New to public issue, California Resources Corp. (NYSE: CRC) is a pure play on the Golden State. Carved out of multinational mini-major Occidental Petroleum in early December into a tough tape on Wall Street, the company, once Oxy’s California portfolio, just wasn’t getting its share of the capex pie despite promising discoveries.

“Go back four and a half years,” California Resources CEO Todd Stevens, immediate past vice president of corporate development for Occidental, said at the company’s first analyst day meeting in November, prior to first trading. In 2009, Oxy announced its Gunslinger discovery at Elk Hills in Kern County, the first major discovery in California in 35 years.

“That Elk Hills area discovery was born from our great technical work in the state, and we also had early success at Elk Hills in the shales,” Stevens said.

But in spite of the discovery and early success in the shales, and having additional reserves ready to develop, Occidental’s overall strategy didn’t change. Extra monies were not invested in California; cash flow instead was siphoned off to fund big projects in the Middle East and elsewhere.

“Along the way, you had some boardroom drama more than once—and now we’re here today,” Stevens said.

Subsequently, Occidental spun out its California assets into California Resources, the first and only publicly traded company with its entire portfolio held within California, retaining a 19.9% equity position that must be divested within 18 months.

CRC debuts as the state’s largest player, producing 188,000 boe/d on a gross-operated basis, ahead of Chevron and Aera (a partnership between ExxonMobil and Shell). It is also the largest private-sector acreage holder in the state, with 2.3 million net acres in four oil and gas producing basins: Los Angeles, San Joaquin, Ventura and Sacramento.

Its assets include conventional fields under primary, waterflood and steam flood recovery, and the Monterey and other shales. Its 744 MMboe of proved reserves give the company a PV-10 value of $14 billion, which the company views as conservative.

The spin-off creates “an industry-leading pure-play E&P focused exclusively on California, a state that imports 90% of its natural gas and 62% of its crude oil,” Stevens said at the analyst day. The company plans to spend within its means, and “cash flow generated from operations in California will remain in and be reinvested in California where we have a world-class, underexploited resource base.

“We believe we can help offset California’s growing energy deficit and reduce foreign oil imports,” Stevens said, “by creating good-paying jobs and reinvesting in the state.”

California Resources CEO Todd Stevens, immediate past vice president of corporate development for Occidental, sees plenty of running room in California, which he calls "the land that time forgot."

Proceed with caution

Not all watchers viewed the launch will such aplomb, however. Some pundits said Oxy made the move to jettison problem assets, citing the EIA’s unofficial but reported 95% write-down of Monterey Shale technically recoverable oil resources from 15 billion barrels to 600,000 last year, referencing challenging geology. EIA administrator Adam Sieminski told reporters in May, “Not all resources are created equal. It turned out that it is harder to crack the reservoirs and get the oil flowing from the Monterey.” However, Sieminski noted that “the rocks are still there,” and much of the oil and gas in the Bakken and Marcellus was previously not considered recoverable. According to research analyst Doug Leggate of Bank of America Merrill Lynch, a focus on CRC’s Monterey Shale development doesn’t reflect that “the strategy for the stand-alone company … is far less focused on unconventional drilling than previously perceived by the market. In 2014, unconventional activity is expected to account for just one-quarter of the total drilling plan.”

CRC's assets include conventional fields under primary production, waterflood and steamflood, and the Monterey and other shales.

Debt weighed on the valuation pre-launch as well. California Resources paid Occidental $6 billion in dividends for the privilege of going solo, and secured another $2 billion in revolving credit. When the spin-off was first contemplated in spring 2014, its debt load didn’t seem unreasonable, what with Brent crude trading around $110 at the time. Closer to $80 now, the price is suppressing cash flow, so the burden seems heavier.

Citing CRC’s leverage, Morgan Stanley analyst Evan Calio placed CRC’s fair-value range between $9 and $12 per share based on a 4 to 4.5x multiple of 2015E EBITDA, with an estimated $2.5 billion EBITDA based on $90 Brent—a discount to the large-cap E&P universe.

The drag on shares, he said, is caused by weak near-term production and cash-flow growth, “significantly higher than average” leverage, absence of yield support, lack of catalysts to unlock NAV valuation, and higher regulatory risk given CRC’s 100% California portfolio.

But, according to Leggate, “CRC’s portfolio of steamflood and waterflood assets offer substantial free cash flow under our base case at $100 Brent and can still offer capacity for modest growth at $70 oil, while still paying down debt. While the temptation may be to aggressively pursue growth with a newly unshackled management able to spend cash flow, we believe that a balanced approach that also targets debt reduction can materially improve the equity value for a capital structure that starts out two-thirds weighted toward debt.”

Leggate initiated coverage on December 1 with a Buy rating and price target of $14, citing “a portfolio we believe can grow” … and “a robust asset base that can drive equity appreciation even if oil prices remain depressed.” He noted that CRC is unique as it is the only pure-play based on California assets, so it is difficult to arrive at a valuation that would normally be based on peer comparisons.

Going forward, what is the outlook? California Resources projects production growth of 6% to 9% in the short term, double-digit growth longer term, with 12% to 15% growth on crude oil production even in the current suppressed price environment. For the first time, its excess cash flow will be re-injected into California assets. Stevens acknowledged to analysts that short-term growth could lag due to pricing.

“Under $90/bbl Brent, we expect CRC’s 2015 production to undershoot the 6% to 9% annual growth guided for 2015-2016 due to lower spend” of $1.9 billion, Calio wrote following the analyst day. “We expect longer-term (2017-plus) growth also to fall short of the 10%-plus target, coming in closer to 6% as CRC struggles to fund capex.”

According to Leggate, “We believe a balanced approach to growth that focuses on debt reduction can drive equity value with a 5% drop in debt driving a 10% increase in value. Specifically we see a favorable outlook for free cash flow, with options to improve equity value even in a depressed oil price, by deferring growth and repaying debt.”

Good news awaits those who are patient, however. According to Calio, “We note that while leverage is an issue in the near term, CRC should be able to delever under our $95/bbl Brent price assumption, with net debt-to-EBITDA coming down to 1x by 2020,” although “leverage and less financial flexibility limit growth.”

Stevens’ comments echoed this analysis, while making a point.

“We look to delever through growth, creating value in our EBITDAX growing over time,” he said, noting he feels good about the leverage situation relative to peers. “The vast majority of our peers are in that category of high yield.”

California has yielded more than 35 Bboe since 1876. CRC thinks there's a lot more to come.

Stevens noted that California Resources has “a lot of operational flexibility and financial flexibility” compared to its peers to invest during times of lower prices, especially since it holds 60% of its 2.3 million net acres in fee with no royalty payments required. It operates nearly all of its 130 oil and gas fields and has only minimal lease expirations.

Risks for CRC are commodity price risk, exacerbated by high leverage and lack of a hedging program, as well as regulatory challenges in California.

Additionally, “If you look at our suite of covenants, you’ll see we have investment grade covenants on our debt. We feel pretty good about that, and it’s recognition by the banks and our bond investors of what kind of assets we have.”

Behind the California curtain

About those assets: Stevens would like you to know that the California assets have been underexploited. With California’s consolidated nature under a few big names, and meager information available over the years, he characterizes the region as “the land that time forgot.”

Stevens paints a picture similar to the Permian Basin, but with tectonics, “a huge amount of stacked pay, and Mother Nature providing natural fracturing, faulting and folding.” In the San Joaquin Basin in particular, “there’s nothing that would prevent it from becoming like the Permian.”

Of CRC’s 2.3 million acres, 70% is undeveloped. The company boasts some 17,700 identified drilling locations and another 6,400 potential ones.

Conventional targets set the base of California Resources’ platform, including a sizeable portion of their growth. The company has 93 primary fields, 17 waterfloods, and 12 other fields that are being developed using steam or other enhanced recovery techniques. With an average conventional well cost of only $1.5 million, initial production rates range from 20 to 225 boe/d, and estimated ultimate recoveries from 50- to 500 MMboe per well. The company estimates more than 40 Bboe of original oil in place across its 130 oil and gas fields.

But a smaller part of the overall growth story, and real option value, lies in the maligned Monterey Shale and other shales. Today, the company produces 50,000 boe/d from the Upper Monterey zone. “We’ve become, I’ll argue to say, masters of the Upper Monterey in California. We’ve been gaining our California shale expertise, primarily with our development of the Monterey at Elk Hills, where we’ve seen steady commercial growth from these shale reservoirs,” said Stevens.

Despite dour prognostications from the EIA, he believes in the Monterey Shale. “We have confidence in our process that we’re able to identify and understand where to go to find that kind of potential.”

CRC drills most of its unconventional wells either vertically or directionally. “We don’t do a whole lot of horizontal drilling,” Stevens explained. “It’s something that’s emerging, but…because of the stacked nature of the pay here, we’re not targeting one little interval.”

Referring back to Oxy’s limited California budget, Stevens said the company didn’t have much opportunity to test other unconventional zones, which provide plenty of upside. First and foremost, that includes the Lower Monterey.

“We didn’t step out and look at the Lower Monterey where there’ve been fewer than 25 wells drilled, completed and tested. To argue that it’s condemned, or that it’s wonderful, is difficult at this point.”

There are more play names as well, scarcely heard outside of California.

“We’re taking learning from our Upper Monterey, which is responsible for one-third of our production today, and applying that to unconventional resources at Kettleman Dome, and in the Kreyerhagen, Vaqueros and Moreno shales.” These, he said, have “a compelling value proposition” and will be tested shortly.

The short- or long-term view

Analysts are also wary of 100% exposure to California’s tough regulatory environment and CRC’s lack of a hedging program. Stevens countered, “Yes, it is a stringent regulatory environment, but it’s misunderstood. It’s about planning and timing as opposed to road blocks.”

And as for not hedging, that is an advantage, he said. “We think people want to buy us because they want exposure to growing crude oil based on Brent pricing.”

Morgan Stanley’s Calio, for his part, is taking a wait-and-see approach. “The key question is whether the market will value [CRC] on NAV [net asset value], or on visible cash-flow generation (on an EV/EBITDA multiple). We are convinced investors will choose the latter, given a relatively low growth outlook and hence no need to give credit for longer-term growth or resource.”

What’s the first thing that is going to change at CRC, Stevens asked rhetorically. “First thing to change is capital allocation.” Then, “we’re going to live within our means and be a prudent steward of capital, but we’re going to do it in a way that creates value, even in a lower price environment.”

CRC ended its first day of trading at $7.37.