As an investor, I believe it is important to understand both the bull and bear theses in detail. To get the bear side of the InterOil (IOC) investment case, I spoke with an Australian hedge fund manager who is a well-known vocal critic of InterOil. I reached out to him to discuss his short thesis in detail. We had two separate conversations. I was left underwhelmed and puzzled after the calls.
Short Argument #1. There is no dolomite in Elk/Antelope (E/A).
The Australian hedge fund manager's short argument on InterOil revolves around the geology of IOC's acreage and an "old geologist" whose name was not revealed. This old geologist supposedly worked in Papua New Guinea (PNG) for years and walked across several miles of IOC's current acreage. The old geologist claims there is no dolomite in InterOil's E/A resource. This made my ears perk up and I was eager to hear why. I asked whether the old geologist had drilled into E/A, seen the extensive drilling data in InterOil's data room, examined core samples from E/A, studied the seismic and aero-magnetic and gravity analysis, looked at the log data in InterOil's presentations, etc. Shockingly, the answer to each inquiry was "no." Hmmm.
What was the old geologist basing his conclusion upon? The Australian hedge fund manager said the old geologist did not see any visible signs of dolomite (dolomite outcroppings) on the surface of the area around E/A. Huh?? There has to be something more to this short argument, right?? Then the Australian hedge fund manager went into a diatribe on the history of InterOil and so on.
Back to this dolomite issue. I asked, "Given there is a data room, and Mitsui has taken core samples from E/A, and all of the logging and testing of E/A was 100% done by world-class 3rd party oil service firms, Schlumberger (SLB) and Weatherford (WFT), and InterOil has released the logs….how is it possible there is no dolomite in the reservoir?" Instead of answering the question, the Australian hedge fund manager backtracked and said, "My biggest concern with my short thesis on InterOil and its geology is that Dave Holland (InterOil's Chief Explorationist) is the best and most trusted geologist in all of PNG." When I asked him to reconcile his perspective with Mr. Holland's analysis, he said, "I cannot reconcile my strong concerns over the geology of E/A (based on nothing other than a visual inspection of the surface of an old geologist) with Dave Holland's very positive statements regarding E/A". Here are the log results from Elk 4, A1, A2 and A3.
Short Argument #2. InterOil has missed deal deadlines in the past, so they will miss this one too.
After receiving the successful drilling results from Elk/Antelope, InterOil hired three world-class investment banks - Morgan Stanley & Co LLC (MS) in the US, UBS AG in Europe (UBS), and Macquarie Capital in Asia - in September 2011 to conduct a formal bidding process for a partial sell-down of the E/A resource. A lot of time has passed since September 2011. Why has it taken so long to get to the finish line? Grand Chief Sir Michael Thomas Somare, was Prime Minister of Papua New Guinea from 2002 to 2011; he had previously been Prime Minister from independence in 1975 until 1980 and again from 1982 until 1985. Mr. Somare was a strong supporter of InterOil and its development plan for E/A. Due to health reasons, Mr. Somare's family announced his plans to retire from politics in June 2011, and Peter O'Neill assumed the role of Prime Minister. The appointment of Peter O'Neill as Prime Minister in August 2011 was brought into doubt, following disputes over whether Mr. Somare was validly dismissed from parliament. Both men declared themselves to be the rightful Prime Minister and the political uncertainty paused InterOil's sell-down process. After a new election in the summer of 2012, Peter O'Neill won and was sworn in as the sole prime minister in August 2012.
Obviously, PNG political events were completely out of InterOil's hands. In September and October 2012, the new cabinet ministers were appointed and the PNG government was back to business. After addressing pressing national matters, the National Executive Council (NEC, the cabinet of PNG), approved InterOil's development plan for E/A in November 2012. Since then, some of the E/A Sell Down bidders wanted to wait for the drilling results from the recently completed Antelope 3 appraisal well. The results, as reported in late November and December 2012 were extremely strong. Now the bidders had all the requested data and the investment bankers set an unyielding calendar with a deadline for firm bids of February 28, 2013.
Short Argument #3. Phil Mulacek will mess up the deal by holding out for too much.
To be fair to Mr. Mulacek (InterOil's CEO), through drive and perseverance, over the last 15 years he took InterOil from running a 35,000 barrel per day refinery relocated from Alaska to PNG into a company that very likely has over 30 tcfe of premium quality extremely low-cost gas across its acreage. That said, entrepreneurs are often not the same person qualified to monetize the enormous value that has been created. As noted in a previous article, the Board of Directors of InterOil removed Mr. Mulacek from the Chairman position in July 2012 to send a strong message to the bidders that nothing or no one (within the control of the company) will stand in the way of a successful transaction. The current Chairman, long-time Board Member Gaylen Byker, is completely and totally committed to the bidding timeline and closing the deal process.
Short Argument #4. InterOil has not performed a long-term flow test on E/A.
This argument has been addressed numerous times before, but it continually resurfaces. After the Antelope 1 well was drilled, InterOil applied for a materials balance test (long-term flow test) with PNG's Department of Petroleum and Energy. Approval was not granted. Given the then record-setting flow rate of 382 million cubic feet of natural gas per day (MMcfd) with 5,000 barrels of condensate per day (BCPD) for a total 68,700 barrels of oil equivalent per day (BOEPD), the PNG Department of Petroleum and Energy felt it would be extremely wasteful and detrimental to the environment to flare the well for an extended period. The objective in a long-term flow test is to produce enough gas to drop the pressure in the reservoir by a measurable amount so a material balance calculation can be completed. The amount of gas that would have to be produced to drop the reservoir pressure in the 8+ tcf Antelope field would be enormous and likely take years.
As I stated before, InterOil went beyond industry standard flow tests by installing production tubing in the wells and opening them up to flow at high rates. The rates and pressures are used to calculate reservoir parameters. After flowing at high rates and then being shut in, the Antelope wells returned to reservoir pressure instantaneously, indicative of the high porosity and permeable reservoir and providing reservoir engineers sufficient data for a thorough reservoir analysis.
To provide more data, InterOil drilled two additional wells (A2 and A3). Further, all wells have extensive wire line log data, numerous drill stem tests were performed, porosity and permeability was extensively tested, all of the drilling and testing results were completely managed and controlled by independent 3rd parties (Schlumberger, Weatherford and SGS). None of the highly sophisticated bidders question the quality of the E/A resource. Three separate independent reservoir engineering firms (Gaffney Cline & Associates, GLJ Petroleum Consultants and Knowledge Reservoir) uniformly believe E/A is an extremely valuable resource with 6-9+ tcfe. Therefore, it is perplexing why the shorts continue to point to this silly argument.
The vocal Australian hedge fund manager I spoke with has encouraged numerous other Australian investors to short InterOil. Further, the Australian hedge fund manager met with numerous US hedge funds over the past two years and strongly advocated shorting InterOil. He even called it an outright fraud. Over the past couple of months, I have had calls with analysts at different US hedge funds that are short IOC. These hedge funds are well-respected and well-known, but none of them have a deep expertise in energy investing. The conversations were eerily similar. When I asked the analysts to explain why they are short InterOil, I heard nearly the same arguments repeatedly….IOC has missed numerous deadlines in the past, the CEO is uncontrollable, IOC never did a long-term flow test, IOC has no proven reserves, IOC will run out of cash, the deal with Pacific Rubiales for the Triceratops field is not arms-length, etc. As we talked through each one of the arguments, they tended to get a bit flustered and then would say something like, "Yeah, but IOC will never get a deal done because the CEO wants too much money." Wow. Seriously?? Is this all the shorts really have?
Over the past two weeks, a few traders that have been active in trading InterOil noted a jump in buying activity coming from Australian investors. Of course, it is hard to know whether the buying is long or short covering, but I view it as extremely encouraging nonetheless. With so many parties involved, it is hard to keep everything secret. It has become obvious to some investors in Australia (PNG's close neighbor) that InterOil is going to announce its long-awaited deal in March. Even with the recent move in the share price, the company is STILL trading at just $0.43/mcf ((9.4 tcfe in E/A + the prelim estimate of 4.9 tcfe in Triceratops X 58.6%) divided by $3.6 billion); this calculation gives ZERO value to 40 other lucrative prospects in InterOil's controlled acreage in PNG. Hence, given the massive (ill-informed) short interest of 11.8M shares (equating to almost 18 days to cover), any announced deal with a supermajor that provides total value of over $1/mcf for a portion of E/A, will likely cause IOC's share price to have a violent and massive move higher. This reality is becoming apparent to investors that are close to the sell-down process. As a result of this, I expect IOC to continue to move higher over the next three weeks and move to $90-$100+ heading into the announcement.
The bidders for the Sell Down of E/A are tweaking, refining, enhancing their bids. Each bid will require a thorough financial analysis by the bankers hired by IOC using a standardized framework across all the bidders. The modeling and analysis process will take some time, even with the bankers working nearly 24/7. There are numerous variables contained in each bid: the percentage of the LNG plant IOC will own, whether there is a cost overrun guarantee provided by the bidder (this is VERY valuable to IOC), amount of cash payment and the percentage paid on signing the definitive agreements vs. various milestones, exploration options beyond E/A and the economics around new resources, etc., etc.. All of this analysis needs to be done for each the 4-6 bids coming in. Given the complexity and the total dollars involved, the IBs will need AT LEAST 1.5 weeks to complete the bid analysis for each bid and get fairness opinions drafted and signed off and make day-long presentations to the IOC Board. Anyone that says otherwise either has not been through these processes (I have been through several as a principal) and/or does not understand the legal standards an IB must meet in order to satisfy the standard of care (as an attorney with 15+ years of M&A and transactional experience involving public companies, I do). Hence, the EARLIEST you should expect the IOC Board to meet is March 9-10. If there is a clear winner, you could hear an announcement from InterOil the week of March 11th.
Of course, there is always the alternative outcome. We could wake-up any morning from now through the signing of the definitive agreements (deal closing, not deal announcement) and see a take-out offer for $150+/share from a supermajor. In this scenario, I would expect several topping bids to emerge and a final transaction to take place well over $200/share.