Description

California Resources Corp. [CRC]

California Resources is a value investor’s way to participate in the rapid energy transition to zero carbon. CRC is the largest oil producer in California but will become one of the most important enablers of the state’s decarbonization plan through large scale carbon capture and storage (CCS) and solar deployment. CRC has already detailed some of its green agenda, but more details will be released on October 6th during their Carbon Update Day, providing a compelling near-term catalyst. CRC has a double digit FCF yield currently, very little debt and has zero of the new green business priced into the stock. As the economic benefit of the initial phase of the CCS and solar plans come out, we see immediate upside to $60/share (45% upside). A substantial hidden asset in 92 acres of undeveloped beachfront property in Huntington Beach add to the upside ($4-$12/share) as well. The long-term opportunity to capture 20mm tons of CO2 for permanent storage could make the stock worth multiples of its current value.

Short Term Catalysts:

• Carbon Update Day on October 6th which will hopefully detail more of the economics behind the CalCapture and Carbon TerraVault 1 (CTV 1) projects

• Possible increase of the 45Q tax credit for CCS from $50 to $85

• CARB inclusion of cement, power gen and ammonia production into the LCFS. While maybe not imminent, there was legislation introduced recently seeking this expansion

Long Term Catalysts:

• Fully subscribing CTV1 by end of 2022

• Securing Funding for CTV’s through green financing and/or SPAC participation

• Continued carbon intensity reductions in CRC’s upstream operations making it the “cleanest” production company in the world

• Monetization of the 92 acres in Huntington Beach which the company believed was worth $300mm to $1B in the past…that value should only have appreciated since then

Background and History:

CRC is the largest oil producer in the state. They operate fields in the San Joaquin and LA basins. According to California Air Resources Board (CARB) data, they have one of the lowest carbon intensity (CI) scores of in-state producers and the lowest of the top 100 producers in the country. They operate a combination of conventional, steam and water flood production methods. Specifically, they do not frac nor use cyclic steam injection for oil production which has become the primary focus of state regulators.

CRC was spun out of Occidental Petroleum (OXY) in 2014. A combination of over leverage and complex JV funding structures going into the Covid lockdowns caused the company to declare bankruptcy in 2020. CRC emerged from bankruptcy late last year and executed a high yield offering that matures in 2026. They are subsequently less than 1x levered, generate substantial free cash flow (14% yield based on 2021 guidance) and have a $250mm buyback in place.

The main pushback for this idea is the risk of being a California in state oil producer. I won’t try to downplay the risk of doing business in a very hostile regulatory environment, but I will try to explain why I don’t think the dramatic headlines fully correlate to existential risk for the company.

California is an “oil island” cutoff from major pipelines and highly reliant on imports and in state production which price off of Brent crude. As you can see from the below chart, in state production has decreased (offshore production eliminated almost entirely) and the gap has been filled by imports from Saudi Arabia, Iraq, and Ecuador. These countries obviously have questionable human rights policies and generally higher CI scores versus CRC produced oil.

This is not lost on the Governor or CARB. California wants to lead the world and be the first heavy producing oil state to eliminate production entirely, but the regulators are aware of the consequences of doing this too early. See video link below of an interview with Gov. Gavin Newsome after he came out with the ban on fracking: https://m.youtube.com/watch?v=deRRVa5rBms

At minute 20 you can hear him address the imports from places that “don’t care much about labor standards or environmental standards and that perversely we’ve raised our carbon footprints globally”.

The governor has set a deadline to stop in state oil production by 2045. That still gives a 25-year runway for CRC’s upstream oil business which I think will be one of the last to shut down. The SJ basin has pipelines directly connected to the LA refineries and the Long Beach production revenues are split with the city. This is a significant revenue source for the city of Long Beach and would not be turned off easily. CRC’s workforce is largely unionized giving them outsized influence over regulatory pressures.

As you can see in the next section, CRC’s standing with the regulators like CARB is set to drastically improve as they help the state decarbonize. If successful, this will eliminate CRC’s “California discount” and turn into an unbelievable advantage.

Solar Opportunity: Potential for $85mm of annual profit or $10/share of value

CRC is one of the largest private surface rights owners in the state with significant acreage in Kern County, one of the best regions for utility scale solar development. The company has identified up to 5,000 acres that are suitable for solar deployment through a combination of behind-the-meter (BTM) and front-of-the-meter (FTM) opportunities.

BTM solar used to power oil production has some very compelling economics in the state. Under the Low Carbon Fuel Standard (LCFS), solar power can lower the CI score of transportation fuels and is eligible for credit generation based on the Innovative Crude Provision. Other operators such as Chevron have successfully applied for LCFS pathways under this provision in Kern County using the same developer SunPower (https://ww2.arb.ca.gov/resources/documents/approved-innovative-crude-oil-applications-under-lcfs).

The general formula is for every MWh of solar used for oil field production, you can generate 0.58 LCFS credits. Per CRC’s sustainability report, they purchased 1.2mm MWh of third-party electricity from the grid, of which 2/3rds was non-renewable. If BTM solar was deployed to cover the remaining non-renewable power, it would generate 455,000 credits annually or $85mm of revenue at $185/LCFS. Importantly, CRC needs to put up ZERO capital for these projects and just needs to be the offtake to secure the credits. Hence this is pure profit and valued at 10x would be worth $10/share for CRC. Granted, this would require almost 350MW solar deployments and CRC has only announced plans for 48MW so far, however we expect this number to grow as they work through more opportunities with the developer.

Separately, CRC has identified up to 1GW of FTM opportunities where they can contribute their land and receive an equity stake in the solar projects. It’s hard to say what these developer type returns could be worth, but a free stream of 20 year cashflows from a solar PPA is a nice way to lower your overhead. Lastly, it wouldn’t surprise me to see CRC partner with a green hydrogen developer on these projects given they are a net water producer for the state. For every gallon of water they buy for oil extraction, CRC generates 3 gallons of reclaimed water from underground. Plug Power just announced plans to construct the largest green hydrogen facility on the West Coast in the Central Valley. Excess land and water will be in increasing supply as renewable hydrogen ramps up in the state.

Carbon Capture & Storage (CCS): $7/share of value in the ST, but LT value over 2x the current share price

California has ambitious plans to reach net zero carbon emissions by 2045. Numerous research papers, including Stanford’s landmark CCS report last year, have been released detailing the need for CCS to meet this goal. The most recent of which was the Lawrence Livermore National Laboratory’s presentation to CARB which calls for capturing and sequestering 125mm tons of CO2 per year:

This report and others have specifically pointed to CRC’s acreage as one of the best sites for CCS given the geology, proximity to emitters and inventory of depleted reservoirs which could be used for storage:

To that end, CRC is planning an aggressive CCS deployment plan which could be worth multiples of the upstream oil business. CRC will target emissions that allow for “credit stacking” of multiple government incentives. Cal Capture is the first CCS project on the drawing board which will capture emissions from CRC’s 450MW power plant which powers their oil fields and exports energy to the grid. Similar to the solar projects, this power plant will generate LCFS credits but also federal 45Q credits and possibly Cap & Trade credits. This should generate over $50mm of FCF to CRC assuming a $70/ton cost to capture which is the current estimate in the Stanford report. More details will be released at the Carbon Update presentation, but I think these assumptions are relatively conservative. Valuing this stream at 10x would equate to $7/share.

The next and much larger phase of CCS deployment would be a range of projects called Carbon TerraVault (https://www.crc.com/carbon-terravault).

CRC has identified 20mm tons of CO2 which could be captured and sequestered in their oilfields. The first phase of this project (Carbon TerraVault 1 or CTV 1) will target 1mm tons of LCFS eligible emissions. The company has begun to file the associated permits and hopes to begin injection by 2025. CTV 1 will target the co-generation plants, refineries and other emiters in Kern County which have close proximity to CRC’s sequester sites. Ultimately Carbon TerraVault will grow to include the large LA refiners as well as cement and ammonia plants which may be included in future LCFS pathways.

In addition to current emissions, California also has an aggressive hydrogen expansion plan which includes biomass derived green hydrogen from forest waste. The LLNL report estimates 100mm tons of incremental CO2 could be captured from biomass based renewable hydrogen and companies like Mote Hydrogen and Clean Energy Systems (backed by Chevron) already have pilot projects on the drawing board and will need sequestration partners.

Assuming LCFS and 45Q credit generation for the 20mm tons, this could become a revenue opportunity of $4B-$6.5B and dwarf the upstream business. I derive an average present value of almost $50/share for Carbon TerraVault assuming a range of credit values, profit splits, multiples and a 25% discount rate. For comparison, a recent initiation report from KeyBank derives a value range of $6-$88 per share using different assumptions.

Valuation:

I will list a wide range of outcomes in this valuation, but the main takeaway is that CRC should approach $60/share just from valuing their upstream business (at a 10% FCF yield) and the first phases of their green expansion plan and assuming zero value for their Carbon TerraVault projects or the beachfront property. Comparing CRC to Denbury, which is also an oil producer looking to transform into a CCS company, would value CRC at $90/share using a similar FCF yield.

Assuming various outcomes for TerraVault you get 3x to 4.5x the current value of the stock. I’m happy to delve into more of these assumptions in the comments, but there is clearly large upside potential for CRC as the state executes on its decarbonization agenda.

RISKS

-          Oil prices

-          Regulation

-          Government subsidies

Catalyst

See Catalyst Section at the top