A Look At The Investment Opportunity In California Resources Corporation Across Its Capital Structure

Summary

• CRC presents interesting investment opportunities across its capital structure (equities and 2nd lien bonds).
• CRC has a huge asset base, with 618Mboe of proved reserves, most of them (71%) already developed – so the full costs per barrel to extract them are lower.
• CRC has also a collection of midstream assets that the company has just started monetizing. This value  can be further unlocked if needed if market conditions deteriorate.
• Inexpensive valuation through the 2nd lien tranche: at a price of 77 for the bonds, the company is created at an EV of $4.0bn, 4x of what I consider a mid-cycle EBITDA and 6.47$/boe of 2P reserves.
• Recent Elk Hills transaction provides additional leverage to the equity story.

Investment thesis

California Resources Corporation (CRC) is a US oil and natural gas producer that operates in California, being the largest producer in this region on a gross-operated basis. Since its spin-off from Occidental Petroleum (OXY) in 2014, CRC has had a tough time navigating the tough oil environment, but so far, it has been able to survive adapting its cost base and using the flexibility of its massive asset base.

CRC is a well-known story among Seeking Alpha readers, because it has been extensively covered in the past by many contributors. The purpose of this article is to review CRC's capital structure after its transactions with Ares (ARCC) and Chevron (CVX) and to assess the investment opportunity both for shareholders and bondholders. This article will also analyse CRC's prospects under three oil price scenarios, so the readers can decide whether the investment is attractive given an oil price outlook. My conclusion is that CRC's 2nd lien bonds maturing in '22 (CUSIP: 13057QAG2) are a very attractive investment opportunity for risk averse investors with huge downside protection, and that CRC equity is the best vehicle available in the oil space if one thinks oil price will continue to march higher - although the upside is not as huge as many commentators have assumed here, mainly due to the fact that CRC barrel of oil equivalent sells at a huge discount vs. Brent (around 30%) and that management capital allocation decisions have been, in general, quite mediocre.

Brief history of the company and description of the assets

CRC was spun off from OXY in 2014, which was put into CRC under a single roof all its Californian assets. Because of the transaction, OXY received $6bn in dividends and CRC assumed a massive amount of debt to finance the payment. Within a $100 oil price environment, the debt at the time looked manageable, but as the oil price collapsed in 2015 and 2016, the company saw how the debt was becoming more untenable. Because the CRC story is well-known in the Seeking Alpha community, I will only mention the main steps the company has taken in order to tackle the debt load:

• November 2015: issue of $2.2bn of 2nd lien notes to address the unsecured notes maturing in '20,'21 and '24.
• August 2016: distressed exchange of the '20, '21 and '24 notes, reducing the debt by $625M.
• February 2017: JV with Benefit Street Partners. BSP agrees to invest up to $250 million for development opportunities in both conventional and unconventional assets.
• April 2017: JV with Macquarie Infrastructure and Real Assets. MIRA agrees to invest up to $300 million for development opportunities focused in the San Joaquin Basin.
• November 2017: new $1.3bn. term loan ("2017 Term Loan") to refinance the previous credit facility and partially repay the '20 and '21 unsecured notes (after the transaction $100M of each class of notes remain outstanding).
• February 2018: JV with Ares Management and capital raise. Ares contributes $750M for the 50% of a JV that holds the Elk Hills power plant, a 550 MW natural gas fired power plant, and a 200 million cubic foot per day cryogenic gas processing plant. Additionally, Ares bought 2.34M of CRC's common stock for $50M. $297M have been used since then to repay the outstanding bank revolver balance.
• Abril 2018: the company has announced it is acquiring from Chevron a further interest in the Elk Hills field for $460M in cash plus $50M in shares. The acres bought produced 13kboped in '17 and have proved reserves of around 64Mboe. The split between liquids and gas is 55%/45%, substantially lower than CRC's legacy asset base.

After these transactions, CRC's original debt of $6bn has been reduced to a gross (and net) debt of $4.9bn. The structure of the debt will be explained below.

CRC's assets can be divided in three buckets. The first one is the reserve base. Per the latest 10K, CRC has 618Mboe of proved reserves, being 71% already developed. The reserve base has been estimated with what I think are conservative price assumptions:¹ $54.42 for the Brent oil price and $2.98 for the NYMEX gas price. The latest PV-10 value of proved reserves is $4.5bn, equal to the value of net debt. Additionally, CRC has 1,129Mboe in 3P reserves (which already includes the 618Mboe in proved reserves) that must have some economic value.² Finally, the Elk Hills transaction have added around 60Mboe in reserves.

CRC's reserves present some interesting geological properties in comparison to CRC's competitors. First, CRC's wells' natural decline is much lower (around 10%) than the one exhibited by the frackers (30%), making CRC's maintenance capital needs lower. Also, CRC's oil reserves are slanted to oil (72% oil). Given the relative prices of natural gas, oil and NGLs, the higher oil content in CRC's sales commands higher price realizations per barrel. And finally, due to the lack of good interstate pipeline connections, CRC's operations in California are subject to international (Brent) pricing, providing attractive realizations versus other US producers, given the current WTI-Brent price gap.³

The second bucket is the midstream assets. After the Ares transaction last February, CRC still owns a substantial array of midstream assets, consisting of i) 8 gas plants with total capacity of 460MMcf/d, ii) 2 power plants with 100MW, iii) 50 steam generators, 400 compressors, 22 water management systems and water softeners and gathering and storage systems and iv) 50% of the assets of the Ares JV (Elk Hills power plant plus a cryogenic gas processing plant).⁴ I suspect that the poor performance of the MLP space of the last couple of years has led CRC not to pursue a wholistic transaction (the creation of an MLP) for its midstream assets. Also, and according to conversations with the management, they thought that because the infrastructure depends completely on CRC's production capacity and no growth is expected in this regard, valuation for these assets in the public market would prove to be difficult.

And the final bucket is the real estate. According to the 10Ks, CRC's acreage position consists of 2.3 million net mineral acres (without taking into account the new acres bought from Chevron), of which 60% are held in fee and 15% are held in production. The ownership of a significant part of its portfolio gives CRC the optionality to drill the parts of its portfolio that makes most economic sense, given that CRC does not face the problem of lease expiration as many of its competitors do. Additionally, and according to discussions with the management, CRC owns 15% out of the 60% acreage held in fee (not only the mineral rights, but the land as well), with some properties that can have some commercial value (according to the management again, the ones with the highest value per acre are some properties by the beach of undisclosed size). Although the latest 10K (p.53) says that "we have undertaken new initiatives to unlock additional value from our real estate. Our developing real estate initiatives include renewable energy opportunities such as solar energy projects; agricultural activities such as the production of fruits and nuts; and commercial real estate", very little has been obtained so far in term of cash flows.

Financials and cash flow scenario analysis

Given the debt load, CRC's production has been declining since 2015, from 160kboe/d to 129kboe/d currently. The company is guiding for a constant level of production for 2018 (ex-Elk Hills acquisition), and the JVs are not expected to contribute to CRC's production until 2019 at least. On the other hand, costs per barrel came lower in 2016 due to high-grading and lower service costs (15.7$/boe), before raising again in 2017 (18.6$/boe). From this point of view and taking into account the still high level of G&A expenses, I think CRC's management team could have done more in terms of cost efficiency, especially in 2017. In any case, I do not expect substantially higher operating costs (except for the Ares' JV, see below) in the future.

The financials for the last three years are shown in the following table (click to enlarge):

A scenario analysis reveals that CRC can generate some cash for debt repayment under a base case scenario ($70 Brent) and barely breaks even in a bear case situation of $55 Brent price.

For the legacy asset base, the crucial assumptions are: i) 70% BOE price realization respect to Brent prices, ii) production of 125kboe/d, iii) maintenance capex of $400M per year, iv) an increase in costs of 2$ per barrel due to the Ares transaction and v) a slight increase/decrease of costs per barrel depending on the oil price scenario.

For the Elk Hills transaction, the assumptions have been basically the same, except that I have assumed lower price realizations vs. Brent, given the lower content of oil production 46% vs. the legacy asset base. Readers should note that I have not adjusted upwards G&A expenses in the base case scenario (I have just assumed the same figure as in '17) to take into account Elk Hills transaction, but I think that given management mediocre cost cutting in G&A over the last few years one should assume a higher expense going forward:

With a Brent price of $85, a shareholder would be buying shares (given the prices 10th of April) with a FCF yield of 15.2%: a very nice opportunity, but not as high as many commentators seem to imply for the oil prices. One of the reasons is that the cost structure is not as fixed as it may seem, and some part of the oil price increase is absorbed by a higher cost structure. The company would be generating an EBITDA of $1.4bn, which at a 6x multiple would imply an equity value of $2.8bn, an upside of almost 3x vs. the prices of 10th of April.

On the other hand, for a Brent price of 55$ the company cannot even cover interest payments, given an FCF of $342M and interest payments of $397M. In other words, under (roughly) 58$ Brent price the only value the company has for shareholders is as a call option for higher oil prices. The very high discount of CRC's barrel of oil equivalent due to the natural gas mix in total production (some years such a discount has been higher than 30%, and in my normalized FCF analysis I am being generous assuming a discount of 30%), although not as high as the one realized by the frackers, is high enough to mute some part of the oil price increases, given that gas prices do not move in tandem in general with oil prices.

The second lien opportunity for risk-averse investors

In terms of debt, as of today (and after the Ares and Elk Hills transaction), CRC's gross (and net) debt sits at $4.9bn. The $441M of cash in the balance sheet that was the result of the Ares transaction has been deployed for the Elk Hills transaction. Given current cash levels, I am not expecting the company will engage in opportunistic purchases at discount of the '22 bonds - as they said they would do in a recent presentation back in February.

CRC does not have to face any material liability until December 2021 (the '20 unsecured notes will not present any problem), when the '16 second-out term loan together with the '21 unsecured notes will have to be refinanced (barring substantially higher oil prices). This means that CRC has an ample runaway to see a market recovery whilst reducing the debt burden under current oil prices:

Given that the 2nd lien debt is currently trading around 80 cents on the dollar, the market is implying the company is worth a bit more than $4bn.⁵ This would imply, using a normalized EBITDA of $1bn. that the company is created at a 4x EBITDA multiple or at a 6.47$/2P multiple, which in my view provides substantial downside protection. These numbers do not take into account the vast amount of resources that would convert into reserves under higher oil prices nor the land that could be monetized. This company, with higher oil prices, reached an EBITDAX of $2.5bn, so we think that an EBITDA of $1bn. with lower oil prices is a reasonable mid-cycle assumption.

Although I think the oil market has a favorable outlook for the next couple of years, I think the current yield in the 22s given should be very attractive for risk-averse investors. One should be happy to hold what seems here to be the fulcrum security and become shareholder of the restructured organization - which, in that case, would have a very manageable leverage ratio of roughly 50% and a developed and proven asset base. In any case, I think the 22s are worth par and are an interesting opportunity from current price levels.

A word about the management

Although as I have mentioned I think the investment opportunity in CRC is quite appealing both for equity and credit, prospect investors should know that I do not hold CRC management in very high esteem. Although they have been quite proactive to tackle the debt load, capital allocation decisions in the core business have not been optimal. I present here some evidence that I think is relevant and that it has been often overlooked by investors in the past:

• General and administrative costs are high. Given that CRC asset base is focused in California one should expect its G&A to be lower than competitors operating in several regions. A cursory comparison against competitors shows that Pioneer (270kboed/d, double than CRC) spends $325M in G&A, EOG (600kboe/d) $434M and Diamondback (80kboe/d and growing) $50M. I understand that there is some flexibility in classifying costs here and there, but still the difference strikes me as very high.
• The management talks about the "flexibility of the asset base" and how they can direct investments from oily wells to gassy wells depending on the relative prices,⁶ but given that oil represents 72% of CRC's total reserves but that oil production has only been 65% over total production, one wonders why management has not invested more in oily fields given the relative prices of oil and gas. This trend is going to continue in 2018: the management plans to invest heavily on the Monterrey formation, which is the asset with the highest proportion of gas reserves.⁷ Given that management compensation is tied to the VCI of every project and that gas projects usually have a higher VCI index (given their faster payback period), I think management is incentivized somehow to develop gassy projects over oily ones.
• The recent Ares transaction has been important, given its size and its impact on CRC's cost structure going forward and current net debt levels. CRC will have to pay annually 13.5% on the $750M and will save around 5% on the $297M paid of the revolving facility, which together with the capital raised ($739-$297) it basically implies a cost of around 19%, quite high if one takes into account that the 22s have not been trading at those levels for quite some time.
• After the Ares transaction, they said that they would allocate the proceeds between debt and capex depending on the price of the 2nd lien notes (under 80 they would buyback the notes). The Elk Hills transaction shows that that was not the case.

Just to be clear, I do not think management concerns offset the investment case, but in any case, prospect investors should keep monitoring these issues in the future.

Downside Risks

• Oil (Brent) prices below 60$ for a prolonged period.
• Management capital allocation decisions and poor performance in reducing the current bloated general & administrative cost structure.
• Geological or weather disasters.
• Poorer performance (and higher capital needs) at the well level after years of low capex and high-grading of the asset base.

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[1] P.29 of the latest 10K.

[2] Raymond James and Associates 39th Annual Institutional Investors Presentation, March 2018, p. 9.

[3] Raymond James and Associates 39th Annual Institutional Investors Presentation, March 2018, pp. 26 and 34.

[4] P.43 of the latest 10K.

[5] Given the small amount left in the '20 and '21 notes, the prices indicated in the table are indicative as per Bloomberg. If real, another (riskless) investment opportunity would be long the '22s and short the '20s, taking thus advantage of the big discount presented by the '22s and additional protection in the capital structure.

[6] Raymond James and Associates 39th Annual Institutional Investors Presentation, March 2018, p. 38.

[7] Latest 10K, pp.4, 9 and 40.

Analyst’s Disclosure: I am/we are long CRC 2ND LIEN BONDS. 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.