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Morningstar | Outlook for California Resources Still Bifurcates on Oil Prices

The outlook for California Resources remains tethered to the trajectory of oil prices. Due to the company's very high financial leverage, the value of its equity is sensitive to shifting inputs, justifying our extreme uncertainty rating. The shares were trading at just over $20 at the beginning of 2018, and we see no justification for the subsequent doubling if our bearish $60/barrel midcycle forecast for Brent is accurate. After incorporating second-quarter results, we have raised our fair value estimate to $28, which is still well below the market price. To illustrate the aforementioned sensitivities, a modest $5/bbl increase to our oil price assumption is enough to make the shares look cheap.

Therefore, a bet on California Resources is still a bet on crude. But this is no longer a simple call option, as we have previously described it. The firm has made huge progress patching up its balance sheet, with about $5 billion total debt (down from $6.7 billion). In the current commodity environment it can continue to reduce the balance owed while increasing EBITDA at a double-digit compound annual growth rate. Thus, while oil prices remain favorable, the firm's ability to tolerate the weaker prices that we eventually expect is increasing. Even if oil reverses course and tumbles to 2016 lows, we would not expect the stock to give up 100% of its subsequent gains. In addition, the company has now layered in hedges to cover a third of expected 2019 volumes, and its production-sharing contracts in some areas are set up to increase its production if prices fall (a natural hedge that provides further downside protection).

Nevertheless, even oil bulls should exercise caution. California Resources' unit production costs remain well above those of other North American producers, especially shale firms. Also, given its unfavorable position on the cost curve, the company is very unlikely to earn its cost of capital in the next five years, even if oil keeps rising.

See "Coping With Frothy Oil Prices" for more details on our forecast for declining oil prices and the disproportionate negative impact on California Resources in particular.