Ménage à trois with oil in California with the California Resources Corporation $CRC.

Probably Not a Value Trap

After digging into coal stocks, it made me remember a standup routine by the late Sam Kinison on cigarettes.  The gist of the joke was that if New York puts enough taxes on a pack of cigarettes so that they cost $7, it’s tempting to just do a line of coke for $9.  Sam Kinison obviously told it better, and outside of the 1980’s it probably lands a little flat.  But when I look at thermal coal stocks trading at a price to earnings ratio of 6, I got the sinking suspicion that maybe I should just buy oil stocks at a price to earnings of 7.5 instead.

The California Resources Corporation (CRC) is a slow decline, traditional (not shale) oil and gas explorer and producer based in California.  The decline rate of traditional oil wells is closer to 10% per year compared to shale’s 40% per year, and the mix of output is approximately 70%-80% oil as opposed to the oiliest shale basins at 50%-60% oil.  California presents its own jurisdictional risk for fossil fuel companies, however, regulations often create a barrier to entry into an industry that benefits the existing players and prevents competition.  There might be a fine line between contrarian and crazy.

CRC just finished the July 1st acquisition of privately held Aera, which while causing about a 30% dilution, and with about $1 billion of debt, it nearly doubled the proven reserves from 377 MMboe to 605 MMboe.  Just to put that into cleaner numbers, by increasing market capitalization from $3.5 billion to $4.5 billion with dilution, CRC went from having about $5.5 billion in proven oil reserves to $9.2 billion in proven oil reserves calculated with a 10% discount rate.  It also went from a production of about 78,000 barrels per day to about 140,000 barrels per day.  The deal was so accretive that management is planning on immediately increasing the dividend, as the 30% dilution increased production by 79%.  It also changed the mix of reserves from 67% oil to 79% oil.  That looks pretty accretive to me.

Management believes they can find about $50 million of synergies within five months, and $150 million within 15 months.  Always healthy to be skeptical of synergies, but Aera was a natural gas buyer, and CRC was a natural gas seller, and their reserves are adjacent with some legacy infrastructure connecting them, so the gas can immediately be piped to where it is needed.  Many of the synergies will probably come over the years as maintenance capex allows for the rationalization of the two separate infrastructures.  

But now for the unwelcome guest at the party, the hostile and petty government of California.  CRC has been tied up in court trying to get their development permitting settled.  They believe they will be victorious and by the second half of 2025, they will be able to stabilize and expand production.  In the meanwhile, they are currently only permitted to operate a single drilling rig which is furiously doing workovers to try and single-handedly stem the 10% annual decline rate of the operation.  This lonely little rig is only able to do so much, and production is expected to fall by about 6% a year until the permitting problems are behind them.  Eventually CRC would like to operate 12 development rigs and 8 workover rigs, at an enormous cost of course.  One of the amazing unintended consequences of the hostile jurisdiction, is that this has forced CRC to focus on return of capital toward shareholders of all places.  CRC engaged in a share buyback program starting in 2021, retiring 17% of shares outstanding for about $650 million.  There is still $675 million unused in the buyback program, and management believes that until drilling is authorized again, future cash will be swept about half toward debt retirement and half to add more fuel to the buyback.  At current prices, that’s enough to retire another 15% of the float, the two tranches of buybacks essentially neutralizing the dilution from the acquisition.  Who would have thought that overregulation would result in consolidation and excess profitability?  Economists.  Economists would have thought that.

So what will the income statement look like going forward?  In 2023 CRC had $564 million of net income from about 80,000 Boe/day production, but spread across 72 million shares for $8.10 per share of earnings.  Going forward, at similar oil prices, we could expect $940 million of net income, minus debt service, from 140,000 Boe/day production spread across 90 million shares for about $10.40 per share of earnings minus interest expense.  That’s hovering right around a price to earnings ratio of 5, although there will be some uncertainty surrounding the digestion of the acquisition, and of course oil prices might fluctuate. CRC could have a bad year here or there, but at a current share price of $50.00, that puts it in my “Probably Not a Value Trap” category.  While the dividend won’t yield anywhere near 10%, the share buyback program plus dividend should be well over the 10% shareholder yield threshold.  CRC currently returns to shareholders about 25% through dividends and 75% through share buybacks.  And since the business is trading at below the $9.2 billion value of their reserves at a 10% discount rate calculation plus about $3 billion of plant property and equipment, not including the assets of the Aera acquisition, the buybacks are very effective.  Capex could start up again in earnest in about a year, but the pent up share buyback program should propel onward for another three or four years from the cash already allocated to the program.

There are other aspects to being an oil and gas explorer and producer domiciled in California.  For one thing, CRC has built out a 550 MW natural gas power plant to use their trapped natural gas.  No pipelines were approved to get gas to Texas export terminals after all.  But since California has overbuilt solar, CRC gets paid twice, once as backup capacity, and once when the gas power plants are operational at night.  If CRC sells the gas, due to no pipelines to Texas, California gas is more expensive than the national average.

Also, one of the environmentalists’ bigger fears is coming true, it is the oil and gas companies themselves who will most benefit from carbon capture regulations.  And why wouldn’t they, they are already experts at dealing with energy permitting, and they have huge cashflows to play around with.  CRC claims that it is two years ahead of any competitor in California toward finishing their carbon sequestration joint venture with Carbon Terravault.  Once those traditional oil wells are pumped dry, companies want to pay CRC to pump them full of carbon dioxide to reduce their carbon footprint.  I’m not enthusiastic about regulatory Rube Goldberg machines, but the odds of the Democratic party, and therefore the environmentalists, losing control of California is pretty slim, so that fat government cheddar might actually be realized some day.  To date Brookfield has already paid out $92 million for the milestones CRC has achieved toward this carbon sequestration program, with the third and final milestone expected to be completed this year, and the first carbon dioxide sequestration starting by the end of 2025.  CRC estimates that this carbon capture JV could bring in $50 million in EBITDA in 2026, and $250 million in EBITDA in 2028.  I won’t hold my breath.

Once permits are approved and drilling recommences, there is no insider buying or active capitalists to indicate that professional management would refrain from spending money how they desire, excessive drilling most likely.  It is only the perniciousness of the California government that is directing capital to shareholders at all.  This means that I would not treat CRC as a buy and hold forever company.  Within a few years, when the buyback money is spent, drilling has resumed, and perhaps earnings are inflated by carbon capture, I would be a seller.  If the pending permitting court case results in a longer period of reduced drilling, preventing CRC from spending too much on capex, I would be interested in a longer holding period.