InterOil (IOC) is rapidly nearing catalysts which will cause its stock price move sharply higher in the coming weeks. InterOil's fair value is literally multiples higher than its current $66/share. Getting fully up-to-speed on the InterOil story will require some time investment, but if the catalysts unfold as expected over the next few weeks, we believe the stock will move up sharply and trade closer to its current net asset value of over $400/share.
IOC is extremely well-positioned to benefit from the surge in demand for liquid natural gas in Asia Pacific. In the Japan spot market, natural gas is trading for $16+/mcf (vs. $2.50/mcf in the US). If you believe that increasing Asian LNG demand is a compelling, structurally attractive investment theme, then we strongly urge you to spend the requisite time understanding InterOil. InterOil is the best play on the Asian LNG theme we have found.
InterOil is a Canadian integrated oil and gas company. The company's upstream activities are conducted on 3.9 million acres of petroleum prospecting licenses in Papua New Guinea. The Company has 2 extremely valuable gas resources along with numerous (40+) other attractive prospects. The first resource is called Elk/Antelope, which obtained a resource estimate of 9.2 trillion cubic feet equivalent (Tcfe) from respected third party assessor, GLJ. The second resource is called Triceratops. A preliminary assessment performed in 2011 indicated Triceratops contains 4.9 Tcfe. Further seismic analysis and drilling results conducted in the last 3 months led Morgan Stanley's analyst to conclude that Triceratops's area under closure could be 2x Elk/Antelope's (Morgan Stanley's June 18, 2012 note on InterOil).
Assume InterOil has 18 Tcfe across both Elk/Antelope and Triceratops. To be extremely conservative, assume ZERO value for rest of InterOil's 40+ other resource targets (some of which look to be promising reefal formations on seismic analysis). InterOil recently sold 10% of Triceratops at $2.85/mcf to Pacific Rubiales. For conservatism, let's assume the value of gas in the ground is just $2.00/mcf. InterOil owns 58.6% of each resource. At just $2.00/mcf, the net asset value of InterOil is just over $21 billion ($421/share). The math: 18 Tcfe X $2.00/mcf X .586 = $21 billion divided by 50M fully-diluted IOC shares
InterOil's Gas is Ultra-Low-Cost
IOC is extremely well-positioned given that it has the lowest cost gas in Asia Pacific. Very few development wells will be required to extract the gas. This is due to the fact that the Elk/Antelope is a reefal structure that is comprised of dolomite with high porosity (8% - 14%). The Elk/Antelope structure is located in the lowlands of PNG, which is quite near the port (minimal pipelines required).
Why the Massive Discount to NAV?
Why is InterOil currently trading at such a steep discount to its NAV? Though PNG is a parliamentary government, doing business in PNG is challenging at times. Once it was realized that InterOil possessed enormous amounts of low cost gas in its licensed development areas, various parties with conflicting interests injected themselves into the process. Also, the Minister of Petroleum and Energy insisted InterOil needed to partner with a world-class LNG operator to get final approval for its LNG plant.
In October 2011, InterOil retained the investment banks Morgan Stanley, UBS and Macquarie to manage the sell-down of 25% - 32.5% of InterOil's Elk/Antelope resource. Part of the sell-down process included bringing in a world-class operator to meet objections raised by the Minister of Petroleum and Energy.
InterOil is nearing completion of its bidding process to sell-down a portion of Elk/Antelope. The bidding has been quite competitive and numerous super majors and world class companies are aggressively competing to buy some/all of InterOil's Elk/Antelope resource. Bidders are rumored to include the consortium of Japex/Kogas/Mitsui, Shell (RDS.A), Exxon (XOM), Chevron (CVX), Total (TOT), Conoco (COP), Marathon (MRO) and some others. At the annual shareholder's meeting on June 15, 2012 InterOil said "bid values today are MULTIPLES higher than the first offers" (page 5). The bidding process is likely to conclude in the next few weeks.
Some investors were waiting for an unambiguous signal that the PNG government is clearly supportive of InterOil's project. Last weekend, Prime Minister O'Neill issued an extremely clear and supportive message for InterOil's Gulf Project. PNG has a national election that begins on June 23rd. Prime Minister O'Neill is expected to retain his position as prime minister, as he is leading in the polls by a wide margin. We believe O'Neill's return as Prime Minister will extinguish any remaining political concerns.
Over the past few weeks, speculation has increased that one of the companies competing in the bidding process for Elk/Antelope will make a pre-emptive offer for 100% of InterOil. The recent incredibly positive drilling results from Triceratops makes a takeover offer for 100% of InterOil much more likely. In the event of a takeover offer, we believe InterOil will conduct a competitive bidding process to sell the entire company. We expect that the final winning bid would be in excess of $300/share. One should look at the recent bidding war for Cove Energy PLC as a close proxy.
Currently, almost 20% of the fully-diluted outstanding shares are held short. We believe at least part of the short thesis was a bet InterOil would lose political support in the PNG government. Obviously, this has not occurred. In fact, quite the opposite has taken place (see Prime Minister O'Neill's recent comments). There are almost 10 million shares short that need to cover. Over 70% of the total shares outstanding are held by insiders and/or very long-term holders that believe IOC is worth many times its current share price (page 15).
Richard Chandler is a self-made multi-billionaire from New Zealand. Mr. Chandler has purchased over 14.5% of InterOil's outstanding shares in the last 6 months. If Mr. Chandler follows his previous investing pattern, he will likely continue buying InterOil shares until he owns just under 20% of the outstanding shares.
As a final sweetener, Triceratops may have "moveable hydrocarbons" in the lower zone of the reservoir. "Movable hydrocarbons" means either highly valuable gas condensate liquid or oil. InterOil is conducting further tests to determine whether the reservoir interval below the gas/water contact in Triceratops contains producible hydrocarbons. These results will be available in the coming weeks.
In the past, InterOil's management frustrated investors with half-hearted attempts to sell part of Elk/Antelope (holding out for higher prices) and delayed milestones (FID, etc.). However, the increased pressure from the PNG government, InterOil's Board of Directors and investors resulted in the company retaining top investment bankers in October 2011 and running a top-notch formal bidding process that is near completion.
Where are we now? There are multiple bids on the table from super majors and national energy companies and the bid amounts are "extremely accretive to shareholders," 10 million shares are short and are quite susceptible to a massive squeeze, a recent deal with Pacific Rubiales at $2.85/mcf provides a frame of reference for the current bid process, a current M&A comp in Cove Energy exists, a multi-billionaire is buying up much of the remaining float, extremely promising drilling results continue from Triceratops and the election in PNG should remove any remaining political uncertainty.
InterOil is poised to move sharply higher in the coming weeks.