An objective reflection upon InterOil's (NYSE: IOC) progress over the past year inevitably yields the conclusion that unprecedented shareholder value has been created. At the end of last year, there were effectively two prime ministers in Papua New Guinea (PNG), InterOil had just been informed by the National Executive Council (NEC) that its proposed LNG Project was in breach of the 2009 Project Agreement, and the company had just hired three investment banks to sell a stake in its resource to a world class LNG operator.
In 2012, the anti-corruption, business-friendly Prime Minister Peter O'Neill took the helm in PNG, InterOil was granted NEC approval for its Gulf LNG Project. There have been independent and management-originated confirmations of multiple accretive bids having been made for the company's resource, including at least two by majors. The company confirmed the Antelope reservoir's continuity by intersecting the reef at its Antelope-3 well. It struck a farm-in agreement with Pacific Rubiales Energy Corp (PRE) (PEGFF.PK) pursuant to which PRE will acquire a 10.0% net participating interest in InterOil's Petroleum Prospecting License 237, and InterOil made a major new gas and condensate reefal discovery with the very successful Triceratops-2 well. Yet, despite the company's progress and a minimum underlying value of in excess of $200 per InterOil share just for Elk/Antelope, the stock is essentially flat this year.
Confusion associated with the terms of the NEC's approval of InterOil's Gulf Project has resulted in the most compelling buying opportunity I have ever encountered ahead of an imminent sell-down of the company's resource. In a Wall Street Journal article titled, "InterOil Offer May Unlock PNG Gas Project," details were provided about a draft submission to the NEC from Prime Minister Peter O'Neill and Energy Minister William Duma. According to the article, the submission:
recommends the state begins talks with InterOil and its partners to acquire a larger interest than 22.5% in the Elk and Antelope gas fields 'on commercial terms reflecting market value to be agreed with the upstream participants', targeting a binding deal by the end of December.
Though market participants perceived the Wall Street Journal leak as a source of additional uncertainty, all of the evidence suggests that 1) the government is unlikely to substantially increase its stake in the Elk/Antelope resource, leaving significant room for a blockbuster sell-down directly to a major, 2) the government's increased stake, if any, will be paid for on commercial terms, and 3) the government's option increases the probability of a larger sell-down rather than the opposite scenario, which is what the market has incorrectly assumed.
On page 10 of Liquid Niugini's presentation at the 12th Investor PNG Mining & Petroleum Conference, the company indicates that the 27.5% government option is for "Either PNG State Power/Infrastructure Project or Gulf LNG Expansion to 6mtpa, ~$3,000 bcfe." Since any State Power/Infrastructure Project would clearly not require gas beyond PNG's already owned 22.5% of the resource, the expansion to a second train will be the likely use of incremental gas. Hence the PNG government's option to increase its stake to somewhere between 22.5% and 50% of the resource would only be exercised if 1) the PNG government believes that there's an arbitrage opportunity in which it could buy into the resource at, say, the $2 per mcf paid for InterOil's stake by the likes of Total (NYSE: TOT), Exxon (NYSE: XOM), Chevron (NYSE:CVX) or Shell (NYSE: RDS.A) with its K6 billion loan from EXIM Bank and retain the corresponding $4+ NAV gas and condensates, or 2) the PNG government decides to entice a major partner to take an even larger stake in the resource than it could otherwise have done if only InterOil and Pacific LNG decided what percentage of the resource to divest. As a November 19th article in PNG Industry News indicates,
At least two supermajors have been involved in the bidding processes for an operating stake of Gulf LNG so far, and these parties could separately host talks with the government over its flagged half share of the Elk-Antelope field.
In either scenario, though the government option would be exercised to some extent, InterOil would receive fair commercial value for its resource. Also, the aggregate portion of the resource that is divested would likely be greater than that if no government option existed, providing more cash with which InterOil could repurchase shares, pay dividends, and accelerate drilling across its reefal trend.
The most likely outcome, however, is that the government exercises little or none of its 27.5% option and has InterOil sell down a one-quarter to one-third stake in the resource to a major. The option included in the NEC submission was most likely just a means of enhancing the Project's perceived value to the Council. If the government were to pursue an arbitrage opportunity, it would diminish PNG's stature as a predictable jurisdiction in which to run private enterprises (though it would also front load InterOil with more cash and would likely be a net positive for the stock).
Very importantly, given that the government is taking its 22.5% of the resource in kind for domestic use, InterOil will control 100% of the Gulf Project's first train, which is the Project's most valuable segment and the component which majors are obviously most interested in buying into. Hence, the government structured its agreement with InterOil such that the highest NAV segment of the Project is 100% retained by the company and its commercial partners, providing almost indisputable evidence that PNG has no intention of arbitraging InterOil's gas or leaving the company with inferior economics. In fact, contradictorily, the approved structure provides unequivocal evidence that the government is seeking to facilitate InterOil's sell-down at the optimal price and to expedite the Project's Final Investment Decision (FID). A closer inspection of the new deal structure with the government will lead market participants to recognize that InterOil's economics have been enhanced with its increased ownership of the first train and correspondingly, that the stock price should have soared post NEC approval.
Unfortunately, the lack of sell-side coverage has played a role in allowing such a prolonged dislocation to exist. Peter O'Neill and William Duma have assembled a deal structure that focuses primarily on benefiting PNG by providing electricity to 90% of the nation's citizens who lack it rather than generating instant monetary gratification by owning 22.5% of the Project's first LNG train, a major win-win for both the country and InterOil.
With InterOil's stock likely trading near $0.40 per mcf of net year-end 2012 resources, even $1.50 per mcf for Elk/Antelope would imply a value of >$200 per share. There is no evidence that suggests InterOil will receive anything less than commercial terms for the government's 27.5% option. In fact, the government has taken two very encouraging recent actions that indicate it is doing everything possible to ensure InterOil thrives.
The Department of Petroleum & Energy (DPE) issued a letter to InterOil earlier this year that threatened cancellation of the Project Agreement; since then, the letter was suspended by the DPE and NEC approval for the Project was subsequently granted. Also, InterOil was brushing up against a tight deadline in which to spud its Elk-3 well in order to preserve its PRL. While the government could have tried to use this deadline as a means of potentially securing the company's resources, instead it provided the extension required by InterOil.
The final step in this chapter of the InterOil saga is the completion of a sell-down. On November 15th, a Morgan Stanley note titled "Onto the Sell-down" indicated that,
A sell-down will: (1) provide cash/carry for up to 32.5% Elk/Antelope sale; (2) establish a clear value for IOC's gas; (3) begin the process of cash flow generation associated with a late 2016, 3.8MTPA LNG start-up; and (4) capitalize IOC allowing it accelerate Triceratops appraisal (PRE deal final) and prospect exploration. IOC enters the "Next Act" with a near record short of ~23% (float).
After many months of resource evaluation by multiple bidders, their bid submissions and continued interest confirm that InterOil's resource is in fact coveted and world class. The successful drilling of Antelope-3 confirmed the reefal reservoir continuity and will result in an increase in the size of the certified resource at year-end.
Majors have an opportunity to almost immediately tack on very high quality P1 reserves by acquiring a stake in Elk/Antelope at a time when reserve growth is increasingly difficult to come by. At year-end 2011, for example, Total had 11,423 Mmboe of reserves, 5,639 Mmboe of which were gas reserves. If Total were to acquire 1/3rd of what could be a 12 Tcf reserve at Elk/Antelope, it would increase the company's total reserves by 720 Mmboe or 6% and its gas reserves by almost 13%. The company could easily fund this expenditure with its ~$20 billion cash balance. Meanwhile, the IRR on the investment would significantly exceed that of the depressed investment income currently being received by the company. The acquisition of a stake in Elk/Antelope would also help rebalance Total's underleveraged capital structure.
The opportunities to invest in world class hydrocarbon resources in benign jurisdictions with project approval granted, workers and equipment on-premise (from Exxon's PNG LNG Project run-off in the case of InterOil's Gulf Project) and FID imminent are few and far between. InterOil has now surpassed all of the required obstacles to closure, and the transformational deal investors have awaited for years is finally imminent. The terms of the NEC submission have been egregiously misconstrued, resulting in what is arguably the greatest dislocation in the stock's history. A closer review of the submission indicates that the new deal structure will only enhance InterOil's economics by allowing the company to retain 100% of the Project's first train.
There have been several confirmations of bids submitted by multiple majors, and interest in the Project could only have increased further with the recent NEC approval and Antelope-3 results. InterOil's short interest exceeds 20% of its outstanding shares, and a single announcement, which could occur literally any day, is likely to inflict immediate triple-digit percentage losses on the army of skeptics who have overstayed their welcome. With management and top long-term shareholders controlling an estimated >75% of the company's shares, there likely won't be many shares to buy when it's time to cover.