Instant Gratification with InterOil Corporation?

It has it all: a gripping story that is about to unfold; a company bold enough to move a whole refinery to the other side of the world; an industry legend billionaire investor taking a 10% stake; a massive natural gas find and now possibly another, even bigger, one; a highly respectable analyst putting a target price four times the market price; disbelievers, believers, a record listing on the regulation SHO list, and, not to forget, a near foolproof way to make money.

We’re talking about InterOil (IOC), of course. They had a massive natural gas find (“Elk1") in 2006 in Papua New Guinea, where they also have a refinery and a near monopoly in gas stations. On Thursday, they announced a second gas find in an adjacent (but connected) field, Antelope (at their Elk4 well, which they're in the process of completing).

According to Wayne Andrews, an analyst from Raymond James, Friday morning:

Elk is a sliver of limestone thrust upon the much larger Antelope structure.

So it's entirely possible that there is a whole lot more gas at Antelope then at Elk itself.

However promising this looks, no DST test has been performed yet; this might provide an extremely good entry point, before they do.

We’ll leave the gripping story for another time and concentrate on the immediate prospects, dominated by two uncertainties which, combined, give an interesting matrix of possibilities and opportunities: (1) IOC is close to the conclusion of drilling at Elk4, and (2) IOC has an outstanding loan ($70M) from Merrill Lynch due May 12th (originally May 4th, but extended Thursday.)

Let’s discuss the drilling first:

InterOil’s Elk prospect is currently estimated to contain between 3.5 and 18.8 Tcf of natural gas. They’ve drilled two wells so far; Elk1 was the discovery well and Elk2 the first appraisal well.

While the first (Elk1) was a runaway success (measuring pressures of 100MMcf+ through a 5 inch tube), the second well (Elk2) was, somewhat unfairly, seen as a failure by the markets.

That failure becomes relative if you consider that the resource estimate actually went up, and T. Boone Pickens (who happens to hold a masters degree in geology), both privately and through his fund, took a 10% stake. Wayne Andrews, analyst at Raymond James, argued that the positives outweighed the negatives and upped his target to $65. Apparently, there must have been something to like.

A DST test showed that the well flowed 40.000 barrels of (highly gas saturated) water (the limestone is a lot deeper at Elk2 compared to Elk1, so it was below the water contact). Hardly the dry hole the shorts claimed it was. More importantly, that flow indicated the all important good porosity and permeability, hence the increase in the resource estimation (the limestone containing the gas is also thicker than previously estimated) and Boone’s buying.

As a side note, we have to say that InterOil’s CEO Mulacek argued that Elk2 showed that there is enough gas for a two train LNG facility, which they are currently in the advanced state of planning (together with Merrill Lynch and Clarion Finanz) through a vehicle called Liquid Niugini.

Elk4/Antelope

Now, in a brief PR on Thursday, the company announced the following:

The Elk-4 well has successfully penetrated the Antelope structure, a new discovery which will significantly augment the gas found at the Elk-1 discovery well. Drilling operations experienced a gas kick and a flow of gas and gas liquids to surface which was circulated and flared. The well is now being prepared to drill deeper under pressure followed by comprehensive evaluation.

"This well confirms the presence of hydrocarbons in the Antelope structure," said Mr. Phil Mulacek, CEO and Chairman of InterOil. "We are very excited about this early result and we look forward to drilling ahead to establish the commerciality of this discovery."

It might be somewhat confusing that they are talking about Antelope while the well is called Elk4, but one has to realize that it’s a connecting field. No DST test was performed yet, but having to flare gas against heavy mud pressure sure looks promising.

At their initial big discovery well, Elk1, a similar event took place (in fact, the gas pressure was so high that they almost blew the well, and CEO Mulacek likened the fight to control it to “stemming the tide of the Mississippi”). The DST test to prove Elk1 was performed considerably later.

Performing the DST test at Elk4 will take some time (although not as much as at Elk1, where they had to fight to stabilize the well), giving investors a unique opportunity as the price reaction to the news is still somewhat muted.

If a DST test proves what InterOil announced Friday, then resource estimates will go up, as Antelope now turns out to be a second (but connected) field containing natural gas.

And it doesn’t even have to stop there. There could also be oil. There have been indications of oil before, and every oilfield in PNG has natural gas, so they seem to come as a package deal. Both Elk1 and now Elk4 contain liquids (which, if in sufficient quantities, can also be used in InterOil’s refinery, providing almost immediate cashflow).

A popular argument used by the shorts is that 'no matter how much gas, it’s stranded', strikes us as particularly nonsensical. The demand (and price) for LNG is exploding, especially in Asia, where it trades at a very significant premium, and big producer Indonesia is diverting gas away from export towards domestic use.

The odds have improved that there is more than enough gas at Elk/Antelope to supply such an LNG facility. There are plenty of Asian parties interested in financing it. And InterOil is in talks with quite a few already.

As promising as it looks today, we need a DST test to nail it.

There is still another outstanding issue that has to be settled, though.

The Merrill Loan

The second issue deciding the immediate fate of InterOil is a bit of a dark horse. A loan from Merrill Lynch ($70M approximately) was due May the 4th; since the Antelope find it has been extended for just over a week to May 12.

The outcome of these negotiations are, not surprisingly, difficult to gauge. Here are some of the ingredients that have a bearing on it:

• ML is 1/3 owner of Liquid Niugini, the outfit that is planning the LNG facility next-door to the refinery in order to process the gas from Elk/Antelope (the other owners are InterOil and Clarion Finanz)
• ML did take $15 from an IOC private placement last November
• ML has been very accommodating with this loan in the past. Last year, they continued the generous 4% interest rate it carries until early May, no doubt to give IOC enough time to finish Elk4 and prove the resource.

So, they do have a common interest, and it would seem odd for Merrill to get tough with IOC now that they are on the edge of getting the Elk4 results. However:

• Merrill’s financial position has worsened considerably
• Merrill does seem to have a pretty strong bargaining position in the short-term
• It might want to exploit that in order to grab a bigger slice of the Elk/Antelope booty.

This issue complicates an otherwise rather straightforward investment thesis. On Elk4 alone, a strangle would have been almost guaranteed success. Either it is a success (which it now very much looks), or it isn’t. Either the stock price shoots up, or it falls. There’s hardly room in the middle.

But the whole Merrill loan issue is clouding that a little. There is now a matrix of possible outcomes:

• Elk4 a success, Merrill refinances. IOC will shoot up
• Elk4 a success, Merrill doesn’t refinance. IOC will, well, that depends, I’ll discuss this below
• Elk4 a failure, Merrill refinances. The stock will go down
• Elk4 a failure, Merrill doesn’t refinance. IOC will crater.

The chances that Elk4 will be a failure seem to have reduced considerably with the news on Thursday regarding Elk4, but we'll have to wait for the DST results to nail that.

The degree to which the Merrill loan issue is a problem depends on IOC’s capacity to organize alternative finance at good conditions at relatively short notice, but this itself depends crucially on the Elk4 outcome.

Merrill will realize this, so it might all be a bit of brinkmanship; it’s leverage is weakened with Thursday’s promising news.

Also, one has to realize that, depending on the success of Elk4, there are other possible catalysts to propel the share price higher:

• Netherland Sewell, a world-class engineering firm, will perform an independent audit of the Elk property
• An agreement with the PNG government about the LNG facility, giving Liquid Niugini (of which IOC holds a third) an almost unassailable lead over competing LNG projects.
• An agreement with outside (Japanese, Korean) investors for a participation in the LNG facility.
• The active negotiation with a strategic partner for the sale of a 10% interest in Elk, which has the potential to create an implied “industry” valuation several-fold higher than the market’s current valuation.
• The possibility of farm-out opportunities to industry partners, which could further accelerate the exploration of the company’s extensive acreage position.

We give you another quote from Wayne Andrews from Raymond James (15 Nov 2007):

We are increasingly confident that $66.18 [which constitutes RJ’s total NAV value for the whole company] should be seen as the floor for InterOil’s value, not a “best guess” and certainly not a ceiling.

If one combines that with the quote from Friday morning about Elk being 'just a sliver of limestone thrust upon a much larger Antelope structure', and if you keep in mind that when Wayne arrived at his $65 price target, LNG prices in Asia were a lot lower then today, this sure seems like a good opportunity.

And, not to forget, 10M shares short (almost half the float!) that will have to be bought back at some time. Those are mostly remains from before the Elk1 discovery, which they never seem to have taken too seriously (and the alternative, covering, would have inflicted rather substantial losses upon themselves; imagine what buying 10M shares would do to the stock price). They might pay a heavy price for that.

Interesting times seem virtually assured. Although we are fundamentally long, some hedging with May, June or September options seems to be the best way to play this.

There is a host of background material on the InterOil situation on our website.

Disclosure: Author holds a long position in IOC

Comments

[Pennington]

I have no idea who you are, but I bought Monday so thanks for the profit today :)

[tombo]

This article gives a good summary of the long case. Here's a link to the short case.

www.valueinvestorsclub...

[shareholdersunite]

Tombo, are you serious?? That short case is from 2005! I think quite a lot has happened since then, all the gloom and doom that was predicted by a few shorts hasn't happened in three years. What's more, they had one, probably now two, massive gas finds and the refinery is finally turning around. LNG prices have quadrupled in Asia, their land is now worth a lot more because of the finds and the rise in energy prices.. I think you will have to do better than that.

[tombo]

I don't know. Much of it is still true today. The refinery is still worth much less than advertised. Basically it's break even. They still need to get constant cash inflows from investors to keep drilling.

They still put out wildly optimistic press releases. Did you read over those press releases from the last 10 years? Seems like every well they drill is a "huge find" and then they cap it and move on. They still have no proven oil or gas reserves.

They only major "plus side" difference I see is they managed to swap out a good chunk of their bank debt in a hugely dilutive stock deal. Which means the short term credit crunch is over. I guess as long as they can keep finding suckers to invest, they can stay afloat. But even in the best case scenario, they are many years away from producing revenue off the Gas "find". What will Natural gas prices be then? How many old and new investors will be taking their cut before shareholders? Extremely overvalued IMO.

[Ronnie]

I used to work as an advisor/branch manager with Raymond James (I now manage a multi-family office), and for what it's worth RJ's small cap research is about as good as it gets. Wayne Andrews (the RJ analyst covering IOC) is a geologist himself and I'm convinced that his projections for IOC are sound. I remember taking a pass on Comstock Resources (CRK) when it was around $3 and RJ was rating it a Strong Buy. It now trades at around $53--I told myself if I saw another opportunity like this developing, then I would try and take advantage of it. I now own it personally and am investing some clients' money in it as well. Obviously, that does not mean that I'm in denial of the "shorts" and their points about this company, the downside risks, etc.
Ron

[tombo]

I agree that Wayne Andrews is a smart guy, but even smart guys make mistakes. And he seems a little too cozy with management on the conference calls. Lofting softball questions and congratulating management as they miss targets time after time. And I believe RJ has a banking relationship with IOC. His earnings estimates on their refinery are certainly rosy, and I believe time will prove him wrong yet again.

T. Boone Pickens has a decent position in this stock, and that carries more weight with me, since I KNOW he's no fool, and he's putting his money where his mouth is. But frankly, I don't care if Jesus Christ has put a $200 target on the stock. If he can't explain why it should be worth that much and make me believe it, I won't be investing.

If I wanted to play PNG oil and gas, I'd buy Oil Search which trades at just 3x Wayne's target for IOC. They actually have proven NG reserves (more than double the best case speculation number for IOC), they're producing oil right now, and their LNG project is going to get done.

Their LNG project will come online late 2013 best case. IOC's project will come online after that if it ever gets done. I realize that LNG prices are sky high right now, but I don't think they are sustainable, and 5 years is a long time.

[Ronnie]

I guess I never really applied the WWJD thing to price targets for small cap oil stocks, but it does bring a smile to my face to think of my Lord on a conference call with these guys, digging into their numbers, etc. I wish He would give a strong target on it, then maybe I would feel more confident in rebutting you. In the meantime, your comments are interesting, and I do agree with you that smart guys make mistakes all the time--including Andrews (but not JC!)
Ronnie


On Jun 03 12:18 PM tombo wrote:

> I agree that Wayne Andrews is a smart guy, but even smart guys make
> mistakes. And he seems a little too cozy with management on the
> conference calls. Lofting softball questions and congratulating
> management as they miss targets time after time. And I believe RJ
> has a banking relationship with IOC. His earnings estimates on their
> refinery are certainly rosy, and I believe time will prove him wrong
> yet again.
>
> T. Boone Pickens has a decent position in this stock, and that carries
> more weight with me, since I KNOW he's no fool, and he's putting
> his money where his mouth is. But frankly, I don't care if Jesus
> Christ has put a $200 target on the stock. If he can't explain why
> it should be worth that much and make me believe it, I won't be investing.
>
>
> If I wanted to play PNG oil and gas, I'd buy Oil Search which trades
> at just 3x Wayne's target for IOC. They actually have proven NG
> reserves (more than double the best case speculation number for IOC),
> they're producing oil right now, and their LNG project is going to
> get done.
>
> Their LNG project will come online late 2013 best case. IOC's project
> will come online after that if it ever gets done. I realize that
> LNG prices are sky high right now, but I don't think they are sustainable,
> and 5 years is a long time.

[Balus]

Interesting to see you guys discussing IOC here w.r.t its activities in PNG. I for one am more into proving what you have in the ground before progressing to infrastructure development...or should I say; its the old rule. Prove what you have before you think any further.

Trouble with me is this: to say the least, what IOC has found in Elk 1 & Elk 4 (not discovered...for discovery is a technical term reserved for proven reserves) are either fracture gas with stressed pressure that gave elevated test results...ofcourse some technical questions to ask would be...what about regional formation pressure with neighbouring wells in the area, or have they proven by extended periods, or have they prove its not fractured and not stressed. I understand that Elk 2 and Elk 3 results did not yield similar results but they were drilled on the same sturcture...Elk/Antelo... So why did they not intersect the same superb reservoir??

IOC has alot of explanations to do...but that I shall leave it to those who want to buy IOC stock to ponder. I just would be very careful...and sell when I Have to.

[shareholdersunite]

There is no Elk3.
Yes, Elk1 was extendedly tested
Yes, there is matrix porosity in Elk4
and Elk2 already destroyed any lingering notions of a fault line argument


On Jul 17 06:35 PM Balus wrote:

> Interesting to see you guys discussing IOC here w.r.t its activities
> in PNG. I for one am more into proving what you have in the ground
> before progressing to infrastructure development...or should I say;
> its the old rule. Prove what you have before you think any further.

>
>
> Trouble with me is this: to say the least, what IOC has found in
> Elk 1 & Elk 4 (not discovered...for discovery is a technical term
> reserved for proven reserves) are either fracture gas with stressed
> pressure that gave elevated test results...ofcourse some technical
> questions to ask would be...what about regional formation pressure
> with neighbouring wells in the area, or have they proven by extended
> periods, or have they prove its not fractured and not stressed. I
> understand that Elk 2 and Elk 3 results did not yield similar results
> but they were drilled on the same sturcture...Elk/Antelo... So why
> did they not intersect the same superb reservoir??
>
> IOC has alot of explanations to do...but that I shall leave it to
> those who want to buy IOC stock to ponder. I just would be very careful...and
> sell when I Have to.