Interoil (NYSE:IOC) has been the subject of much debate over the past few years. It achieved some of the most impressive natural gas production tests worldwide in recent history. It has booked massive contingent reserves while garnering a multi-billion dollar market cap, for assets based in Papua New Guinea. And it has secured a joint venture partnership with an even larger, international multi-billion dollar company, Pacific-Rubiales (NYSE:PRE). At the same time, it has been the subject of numerous critiques by short-sellers and others, pointing to potential flaws with reserves and well tests, and seemingly interminable delays in project development.
It is possible to go back and forth between the positive and negative attributes of IOC on its own, and such back and forth has gone on for years both in published articles and online comments and message boards. If the positive articles are to be believed, Interoil is tremendously undervalued and could trade up to $150 or $200 (from a current approximate $72 stock price) when a new joint venture deal is announced with a super major or national oil company. And if the negative articles are to be believed, there will never be a new joint venture, the contingent reserves will not translate into proved reserves, and Interoil is tremendously overvalued and could go to 0 or near 0.
One approach that I have not seen is a side by side comparison with a more conventional oil company, which can highlight some interesting aspects of Interoil's business, both positive and negative. The company I will use to compare Interoil with is Austex Oil (OTCQX:ATXDY), which I have written about in more detail here.
Location of fields - political risk and infrastructure
Interoil's fields are located in Papua New Guinea (PNG), a country situated on islands in the South Pacific that became independent from Australia in 1975. According to Wikipedia, in PNG "many people live in extreme poverty, with about one third of the population living on less than US$1.25 per day." There has been news of potential movement towards resource nationalism in PNG - "changes are being made as landowners feel they are missing out on the resources boom."
In comparison, Austex's fields are located in Oklahoma and Kansas. The US is widely considered one of the best places in the world to do business, with consistent property laws and respect for property rights. The odds of expropriation, nationalization, or substantial additional asset taxation in the US are widely considered lower than almost any other country on the planet. And Oklahoma and Kansas are particularly attractive states in which to do business, with low state income and property taxes and pro-business regulatory environments.
Proved Reserves vs Contingent Resource
Interoil has substantial estimated contingent resource in place.
Investors may not be familiar with what contingent resource actually means, so here is the definition of it from Wikipedia/ the American Association of Petroleum Geologists :
Contingent resources are those quantities of petroleum estimated, as of a given date, to be potentially recoverable from known accumulations, but the applied project(s) are not yet considered mature enough for commercial development due to one or more contingencies. Contingent resources may include, for example, projects for which there are currently no viable markets, or where commercial recovery is dependent on technology under development, or where evaluation of the accumulation is insufficient to clearly assess commerciality.
Austex, unlike Interoil, has substantial proved reserves in place.
For investors not familiar with the definition of proved reserves, I have included the Wikipedia definition here:
Proven reserves are those reserves claimed to have a reasonable certainty (normally at least 90% confidence) of being recoverable under existing economic and political conditions, with existing technology. Industry specialists refer to this as P90 (i.e., having a 90% certainty of being produced). Proven reserves are also known in the industry as 1P.
Proven reserves are further subdivided into "proven developed" (PD) and "proven undeveloped" (PUD). PD reserves are reserves that can be produced with existing wells and perforations, or from additional reservoirs where minimal additional investment (operating expense) is required. PUD reserves require additional capital investment (e.g., drilling new wells) to bring the oil to the surface.
Until December 2009 "1P" proven reserves were the only type the U.S. Securities and Exchange Commission allowed oil companies to report to investors. Companies listed on U.S. stock exchanges must substantiate their claims, but many governments and national oil companies do not disclose verifying data to support their claims. Since January 2010 the SEC now allows companies to also provide additional optional information declaring "2P" (both proven and probable) and "3P" (proven + probable + possible) provided the evaluation is verified by qualified third party consultants, though many companies choose to use 2P and 3P estimates only for internal purposes.
From these definitions, it is clear that proved reserves are a much higher standard than a contingent resource estimate. One part of the contingent resource definition stuck out - projects assigned contingent resources are "not yet considered mature enough for commercial development due to one or more contingencies." Proved reserves therefore are an indication of a project's likely commerciality, while contingent resources are an indication of lack of commerciality, at least for the time being, for one or more reasons.
Reserve Risk - Nearby Wells/Production/Other Operators
Interoil's Elk, Antelope and Triceratops fields are huge both from a contingent resource perspective and from a physical perspective, covering large swaths of land. This is a blessing and a curse - it is a blessing in that there may be a large resource in place, but it is a curse in that there is no nearby existing production from the identified reservoirs. This makes it extremely difficult to validate the resource estimates via "close-ology" or "triangulation", meaning the reserve reports need to be evaluated that much more closely, core samples need to be double and triple checked, etc in order to get comfort with the resource in place.
Austex's Snake River field in Oklahoma is surrounded by other operators and both new and old wells to the Mississippian formation. In particular, a multi-billion dollar public company, Range Resources (NYSE:RRC) has drilled hundreds of vertical wells bordering the Snake River field, and Range has actually operated 2 wells in which Austex held a minority working interest. These third party results and engineering help provide potential investors substantial comfort that the oil and gas is in place in the rock and that it is recoverable. Combined with proved reserves booked by a licensed reserve engineering firm, it is almost certain that Austex's reserves are actually in place and that they are economically recoverable. The same cannot be said for Interoil's estimated contingent resources. (This is true by definition, as contingent resource estimates are inherently contingent, and the lack of nearby existing production does not help in mitigating reservoir risk).
Valuation: Cash Flow, Reserve Value
Interoil appears to be valued in the market based on an estimated value of its contingent resource in an asset sale or joint venture, combined with the value of cash flows from ownership of a smaller portion of the project, after such a sale and after development of the project. At a $3.75 billion enterprise value, and with 6 tcfe of contingent resource, Interoil is being valued at $0.63/mcfe of estimated contingent resource. It is difficult to evaluate this compared to proved reserves, as no engineering value for future development is provided, due to contingent nature of the project. Interoil generates minimal cash flow, which is not expected to change unless/until its projects are developed, which seems to require a significant capital infusion.
Austex is much simpler to value and evaluate. It has an approximately $75 million enterprise value, versus $198 million in proved reserve value and a $395 million 3P value (most similar to a contingent reserve estimate). It is currently producing ~700 boepd, (72% oil), and is on track to produce over 1,300 boepd by the end of the year, generating an expected ~$15 million in EBITDA in 2013, and exiting 2013 at a $20+ million run-rate. And despite already proving its reserves and already being in the process of ramping up production, Austex trades at $0.64 per mcfe of 3P reserves, very close to the $0.63 per mcfe of contingent reserves Interoil trades for.
Interoil's assets are in a politically potentially risky country. Its reserves are "contingent resources" because they "are not yet considered mature enough for commercial development". There is limited third party information available about the productive capacity or economics of the reservoirs, due to the geographic isolation of Interoil's fields. And Interoil trades for $0.63/mcfe of contingent resource.
Austex's assets are in the US, considered one of the least risky countries in the world to do business. Its reserves are proved and are audited by a licensed reserve engineering firm. Its main field overlaps with a field operated by a multi-billion dollar public company, Range Resources, and is surrounded by other fields operated by other large public and private oil companies, and by old wells that have produced for decades from the same rocks. And Austex trades for $0.64/mcfe of 3P reserve, and at less than ½ of its proved reserve value.
Not surprisingly, I have a position in Austex and do not own stock in Interoil. Austex is a small company and small companies incur additional risks to investors - caveat emptor.