Fitch Rating has affirmed California Resources Corporation's (CRC) Long-Term Issuer Default Rating (IDR) at 'B+' following the announced agreement to merge with Aera Energy, LLC (Aera).

The Rating Outlook remains Stable. Fitch has also affirmed the issue-level ratings for the company's secured reserve-based lending credit facility (RBL) at 'BB+'/'RR1' and senior unsecured notes at 'BB-'/'RR3'.

Under the terms of the agreement, CRC will merge with Aera in an all-stock transaction valued at approximately $2.1 billion, inclusive of Aera's debt. At close, Aera's owners will receive 21.2 million shares of CRC's common stock, equal to approximately 22.9% of CRC's fully diluted shares.

CRC's ratings reflect its large, low-decline asset base with exposure to Brent pricing, conservative capital structure, forecast sub-1.5x mid-cycle leverage, expectations of positive FCF through the rating horizon and proactive hedging program that limits downside price risks. These factors are partially offset by the company's high cost structure, which limits economic drilling prospects, and exposure to California's stringent regulatory environment which could disrupt permitting, drilling and financing options and will still persist following the transaction's close expected in 2H24.

Key Rating Drivers

Credit-Neutral, Scale-Enhancing Transaction: Fitch believes CRC's all-stock merger with Aera is neutral to the credit profile. The transaction is attractively priced at a 2.6x EV/EBITDAX multiple and will materially increase scale with approximately 76 thousand barrels of oil equivalent per day (Mboepd) of oil-weighted, low-decline production in California. Management estimates pro forma 2024 production at approximately 150 Mboepd (76% oil) and proved reserves of approximately 680 MMboe (90% proved developed) with exposure to five of the largest oil fields in the state. Fitch recognizes the pro forma scale benefits for the company, but CRC will still be exposed to California's stringent regulatory environment which could impact drilling and permitting options in the near and medium term.

Enhanced FCF; Synergy Opportunities: Fitch expects the merger will nearly double the company's FCF generation and the complementary nature of the assets provides achievable synergy opportunities. Management projects pro forma FCF generation of approximately $685 million at strip pricing of approximately $80 Brent and $2.65 Henry Hub, assuming capex of approximately $450 million. The company has also identified $150 million of annual synergy potential through lower operating costs, capital efficiencies, G&A reductions and optimization of field infrastructure which Fitch believes are achievable in the near term. Fitch expects CRC will continue to allocate its FCF toward shareholders via its fixed dividend and increased $1.35 billion share repurchase program and toward its CM businesses while maintaining a conservative capital structure.

Near-Term Hedging Protection: Fitch views the pro forma company's strong near-term hedges positively and will help solidify FCF generation. Approximately 80% of the pro forma company's oil production will be hedged at attractive Brent prices at around $70/bbl which will reduce downside price risks. Fitch expects hedging will continue, albeit potentially at lower levels, since CRC's credit facility requires minimum hedging of 50% to 0% with leverage above 2.0x or below 1.5x, respectively.

High Cost, Low Netback Producer: CRC's cost structure is higher than most Fitch-rated U.S. onshore E&P peers. Fitch-calculated 3Q23 total cash operating costs (which includes operating costs, transportation expenses, G&A and production taxes) of $39.60 per barrel of oil equivalent (boe) remain at the higher-end of Fitch's aggregate E&P peer group and lead to lower unhedged cash netbacks and a higher breakeven oil price.

Sub-1.5x Mid-Cycle Leverage: Fitch-calculated gross debt/EBITDA is forecast to remain below 1.0x in 2024 and 1.5x through the remainder of the forecast given the company's conservative capital structure. Fitch believes management could look to refinance a portion of Aera's debt in the near term through the capital markets and could use cash on hand for additional debt reduction.

Merger Accelerates Carbon Management Initiatives: Fitch believes the merger will accelerate the company's CM initiatives through the addition of surface rights and pore space. CRC continues to advance its CM businesses, driving management's goal of reliable, safe and ESG-driven operations. The company's strategic joint venture (JV) with Brookfield Renewable also helps advance CRC's energy transition strategy, substantially de-risks its CM funding needs and should help reach the JV's goals of first CO2 injection by the end of 2025 and five million metric tons of CO2 storage per annum (200 million metric tons of total CO2 storage capacity) by the end of 2027.

Fitch views the JV favorably given its focus on reducing carbon emissions, Brookfield's significant expertise and investment with CM projects, and the potential cash flow streams and tax credits the segment could provide in the medium and long term. Fitch's base case scenario includes the company's expected capital investments, but does not include any revenues from CRC's CM businesses given the uncertainty around timing and magnitude of cash flows along with the potential for separation of the E&P and CM businesses.

California Regulatory Considerations: California has adopted some of the most restrictive regulations on in-state produced energy as the state shifts toward cleaner, more renewable forms of energy. The state has established limits on greenhouse gas (GHG) emissions, which decline annually to a target of at least 40% below the 1990 level by 2030. This is in addition to the established policy toward becoming carbon neutral by 2045. While there is a need to drill in California to meet the excess demand for oil and gasoline in the state, Fitch cautions that regulatory and legislative actions in the state could disrupt drilling, permitting and financing options for the company.

Derivation Summary

Pro forma the merger, CRC will produce approximately 150 Mboepd (76% oil). The company will be larger than Canadian producer MEG Energy Corp. (BB-/Stable; 102 Mboepd [100% bitumen]), similar in size to Baytex Energy Corp. (B+/Positive; 151 Mboepd) and SM Energy Company (BB-/Stable; 154 Mboepd), but smaller than Permian Resources Corp. (BB/Positive; pro forma production of approximately 300 Mboepd).

CRC's realized prices are typically higher than peers given the exposure to premium Brent pricing and the low-decline asset base leads to lower capital intensity versus peers. This is partially offset by the company's high cost structure which results in lower Fitch-calculated unhedged cash netbacks compared to Fitch's aggregate peer average.

Key Assumptions

Brent oil prices of $80/bbl in 2024, $70/bbl in 2025, $65/bbl in 2026 and $60/bbl thereafter;

Henry Hub prices of $3.25/mcf in 2024, $3.00/mcf in 2025 and $2.75/mcf thereafter;

Pro forma production of 150 Mboepd followed by flat growth thereafter;

Capex of $450 million in 2024 with growth-linked spending thereafter;

Measured increases to shareholder returns;

Announced Aera merger closes in 2H24.

Recovery Analysis

KEY RECOVERY RATING ASSUMPTIONS

The recovery analysis assumes that CRC would be reorganized as a going-concern in bankruptcy rather than liquidated.

We have assumed a 10% administrative claim.

Going-Concern (GC) Approach

Fitch's projections under a stressed case price desk, which assumes Brent oil prices of $50 in 2024, $35 in 2025, $45 in 2026, $48 in the long term.

The GC EBITDA was increased to $625 million following the announced transaction and reflects Fitch's view of a sustainable, post-reorganization EBITDA level upon which we base the enterprise valuation, which reflects the decline from current pricing levels to stressed levels and then a partial recovery coming out of a troughed pricing environment. Fitch believes a weakened pricing environment would lead to production declines, reduce the borrowing base availability and materially erode the liquidity profile.

An EV multiple of 3.00x EBITDA is applied to the GC EBITDA to calculate a post-reorganization enterprise value. The choice of this multiple considered the following factors:

The historical bankruptcy case study exit multiples for peer companies ranged from 2.8x-7.0x, with an average of 5.2x and a median of 5.4x;

The multiple reflects the expectation that the value of CRC's oil producing properties will decline given the company's high cost structure and reduction in capex to preserve liquidity. The multiple also considers the stringent California regulatory environment and highly concentrated market which severely limits the number of potential buyers and valuation for the assets.

Liquidation Approach

The liquidation estimate reflects Fitch's view of the value of balance sheet assets that can be realized in sale or liquidation processes conducted during a bankruptcy or insolvency proceeding and distributed to creditors.

The revolver is assumed to be 90% drawn upon default with the expectation that commitments would be reduced during a redetermination.

The allocation of value in the liability waterfall results in recovery corresponding to 'RR1' recovery for the first lien RBL credit facility and a recovery corresponding to 'RR3' for the senior unsecured notes.

The RBL is assumed to be fully drawn upon default.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Diversification through meaningful EBITDA generation from CM or other non-E&P business lines;

Material E&P diversification outside of California;

FCF generation that supports the liquidity profile and limited borrowings under the RBL;

Commitment to conservative financial policy resulting in mid-cycle EBITDA leverage sustained below 1.5x.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Unfavorable regulatory actions that result in material production declines and/or weakened profitability;

Deteriorating liquidity profile, including material revolver borrowings and inability to generate positive FCF;

Mid-cycle EBITDA leverage sustained above 2.0x.

Liquidity and Debt Structure

Strong Liquidity: Pro forma the merger, Fitch expects CRC to maintain strong liquidity through meaningful availability under its RBL facility, cash on hand and forecast strong FCF generation. Management intends to refinance Aera's outstanding debt in the near term and has also secured a firm commitment for a $500 million bridge loan to facilitate the transaction close.

Issuer Profile

California Resources Corporation is an integrated public E&P company that operates solely in California. Pro forma the Aera transaction, the company will produce approximately 150 Mboepd (76% oil) and hold more than 1.9 million net mineral acres.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

CRC has an ESG Relevance Score of '4' for Exposure to Social Impacts due to the oil and gas sector regulatory environment in California and its exposure to social resistance, which has a negative impact on the credit profile, and is relevant to the rating in conjunction with other factors.

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit https://www.fitchratings.com/topics/esg/products#esg-relevance-scores.

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