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On October 10, 2006, Interoil (NYSE:IOC) put out a drilling report for the progress on the Elk-1 well. Management would like us to forget that they were initially looking for oil, and we are supposed to get excited if they find gas (yawn...). We already knew they have gas in there… the question is does it add any shareholder value?

Gas is like real estate -- it is all about location, location, location. If you discover gas in Kansas 10 miles from a pipeline, than all is good. Yet, when you discover gas in the middle of the jungle in Papua New Guinea, it has little to no value.

Just ask Cheetah Oil and Gas [COGL.OB]. Cheetah is sitting on 3.6 trillion cubic feet of gas in PNG.

Yet their stock price is lingering around 70 cents.

It is very simple. Right now Papua New Guinea has 22.5 trillion cubic feet of natural gas reserves – all of which is currently stranded. There is no economic value to finding more.

Any hope that Interoil ever had in commercializing gas got flushed down the drain last week when the pipeline project between PNG and Australia was suspended for lack of customers. As Australia has been able to make use of coal methane, their need for a multi billion dollar undersea gas pipeline from PNG has been eliminated.

Raymond James

The suspension of the pipeline project was never discussed by Interoil or their main cheerleader, Raymond James. It becomes difficult to call them analysts because we are having difficulty understanding what they analyze.

In their most recent piece defending Interoil, on October 10, analyst Wayne Andrews writes “currently under consideration is a natural gas pipeline to Australia.” Is Raymond James’ analyst even aware of the status of the pipeline? Is that his job?

Raymond James has never even acknowledged that the company hopelessly missed their analyst’s current year EPS estimates. (They still publish an (.81c) projection for the year, although the company has already posted losses of (1.09) over 2 quarters, and we still have two more to go) This “analysis” appears to us as just blind hope. Here are Stocklemon’s previous comments on Raymond James/Interoil.

Midstream Problems

Interoil reports in a few weeks and we are excited to see how the refinery performs. Historically we have seen dismal refinery operations losses – one quarter profitable (1 million midstream net income) vs. 7 quarters losing 60 million dollars.

Stocklemon believes there is a looming writedown on the refinery asset, currently booked at 237 million, and subject to devaluation based on profitability.

But here is where it gets really scary -- Halloween style.

Interoil’s inventory doubled from 50.1 million as of March 31 to an eye-popping 101.5 million as of June 30. If not properly hedged this could be big trouble.

The first obvious question: Why does inventory double when gross revenues are up only 10% quarter over quarter? (Inventory values are now 80% of an entire quarter’s gross revenue)

What valuation writedown is looming on exposure to such a huge inventory, based on the price of crude oil between the June 30 and September 30 interval? (Hint: Crude oil lost 25% of its price between June 30 and September 30.) 100 million in oil products is subject to an inventory writedown approaching 25 million dollars – which flows right to the bottom line. That’s 25 million in addition to whatever losses Interoil is forced to report due to its “normal” operations.

Corporate Defections and Control Problems

The company is operating without a CFO. CEO Phil Mulacek, with no formal accounting training, is now operating as the CFO.

It just slipped a restatement of 2005 results in the back door.

And just a few weeks ago, an independent director resigned, with no replacement announced. The director was also the deputy Chairman of the Board.

Here is a look into the Stocklemon crystal ball.

In December of 2005, Interoil stock soared 50% on positive drilling prospects on the Triceratops well

3 weeks later the well was plugged and abandoned and the stock dove 40% in a day.

Conclusion: Déjà vu? Cautious investing to all.

Disclosure: Author is short IOC

Source: Interoil Has Major Drilling and Pipeline Problems