InterOil: A Free Cash Flow Machine With An Unparalleled Reserve Growth Profile

| About: InterOil Corporation (IOC)

The global oil and gas exploration and production (E&P) sector is facing unprecedented headwinds. Over the past decade, aggregate exploration expenditures for the five supermajors have increased almost four-fold, and their exploration spend relative to production levels has increased by a comparable proportion. Aggregate development capex per barrel of oil equivalent (BOE) produced for the sector is up from approximately $5 in the beginning of the last decade to $20 today, and the majors are now spending approximately $25 per boe of annual upstream capex just to sustain production at current levels. Meanwhile, the group's 3-year average organic reserve replacement has barely exceeded 100% since 2003, and average production growth has declined by approximately 1% per annum over the past 8 years.

Although the integrated oil companies trade at only 4.3X EBITDA, the depletion of economical projects, dearth of new world class discoveries, rapidly rising costs, and consequent necessity to increase spending in order to sustain reserves have resulted in poor free cash flow (FCF) conversions across the industry. The average FCF yield for the integrated producers on 2014 estimates is a meager 4.5%; hence the group's low EV/EVITDA multiple is a misleading indicator. Royal Dutch Shell (NYSE:RDS.A), for example, recently guided to aggregate cash flow from operations of $175bn to $200 billion for the four year period between 2012 and 2015. The company's estimated FCF yield in 2015, however, is expected to just barely exceed 2% primarily as a result of its significantly higher capex requirements.

Between 2000 and 2012, Shell's total upstream capex per boe of production has increased over six-fold from $3.3 to $30 per boe. In the fourth quarter of 2012, Shell generated a worldwide unit profit of just $14.18 per boe, down 17% from a year ago and 22% sequentially, while its Americas division generated a unit loss of $0.99 per boe, down 110% from a year ago and 39% sequentially. Following the delivery of its "big three" projects, Pearl, Qatargas 4 and 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 opportunities in recent years.

The history of InterOil and the prospectivity of its Eastern Papuan Basin acreage:

InterOil (NYSE:IOC) is one of the very few hydrocarbon plays in the world with a unique combination of discovered world class resources and an accompanying exploration pipeline that is capable of generating significant FCF and reserve growth simultaneously; this combination is virtually nonexistent in the energy industry today, as many of the world's most prolific fields have matured and prospective acreage has been exploited. Upon consummating the sell-down of InterOil's Elk/Antelope resource and having additional capital injected to fund the expansion of its drilling operations, the company's stock will almost certainly transition from trading at a steep discount to its net asset value (NAV) to a significant premium, and the company will be perceived as a crown jewel of the industry. Of the hundreds of natural resource equities I have thoroughly analyzed during my portfolio management career, InterOil is the most compelling opportunity that I have ever encountered.

InterOil was founded in 1997 and began a modern exploration program in Papua New Guinea's (PNG) Eastern Papuan Basin in 2001. 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. 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. While this negative thesis deterred the major oil and gas companies from operating in the region, InterOil's discovery of the Antelope shallow marine carbonate platform and reef complex onshore in the Eastern Papuan Basin contradicted existing basin models that were developed based on the historical work from the 1950's to the 1990's.

Using Antelope as a model, InterOil discovered an additional potential reef location near the Bwata-1 well, and it was recently confirmed by the Triceratops-2 well. 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 towards resource replacement for a major oil company.

InterOil's unparalleled cost structure and FCF potential:

InterOil has discovered 1.718 billion boe equivalent of economical natural gas and condensate resources, virtually all of which will soon transition to commercial reserves. Although the company's wells have individually been expensive to drill, based on my calculations its aggregate exploration expenses are only approximately $0.32 per boe of 2C resources, a fraction of the industry's costs. A successful subsequent well at InterOil's Triceratops reef could further reduce this figure, as GLJ Petroleum Consultants, Ltd. is awaiting confirmation of reservoir continuity to bolster the structure's resource estimate, just as it did prior to the drilling of the company's second Antelope well. InterOil's plethora of onshore reefal prospects is likely to result in sustainably low finding and development (F&D) costs for a prolonged period of time.

The high flow rates of the Antelope and Triceratops reefs result in much lower upstream development costs than those of the oil and gas industry. Based on its LNG Project Update Investor Presentation issued on September 29, 2012, InterOil's upstream development and operating costs are approximately $6 per boe, implying aggregate upstream expenditures of less than 25% of the integrated oil companies' upstream spend required to sustain their reserves and production.

Though the final design of InterOil's Gulf LNG Project is yet to be disclosed, the imminent spudding of Elk-3 and recently acknowledged intent to spud Antelope-4 indicate that the company's top priority is to drill production wells in Elk/Antelope to underpin at least a 2-train LNG facility. In its LNG Project Update Investor Presentation, InterOil provides a model that derives $4 - 5 billion of annual cash flow potential for an 8 million ton per annum (mtpa) plant. Based on my discussions with an experienced industry expert who has assessed many liquefaction projects, InterOil's model assumptions are reasonable. The Gulf LNG Project's superior economics relative to Exxon's (NYSE:XOM) PNG LNG Project are partially derived from an onshore pipeline that is one-third the length of Exxon's, significantly lower upstream development costs, and the availability of labor as the construction phase of PNG LNG winds down this year. Amortizing the projected upstream capex for the Gulf LNG Project over a 20 year period and embedding a reasonable interest expense yields annualized FCF of approximately $3 - $4 billion upon initiating production from a second train, or $1.7 - $2.3 billion net to InterOil based on its current share of the project. Even if the stock were to paradoxically trade at double the integrated oil and gas industry's FCF yield, the Gulf LNG Project is worth in excess of $11 billion today (discounting the future value at a 10% rate), more than $200 per share net to InterOil.

PT Arun NGL, the largest LNG producer in Indonesia, demonstrates the magnitude of LNG capacity that can be underpinned by InterOil's Antelope and Triceratops reefs. The history of Arun also serves as a guide for the potential LNG production trajectory of InterOil's Project. In late 1971, natural gas reserves under the village Arun were estimated to comprise 17.1 tcfe, which is close to the aggregate resources estimated by many experts to be contained in InterOil's two discovered reefs. Arun's reefal reservoirs bear similar geological and molecular characteristics to those of InterOil, and the Gulf Project's strong economics imply that InterOil's reefs will rapidly supply multiple trains. Arun's first three LNG trains were built in 1974 and completed in 1978 by Bechtel. Three additional trains were then completed at Arun in subsequent years. InterOil's Gulf Project is on a similar schedule to that of Arun Project 1, which comprises its first three trains. With exceedingly low development costs and liquids rich gas, InterOil's resources at PRL 15 and PPL 237 justify an accelerated monetization schedule.

There aren't many hydrocarbon projects left in the world with greater than 20% IRR's, and with excess capital in the industry is at its highest level ever, money should start to flood into InterOil's projects and exploration endeavors.

InterOil's accelerated drilling operations will result in a significant premium to NAV:

Upon consummating a partnership agreement, InterOil expects to attain the financial flexibility to expand its exploration activities and accelerate its resource growth, a development that should transition the stock's valuation from its current discount to NAV to a significant premium. Surging costs for Australia's LNG projects are causing an unprecedented number of them to be shelved. Meanwhile, the Gulf of Papua region in which InterOil's acreage is located has garnered significant attention and capital commitments in recent months. The prospectivity of the Gulf acreage for large and productive reefal structures like Antelope and Triceratops has become recognized by the global major oil and gas companies. Last year, Oil Search struck a farm-in agreement with TOTAL (NYSE:TOT) on its Gulf acreage following an extensive bid selection process, which included a range of international, LNG-capable, independent oil and gas companies. Jean-Marie Guillermou, Senior Vice President of TOTAL, Asia-Pacific said, "This acquisition represents an exciting opportunity for TOTAL to enter the upstream in the resource-rich Papua New Guinea… The farm-in reinforces our exploration portfolio in the foothills and carbonates plays and it is in line with our strategy to strengthen our presence in the Asia Pacific, particularly in the gas and LNG sectors." InterOil has identified several reefal anomalies surrounding its already discovered Antelope and Triceratops reefs, so its acreage is arguably much more valuable that Oil Search's unexploited and speculative Gulf territory.

A confluence of recent and groundbreaking developments has virtually guaranteed that any hydrocarbon resources discovered by InterOil going forward will be expeditiously commercialized:

1) Receipt of compliant bids for Elk/Antelope - On March 1, 2013 InterOil announced that "its advisors have informed the Company that several bids to partner with InterOil in its Gulf LNG project have been received". According to a recent article in the local PNG press, "With weeks to go before InterOil announces its joint venture part­ner in the Gulf LNG project development, corporate development executive vice-president Christian Vinson told The National that the Gulf LNG project was going on well." The first glimmer of specificity on the sell-down was revealed last week, when Upstreamonline reported that "Canadian company InterOil is poised to sign a partnership agreement with a major company to join the proposed Gulf liquefied natural gas project in Papua New Guinea, with Anglo-Dutch supermajor Shell tipped as the likely party." A partnership with Shell in which the supermajor assumes the operatorship of the Gulf LNG Project would satisfy the primary condition for project approval and consequent final investment decision (FID). InterOil acknowledged that it will be spudding its Elk-3 well "over the next few weeks", an indication that the progress in its sell-down process has instilled confidence that the company's gas will be commercialized. InterOil's gas resources at Elk/Antelope exceed those underlying Exxon's 6.9 mtpa PNG LNG liquefaction project, so at least two trains of capacity could easily be underpinned by the gas already discovered by the company.

2) Dismantling of Petromin - On April 3, 2013 PNG Industry News reported that "Petromin PNG Holdings is to be disbanded, with its mining and petroleum assets transferred into two other state-owned companies. Petromin's long-standing managing director and chief executive officer Joshua Kalinoe has already tendered his resignation." Petromin's petroleum assets are set to be transferred into an entity named Kumul Petroleum, over which Prime Minister Peter O'Neill will retain significant control. This article alleges that "Petromin schemed "Project Zebra" under which it mounted a hostile takeover or dilution bid of InterOil's LNG project equity position as a condition of Shell's engagement as Gulf LNG project operator". Irrespective of the validity of these allegations, the lack of public support for InterOil expressed by Petromin over the years seems to be indicative of an unproductive relationship between Kalinoe and InterOil. With Prime Minister O'Neill extinguishing corruption and assuming an active role at Kumul, InterOil should be able to expedite its commercialization initiatives going forward. The State is the largest single stakeholder in InterOil's Gulf LNG Project, and hence it is incentivized to promote the company's success in order to subsidize the country's education and health care.

3) Additional trains at PNG LNG - The two largest stakeholders in the $19 billion PNG LNG Project, Exxon and Oil Search, have both recently conveyed that a top priority is to add trains to their liquefaction facility. They, however, currently lack the resources to underpin additional capacity and have struggled to make new successful discoveries in recent years. This conundrum presents an opportunity for InterOil's gas to be pipelined to Exxon's Project, which is already in excess of two-thirds complete and will produce first gas at the beginning of next year. Assuming a 250 mile pipeline is built between one of InterOil's reservoirs and the PNG LNG facilities at Napa Napa at a cost of $4 million per pipe mile, the capex required to transport the gas would be $1 billion (note the PNG LNG pipeline is less than 100 miles from InterOil's reservoirs). Based on discussions with industry experts, the cost of additional trains at an existing liquefaction facility is approximately $1,000 per ton per annum. Exxon has a significant incentive to buy into InterOil's resources in order to benefit from the economies of scale associated with its world class project. If gas from Elk/Antelope or Triceratops were to underpin two additional trains at PNG LNG, the incremental estimated capex required to double the Project's capacity would only be 42% of the capex that Exxon and its partners are spending for the facility's first two trains. The PNG LNG Project already boasts a world leading estimated IRR of approximately 18%, but additional trains would significantly enhance these returns.

4) Statutory Approvals - On April 15, 2013, InterOil announced that the Joint Venture Operating Agreements for operations in its Petroleum Retention License 15 and Petroleum Prospecting License 237 were approved by the Minister for Petroleum and Energy, William Duma, and registered under the Oil and Gas Act. These approvals are indicators of Minister Duma's increasingly constructive relationship with InterOil and his recognition that expediting the company's monetization initiatives is in the best interests of the country.

The final chapter of the sell-down is just the beginning for InterOil:

On April 15, 2013, PNG Industry News reported that more than one bidder is involved in the final sell-down negotiations, and on April 11, veteran energy reporter Russell Searancke Wellington indicated that Shell was tipped as the leading prospective partner on the Gulf Project. The increasing incidence of such reports over the past week implies that the interest in InterOil's Project is very strong and a conclusion to the sell-down is near. It is likely that InterOil is progressing to closure with multiple parties in parallel in order to ensure that it attains the best outcome for shareholders and that it won't have to depend on the whims of a single entity that isn't pressured by a competitive process. This is a standard practice for asset sale processes in the energy industry that garner robust interest and bidding activity. It is doubtful that InterOil would have announced its intent to spud Elk-3 in the coming couple of weeks if it weren't exceedingly confident of securing capital through the consummation of a sell-down by the commencement of drilling or shortly thereafter. Very importantly, Monday's PNG Industry News article stated, "The CFO also clarified that the PNG government was 'involved in the process to conclude negotiations and achieve FID'." This implies that the government has been involved in the selection process and project development plans; hence positive FID and the transferal of resources to reserves may immediately follow a sell-down announcement.

InterOil's Gulf LNG Project is poised to comprise at least 2 trains, as the continuity of the Antelope reef was confirmed with the drilling of Antelope-3. According to the company's presentation at the IPAA conference this week, "[its] resources [were] confirmed by two internationally recognized independent reservoir engineers". The company's FCF yield upon the Gulf Project's ramp to 2 trains is expected to exceed 50% at its current market capitalization. With exploration costs per flowing boe of less than a quarter of the industry's, an unparalleled pipeline of large reefal prospects, expanded drilling activities with the infusion of capital from an asset sell-down, and an LNG Project that will boast world leading returns, InterOil is poised to emerge as one of the most coveted energy stocks in the market. Other natural resource companies have been plagued by a deadly combination of falling commodity prices and rising cash costs, but as the low cost producer in the increasingly tight global LNG market, InterOil will attract significant market share and accompanying cash flow from the higher cost Australian LNG projects that are increasingly struggling. The shelving of Australian LNG projects such as Woodside's Browse facility will result in tens of billions of dollars of excess capital in the pockets of integrated and independent oil and gas companies that will flood towards low cost LNG development opportunities; this is an arena in which InterOil is uniquely positioned.

In my previous article, I argued that acquiring InterOil, its Gulf LNG Project or its highly prospective acreage in PNG's Eastern Papuan Basin could provide Shell with exactly what it needs to change course by bolstering its reserves and returns. Although Shell surprisingly has not yet pursued a hostile takeover of InterOil, last week's Upstreamonline article referenced earlier confirmed that Shell is in fact engaged in the bidding process for Elk/Antelope and is currently leading the race against other major oil companies.

InterOil's announcement on Monday that "confidential negotiations with more than one bidder are ongoing, and the process is moving forward as planned" most likely implies that following an extensive due diligence process, several major hydrocarbon companies will walk away without a stake in the company's assets or a foothold in PNG. Assuming standstill provisions are set to expire upon the consummation of a deal, a hostile bidding war for InterOil is very likely to transpire, even if the stock is significantly revalued following an asset sell-down announcement. If InterOil's shares were to double from current levels, for example, they would still trade at less than Chevron's (NYSE:CVX) net cash position and approximately one quarter's worth of the supermajor's earnings, a small price to pay considering that the acquisition could bolster Chevron's reserves by approximately one-tenth following FID of the Gulf LNG Project. Given the plethora of large energy companies that have become acclimated with InterOil's assets through their recent due diligence on Elk/Antelope and the Gulf LNG Project, any hostile takeover attempt would likely be followed by a fierce bidding war.

Disclosure: I am long IOC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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