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Morningstar | Despite Rapid Deleveraging, California Resources Is Still a Call Option on Crude

California Resources delivered production of 136 mboe/d in the third quarter, which was right in the middle of the guided range. The result marks the second consecutive quarter of growth after a lengthy period of severe capital constraints, and pegs year-on-year growth at 6%. But the firm’s financial health is steadily improving, thanks to a combination of higher oil prices and an influx of joint venture capital that enabled the firm to re-enter growth mode. That sets up a virtuous circle--management has increased the fourth-quarter budget by about $50 million to take advantage of the current environment and drive further growth. And the firm’s financial results were generally in line with consensus estimates as well, with adjusted EBITDA and adjusted earnings per share coming in at $304 million and $0.81, respectively. After incorporating these results, we have lowered our fair value estimate to $25 per share from $28.

We have long held the view that California Resources’ hefty debt-load makes the stock so sensitive to commodity prices that it is effectively a call option on the commodity. Thus, our bearish stance on long-term crude prices underpins our negative thesis. The recent performance of the stock effectively illustrates this sensitivity--Brent crude advanced 30% through Oct. 3 this year, before slipping 16% amid a broader market rout. And over the same periods, California Resources' shares gained 150% and lost 37%. Therefore, a bet on the company is a bet on crude, and the outlook is highly uncertain. Iranian shortfalls could drive up prices in the next few months, but the impact of higher gasoline prices and an escalating trade war are not fully baked into the market view on demand, in our opinion.

In the long run we see Brent crude averaging $60/bbl (18% below the current price). Bulls may believe that the firm’s rapidly improving financial health will minimize the stock’s crude sensitivity, but that isn’t quite right. To be sure, the firm is now in striking distance of 3 times net debt to EBITDA, and this metric could reach 2 times by 2020. That’s extremely impressive for a firm that we did not expect to survive the 2015-16 downturn, and management deserves full credit for proving us wrong. Nevertheless, it is the firm’s high debt to capital ratio that makes the stock swing wildly in response to commodity fluctuations. And that metric is expected to remain north of 80% for the next several years. Given extreme uncertainty about the trajectory of oil prices in the next few months, we recommend that investors take profits.