Why There's More Downside To Come For InterOil

| About: InterOil Corporation (IOC)

After InterOil (NYSE:IOC) announced its long-awaited asset monetization deal with energy supermajor Total (NYSE:TOT) on Thursday night, the stock plunged 37% on Friday (before popping 10% Monday) because the deal failed to meet investors' overheated expectations. So is it time to declare victory on what was my largest short position and move on? No. Though I took some profits Monday, I maintain a short position because I think there's more downside to come for InterOil.

Rather than engaging in breathless speculation about InterOil's future (fueled by the most clueless, conflicted "analysts" and venomous, anonymous message board trolls I've encountered in my career), it's now possible - at last! - to analyze this company based on real information. Here are the links:

  1. InterOil's press releases and presentation (here, here and here)
  2. Total's press release
  3. InterOil's conference call (audio here and transcript here)
  4. The 80-page "PRL 15 Sale Agreement" that IOC filed on Friday

The deal guarantees InterOil $613 million upon signing (expected in Q1 '14), with two additional payments contingent upon the joint venture reaching final investment decision (FID), which Total expects in 2016 ($112 million), and first LNG cargo ($100 million), for a total of $825 million. Then, the remaining payments are mostly tied to how much gas (if any) there is in PRL 15 (the area covered by the agreement). Here is a table showing how much InterOil will received based on various resource levels:

How this translates into fair value for InterOil's share price is subject to many variables, including (my estimates are in parentheses): date of payments (as outlined in press releases), discount rate (10%), minority interests (40%), value of InterOil's refinery ($200 million), value of Triceratops and other assets ($500 million), the company's overhead ($25 million annually), net debt levels (constant) and share count (51 million). Using these estimates and then plugging in a range of possible resource levels (the latter five are the ones in InterOil's press releases), I come up with a fair value for the stock today ranging from $11 to $98, as this table shows:

The current share price of $61.13 is near the middle of this range, so does that mean the stock is roughly fairly valued? I don't think so because I don't believe these scenarios are equally likely.

I've long believed that there was only a small - say, 20% - chance that PRL 15 would ever yield any economically producible gas for reasons that are summarized well in these four reports:

  1. InterOil (IOC): "Major Momentum" Or Just A Castle In The Air? (click here; focus on the history section, which documents the many energy companies that have explored PRL 15 for more than 50 years without success, and the geology section, which explains why: "There were no sustainable hydrocarbon flows - just a spectacular initial flow followed by failure.")
  2. Presentation by Lakeview Investment Group (click here)
  3. A write-up on ValueInvestorsClub.com (click here; log in as a guest)
  4. InterOil: Three Strikes, You're Out, And A Beanball To The Head On The Way Back To The Dugout? (click here)

But doesn't the deal with Total, which guarantees InterOil $613 million up front, prove that there must be at least some economically producible gas in PRL 15? Not necessarily - though it does improve the odds (see below). Total is one of the world's most profitable companies, so $613 million represents a mere 2.2% of its $28 billion in pre-tax income in the past year. Thus, it may view the deal with InterOil as a cheap call option - perhaps worth nothing, but a risk offset by the potential large upside.

If I were to guess, I think Total would ascribe the following probabilities to the range of outcomes for PRL 15:

If so, the resulting expected value for InterOil's stock, using the share price estimates above, is $44.

But I think these probabilities are much too high and would instead estimate the following:

If these probabilities are correct, the resulting expected value for InterOil's stock is only $31.45, barely half of yesterday's closing price of $61.13 - which is why I remain short the stock.

So who's right: one of the world's largest energy companies, with vast experience and resources, or little 'ol me? While it sounds like the height of arrogance to say so, I think I am. Big companies do dumb things all the time. Remember when HP (NYSE:HPQ) announced in April 2010 that it was acquiring Palm for $1.2 billion in cash? That very day I went on CNBC and said it was a bone-headed acquisition - and was eventually proven right.

I've been short InterOil's stock for more than four years and have been closely following the company even longer. In contrast, I suspect that Total has only been looking seriously at InterOil for the past few months, given that for most of this year, InterOil was in exclusive negotiations with Exxon (NYSE:XOM). In addition, InterOil over the years has been rumored to be on the verge of a deal with a nearly endless parade of partners - but Total's name rarely came up. In March 2009 a Reuters story mentioned Total, and since then InterOil, its analysts, and the media have mentioned 19 other potential partners!

By far the most logical partner for InterOil is Exxon, which has a $19 billion LNG project on the verge of completion, with scheduled shipments to begin next year. The economics of Exxon doing a brownfield expansion are far superior to Total building a greenfield liquefaction terminal so, naturally, all of the focus has been on Exxon. Despite its superior economic position, however, Exxon wasn't even willing to match the disappointing deal InterOil agreed to with Total. This fact pattern certainly lends credence to the notion that Total doesn't have a clue and/or is taking a gamble as it struggles to replace reserves (a problem many of the supermajors are grappling with). As a result, I think Total is likely flushing $613 million down the drain.

An article in the Wall Street Journal in July offers some clues to what I think happened. It notes that "Exxon's $19 billion project, dubbed PNG LNG, is among the more advanced in Papua New Guinea," whereas Total's "foray into Papua New Guinea has gotten off to a shaky start, with two exploration wells yielding only "modest" amounts of natural gas." Having struck out on their own and under pressure to, in general, build reserves and, specifically, catch up with Exxon in PNG, I wouldn't be surprised if we later learn that Total rushed its due diligence and convinced itself that PRL 15 is a major resource when, in reality, there's no economically producible gas whatsoever.

To see what I think will happen to InterOil, look at OGX (OTCPK:OGXPY), a heavily promoted energy company in Brazil that is now in bankruptcy with its shares down 99% from their peak. This Bloomberg article summarizes OGX's history:

OGX was founded in 2007 and raised $1.3 billion from private investors to buy oil concessions in November of the same year, a month after state-run Petroleo Brasileiro SA, or Petrobras, announced the discovery of a giant offshore oil province south of Rio de Janeiro.

Seven months later, Batista raised 6.7 billion reais ($4.1 billion) for OGX in an initial public offering in what was at the time the biggest IPO in Brazilian history.

A year after that he was drilling wells. A period of rapid success in finding oil led OGX to briefly outstrip Petrobras as the most successful explorer in Brazil by strikes registered.

OGX pumped its first oil in January 2012, but by mid-year it became clear that the field would not produce near expectations and the company's stock began a drawn-out decline.

In the last year alone, OGX's share price has plunged about 95 percent…

I think we'll eventually learn that, like OGX, InterOil's PRL 15 field will "not produce near expectations" and that InterOil's stock will suffer "a drawn-out decline."

That said, we won't know anything for sure until the appraisal wells are drilled and the resource is certified (or not), which might not happen until 2015. Until then, InterOil bulls may be able to pump this stock up once again, so I'd advise short sellers to size this position small for now and look to ramp it up shortly before the results of the appraisal wells are released. At that point, if the results are as dismal as I expect, the stock will collapse.