Why Exxon Can't Afford To Let Shell Steal InterOil Or Its Resources

| About: InterOil Corporation (IOC)

On Friday morning, Russell Searancke Wellington, arguably Papua New Guinea's (PNG) most connected oil and gas journalist, reported in an article titled "Shell joins battle for InterOil's gas output" that "well-placed sources said Shell (NYSE:RDS.A) has submitted a new offer for InterOil's natural gas resources". Shell's recent bid for InterOil's (NYSE:IOC) assets likely provided a compelling alternative to InterOil for the monetization of its Petroleum Retention License (PRL) 15, which hosts the world class Elk/Antelope gas and condensate resource. This new development was also presumably at least partially responsible for InterOil's allowing an exclusivity provision to lapse in its negotiations with Exxon (NYSE:XOM) for a sell-down of its PRL.

Shell's "new offer for InterOil's natural gas resources" in conjunction with the lapse in Exxon's exclusivity provision in its negotiations with InterOil imply that Exxon now risks losing one of the highest return projects in the entire global oil and gas industry if it doesn't consummate a sale and purchase agreement (SPA) with InterOil imminently. On its second quarter conference call three weeks ago, Exxon indicated that its PNG LNG project is 88% complete and that the company is "advancing expansion opportunities, including negotiations with InterOil Corporation and Pacific LNG on the future development of the Elk/Antelope resource". Exxon further acknowledged that "major terms have already been agreed and should negotiations successfully conclude, ExxonMobil 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."

PNG LNG is Exxon's $19 billion 6.9 MMtpa project in Papua New Guinea. It is scheduled to begin production next year and its first 2 trains will bolster the company's global LNG capacity by in excess of 10%. I estimate the IRR for the Project's first 2 trains will exceed 19%, which is in excess of 5% higher than comparable Australian LNG projects and one of the highest returns of any LNG project globally. PNG LNG's estimated net income/boe is estimated to be approximately $40, more than twice the current company-wide average, and its capex of $2,750/MMtpa is significantly below that of most LNG projects. The PNG LNG project will have a material positive impact on two primary metrics that have been sources of consternation among Exxon shareholders, output growth and net income/boe.

With PNG LNG's first two trains nearly completed, Exxon has been working diligently to expand the project's capacity. The economies of scale associated with the project are significant, as less infrastructure and capex are required for additional LNG trains. Of the $19 billion capex that Exxon and its partners are incurring to build PNG LNG, an estimated $7-$9 billion is comprised of the two trains (based on my industry contacts' estimated costs of $1,000 to $1,200 per ton) while the remainder is comprised of nonrecurring items such as building an airport in PNG's highlands, a 450 mile pipeline crossing 10,000 foot mountain ranges, and complex gathering and separation systems for the 3 separate gas fields feeding the Project. If Exxon consummates its SPA with InterOil, it could increase PNG LNG's capacity at less than half the capex/MMtpa of the first two trains and feed multiple additional trains with a single homogeneous ultra-productive field. I estimate that two additional trains at PNG LNG underpinned by InterOil's Elk/Antelope resource could increase Exxon's global LNG capacity by in excess of 10% and generate a whopping 36% IRR. With Exxon struggling to bolster its net income/boe and production growth and with the project almost completed, the expansion of PNG LNG is arguably the easiest and most important opportunity in the supermajor's entire global portfolio.

Exxon and its PNG LNG partner Oil Search have been unable to grow reserves organically despite pursuing an aggressive drilling program for a prolonged period, and Exxon now risks completely blowing its PNG LNG expansion opportunity if it is unable to consummate an SPA with InterOil before Shell supplants the world's biggest oil and gas company. As Russell Searancke reported in Friday's article, "if ExxonMobil is successful, it looks more likely that Elk-Antelope will underpin the third train at PNG LNG following revelations by project co-owner Oil Search that resources such as P'nyang and Juha North and the Hides expansion are still two years away from being ready for a final investment decision."

Oil Search reported year-end 2012 2P reserves and 2C resources increased by 9%, from 870.3 mmboe to 947.5 mmboe (following a slight decline in 2011) primarily driven by the P'nyang South discovery, which intersected a 184 meter gross gas zone over the Toro to the base of the P'nyang sands. Oil Search acknowledged last week, however, that "development work [at P'nyang is] expected to continue through 2013 and into 2014 to support submission of [a] production development license application in 2015". Hence with Oil Search's critical confirmation of the extensive time that it will take to define and develop sufficient resources for an additional train, Exxon risks deferring final investment decision (FID) on the PNG LNG expansion by two years or more if it can't secure gas from InterOil's Elk/Antelope field, which already has adequate certified natural gas resources for two additional trains.

Though Oil Search projects total 2C gas resources at P'nyang of 2.5-3.0 Tcf, it has only drilled one well and is still collecting seismic data on the field. P'nyang is far away from the other PNG LNG gas fields, and a 90 kilometer pipeline built to between P'nyang and Juha, which is part of the current PNG LNG development, would have to traverse very remote and rugged territory. Consequently, industry experts with whom I've spoken estimate that the development of P'nyang would add $1.5 -$2 billion to the cost of underpinning an additional LNG train. With no other major natural gas resources in PNG and only limited additional potential at Exxon's lucrative Hides field, the supermajor's finding and development costs are set to increase dramatically and it's possible that Exxon will never be able to attain adequate resources organically for an expansion of PNG LNG. Hence Exxon's inability to close an SPA with InterOil imminently will be considered by Wall Street analysts to be an unforgivable blunder, especially if Shell prevails in securing InterOil's prized possession.

Searancke reported on Friday that his "sources said this intriguing saga could take another turn if ExxonMobil closes a deal with InterOil in which case Shell could contemplate a takeover of the Canadian producer." With an aspiration to expand its world class PNG LNG Project to up to 5 trains and an inability to underpin even a single additional train through organic resource growth, Exxon's only logical path is to consummate a deal with InterOil. Its inability to do so during the exclusive negotiation period in conjunction with Shell's reported "new offer for InterOil's natural gas resources" now poses a major risk to the beleaguered supermajor, which is the worst performer in Dow Jones Industrial Average this year. Hence it should not come as a surprise that Searancke's "sources said Exxon­Mobil is keen to close the deal as soon as possible, given the end of the exclusivity period and InterOil being receptive to other offers".

Shell is clearly anxious to secure InterOil's world class Elk/Antelope resource, which InterOil CEO Michael Hession recently described as "the biggest discovery in Asia in the last 20 years." Dr. Hession engaged independent specialists and after attaining "a reasonable verification of what we've got in the ground from Gaffney Cline and GLJ," he concluded that "the certified resource at the Elk and Antelope fields is sufficient for a multi-train development." If Shell were to acquire InterOil, it could significantly bolster the supermajor's production and reserve growth, free cash flow profile, and aggregate returns over the next several years, so Exxon is facing a motivated and formidable competitor.

If Exxon CEO Rex Tillerson is paying attention, he must recognize that allowing the InterOil deal to slip into Shell's hands would be one of his biggest failures since taking the helm. He is a keen manager, however, and hence I anticipate Exxon will consummate an SPA with InterOil imminently. Shell may subsequently bid for all of InterOil at significantly higher prices, or alternatively, it may prevail in winning the operatorship for InterOil's Gulf LNG Project and accelerate the monetization of InterOil's residual resources beyond the 4.6 Tcf committed to Exxon. It is therefore possible that all three players could coexist in a symbiotic relationship that would result in InterOil's share price swiftly soaring to several hundred dollars a share.

Multiple supermajors are vying for InterOil's resources, the company has attracted one of the most qualified CEOs in the oil and gas industry, it discovered the massive Triceratops reef last year, it is currently preparing to drill a high impact well in its Wahoo structure, long-term LNG prices have soared to $16.80 per mmBtu, the leaking of contaminated water from Japan's Fukushima Daiichi nuclear plant has forced the country's nuclear watchdog to declare a level 3 incident on an international scale last week, further delaying the prospect of the world's biggest LNG importer restarting its nuclear capacity, proposed Australian LNG capacity is being shelved as a result of soaring costs and most LNG oriented stocks are trading at or near all-time highs. Yet InterOil's stock has been stagnant for almost 4 years and trades below the price at which insiders recently exercised options well in advance of their expiry. InterOil's stock is a corked spring that is an imminent catalyst away from unlocking billions of dollars of market value. The crescendo is near.

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