Description

California Resources [CRC]: I wrote this up a year ago and despite many of the positive catalysts coming to fruition, the stock is dead flat. I was planning to do a lengthy comment post, but figured it would be better as a full idea update. See my old write-up for context, but I still think CRC is worth $60 (+50%) in the near term and +$100 in the next few years if their CCS partnership is successful.

Positive Developments in the last year (I’ll expand on these later):

1. Passage of the Inflation Reduction Act which boosted tax credits for CCS by 70% and extended them until 2033

2. Brookfield has committed an initial $500mm to a JV with CRC which values their acreage at $1B

3. CRC’s peers in CCS and upstream oil are being acquired or put up for sale. DEN is rumored to be for sale as is BRY. Aera Energy was already bought for $4B

4. Oil prices are up since my last write up and the company has bought back $270mm of stock (~10% of shares outstanding)

Next Set of Catalysts:

1. Signing up emitters under the new Brookfield funding structure

2. DEN takeout would leave CRC as one of the only CCS plays in the public universe

3. CARB re-scoping plan will ratchet up the GHG reduction targets bringing more emitters to the table and boost the LCFS and CCA prices

Inflation Reduction Act [IRA]:

After months of flip-flopping, the Inflation Reduction Act was signed into law on August 16th. The bill allocates $370B of spending for clean energy production and is the single largest climate package in U.S. history. Most of the funding comes in the form of ten-year tax credits for renewable energy sources like solar, wind, batteries, nuclear and carbon capture and storage (CCS). I help manage a decarbonization strategy and almost all our positions had positive benefits from the IRA, however I think the CCS provisions are probably the most generous/impactful outside of maybe green hydrogen. If you’re looking for a winner from the IRA, I think CRC is one of the best.

45Q is the tax credit for carbon capture which had been increased a few years ago, but many industry leaders complained that it wasn’t enough to cover the capture costs for most industrial users outside of ammonia, ethanol and gas processing facilities. The IRA boosts the tax credit by 70%, extends the timeline to 2033 and makes it much more flexible to utilize. The result is that many more projects will pencil and since CRC also utilizes the LCFS as a revenue source, their projects will have higher returns and can target cement plants, refineries, power plants, etc. The slide below is the most comprehensive summary of the IRA upgrades to the 45Q that I’ve seen so far:

Brookfield Renewable JV:

Brookfield announced a $500mm commitment to fund the initial Carbon TerraVault CCS project via a JV where CRC will contribute their storage space in return for 50% ownership in the partnership. This investment values CRC’s initial storage space at $1B or $13/share. CRC expects to generate a range of EBITDA from the JV with a midpoint of +$200mm by 2027. This is just the first of five expected CCS projects which could be funded by Brookfield. Importantly, CRC is putting almost zero capital at risk by purely contributing their storage capacity. We couldn’t think of a better investment partner than Brookfield Renewable which is one of the largest and well-respected renewable asset developers in the world.

Importantly, this solves the “chicken and egg” problem that most CCS projects have run into previously. This first project will require $2.5B in capital for ($12.50/ton of capex on 200mm tons). Who would raise this capital? The emitter, CRC or a third party? Now Brookfield has solved this problem by providing end-to-end funding for the entire project. See below for a summary slide on the deal structure, but essentially Brookfield will put in all the equity capital, CRC will provide the pore space and the JV will target a 50% debt structure. 

So Brookfield will contribute cash of $1B (50% of $2B valuation based on 200 tons @$10/ton) plus an equity contribution of $613mm of capital for a total investment of around $1.6B and the rest will be funded with debt.

The resulting EBITDA from these long term contracts should average $93mm/ton or $465mm of EBITDA/year for the length of the contract (asset life of storage assumed to be 40 years). 

This results in IRR’s ranging from 10%-30% for the JV and Brookfield has said publicly that they expect at least mid-teens returns (see below):

Now the JV needs to actually go sign up these emitters and I expect that to be the next major catalyst. This will probably be a mix of brownfield (power gen, cement, gas processing, refiners) and hopefully includes some greenfield as well (biofuels plants, blue hydrogen, DAC).

Using the framework in the latest CRC deck we can derive a matrix of possible values for the CCS business using the following assumptions:

1. $93/ton EBITDA

2. CTV1-CTV5 will be built @ 5mm tons/yr for 40 years

3. Capex for each CTV will require $1.25B of debt

4. CRC will continue to accrue half of the economics

5. Assume a range of EBITDA multiples for a highly contracted 40 year asset 

Peers either getting acquired or hiring advisors for possible sales:

Denbury (DEN) and CRC are two of the only publicly traded companies where CCS is the main growth driver. OXY and other oil majors are trying to enter the market, but it will never be a 2-3x bagger like it could be for DEN/CRC. Now Denbury is exploring a sale and has hired JP Morgan as an advisor (per Bloomberg). XOM is considered to be the frontrunner and an acquisition could make excellent strategic sense given DEN’s CO2 pipeline in the heart of XOM’s proposed CCS hub and could be the cornerstone for their Gulf Coast carbon projects. XOM could easily value the pipeline at tens of billions of dollars, so the premium could be substantial.

CRC doesn’t own a pipeline, instead they own scarce acreage (storage) assets in California, so it’s not quite apples-to-apples, but this will provide another barometer on value and more importantly will leave CRC as one of the only credible ways to play CCS in the public markets.

In addition, California’s in-state oil producers are also getting attention. Recently, Aera Energy, the #2 producer in the state behind CRC, was sold for $4B. This is a decent comp for CRC’s upstream business given similar production profiles. This implies a $50/share price for CRC’s upstream business alone, although I would expect CRC’s business is worth more given a stronger acreage position.

Now the #3 producer, Berry Petroleum (BRY) is also rumored to be up for sale too. I think these transactions will help put a floor in CRC’s valuation. Eventually the CCS business could be a standalone company with the legacy upstream business being sold off.

Land Value: One of CRC’s largest shareholders is positioning the company to monetize their 92 acres of beachfront property in Huntington. 

“Kimmeridge has indicated to California Resources the acreage in Orange County could fetch around $800 million if sold for conversion to residential real estate, according to the sources.” -reuters (8.15.22)

That mark would be worth over $10/share, however it will take years to permit and develop the site, so that $800mm can’t be realized right away. Nonetheless it’s a nice inflation hedge and free call option.

Updated Valuation:

I value the upstream business on FCF yield and use multiple cases for the CCS business:

Low case: $10/ton or $13/share which just assumes the Brookfield mark and no return on investment or development of further CTV assets. Assume zero for the land value.

Base Case: Assume average CCS value in valuation matrix. Then discount that back by 15% for five years to arrive at an NPV. Then take the midpoint of that NPV and Brookfield’s mark. Assume only $300mm for the land.

High Case: Assume full value of discounted CCS NPV from valuation matrix and assume $900mm for the land since previously the company had indicated the valuation could approach $1B.

Risks / “Why hasn’t this worked yet?”:

Some people just won’t own an oil producer in California. I get it. The state always comes out with new regulations or laws to penalize the industry and it has a target to end oil production by 2045. That said, CRC will generate close to its whole EV at current oil prices over the next 5 years, so I think you’re being compensated for that risk. Plus, as you shift from being a net carbon emitter to a sink, the state’s environmental laws swing from a negative to a positive.

Since CO2 injection won’t start in earnest until 2025, many investors think this is too far off. It will take years to get the capture equipment built out and storage sites fully permitted. Since you are getting the CCS business for free at this valuation, I think it’s more than worth the wait. Plus contracts will be struck over the next 12 months which will shift the risk to pure construction/execution.

Catalyst

- Signing Up Emitters

- DEN or BRY sale