I have encountered many investment opportunities with significant dislocations over the course of my career, but there were only a handful in which the catalytic path towards a revaluation has been so clear and imminent. It is rare to discover a stock with a steep upward sloping price trajectory that could be considered a distressed asset, but InterOil's (NYSE: IOC) exploration success in the past several years has far surpassed the appreciation in its market value.
As an example, following an exceptional year with the drill bit during which Interoil's certified resource estimate grew to 9.1 Tcfe gross (5.2 Tcfe net), the enterprise value (EV) at the end of the year was $3.3 billion. Despite an improved LNG market, finding another significant structure, and identifying several additional prospective targets, the company's EV is roughly the same two and a half years later. InterOil's current net 5.6 Tcf of exceedingly low cost natural gas and condensate resources in the Eastern Papuan Basin trades at a depressed valuation of ~$0.60/mcfe excluding any value for its exploration acreage, downstream assets, and its recent Triceratops discovery, a reefal structure with twice the aerial extent of Antelope.
InterOil is in the midst of concluding a multi-billion dollar sell down of Elk/Antelope to internationally recognized LNG partners, and the imminent culmination of this process is likely to catalyze a revaluation of the company in excess of $200 per share. The NAV of InterOil's resources significantly exceeds the arbitrary value being ascribed by the market, and the upcoming sequence of catalysts will make this dislocation very clear. Australia is the marginal producer at costs in excess of $6 - $11/mcf. Conventional gas resources such as those possessed by InterOil in PNG have substantially lower F&D costs and much more prolific production rates than coal bed methane resources and hence have much higher NAVs.
The most relevant recent LNG transaction was arguably Marubeni's acquisition of a 1% stake in the PNG LNG project through its purchase of a 20% stake in Merlin Petroleum in November of 2011. The stake equates to ~$3 per mcf of reserves or in excess of 5X InterOil's current valuation, excluding Triceratops and its other assets. InterOil's Elk/Antelope reservoir, however, has higher productivity and lower costs than other structures in PNG and has among the lowest F&D costs globally. Also, InterOil's plant and infrastructure costs are estimated to be approximately half those of Exxon's PNG LNG project. Liquid Niugini's FOB breakeven price was estimated to be $0.70 per mcf while that of PNG LNG was estimated to be $7.50 per mcf. Assuming a $7 FOB breakeven differential for a 6 Mtpa LNG project with a 20 year life and a 20% discount rate, Elk/Antelope's resources would be worth ~$1.75 per mcf more than PNG LNG's resources.
PNG LNG will commence operations approximately 2 years in advance of the Liquid Niugini project, so the differential is somewhat mitigated, but it's difficult to model a scenario in which the intrinsic value of InterOil's resource is not significantly in excess of $3 per mcf, even if LNG prices, which are linked to crude oil in Asia, come off their current elevated levels.
There are several possible reasons for which InterOil trades at a substantial discount to its intrinsic value, but the stars are now aligned for a transformational sell down of Elk/Antelope and FID on its Gulf LNG Project to revalue the company substantially higher in the coming weeks. The company had been caught in a whirlwind of political resistance over most of the last year, as the PNG Department of Petroleum and Energy (DPE) did not support InterOil's modular and floating LNG strategy, which may have breached the 2009 Project Agreement. Also, the return of Michael Somare to PNG during PM O'Neill's reign complicated the political landscape, as the Supreme Court ordered O'Neill to step down and Sir Michael to be reinstated as recently as May of this year.
With the elections in PNG having commenced and the writs scheduled to be returned this week, political stability is on the horizon. Last month, PM O'Neill issued an unprecedented press release in support of InterOil and its Gulf Project. In his release, O'Neill wrote, "Our government fully supports this second LNG project for the country, and we hope InterOil will develop it as quickly as possible." The release also urged the Department of Petroleum and Energy to assist InterOil in proceeding rapidly. There is already strong support for the Gulf LNG Project on the provincial government level, as a state-owned company has been formed to develop a new port and a highway connecting the Gulf to the Southern Highlands Province.
Vote counting is more than half-way through in the PNG elections, and O'Neill's People's National Congress Party is off to a strong start with 20 of the 67 declared candidates. There is also speculation that O'Neill's coalition government will not include Energy Minister Duma, who has been an obstacle for InterOil over the past 12 months. Michael Somare's National Alliance Party, which won 27 seats in the 2007 elections and has always been very supportive of InterOil, is likely to emerge as one of O'Neill's coalition partners. Thus far, the best case election scenario for IOC shareholders is in the midst of playing out, and the market has not yet contemplated the magnitude of its implications for the stock.
Irrespective of who leads the country, however, the new government will have a very strong incentive to expedite InterOil's project as long as a major LNG operator is on board and the terms of the 2009 Project Agreement are adhered to. Meanwhile, InterOil may have already reached an agreement to sell a significant portion of Elk/Antelope to a major strategic partner. In its June 15th AGM presentation, InterOil issued uncharacteristically specific statements about the terms and timing of a prospective deal including, "Our sell down and partnering process has now reached a stage where we expect to be able to demonstrate to the DPE, in the coming weeks, our ability to abide by all of the terms of the 2009 Project Agreement" and "The best outcome for our shareholders is balanced gas monetization strategy, represented by a sale of 25% to 32.5% of the Elk and Antelope fields to a recognized LNG partner."
It has been five weeks since these statements were issued, and it wouldn't be surprising to attain more clarity and specificity on a deal in the imminent future. A joint venture comprised of KOGAS, JAPEX and Mitsui is considered to be the winning bidder after local news reports in March indicated that executives from the companies met with PM O'Neill and attained his acceptance of their intended proposal to invest in the Gulf LNG Project. More recently, speculation has emerged that Exxon is the leading bidder, as the cost of buying gas from InterOil even at $3/mcf may be substantially less than its cost to attain new gas resources. Shell has also indicated its interest in returning to PNG. Irrespective of which companies prevail in buying a stake in the project, InterOil's compliance with the 2009 Project Agreement in conjunction with the government's incentive to expedite the project will almost certainly result in a very positive outcome.
Liquified natural gas is benefiting from a confluence of several positive factors, including its pricing link to crude oil, virtually all of Japan's nuclear reactors being shut down, and rapid growth in the penetration of China's gas-fired power production as a percentage of its electricity output (natural gas consumption in China accounts for <5% of its domestic energy needs vs. coal, which accounts for almost 70%). Conventional natural gas assets that reside on the low end of the projected cost curve are more coveted than ever, and companies like Cove Energy and InterOil arguably have an unprecedented amount of scarcity value. Shares of Cove Energy have generated a ~4X return just since last August as it had been caught in a bidding war between Shell and PTT.
Although the idea of InterOil being a willing seller at the right price may once have been virtually unfathomable given management's exorbitant appraisal of its assets, the company's recent move to replace its CEO, Phil Mulacek, with Gaylen Byker, may be symptomatic of a pivotal shift in the company's philosophy away from seeking maximum control over its assets and towards maximizing shareholder value and de-risking its projects to repatriate capital to shareholders. Potential suitors undoubtedly have taken notice of this development.
Subsequent to the discovery of the massive dolomite reef at InterOil's Antelope reservoir, extensive seismic activity indicated a string of pearls that includes reefal structures such as Bwata/Triceratops, Mako, Wahoo, Tuna, Big Horn and Mule Deer. Exxon and Oil Search have not had much recent exploration success in the Highlands and there has been a significantly increased focus on the Eastern Papuan Basin since the discovery of InterOil's Antelope reef and successful Triceratops delineation well. Oil Search has been voraciously acquiring acreage in this region, for example, and Talisman recently struck a $280 million farm-in deal with Mitsubishi for a 20% interest in nine Western Province properties.
Last quarter, Oil Search said that "Discussions with potential partners were ongoing during the quarter and a number of bids to farm-in to these licenses were received late in the reporting period." With petroleum licenses covering approximately 4 million acres spanning a string of pearls and repeated success in confirming prolific reefal structures, InterOil's unexplored acreage could be worth billions of dollars to a major. Also, the company's recent deal with Pacific Rubiales for a 10% interest in its upstream holdings in PPL237 for $2.85 per mcfe of 2C resources establishes a value for InterOil's stake in Elk/Anetlope of >$300 per share. If Triceratops is defined as a comparably sized resource to that of Elk/Antelope in year 3, it could add in excess of $150 a share to the company's NAV using a discount rate of 20%.
It is difficult to fathom how InterOil's stock price could possibly be trading at only $77 per share with many hundreds of dollars per share of defined resource NAV, significant exploration upside and a clear catalytic path in the weeks ahead, but investors seem to be extrapolating upon the seemingly perpetual stream of missed time lines and disappointments in the past rather than objectively assessing the current juncture. It's likely that the story's unfolding will have a calamitous impact on those who choose inertia and myopia over objectivity.
InterOil's short interest was last reported at 8.6 million shares, up over 1 million shares just since the beginning of this year. As the following article explains, most of the float has been soaked up by insiders and institutions which are generally long-term shareholders with price targets significantly in excess of the current share price. Billionaire Richard Chandler recently accumulated ~15% of the InterOil's outstanding shares, and many investors suspect that he intends to continue to accumulate. With 75% of the outstanding shares held by insiders and the top 10 shareholders and almost 20% of the outstanding shares sold short, there may not be much incremental buying required to initiate a significant squeeze. Also, the stock's volatility over the past three years has shaken out weak shareholders and deposited shares into stronger hands like Chandler who likely will retain their positions even if the stock doubles or triples in the near-term.
When the transformational catalysts take hold, it's logical to assume that most longs will continue to latch onto their positions while shorts scramble to find sellers willing to help them cover their positions and limit their losses. The Cove Energy price appreciation over the past year demonstrates just how fiercely and rapidly such stock price appreciation can transpire for a company with valuable hydrocarbon resources and aggressive suitors for its assets.
Disclosure: I am long IOC.