OXY-Cleaning Up Its Portfolio – California Resources Spinoff Set For End Of November

California, the great state known for its warm weather and environmentally friendly laws is about to get its own dedicated oil and gas business. Yes, you read that correctly. On December 1st, the California Resources Company (CRC) will begin trading on the NYSE as an independent entity after Occidental Petroleum’s (OXY) board of directors formally approved its spinoff last week. OXY shareholders as of November 17th will receive 0.4 shares of the new company, CRC, for every OXY share owned so expect some odd position sizes. Interestingly, the parent company will hang on to an ~20% stake in the spinco, which in plans on disposing of within the next 18 months:

Occidental expects to dispose of all of the Retained Securities by making one or more offers to exchange such Retained Securities for outstanding shares of Occidental common stock. For each share of Occidental common stock tendered for exchange, the holder of such Occidental common stock will receive a number of shares of CRC common stock based on an exchange ratio to be determined by Occidental. Any Retained Securities Occidental does not dispose of through such exchanges will be distributed pro rata to Occidental shareholders no later than 18 months after the spin-off.

Exchange offers can be provide the chance to acquire shares at a discount, but we will cover that transaction in due course. Aside from geography, the companies share many traits:

California Resources will be California’s largest natural gas producer and the largest oil and gas producer on a gross-operated barrels of oil equivalent basis. It will be the largest oil and gas mineral acreage holder in California with approximately 2.3 million net acres and will have major operations in the state’s high-potential oil and gas basins, including Los Angeles, San Joaquin, Ventura and Sacramento.

Occidental is one of the largest U.S. oil and gas companies, based on equity market capitalization. The company will have exploration and production operations in the Permian Basin and other parts of Texas, the Middle East region and Colombia. It will also have a midstream and marketing segment and a chemical subsidiary, OxyChem. Each of these segments is a leader in its respective sector.

California Resources also owns:

A network of strategically placed infrastructure assets, including three gas plants, oil and gas gathering systems, a power plant and other related assets to maximize the value generated from our production

OXY also announced that it would be increasing its share buyback program by an additional 60 million shares. The repurchases will be funded ‘from available cash from operations, excess cash on hand and proceeds from asset sales as part of the previously announced strategic review, including a dividend of approximately $6 billion from California Resources to Occidental.’ Yup, another big dividend paid by a spinco to its parent and in Henry Waxman’s backyard no less! While obviously impacted by commodity prices, OXY’s share price has benefited from its recent shareholder friendly actions such as the spinoff and share buyback.

This should be an interesting one to watch as this is a somewhat unusual spinoff. Most of the oil and gas spinoffs have involved breaking up different parts of the value chain (upstream vs downstream etc.) with (theoretically) different cycles and levels of profitability. Despite touting California’s legacy as a premier oil state, it’s difficult to understand the benefits of a California-only oil and gas company. The Form 10 tries hard, no doubt, including touting such spinoff benefits as:

• Creating two independent businesses that will be competitive industry leaders in their respective
  areas of operations AND
• Enhancing each company’s market recognition with investors because of its status as an industry
  leader in its geographic areas of focus.

…but it’s not very convincing. The company’s comments on the subject are telling:

We believe that over the last several decades the oil and gas industry has focused significantly less effort on utilizing modern development and exploration processes and technologies in California relative to other prolific U.S. basins. We believe this is largely due to other oil companies’ limited capital spending in California, focus on shallow zone thermal projects or investments in other assets within their global portfolios

So it seems like California is purposely being ignored for big investment by the rest of the oil and gas community and possibly by OXY itself. Other parts of the Form 10 seem to suggest this as the new company proudly touts its ability to ‘reinvest substantially all of our operating cash flow in our capital program for the foreseeable future as we will no longer be required to distribute cash to Occidental.’ Basically, right now OXY takes its California FCF and invests it elsewhere in the world (including other parts of the US) where it believes it can achieve a higher return. So the real question becomes why should investors act any differently post-spinoff?

Well, it’s not all bad in California and it’s not like there are no positives to CRC. Yes, the regulatory risk is probably higher than anywhere else in the world given the state’s green focus, slow approval times and wacky ballot measures. That said, the company generates a healthy amount of cash flow and has been growing revenues, EBITDAX and production of both oil and NGLs over the past few years. There is value in just managing out steady production. The company has big plans for the future though, including a greater focus on oil, which comprised 53% of its 2013 net production:

We expect the percentage of oil production to continue to increase over time and favorably impact our overall margins as we anticipate directing virtually all of our capital expenditures towards oil-weighted opportunities in 2014 and beyond to the extent the current oil to gas price relationship continues After the spin-off, we intend to  We expect to increase our production by 6-9% on a compound annual basis in 2015 and 2016 with a 15% compound annual increase in our oil production for the same period. Over 90% of our expected production for this period is from currently producing fields where we have existing or permitted capacity in our production facilities.

The company also will try to get more out of its existing assets by using better technology (a process it’s already started) and by developing more unconventional assets like shale. Of course, recent studies suggest that may not be as great an opportunity as previously thought. Another possible headwind is that right now the company benefits from selling its crude at a nice premium to WTI because California is forced to import most of its oil. New rail terminals bringing shale oil from North Dakota are in the works though and if they get approved, that premium would vanish thereby reducing California Resource’s revenue and margins.

Furthermore, despite achieving independence, the company doesn’t have a whole lot of freedom to look outside of California for investments. Although it will re-invest nearly all of its proceeds (expected dividend is only 1 cent per quarter), as part of the spinoff, the company will enter into a 5 year ‘Area of Mutual Interest Agreement’ with Occidental that ‘provides Occidental the right to acquire % of certain oil and gas properties we acquire in the United States outside of the state of California.’ So tough luck if things aren’t going well in the home state.

Ultimately, it will come down to valuation and given the assets and the risks involved, I expect there to be quite a wide range of opinions on value. California-only comps will obviously be hard to find, but a better understanding of its asset base, reserves and future opportunities can be found within the most recent Form 10.

Disclosure: Author holds no position in any stock mentioned.