In its second quarter earnings conference call last week, Exxon's (XOM) David Rosenthal highlighted the importance of Papua New Guinea [PNG] in its global portfolio and touted the construction and commissioning progress on the first two trains of its PNG LNG Project. Rosenthal made it clear in Exxon's prepared remarks that the expansion of PNG LNG has become a priority for the company and that its strategy to add new LNG trains revolves largely around the consummation of a sales and purchase agreement [SPA] with InterOil (IOC). He stated:
We are also advancing expansion opportunities, including negotiations with InterOil Corporation and Pacific LNG on the future development of the Elk/Antelope resource. Major terms have already been agreed, and should negotiations successfully conclude, Exxon Mobil is proposing that 4.6 TCF of the gas resource from the Elk/Antelope field be used to underpin the construction of an additional train at the PNG LNG project site.
In response to Morgan Stanley analyst Evan Calio's inquiry about the timing and economics of Exxon's expansion opportunity in PNG, Mr. Rosenthal said:
"Clearly as would be true of your project once you've got all the facilities in place, the pipelines, the capacity, the trains, the utilities, all the common facilities, any addition is typically going to be quicker and have quite attractive incremental economics. So we certainly have the ability to as rapidly as possible expand that facility over the course of the next few years". Rosenthal also acknowledged that Exxon "view[s] that project (PNG LNG) as quite attractive for us and we certainly look forward to bringing forward some expansion opportunities and continuing to improve further on those economics."
Let's explore the implications of Exxon's commentary on PNG for InterOil, which has in excess of 10 Tcfe of low cost natural gas and condensate resources in the country. Following over two months of negotiating with InterOil since "major items both commercial and technical [were] agreed in a detailed term sheet," Exxon's positive report on its progress towards consummating an SPA is an encouraging signal that a deal is near. Exxon also made its need and sense of urgency to secure gas from Elk/Antelope transparent through last week's admission of the lucrative incremental economics and expedited time to commercialization of the PNG LNG expansion and its emphasis on successfully completing its negotiations with InterOil.
The PNG LNG Project already boasts a world leading IRR of an estimated 18%, but with the Project's pipeline, LNG storage tanks and export facility optimized for 3 trains, I estimate an additional train underpinned by Elk/Antelope could generate an IRR of in excess of 30%, almost triple the IRR of most new greenfield LNG projects. Oil Search, which owns 29% of Exxon's PNG LNG Project, reported slow progress last quarter in delineating additional resources at its structures, making Exxon's need for InterOil's gas increasingly evident. Oil Search indicated that engineering scoping work on the potential development of its P'nyang gas field in PRL 3 continued, 43 km of 2D seismic over the structure was acquired, additional seismic was acquired at its Juha North field in PDL 9, and both programs have now been suspended for the rainy season. More than adequate resources at Elk/Antelope have already been delineated to underpin an additional train at PNG LNG, and with Oil Search's glacial delineation progress, Exxon risks losing one of the highest return projects in its global portfolio if it fails to consummate a deal with InterOil. Hence contrary to what many skeptics believe, InterOil is in a very strong negotiating position as was highlighted by Exxon's acknowledgment last week of the importance of InterOil's resources to its growth strategy.
An interesting twist to the InterOil story, however, emerged last week when Upstreamonline's Russell Searancke Wellington reported that his:
Sources said Shell (RDS.A) is sore at missing the opportunity, and is waiting in the wings if the ExxonMobil-InterOil talks falter.
The failure of Exxon and InterOil to consummate an agreement, however, looks increasingly unlikely following Exxon's positive commentary last week on the advancement of negotiations and its acknowledgment that "major terms have already been agreed". As Searancke also indicated:
[PNG Energy Minister William] Duma endorsed Shell as an ideal partner for InterOil in developing a standalone LNG project [and] Shell subsequently held discussions with InterOil and was seen as the favourite to partner [with] InterOil.
Shell may have developed a false sense of security that Duma could obstruct InterOil's deal with Exxon and push Shell into a favorable negotiating position to buy a stake in InterOil's PRL 15. Recent political developments, however, have made such an occurrence virtually impossible. On July 23, when InterOil announced its exclusive negotiations with Exxon, ABC Papua New Guinea Correspondent Liam Fox reported:
PM [Peter] O'Neill said ExxonMobil is the 'preferred partner'. Petroleum Minister William Duma, who's been supporting Shell, didn't look too happy.
The following month, Duma expressed:
... some concern that it may not be a wise thing to allow one major energy company to dominate the industry in the country,
but such rhetoric has since dwindled. PNG uses minimal quantities of natural gas domestically, and LNG is solely an export product; hence Exxon's industry dominance would not have any detrimental impact on the country. Duma has since changed his tactic and pushed for InterOil to develop the Gulf LNG Project in conformity with its 2009 Project Agreement, leaving the door a crack open for Shell to enter the fray. Given the superior economics, expedited timing and lower cost of channeling gas from Elk/Antelope to the 90% completed PNG LNG Project as opposed to a greenfield Gulf LNG Project in conjunction with PNG's significant economic stake in InterOil's resource, however, the Energy Minister seems to be advocating an outcome that is against the best interests of the country and its citizens.
Fortunately for InterOil and Exxon, PM O'Neill commands the support of 101 of the 111 members of Parliament, and as Russell Searancke Wellington reported last week:
The discussions between the two parties are understood to have the blessing and support of Prime Minister Peter O'Neill, who sources said wants to maintain the momentum achieved from the PNG LNG project and meet one of his own goals for infrastructure development.
To make matters worse for Duma and Shell's aspirations, a groundbreaking and widely circulated letter issued last week provided specific allegations of corruption at Duma's Department of Petroleum and Energy, placing an already weakened Duma under the spotlight. As PNGIndustryNews reporter Blair Price opined last week,
Clearly if there was an opportune time to get rid of Duma - it's emerging now… While Duma and his URP numbers were handy when O'Neill was first counting heads after the 2012 election, relegating them to the few remaining in Opposition ranks will no longer have much impact for the PM.
With Shell's last hopes for external intervention pushing it into a favorable negotiating position with InterOil all but gone, and with Exxon's deal with InterOil almost completed, it seems increasingly probable that Shell will try to buy InterOil. My prognostications for such an occurrence over the past year were premature, but PNG's increasing frustration with Duma's unpatriotic antics and the detailed account provided last week of his Department's corruption and ineptitude may result in Shell's taking more aggressive actions to secure InterOil's unparalleled resources and Gulf LNG Project.
Last week, Shell reported another abysmal quarter. The company's E&P cash margins continued to come under pressure, reaching their lowest level since 3Q09, and earnings were 22% below consensus. Shell's upstream unit production costs have increased in 11 of the last 12 quarters, rising 30% over this period. Following the delivery of its "big three" projects, Pearl, Qatargas4 & Athabasca last year, Shell's growth over the next 5 years is set to come from over 25 smaller and lower return assets, and its projects are projected to deliver among the lowest IRRs in the sector. Shell also withdrew its 2017-18 production growth objective of around 4 million boepd.
As I argued in my previous article, InterOil 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.
I also calculated that a two-train Gulf LNG Project underpinned by Elk/Antelope could generate up to $4 billion of annual free cash flow, or $1.7 - $2.3 billion net to InterOil based on its current share of the project. To put this into context, the $200 billion Shell is on track to generate only approximately $10 billion of free cash flow this year, and I estimate this figure will contract to approximately $5 billion by fiscal 2015. InterOil's market cap is only $4 billion.
InterOil proved that the Miocene depositional setting its Eastern Papuan Basin license areas 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 top tier return liquids and LNG production growth for a major oil company like Shell. Total's (TOT) lack of success in drilling its first two exploration wells in the Gulf of Papua further highlight the value and scarcity of InterOil's reefal complex, and it's no surprise that InterOil partner Pacific Rubiales' SVP of Exploration Jairo Lugo recently said:
We understand that there is some sort of a beauty contest now between the majors to acquire those positions.
Last month, InterOil announced that Dr. Michael Hession joined the Company as CEO. Hession has over 25 years of international exploration, operational and commercial experience, and he was most recently responsible for the development of the Woodside's biggest hydrocarbon resource and one of the world's largest global energy projects. During his 12-year career at Woodside, he held several leading roles related to the Pluto LNG Mega-Project and the exploration and development of assets in North Africa and North America. Hession began his career at BP International and attained his Doctorate in Geophysics from the University College Wales and his Bachelor's degree in Geology from the University of Hull. Hession conveyed that "The certified resource at the Elk and Antelope fields is sufficient for a multi-train development," an independent confirmation of the extraordinary size of InterOil's reservoir from an exceedingly qualified expert who likely had uninhibited access to the company's data room. As Hession indicated in last month's press release, "InterOil is at an inflection point in its history, and I expect that it will start to realize the value that it has carefully built over the past sixteen years."
InterOil's stock continues to trade at a small fraction of its NAV, even excluding its Triceratops reservoir and its sizeable exploration position comprising a plethora prospects like Wahoo/Mako for which seismics demonstrate reefal character. Hession will unlock InterOil's intrinsic value beginning with the impending Exxon transaction unless, of course, another supermajor like Shell seizes this transient opportunity to make a run at the company while it still maintains its distressed valuation. The potential for such an outcome, which could result in Exxon's losing access to InterOil's gas for its PNG LNG expansion, should provide urgency for Exxon to close the SPA as soon as possible.
PNG's increasingly stable political environment and fiscally supportive policies under PM O'Neill and the supermajors' elevated interest in buying and developing InterOil's liquids rich natural gas resources place the company in an enviable position, which could soon translate into a share price that is several multiples of its current value.