California Resources: Thank Goodness For A Strong Balance Sheet (NYSE:CRC)

California Resources (NYSE:CRC) announced a merger with Aera Energy. This merger was possible because California Resources kept the debt low. Therefore, acquiring a higher debt company like Aera was not going to be a traumatic experience for shareholders. Combining the two companies should produce some cost savings through a larger company rather than two separate companies. However, the surviving company is still a higher cost producer that needs to keep debt very low in the future to successfully navigate this low visibility industry.

Carbon Dioxide Sequestering

The other very good reason for this business combination is that the acquired company will possess considerable ability to permanently store carbon dioxide.

Like much of the industry, this company will have considerable ability to aid some climate change goals concerning carbon dioxide. Left out of the presentation is whether any of this gas can be used to aid in the recovery of oil and gas.

Carbon dioxide is used throughout the industry in secondary recovery. That use is likely to expand as unconventional wells age. California does not have a big unconventional industry because the state has not been very pro-fracking. However, older fields such as the ones in California are likely to use more and more higher cost recovery techniques simply because the easy production is long gone. That includes using carbon dioxide to maintain reservoir pressure.

Merger Proposal

California Resources shareholders will continue to own most of the combined company after the merger closes.

It should be noted that both companies have been embracing California’s move towards green energy. As a combined company, this should be a much safer proposition as many of the California initiatives have yet to be proven on a large scale.

For an example of what can happen in this push to change energy sources, utility bills in the state have climbed dramatically recently. Peak rates in my area have topped $.50 KWH under the right conditions. This is something not foreseen with all the things that the voters and the state want utilities to do. But there has long been the mistaken impression that big corporations can “handle it”. The truth of the matter is that utilities simply add the cost to costs already known while tacking on a reasonable profit and passing the whole thing onto consumers. As the green revolution proceeds, this example may need to stay in the forefront.

Both companies look as really unrelated businesses like solar energy use of the acreage, which can exist along with oil production because the oil is below the ground while solar energy production is above ground. It will therefore be interesting to see how all of this works out going forward. But clearly, one larger company is better able to handle the unknowns rather than two smaller companies.

Oil & Gas Business

Of course, California itself does not realize it. But the oil and gas business is likely to be around for a long time to come. California is now bumping into some realistic hurdles in its transition to less pollution. Politicians are only just beginning to realize that the past progress was far easier than what is needed going forward.

Therefore, it makes sense for the two companies to combine what is likely to be a long-standing future business.

The proposed combination of the companies will lead to some overlap. But probably the biggest advantage is the combination of knowledge in dealing with older fields that have been producing for a very long time.

Management stresses the Brent pricing received. That is better than the WTI pricing in a lot of other places. However, that low decline rate is a function of older, more costly production. Even after the merger, this will still be a high cost producing company.

Therefore, it is probably best to repay the debt that the company will inherit from the merger. California Resources had less than $600 million of debt at the end of the third quarter. Ongoing debt purchases have probably reduced that some more.

But Aera had considerably higher debt levels. That debt combined with a lack of interest in California throughout the industry in general may have contributed to this merger proposal.

The deal appears to be good enough to be immediately accretive to shareholders. But navigating California and the green revolution ideas will likely be more challenging than it is in other parts of the country.

Risks

California (the state regulatory environment) provides the greatest risks going forward. California has plunged forward into the green revolution without realizing the infrastructure required to get there. Shareholders should likewise expect a very messy progression towards a climate change response.

As an aside, it should be noted that the state has some of the best geology for the industry in the whole nation. Therefore, the state could, if it wanted to, reasonably open things up with safeguards to go from an oil importing state to an oil exporting state. The fact that it has not is a big warning to the industry about doing business in the state.

The loss of key personnel could also damage company prospects.

The company does receive Brent pricing and will after the merger. However, the high cost of production is a risk during any severe and extended commodity price downturn.

Summary

California Resources has done well in California considering all the hurdles the industry faces in the state. This company will be a leader in the green revolution just due to the business conditions in the state.

Now, whether that makes for a satisfactory investment is really up to the investor. The business environment in California is very pro-green. That is not good for an industry like oil and gas, no matter how necessary the industry is.

Therefore, this company may trade at a discount to others in the industry.

For me, the current situation is speculative at least. The company knows its business and the California regulatory environment better than probably just about any other company I follow. However, that is not good enough for me to consider this an investment. For me, it is a watch from the sidelines hold to see how this unfolds. This company could well become a green revolution leader with a completely different valuation. Right now, it is hard to tell.

However, for those venturesome investors, this company could be a possibility as it has done well since the reorganization. It may continue to do well in the future because management is very good at what it does. What I do not know is how the state will continue to navigate the transition to cleaner energy.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.