[Editor's note: For a bearish view on InterOil, see here]
InterOil (IOC) announced on Friday that it has entered into exclusive negotiations with ExxonMobil (XOM) on the development of its Elk and Antelope resource. The market's unscrupulous misinterpretation of the details provided in InterOil's press release resulted in the stock's declining 7.5% on much higher than average volume. Investors incorrectly construed the proposed deal structure to be nonbinding and contingent upon a recertification of the resource in InterOil's Elk and Antelope fields, but it is clear that the purchase and sale agreement articulated in Friday's press release will be binding, unconditional, and utterly transformational for InterOil. I will explain what allowed the press release to be misinterpreted and why the proposed deal structure with Exxon is a best case scenario for InterOil shareholders.
Here is a list of items incorporated in the press release and an accompanying explanation of their significance:
InterOil Corporation and its joint venture partner, Pacific LNG Group, have entered into exclusive negotiations with ExxonMobil Papua New Guinea Ltd., a subsidiary of ExxonMobil, on the development of Petroleum Retention License 15 (PRL 15)
Interpretation and implications: Following receipt of final bids from and extensive negotiations with major energy companies, InterOil revealed that it is in exclusive negotiations with Exxon about a sell-down of its PRL 15, which contains the Elk and Antelope gas and condensate fields. Friday's disclosure implies that the deal terms have been agreed upon and that InterOil had attained an adequate degree of certainty, both from Exxon and the Papua New Guinea (PNG) government, that the deal will be consummated and accepted by all parties. Otherwise, InterOil would have had no incentive to furnish Exxon with exclusivity. PNG Prime Minister Peter O'Neill stated, "This is an important announcement for the development of these assets, and I'm certain all stakeholders will welcome this. As a stakeholder, the government is pleased that InterOil and its partners are taking the next significant step towards the development of our vast natural gas resource". The exclusive arrangement also implies that Exxon's bid was superior to that of other supermajors, which competed for PRL 15. The confirmation and acceptance of Exxon's bid is an important validation of InterOil and the magnitude and commercial viability of its resources.
InterOil and Pacific LNG selling ExxonMobil Papua New Guinea Ltd. an interest in PRL 15 that is sufficient to supply gas to develop an additional LNG train at ExxonMobil Papua New Guinea Ltd.'s Konebada site. There will be staged payments before and after production commences.
Interpretation and implications: InterOil will enter into a definitive agreement to sell an adequate amount of gas to Exxon to support one additional train at Exxon's PNG LNG Project. The quantity of gas required to supply one LNG train is generally 4 Tcf, which would account for 43% of the current best case estimate of 9.4 Tcfe of gas and condensates in InterOil's Elk and Antelope fields according to GLJ Petroleum's latest resource estimate.
Monetizing the first 4 Tcf of gas through an additional LNG train at Exxon's PNG LNG Project provides significant advantages to InterOil shareholders compared to building the first train of a new Gulf LNG Project. The company would presumably be required to fund its equity stake in the infrastructure required to develop PRL15, including the gathering system, condensate stripping plant, and pipeline to the coast, but it will not have to incur any of the costs associated with building an LNG plant. If there are 5.4 Tcfe of gas and condensates remaining in Elk/Antelope net of Exxon's purchased volume, InterOil will own 58.6% of the residual resource. InterOil will retain the option to 1) build its own plant with a qualified contract operator, 2) bring in a second partner in a sell-down that incorporates a significantly higher price for the resources, or 3) sell more gas to Exxon, which can afford to be competitive given its economies of scale in channeling gas from PRL 15 to supply additional trains at its PNG LNG plant. InterOil's Triceratops reservoir could complement the gas from Elk/Antelope to ensure that at least 2 additional trains are underpinned by the company's resources.
If Exxon and InterOil were to build the Gulf LNG Project rather than use the gas for PNG LNG, InterOil would have had to fund the equity portion of its pro rata share of the capex associated with the plant infrastructure. Hence if, for example, the company retained a one-third stake in the Gulf Project following the sell down, its required capex for a single train would be approximately $2 billion, $600 million of which would be equity funded based on the capital structures of other LNG projects. Since InterOil has decided to use its first train of gas for Exxon's PNG LNG Project instead, the company will not have to incur capex for plant infrastructure, enabling a greater portion of cash flows from Exxon's staged payments to be used by InterOil for additional drilling, dividends and share buybacks.
Lastly, adding another train to an existing plant typically takes approximately 2 years, a much shorter period than the 4 year duration associated with building a green field LNG project. This implies not only that the staged payments to InterOil will occur sooner than previously contemplated but also that the gas from PNG LNG's third train could hit the market by 2016, enabling Exxon to secure favorable offtake agreements by meeting LNG buyers' near-term needs before new green field projects come online.
InterOil and Pacific LNG will be funded to drill additional delineation wells in the Elk and Antelope fields, which will be followed by recertification of the resource.
Interpretation and implications: This item was the primary source of confusion on Friday and added to the precipitous decline in InterOil's stock price. Investors incorrectly assumed that InterOil's sell-down is contingent upon the recertification process and that somehow this contingency nullifies the definitiveness of InterOil's impending gas sale to Exxon. As the first "item under consideration" in InterOil's press release conveys, Exxon intends to buy an interest in PRL 15 sufficient to supply an additional LNG train at its site which is not subject to further delineation. Hence the recertification of the resource could only subsequently be used to determine Exxon's relative interest in the PRL. The proposed transaction contemplates Exxon's buying sufficient gas to feed an additional LNG train and owning the relative proportion of InterOil's PRL 15 required to deliver an estimated 4 Tcf after the resource certification cited in the release.
If the delineation program continues to support the current best case estimate of approximately 9 Tcfe of recoverable resources, and for simplicity 4.5 Tcf of gas is required to feed the additional PNG LNG train, Exxon would have a 50% stake in PRL 15 before the PNG government's 22.5% interest, and InterOil and Pacific LNG would own the other 50% before the PNG government's interest. If the recertified resource is bigger than the current estimate, InterOil would own a higher interest in PRL 15. If it is lower than 9 Tcfe, the company would own less.
If, for example, Exxon pays $1.50 per mcf for 4 Tcf ($6.0 billion, or $3.5 billion net to InterOil), and subsequent to drilling additional delineation wells the resource is recertified at 12 Tcfe, Exxon's purchase would only entitle it to one-third of PRL 15. The remaining 8 Tcfe (4.7 Tcfe net to InterOil) would be worth significantly more than the value that Exxon pays for the first train of gas from Elk/Antelope, as the gathering system, condensate stripping plant and pipeline to the coast will add significant value to the resource. How high could InterOil's residual resources be valued? One recent relevant transaction was Marubeni's acquisition of a 1% stake in the PNG LNG project through its purchase of a 20% stake in Merlin Petroleum in November of 2011. The stake equates to ~$3 per mcf of reserves.
With InterOil's "resources confirmed by two internationally recognized independent reservoir engineers", additional delineation wells will likely only add to the size of the resource, providing less dilution to InterOil's stake in PRL 15. This is a very positive outcome for InterOil, as the transaction for a train of gas will be consummated immediately upon deal closure, but the portion of the resource this volume represents will be determined by drilling additional delineation wells. Contrary to what many market participants believed on Friday, I believe that the recertification provision was sought by InterOil, as only 5 producing wells have been drilled in Elk/Antelope, resulting in an excessive discount being applied by the reservoir engineers in their current resource appraisals.
Exxon's funding of the additional delineation wells at Elk/Antelope makes it clear that the supermajor is seeking to use incremental gas from Elk/Antelope to supply additional LNG trains beyond PNG LNG train 3. Hence the deal structure set forth in Friday's press release provides a clear path for InterOil to expeditiously monetize additional gas as the year progresses without having to incur any LNG plant capex.
InterOil and Pacific LNG will have the optionality to either independently develop a second LNG project in the Gulf Province that may also use gas from PRL 15 and potentially other discoveries, such as Triceratops, or pursue further development with ExxonMobil Papua New Guinea Ltd.
Interpretation and implications: The brilliance of this deal for InterOil revolves around not only the credibility of its partner, the accelerated timing of anticipated cash flows, the lack of required LNG plant capex associated with its monetization of PRL 15, and the clear path to progressive sell-downs and cash annuity build ups, but also to the flexibility furnished to InterOil in maximizing shareholder value with additional resources at PRL 15 and its other PPL's. Given that PNG LNG has capacity for an additional 6 trains of gas, InterOil has an opportunity to create an estimated $30 billion of shareholder value (well over $500 per share) in the next few years just from selling gas to Exxon for its existing plant. If, for example, a total of 24 Tcfe of resources are contained at Elk/Antelope and Triceratops, this would be adequate to supply 6 trains at PNG LNG. At $2 per mcf of NAV, InterOil's current stake in PRL 15 and PPL 237 would provide $28 billion of shareholder value. If, however, for some reason there is more value to be created from building the Gulf LNG Project, the company could pursue additional sell-down transactions with other partners. The flexibility embedded in InterOil's deal with Exxon also leaves the door wide open for a bidding war between the supermajors for the entire company.
With Friday's announcement, the binary negative outcome of a deal to monetize InterOil's resources falling through has been taken off the table, resulting in a substantially derisked investment profile. The stock's current valuation implies only about 4 Tcfe (~2.5 Tcfe net to InterOil) of aggregate gas and condensate resources at only $1.50 per mcf. This equates to less than half of GLJ's certified resource estimate just for Elk/Antelope. InterOil has structured a deal with Exxon that accelerates its resource monetization, limits capex, and could provide several billion dollars of annual free cash flow by replicating the deal that it is close to consummating.
There is no question that InterOil's transaction with Exxon will optimize the value of the resources in PRL 15 and provide a tremendous victory for both companies. It won't be long before Exxon tries to buy out all of InterOil at a significant premium in order to secure access to InterOil's plethora of reefal prospects, but I anticipate that Total (TOT) and Shell (RDS.A), which reportedly competed against Exxon for a stake in InterOil's resources, will not allow the company to fall into Exxon's possession easily.