Cutting Through The Fog At InterOil

| About: InterOil Corporation (IOC)

A week or so ago, rather scary headlines came out of the press in Papua New Guinea regarding InterOil's (NYSE:IOC) plans to build a couple of LNG facilities (on floating LNG plant or FLNG with Flex of Norway, a condensate stripping plant [CSP] with Mitsui of Japan and a modular LNG plant with EWC of Australia). According to the news, the project was supposedly shelved.

We already argued that this wasn't very likely, and the more that comes out of PNG, the more we are confirmed in that opinion.

Supposedly, InterOil hadn't observed some of the original specifications in the agreement with the PNG government, signed in 2009, which involved a traditional LNG plant next to their refinery at Napa Napa (and CSP somewhere near InterOil's Elk/Antelope resource), while the current plan involves the three plants much closer to the Elk/Antelope resource in the Gulf province.

This was rather odd, because the changes in the plans were known for over a year and until recently, received warm support from everybody, including Energy Minister William Duma, who now seems the driving force behind 'shelving' the project in its current form.

Much of the attack by Duma was an outburst for allegations in another newspaper over the weekend regarding an attempt by Shell to muscle into the project, first by partnering with state resource company Petromin (a partner of InterOil in the project), perhaps in an unethical or even illegal way (the article mentioned a $100M offer to diminish InterOil's grip on the project). Notably, Mr. Duma didn't deny this, but accused InterOil of breach of contract instead.

InterOil vehemently denied such breach of contract, but saw at least some writing on the same wall and hired three investment banks to look for a partner.


The shares sold off heavily on this news, and perhaps this sell-off had already started in April when Shell was supposedly making its move. Now, we have reasons to believe that the problem is considerably less than the scary headlines suggest:

1) The PM reassures

Multiple reassurances from PNG prime minister Peter O'Neill (the latest as recent as last week) that InterOil won't lose its licenses and the government is backing the project. It is also difficult to see how this would be in the interest of PNG, its reputation for a friendly destination for foreign direct investment [FDI] would be seriously hampered. Here is the PM last week in Brisbane

My government is not about creating sovereign risks for my nation’s foreign investment and development potential. My government is not about making life difficult for foreign investors, especially those that have invested millions of dollars in speculative exploration and later to develop and underpin emerging world class mining and hydrocarbon industries in PNG. I have cautioned, and will caution again, my ministers and State-owned corporations, involved in the mining and hydrocarbon industry, to desist promptly from giving misleading signals to the foreign investment sector.

It is not my government’s position to create insecurity, political risk or threaten foreign investment with expropriation. Some of these negative signals have been made since my government took office. I will vigorously investigate this deception targeted at the progress of the two multibillion dollar LNG projects and take corrective action in the coming days. Let me reiterate in the strongest terms that I lead an inclusive and consultative government that will not fall back on the bad habits of governments that have been in power previously in PNG. [EWC]

Now, these might just be words. But his, and PNG's reputation as a welcoming destination of foreign direct investment (on which the economy crucially depends) are on the line here, so they might actually be just a little more than just words.

2) The Gulf location is still on

The PNG government has not expressed any reservations about the location change from Napa Napa to the Gulf province. Indeed, this would be odd, as Petromin, the state owned resource company at the heart of Shells overtures has extolled the virtues of the Gulf location in no uncertain terms. From Petromin's own presentation:

Longer pipeline construction to Port Moresby is potential major cost factor that operators need to consider in deciding between a conventional LNG Plant or a LNG FPSO facility. Higher pipeline cost can decrease the economics of a conventional onshore LNG project.[p5]

ExxonMobil led PNG LNG Project is now in early Project Execution phase. Partners believe that there will be limitations in skilled labor and infrastructure for the Elk/Antelope onshore LNG facility in Port Moresby Result in pressure on resources and services within the Port Moresby region and Papua New Guinea as a whole. Project will therefore possibly face the risk of increased capital expenditures and delays For LNG FPSO, cost and schedule risks will be mitigated through the construction of the facility within a controlled and systematically organized environment at the shipyard owned and operated by DSME in South Korea. Initial capital expenditure estimates indicate LNG FPSO option is significantly lower than onshore LNG Plant.[p15] Advantages for the utilization of the LNG FPSO facility to Papua New Guinea are as follows : Timely delivery of the LNG FPSO facility – no delay risk, construction in controlled environment of shipyard in Korea. Early cash flow – shortened construction period, earlier payback. Cost reduction – no long pipeline to Port Moresby, no jetty construction, and optimized fabrication technology of DSME. Early economic benefits to all stake-holders. Participation of Petromin and Papua New Guineans in the full chain of the LNG FPSO business Frontier of gas development [p17]

And indeed, this was confirmed by acting Petroleum and Energy Secretary Rendle Rimua only very recently (October 4):

Rimua said the government had no issues with the location for the Liquid Niugini Gas project and acknowledged that the Gulf Province could provide the best possible location for an LNG project for the sake of spreading or decentralising major resource project development. [energynewsbulletin]

3) Technology doesn't seem to be an issue

Technology issues do not seem to be the problem either, since Petromin itself has plans for a FLNG plant and entered into an agreement to for this on the July 14 of 2011:

Papua New Guinea’s national oil, gas and minerals company, Petromin PNG Holdings Limited, today entered into a Cooperative Development Agreement [CDA] with two international partners to investigate the prospects of introducing LNG Floating Production Storage and Offloading [FPSO] technology to Papua New Guinea. The partners are DSME E&R [ENR] a subsidiary of Daewoo Shipbuilding and Marine Engineering [DSME] of South Korea, and Höegh LNG of Norway [HLNG]. [Petromin]

We might also point out that the Gulf area is considerably less developed and therefore less suitable for a traditional LNG plant which is build on-site.

4) What seems to be the issue is the size of the project and the operator

With regard to the operator, there seems to be no problem with Petromin's prospective operators for its FLNG (or FPSO, as they call it):

The parties will jointly operate the LNG FPSO facilities under the leadership of HLNG and ENR, where Papua New Guineans will be trained to operate the systems and processes of both the ship and the processing facilities. [Petromin]

Höegh of Norway operates a fleet (of seven) LNG carriers. That's not quite the same as operating an LNG plant, but we suppose it helps. The other prospective operator is DSME E&R, a subsidiary of Daewoo shipbuilder. It's expertise lies in:

DSME E&R is one of subsidiaries of DSME (Daewoo Shipbuilding & Marine Engineering) Group) and has lots of experience with respect to the underwater vehicles and instruments such as AUV, Side Scan Sonar system, Sonar Boat, and underwater multi-directional Cameras. [DSME E&R]

These don't strike us as any more 'world-class' operators than InterOil's parners Flex and EWC (the latter at least has experience actually operating an LNG plant), but perhaps the requirements for InterOil are way more severe. In any case, InterOil was already looking for an operator and how this process seems to be on an accelerating path.

Size might be a remaining issue. As Reuters stated, the original agreement contained plans for 7.6 to 10.6 million tonnes per annum (mtpa), while the new plans involve a start-up capacity of 5mtpa (Reuters claims 4mpta but the agreement with EWC was modified to increase the -EWC + Flex - total to 5mpta). But the advantage of modular is that it can be expanded, and if InterOil manages to get a partner (and/or additional offtake deals for long-term gas sales), this should not necessarily be a problem.

What seems at stake is that part of the PNG government wants a 'world-class' operator', but not necessarily Shell (even though that is their preferred solution). Here is acting Petroleum and Energy secretary Rendle Rimua again:

He said Petromin would work with any world class LNG operator the state wished to bring into the country, including Shell, to develop the gas resources, which were owned by the state and people of Papua New Guinea.

Which is why InterOil hired three investment bankers to look for one, if they weren't already. So that would probably satisfy those parts of the government who have asked for it.

5) Partners Flex and EWC argue nothing has shelved

First came Flex, on Sept 28, final investment decision [FID] is still on before the end of this year:

FLEX LNG and its partners continue to work hard to achieve FID for the Gulf LNG project within 2011. FID for a large LNG project requires complete dedication by all parties involved and we are confident that all stakeholders involved in the Gulf LNG project are committed towards a timeline that would see LNG produced in 2014.

And Mulacek, InterOil's CEO is quoted as stating:

LNG development in the Gulf Province has significant support in Papua New Guinea, as well as by the Gulf Ministers and local landowners where we have our vast gas and condensate development, as stated by the Minister of Petroleum late last night, and re-confirmed by the Prime Minister today in our meetings. A clarification which we agreed to today with the Prime Minister, is that the Petroleum Minister would like a proven LNG operator to join the project to strengthen LNG operations. InterOil has committed to ensure this occurs and will be working with all parties for a solid and successful outcome.

While we're at it, one might also keep the following in mind:

FLEX LNG has invested close to 500 million USD in equity in the construction contracts with SHI and a substantial amount of this equity will be allocated to the Gulf LNG project. The equity already paid in by FLEX LNG to Samsung Heavy Industries will cover all payments to Samsung Heavy Industries until delivery of the FLNG unit, when one final instalment will be due. Between Final Investment Decision (“FID”) and first LNG production from the Gulf LNG project, FLEX LNG’s funding requirement is limited to general working capital and project management cost in the period.[Flex]

Then came Energy World Corporation [EWC] stating that they have received no cancellation notice from InterOil (or any other project and they couldn't confirm any of these scary press stories).

It might also be stressed that EWC's modular concept is using 'modules' produced by 'world-class' engineers like Siemens and Chart. It doesn't have a patent on its modular concept. Also, it got the go-ahead from Indonesia to build a similar modular LNG plant (after a very long bureaucratic in-fight) and the likes of Tokyo Gas wanted considerable involvement in that project (a 25% stake in the project and a 0.5mtpa off-take agreement for LNG purchase and first right of refusal on investments in similar projects).

The upshot

  • The strategy change (from a traditional plant build on-site
  • The new location and plans have such inherent advantages (large cost savings, four years earlier start-up, much less taxing on PNG infrastructure, as the plants are not built on site but on wharfs (Samsung) or plants, under controlled circumstances) that it isn't in the PNG government interest to 'shelf' this.
  • On closer inspection, that's not what they want. They want a world-class operator of the plants, and possibly with a higher start-up capacity.
  • Which leads us to conclude that it is even quite unlikely Flex/Samsung and/or EWC will be ejected from the project
  • A crucial player in this situation, acting Petroleum and Energy Secretary Rimua is on record that Shell is the preferred operator, but any world-class operator would do.

What is going to happen next?

We understand that people were panicking on the headlines, and with PNG politics being not terribly transparent even for some of the cognoscenti, there was a great deal of 'sell-first, ask questions later'. We hope we have answered a few of those questions above.

We're as good as convinced that the present project will more or less go ahead as planned (there might be some alterations, but the essential make-up will more or less stay as it is). Any alternative will produce years of delays, and not only is that not in the interest of PNG itself; on closer inspection there is already a good deal of backtracking from the 'project shelved' language used earlier.

We think a competitive bidding process will ensue. It remains to be seen for exactly what, but the right to operate the plants and a stake in parts or even the whole venture is likely at stake. While it might seem that InterOil's negotiating position is impaired due to the seemingly 'forced' nature of these talks, one has to realize that this is both a very attractive project generating potentially massive returns, namely, InterOil's assets, like its Elk/Antelope field and prospective licenses with 56 structures with 14 possible exploration frontiers with mouth watering potential, and the demand for LNG in Asia is booming.

At present, InterOil is trading way below 50 cents per Mcf, with the Mcf count likely to expand further before year-end, because of the drilling prospect. Triceratops already is known to contain gas, and has shown a large reef on recent seismics.

While the price might not fetch full value (it rarely does), a substantial premium to present valuations seems eminently possible. We think the sell-off is way overdone.

Disclosure: I am long IOC.