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Royal Dutch Shell (RDS.A) is perhaps the best example of a major that is suffering from diminishing returns on capital, faltering reserve replacement ratios (RRR), and significant excess capital yielding paltry returns. The stock has declined 4.83% year-to-date and 9.95% over the last year, while the S&P 500 is up 6.8% and 11.5% respectively in these periods. Shell's dramatic underperformance was exacerbated subsequent to the company's fourth quarter earnings release at the end of January. Shell generated a worldwide unit profit of just $14.18/boe, down 17% from a year ago and 22% sequentially, while its Americas division generated a unit loss of $0.99/boe, down 110% from a year ago and 39% sequentially.

Following the delivery of its "big three" projects, Pearl, Qatargas 4 & Athabasca, Shell's future growth is set to be derived from in excess of 25 smaller and lower return assets. Approximately 40% of this growth is attributed to unconventional assets in North America, where realizations are likely to remain compressed. Shell's heavy exposure to high-cost Australian LNG and US unconventional natural gas, in conjunction with its lack of momentum in exploration, demonstrate the company's inability to deploy capital on high return generating opportunities in recent years. Shell's 2012 organic reserves replacement of 50%, which includes price effects, is below its peers' subpar average RRR and has resulted in the company's increasing its estimated exploration expenditures to more than $7 billion in 2013 from $6 billion last year.

Though Shell is on track to deliver total 2012-2015 operating cash flows of $200 billion at $100/bbl Brent crude, the company's misallocation of capital to crowded and low return profile hydrocarbon plays has depleted investors' confidence. Shell seems to have fallen into the trap of chasing projects that are perceived as safe either because they are in benign jurisdictions or because they are the types of assets in which other majors are interested. In doing so, the company has exacerbated its risk profile by paying up for projects that depend on flat to rising commodity prices in order to generate acceptable returns. Shell's woes in Alaska are a good example of the risks inherent in a region that conventional wisdom considers to be safe. The company has already spent $2.2 billion for leases to drill in offshore Alaska and approximately $2.8 billion for operations in the area over the past six years, without making any new discoveries. Shell failed last year to complete two exploration wells in offshore Alaska during the short ice-free summer season, and its drilling rig ran aground after breaking free from tow ships in high seas.

Though Shell was early in recognizing East Africa's LNG potential, the company dropped out of a bidding war with PTT Exploration & Production Pcl, Thailand's biggest publicly traded oil and gas explorer, for Cove Energy, an East Africa focused independent E&P company with an 8.5% interest in Area-1 offshore Mozambique.

Purchasing InterOil (IOC), its Gulf LNG Project or its highly prospective acreage in Papua New Guinea's (PNG) Eastern Papuan Basin could provide Shell with exactly what it needs to change course by bolstering its returns, enabling it to generate easy exploration success, and lowering its LNG costs. As I articulated in my August 19 piece titled "Why Royal Dutch Shell Is Likely To Bid For InterOil Imminently", Shell is running out of options to cheaply secure what may emerge as one of the most prolific series of onshore natural gas prospects ever discovered.

Early exploration results in the Eastern Papuan Basin resulted in the view that the Miocene limestone in the onshore portion of the basin is a deep water brittle limestone with moderate fracture porosity. Wells drilled into this type of limestone are capable of high flow rates but have little storage capacity. The Kuru 1, Puri 1, and Bwata-1 wells, which were all drilled on surface structures with little additional geology, penetrated fractured limestones with gas or gas and condensate, with the exception of the Puri well which flowed up to 1,600 barrels of oil per day before watering out in just over a week. Puri was determined to be a small oil discovery and gas had no real value anywhere, let alone the jungles of PNG, in the 1950's.

Well

Location

Reservoir

Result

Discovery

P/C 50

Year

Res BCF

Kuru 1

Onshore

Fractured Lmst.

Gas

1956

Puri 1

Onshore

Fractured Lmst.

Oil & Gas

1958

Bwata 1

Onshore

Fractured Lmst.

Gas Cond.

1959

Uramu 1A

Offshore

Reef

Gas Cond.

1968

92

PASCA A-1

Offshore

Reef

Gas Cond.

1968

160

Pandora 1

Offshore

Reef

Gas

1988

Pandora B1

Offshore

Reef

Gas

1992

644

Elk-1

Onshore

Fractured Lmst.

Gas Cond.

2006

Elk-4

Onshore

Reef

Gas

2008

Antelope-1

Onshore

Reef

Gas Cond.

2008

Antelope-2

Onshore

Reef

Gas Cond.

2009

9,363

Ticeratops-2

Onshore

Reef

Gas Cond.

2012

Antelope-3

Onshore

Reef

Gas Cond.

2013

There was more success offshore where the Uramu, Pasca and Pandora discoveries were made in the late 1960's through the early 1990's. Reef discoveries were made, but the fields were not large enough to warrant development. The fractured limestone discovered onshore resulted in the conclusion that the Miocene depositional environment in the Eastern Papuan Basin was deep water marine, and hence there was a complete dearth of interest by majors in deploying capital on exploration in the region. Shell, for example, effectively exited the country by selling its Shell Papua New Guinea Limited subsidiary to InterOil in 2006 while Exxon (XOM) remained focused on exploration in PNG's highlands to identify additional gas resources to underpin its PNG LNG Project.

InterOil, primarily chasing the promising lead of oil in the Puri well, began a modern exploration program in the Eastern Papuan Basin. The company hired the most experienced PNG geologist, David Holland, and applied modern exploration technology to a minimally explored basin with demonstrated hydrocarbon potential. InterOil used surface mapping to identify over 120 anticlines on its original acreage position. The company then acquired aeromagnetic and gravity surveys to high-grade the anticlines into leads and prospects. Seismic was acquired over the most promising structures near previous key wells like Puri and Bwata. The first high quality reef discovered in PNG was Antelope, which was drilled on a gravity anomaly shot with seismic near the Puri well. The discovery of the Antelope shallow marine carbonate platform and reef complex onshore in the Eastern Papuan Basin did not fit existing basin models that were developed based on the historical work from the 1950's to the 1990's, and these antiquated models served as the basis for which the majors lacked interest in the region.

Using Antelope as a model, InterOil determined a potential reef location near the Bwata-1 well which was recently confirmed by the Triceratops-2 well. As is demonstrated in InterOil's recent Upstream Investor Presentation, Antelope and Triceratops invalidate old palaeogeographic models. The company has identified two similar anomalies between Antelope and Triceratops that look very promising. Tuna and Wahoo/Mako demonstrate reefal character on the seismics and look to extend the trend into block 236.

InterOil proved that the Miocene depositional setting includes a shallow marine carbonate platform with a well-developed reef complex that may contain additional billion barrel of oil equivalent fields, which could go a long way for resource replacement for a major oil company. With InterOil's success, the majors now seem to recognize the Eastern Papuan Basin's extraordinary potential, as Shell recently opened an office in PNG to pursue LNG export projects and Total (TOT) signed five licensing agreements with Oil Search for its Eastern Papuan Basin acreage last October. This is Total's first foray into PNG. Also, Chevron (CVX) reportedly met with PNG Treasury minister Don Polye last year to discuss its interest in InterOil's LNG Project.

On January 24, "InterOil announced that it has advised bidders with which the Company has been in discussions that the final binding bid solicitation period for the partnering process currently being undertaken will close on February 28, 2013." InterOil's Board of Directors intends to meet the Company's advisors in March for the purpose of evaluating bids received and selecting its partner(s) for the development of the Gulf LNG Project utilising gas from the Elk and Antelope fields. Though a takeover of InterOil has become a more likely prospect following the recent replacement of CEO Phil Mulacek with Gaylen Byker as the Chairman of the Board of Directors, the conclusion of the company's sell-down process next month will almost certainly materially revalue its shares and make an acquisition of the company a much more difficult feat.

According to a recent article in PNG Industry News, "The CFO said the shortlisted parties were not legally prevented from making a friendly bid for InterOil. [InterOil CFO Collin] Visaggio also indicated what would happen if a supermajor outside of the Gulf LNG bidding process made a hostile takeover attempt for InterOil. 'If it's someone who is not involved in the process we can release the existing shortlisted bidders to make a bid should they wish - that's the white knight story.' Such a move would surge InterOil's share price upwards and could thwart a hostile takeover." Last month, InterOil's CEO stated, "The interest demonstrated by major oil, national oil and global utility companies remains strong, and bodes well for the conclusion of our sell down of interest in the Elk and Antelope fields and partnering in the Gulf LNG Project."

In recent years several risk factors have plagued InterOil's shares, but all of these risks have largely or completely abated. Until last year's national elections, both Prime Minister Peter O'Neill and former Prime Minister Sir Michael Somare claimed PNG's helm, resulting in a logjam in decisions and approvals that InterOil required to move its project ahead. In August 2012, the anti-corruption, business-friendly Prime Minister Peter O'Neill won the national election, five of the largest political parties in the country, all of which recognize the need for government stability to attract foreign investment, joined to form the strongest coalition government in the country's history, and InterOil's project was granted approval by PNG's National Executive Council. PM O'Neill recently stated, "Our government will assist InterOil to move faster on its LNG development timelines".

Another risk factor that has been significantly mitigated is whether the Antelope reef contains adequate natural gas resources to underpin a 2 train LNG project. Though Elk/Antelope's 9.4 Tcfe of gas and condensate resources is more than adequate to support such a project, until InterOil's recent success in drilling its Antelope-3 well, there was no definitive confirmation of the reservoir's continuity, as the previous two Antelope wells were drilled on the periphery of the reef. Perhaps the best example of the potential value creation that's possible for an independent E&P company in PNG is Oil Search, which has substantially all of its assets in PNG, a ~$10 billion market cap (up 972% in the past 10 years), and less resources than InterOil even without ascribing credit for InterOil's Triceratops reservoir. One primary difference between the two companies is that Oil Search is partnering with Exxon to build the PNG LNG Project while InterOil is in the midst of selecting a world class LNG partner. If InterOil is successful in inking a deal with a major for its Gulf LNG Project, its valuation could appreciate towards or even exceed that of Oil Search.

The InterOil saga is finally coming to a head, and if the company isn't acquired before it consummates a sell-down of Elk/Antelope, the shareholder value creation from developing Triceratops and other prospects like Tuna and Wahoo/Mako this year could add significant shareholder value beyond the accretion from the approaching transaction and final investment decision on the Gulf LNG Project.

Source: Why Royal Dutch Shell Needs To Acquire InterOil Now