of production, 55% of which was liquid, from acreages that CRC already owned a ~78% to ~80% interest in.

The deal price was $460 million in cash + 2.85 million shares in equity (~$51 million) for a total price tag of around ~$511 million.

This was probably the lowest risk deal CRC could have done using that cash. The deal metric is not out of whack with the price per flowing boe/d around ~$39.3k, which is slightly lower than where CRC trades today on a per flowing boe/d basis. The multiple paid was around ~5x cash flow.

On a pro-forma basis, using our $70/bbl price deck, the free cash flow increases from $159 million to $221 million or an increase of $62 million. In addition, the probability-weighted price target increases from $92 per share to $122 per share.

The reason why FCF didn't increase by the deal cash flow is that CRC revised higher capex plans for 2018 by ~$100 million. This has also raised our production guidance from ~126k boe/d to ~141k boe/d, or an increase of 15k boe/d (13k boe/d of that is from the deal).

Positives

The major positives of this deal are that it is a very low-risk deal in nature. A roll-up of your own assets will always be deemed much safer than buying a new producer, which we previously thought was the case. If CRC had bought Berry Petroleum, the deal price along with the potential execution risks would have presented overhang issues. The deal with Chevron (CVX) essentially eliminates a major part of the execution hurdle, so we find that as the major positive.

The increase in production will also allow CRC to realize currently higher oil prices. In addition, Elk Hills produces 36 API gravity oil, so the realization to Brent will increase from ~97% to ~99% on a corporate basis, which further boosts cash flow. We have made a few adjustments in the model.

Lastly, optically speaking, this deal enhances the leverage ratios, which has been a keen focus by the management team.

Negatives

The big negative, in our opinion, is the share dilution that came along with this deal. The 2.85 million share issued was completely unnecessary, because the company had ample liquidity in the line to pay the extra $51 million or so needed to close the deal. One possible explanation for this is that Chevron wanted to retain some upside optionality with the field, so it chose to do a portion of the deal in equity as opposed to cash. If this was indeed the case, then Chevron wouldn't sell the shares, and there won't be an overhang of 2.85 million shares.

Other than this reasoning, we can't find another logical response to this, and we will need to await the management team for more clarity.

This deal also boosts CRC's operating leverage to higher oil prices materially, given the unhedged production increase. In the event that oil prices fall materially, then this deal would not have been as economical. This is the issue with deals like this where cash is exchanged for production. The risks are symmetric.

Overall

We find the deal very encouraging as we dreaded that a high execution risk acquisition would have resulted from the use of the cash. In CRC's position, how it deploys capital from here is the utmost precedence given the "not overwhelmingly" bullish oil price environment. If Brent was at $100/bbl, this deal would be insignificant given the amount of FCF CRC would generate. But with Brent closer to $70, caution is needed and we liked the particularly low operational risk nature of this acquisition.

The increase in implied price target and probability weighted price target also reflects the positiveness of this deal, but the negative to all of this is the equity dilution, which could only be explained by Chevron wanting to retain some equity in the basin. We would need to see how management explains the 2.85 million share equity dilution.

Overall, we find the deal positive. CRC remains a highly levered bet on higher oil prices, and following this deal, the leverage aspect of the equity moved higher.

-----

Note: This article was first posted to HFI Research subscribers. Following the CRC deal, the details of the deal were discussed live on the subscriber-only chat followed with prompt Q&A. If you are interested in what our premium service has to offer, please see here for more info.

In addition, the CRC excel model is only available to premium subscribers.

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.