Description

Short equity, buy 2L bonds coming due in 2022

CRC is a 2014 spinoff from Occidental Petroleum of their California assets.  CRC's most pressing problem is the debt coming due over the next couple of years.  They've amended their credit agreement 9 times.  They've created JV agreements with external capital providers which free up cash that the company then uses to pay down debt.  They are paying down debt, but they're not doing it fast enough. It doesn't look like they'll be able to refinance given current capital markets.  Evercore suspended coverage of their equity in mid-October and they market thought a restructuring was going to happen.  But not so far…

Their next most pressing problem is that all their future drilling opportunities are located in California.  Despite plenty of oil, the government may cease to offer drilling permits.  A scandal occurred earlier this year where too many permits were issued.  You can read all about it elsewhere.  I have no opinion on any of that.

Common Stock:  $400 million market cap.  $9/share.  It was up 50% on Friday.  35% is sold short.  For the common stock here are the possible outcomes: (1)they don't raise enough money with JV/asset sales to pay debt and they restructure.  There is so much ahead of equity that it will be left worthless in a restructuring.  (2) They raise enough money with JVs and asset sales to stave off creditors but doing so is at the direct expense of equity because they have to sell all their future drilling opportunities.   Even if they retain some future opportunities, the state may come in and say no.  If they survive on this path, equity's access to profits is pushed far into the future. The government still might effectively shut them down by not letting them drill (3) They sell the entire company back to Occidental or some other major.  I don’t know who would buy this.  On an EV/flowing barrel they're very expensive - $50k/flowing barrel.  Whiting Petroleum is half that.  Selling the entire company doesn't seem likely but the market cap was 5x the current market cap in 2014 at the time of the spinoff so anything is possible.  At $65+/barrel a lot of their projects have high NPV, and the equity could theoretically do ok someday. 

The bonds, discussed below, are priced such that shorting the equity against them is a viable strategy if you can stomach the price-action mismatch.  There was some surprising news concerning the bonds on Thursday last week and rapid rebalancing took place.  Still, nothing that substantial happened to improve the long term picture for the equity holders.  The company still has a wall of debt coming due.  The equity is probably a zero. This short would be an excellent addition to a diversified short portfolio but a concentrated position would lead to angst (as last Friday proved).  Another strategy would be to buy 2x as many of the 2L bonds as you have shorted equity. That is what I recommend.  If they went bankrupt you would lose money on your bonds but have a taxfree gain on the equity such that the net wouldn’t be too bad.  If it goes the other way you will make money so long as the stock doesn’t go up more than 600%.

There are many debt investments outstanding, at various maturities and seniority, all with unique risk/return characteristics:

(1)  96 cent Jr, unsecured debt coming due in January:  This makes up 2% of their outstanding debt.  They have the revolver capacity to pay this off.  As a trade it seems like a reasonable - like picking up a dime in front of a steam-roller.  You'll probably get the dime.  CRC needs to pay this debt off to keep the dream alive for another year and a half until the next debt comes due.  Given the market price of $.96, Mr. Market indeed thinks this is going to get paid off.  

Still I disagree with Mr. Market's price on this.  I'm not sure it is worth the risk to own this given the huge downside.  I imagine restructuring consultants have already whispered in management's ear "after restructuring you will have generous new performance compensation reset to new levels. You'll have balance sheet freedom.  You can build your empire.  You can drill baby drill.  It is good for the stakeholders. It’s good for your resource.  Look at all the other CEOs who did this - they're sitting pretty!"  For management, redeeming or buying back any piece of this class of debt is a disadvantage if they already have it in their minds to restructure - money down the drain. This debt, along with others in its class, make up less than 7% of the entire debt outstanding. It will have little influence in a restructuring.  It may just piss off senior lenders who they need to make happy in a restructuring. The probability of management throwing in the towel before the bonds come due is LOW but still higher than Mr. Market thinks based on the $.96 price.  If you like grabbing dimes in front of steam rollers then maybe this is for you.  It will probably work but if it doesn't the pain will be substantial as you will be almost last in line in any recovery.  

Here are my probability weighted returns for this trade:

Estimate of recovery on Y-axis, Probability of Bk on X-axis

(2)  If picking up a dime in front of a steam roller isn't your thing maybe you would you pay $.25 for this same class of debt coming due in 2024.  If they keep the dream alive you'll receive $.06/year while you wait and the upside is huge if they can stave off bankruptcy.  If there is a bankruptcy, you'll be out a lot less than the $.96 you might've paid for 2020 debt.  2024 is so far off and California (where I live) is so weird I don’t think I could keep this trade on that long. 

(3)  The next class of debt is the Second Lien secured coming due in 2022.  It trades at $.40.  I heard on the conference call that this is the most liquid energy junk bond and as such is heavily shorted by market constituents.  I don't know how to verify that.  This is the debt they've been paying off all year.  They took a big bite out of it in 3q which shocked the market and caused the short-covering of equity.  I imagine the same consultants that whispered in their ear about the glorious advantages of a bankruptcy might say that paying off this debt ahead of bankruptcy (at a discount) is not a complete waste of money like paying off the junior.  Adding color to that, management has said that their senior creditors are in the "front seat with them."   The jr. debt trades at a bigger discount and they have never bought that back - adding credibility to this.  It was mentioned that paying off this 2L debt has a positive effect on one of their coverage ratios.  Ratings agency said it would recover 80% last year, steadily improving over the years.  Regardless of all that, the reason this is simply a better bet is the (1) the coupon is higher, (2) It makes up 41% of the outstanding debt so this class will have more influence in restructuring (3) it should recover some assets in bankruptcy. 

The way to read my little probability tables is that if you made 10 identical investments and 8 of them flopped (flop = $.30 payoff on Y-axis) and 2 of them were successful (.8 probability of success on the X-axis, payoff is $1 + $.28 in coupons) then your cumulative return would be 1% for all 10 investments (including the winners and losers). 

Let’s look at their assets.

The PV-10 from 2018 10k was $9.4 billion.  Seems like plenty for everybody!

The 2017 Pv10 was $4.5 billion.  This is a reflection of price expectation as the amount of oil reserves stayed roughly the same.

In the most recent slide deck, they estimate their assets are worth:

$10 billion @ $55/barrel Brent

$16 billion @ $65/barrel Brent

$20 billion @ $75/barrel Brent

what are the debts:

First Lien bank debt due 2021 and 2022 - $2.5 billion face 

Second Lien bonds due 2022 - $1.9 billion face (trading at $.40)  <--- I'm buying these.

Jr bonds - $344 million face (trading at $.96 for 2020, trading at $.25 for 2024). 

For every $1 of common stock you short, buy $2 worth of the 2^nd Lien bonds for $.40.

If they go bankrupt, you will have a tax free gain on the common stock short, and a tax deductible loss on the bonds.

If they don’t go bankrupt it is hard to imagine the common stock being worth over 6x the current share price – which would need to happen to lose money on this side of the trade.

Catalyst

Restructuring or Asset sales.