While there are many variables involved, I am going to begin supporting my bullish view of Interoil (NYSE:IOC) by comparing IOC's proposed Gulf LNG Project to Exxon Mobil (NYSE:XOM) and Oil Search's PNG LNG Project. First, I will compare the very structure and expected construction costs for each project. To do this I recommend you look at slide 18 of recent IPAA Presentation.
Note some important points:
- IOC's Elk/Antelope (E/A) field is adequate size to supply the initial 4 Mtpa and Train 2 which will provide an additional 4Mtpa. (Note also on slide 18 that Bwata/Triceratops field is shown to tie in, which could allow for additional low cost expansion beyond 8 Mtpa since Bwata/Triceratops had a pre-Triceratops-2 drill estimate of 4.7 Tcfe of gas in place. Also, after Triceratops-2 was drilled IOC partner Pacific Rubiales (PRE.TO) provided the following update, stating "petrophysical, test and seismic data to date, indicates a P50 structural closure of approximately 10,000 acres with net pay of 1,700 feet, and high quality reservoir with average porosities of 6% and water saturations of 20%, for the Triceratops structure." Contrast this to XOM/OSH which has to aggregate multiple fields and drill a multiple of more wells for adequate supply, and
- XOM/OSH's pipeline is several hundreds of miles longer, with large changes in altitude, traveling through more populated areas (increases the likelihood of land owner issues), along with a sub-sea portion.
Combining points 1 and 2 above that XOM/OSH Project will cost at least $10 billion more to construct 1.1 Mtpa less in production (6.9 Mtpa vs 8.0 Mtpa - more detail below). Exxon said the cost overrun would be offset by higher output capacity of 6.9 million metric tons a year, up from 6.6 million tons, as well as a 30% rise in the price of LNG since construction of the project began in 2009.
This substantial cost difference obviously reduces the favorability of XOM/OSH's Project relative to IOC's Project. This of course means that IOC should receive a higher price relative to XOM/OSH comparables.
Next, I will mention two comparables. First, it is important to note that these transactions were prior to XOM/OSH's recently announced cost overruns of $3.3 billion to an estimated total of $19 billion. To show that these comparables are still meaningful, note the current cost of XOM/OSH Project is approximately $10 billion more than IOC's Project, therefore, prior to the $3.3 billion cost overrun the price differential was $6.7 billion, which shows IOC's Project was still substantially advantaged compared to XOM/OSH even prior to the recent cost overruns. Hence, the comparables are still meaningful and still biased against IOC's project.
Comparable 1: Nippon Oil buying out AGL Resources 3.6% ownership of the PNG LNG project for $795 million in 2008 (around $2.2/mcfe), which should be producing in 2014. Based on that comparison, what is the implied value of IOC? Same country and same tax rules in the project agreement, so the required calculations are greatly reduced. Assume that IOC owns 50% of the entire project (actually, upstream they own 58.6%) and using early 2013 with expected production in 2017, which is similar to the time until production when the Nippon Oil purchased their 3.6% interest in the XOM/OSH Project. Next, for ease, let us assume both projects will produce the same Mtpa (actually, XOM is scheduled to produce 6.9 Mtpa, whereas IOC is schedule to produce 4.0 Mtpa in 2017 followed by another 4.0 Mtpa in 2019) and that construction costs are the same even though we know the XOM pipeline is hundreds of miles longer, aggregating multiple fields, with a large drop in altitude and even including a sub-sea portion. So, with these convenient assumptions, then based on the AGL transaction the IOC's Gulf LNG project is worth an estimated ~11 billion ((50%/3.6%)*$795 million = $11.041 billion), this is significantly higher than IOC's current market cap of $3.5 billion. Also, this valuation doesn't include Bwata/Triceratops or the ~40 other prospects, which look quite promising. Additionally, it is worth mentioning that this purchase was prior to the surge in LNG pricing after the Fukushima disaster in Japan.
Comparable 2: (As mentioned in an author reply to a recent Seeking Alpha article, Marubeni acquired a 1% stake in the PNG LNG project for $300M through its acquisition of a minority holding in Merlin Petroleum in November 2011. This transaction valued the gas in the LNG PNG project at approximately $3/mcf. Granted the XOM/OSH cost overruns were announced after this transaction, but see discussion above to support why this comparable is still meaningful.
Currently, IOC trades at $0.63/mcfe only based on Elk/Antelope's P50 results prior to Antelope-3 well. Given the comparables discussed above and the announcement that "final binding bid solicitation period for the partnering process currently being undertaken will close on February 28, 2013", IOC appears to be significantly undervalued.
Rovuma field comparison:
Now I would like to address a comparable that is commonly mentioned without all the applicable details, specifically, using PTTEP's purchase of Cove Energy's stake in the Rovuma field to IOC's Project.
Since the tax rates are known, let's focus on those. The hard part is determining when the rates change (nonetheless, I still attempt to estimate them, see below), but we can at least know the starting and ending points with some reasonable certainty.
PNG taxes will be a flat 30% plus 2% in royalties. So 1-(1-2%)*(1-30%) = 31.4% total tax. Note, as confirmed by IOC, the Additional Profits Tax does not apply.
Mozambique tax rate is 24%, but then increases to 32% the 9th year, royalties begin at 2% but increase to 6% after the 10th year. Also, in Mozambique one must consider the allocation of profit petroleum rules, which until the simple ratio of Cumulative CFs from the project over Cumulative Project CapEx (called the R-Factor, which is discussed on page 27-29) exceeds 1, Mozambique government gets 10% of profits, when that ratio is between 1 and 2 the Mozambique gov't gets 20% of profits, between 2 and 3 Mozambique gov't gets 30% of profits, between 3 and 4 Mozambique gov't gets 50% of profits, when the ratio is above 4 the Mozambique gov't gets 60% of profits.
(The percents cited above come from a Cove document that is no longer available, but I have placed on Google, see page 20). Also, note that the R-Factor is a simple ratio and does not consider time value of money, so it treats CF years out the same as year 0 CapEx (CFs out), accelerating the increase in the ratio, which reduces the profits to the resource holder.
So the estimated first year the tax rate is 1-(1-2%)*(1-24%)*(1-10%) = 33% and later on the tax rate can max out at 1-(1-6%)*(1-32%)*(1-60%) = 74%. The big question is at what rate this happens. If one chooses a mock project with a 30% IRR for a 25 year period, then based on those estimates the 33% tax rate would end after the first 3.53 years of the project (includes 10% profit sharing) and the 74% tax rate would begin the 13th year (includes 60% profit sharing). Also, note base on my estimate that the 20% profit sharing will begin after 3.53 years, the 30% begins after 6.31 years, and the 50% begins after 9.09 years.
Click here for the spreadsheet I used to estimate these breakpoints and tax rates. Feel free to modify the CFs as you like to come up with your own estimates. Also, let me add I understand that as the tax rates increase the CFs will decrease, but for ease I largely use flat CF estimates, plus this is likely somewhat offset by expected increases in energy prices. If anyone takes the time to fully model each year, I would love for you to share the results. For this discussion, I believe my rough estimates are adequate to show the large tax disparity between PNG and Mozambique.
The next question is, how much would this tax rate affect the bidding? If my estimates are reasonable for the ramp up of the tax rate, then the average tax rate for the Rovuma field will be 61.9% over a 25 year project life compared to 31.4% for Elk/Antelope, a difference of 30.5%. So the overall tax/PS rate will be about twice as high. Surely Shell and PTTEP knew estimates of the Mozambique tax rate when they bid, right? It is obvious to state that the tax rate negatively affected the bid price relative to a PNG project.
Next question, what does that tax rate differential mean in a dollar amount per mcf? If you will accept an estimate that it takes $6/mcf to get gas to the LNG Plant, then add $1.25/mcf for OpEx, then round up to a total of $8/mcf for interest and miscellaneous expenses. That means if each mcf is sold for $14/mcf, then the taxable portion is $6/mcf. The tax difference of 30.5% equates to a difference in value of $1.82/mcf (30.5%*$6/mcf). In other words, on average over the life of the project, it means that each mcf generates an extra $1.82/mcf under the PNG tax regime compared to PTTEP's newly acquired Rovuma field property. That is a very large number and it gets larger the more profitable LNG project.
Two additional things to consider when comparing Rovuma field prices to PNG.
First, there is no capital gains tax in PNG, but there is in Mozambique, which did negatively affect Cove's pricing. It would stink to have to pay those taxes again if they later sell their holding. Also, "Mozambique has said that the sale of Cove will be subject to a 12.8 percent capital gains tax. PTTEP's offer for Cove excludes the 12.8 percent capital gains tax due to the Mozambique government".
So what are the expected development costs for the Rovuma field? Well, "Wood Mackenzie estimates a two-train, greenfield LNG development in the region will cost at least $25bn."
So to summarize, there are certainly some nice PNG comparables for IOC's proposed LNG project relative to its current valuation. These comparisons are easily analyzed since they have the same country risk and taxation. While there is always the risk of overruns in such large projects, given the advantaged nature of IOC's resource, IOC's project is likely to be more profitable than XOM/OSH's project since their starting cost estimate is more than $10 billion less than XOM/OSH's project cost. Important to note that IOC will benefit from the XOM/OSH trained workforce, that will transition to IOC's project as the XOM/OSH's Project winds down.
While it is tempting to compare PNG projects to Rovuma field prospects, the comparisons are very tricky and the large difference in taxation must be considered. Ultimately the question is, what should we expect IOC's value to be post sell down and partnering? I am afraid I cannot precisely answer that, but in my opinion the large margin of safety that exists to fair value justifies the investment.
Other things to consider when researching this investment: large short interest (~11.5 million shares short compared to ~48 million outstanding), past political turmoil in PNG (which has settled dramatically under the leadership of PM O'Neill), and the corruption that exists in PNG (which thanks to PM O'Neill appears to be lessening as well).