InterOil (IOC) is a very controversial oil and gas company that I have written about before. Lately, there has been a lot of excitement with the company reaching a potential deal with a major partner to operate it's Papua New Guinea (PNG) gas wells. However, I continue to believe that a major operator will never sign with IOC. In my opinion, the spot where IOC's stock is now, in the $80s, is the highest it will ever be again. So much damage has come to the company in the past week, such as reports it's refusing to show Royal Shell its well data, a bad quarter causing liquidity problems, and news that George Soros completely liquidated his position last quarter, that it won't be able to recover.
I have recently done a lot of research on the Company and have dug up some interesting information from various sources. Some of these sources are experts in the field of oil and gas exploration, others are experienced investment analysts. As a service to the Seeking Alpha community, I am sharing some of what I have learned.
InterOil's CEO, Phil Mulacek, claims that InterOil and Royal Dutch Shell are in negotiations over making Shell the operator of InterOil's Elk-Antelope gas fields. Royal Shell's CFO, Simon Henry, also claims that they have had discussions over "quite some period of time."
However, now things don't seem quite right. Mr. Henry is quoted as saying:
"At the end of the day we haven't been in the data room and we're not in an ongoing discussion. It's very difficult to have an interest in the asset that the license holder (InterOil) doesn't want to talk to you (Shell) about."
Regarding this situation, a hedge fund manager, who requested anonymity, who says IOC is his "highest conviction short idea" wrote:
"Did you see last week that, after the company basically promised a HUGE deal with Shell (which is the main reason why the stock ripped up $20), it turns out that IOC never let Shell into its data room?! (this is the most basic first step in the process IOC claims is going on). Why won't IOC let potential partners into its data room? Because if any knowledgeable person saw the real data (or, specifically lack thereof) the game would be up...
Also, The condensate stripping plant expenses are comically low. The issue with the condensate stripping was always going to be dry hole blow back. You can't test for that for $4 million. Only evidence - they have done NOTHING on the condensate stripping plant that is worth doing."
This article is regarding the first accusation by the hedge fund manager in that InterOil doesn't have good data on its wells and therefore is hiding it. I may follow up later with another article discussing the cash flow issues that InterOil has and the strange expenses from last quarter.
InterOil's Incomplete Wells
There is strong evidence that the wells don't have the gas that IOC claims. First off, the company still has not done an SEC-compliant resource estimate. This is after three years of discovering the Antelope-1 and Antelope-2 wells in 2009, and four years of discovering the Elk-4 well in 2008. Instead, the company got an independent resource estimate from Candian firm GLJ.
Secondly, IOC has been drilling in an area of PNG around the Puri Creek that has been known to contain hydrocarbons. Companies have tried to drill in this area for decades, but to no avail. If IOC had really managed to find significant oil or gas in this geography, then it will be the first company in history to have been commercially successful.
Here is a newspaper article of a partnership between BP and a company called Vacuum Oil from 1958, which initially looked like the company had stumbled upon quite an oil well. You can see that this well was also in Puri Creek and it had generated quite a bit of excitement in the stock (some things don't ever change).
But then, as shown in this article, it was found that the first great oil flow was never found again. The rest of the well was just water-bearing.
Another company called Kundu Petroleum drilled a well in the 1980s, but eventually went bankrupt.
In addition to the examples above, much more exploration has been conducted and wells drilled with no commercial success in the carbonate reservoirs around Puri Creek. There is just too much water where oil and gas were expected to be. Over the decades, oil and gas companies have always let their licenses expire in Puri and moved further west to explore PNG's sandstone reservoirs.
It is in this area that the only commercial successes in PNG have occurred, with all of PNG's current oil and gas production operated by Oil Search (OSH AU), Exxon's (XOM) partner in the LNG facility. Oil Search purchased BP's E&P assets in PNG for $400 million in 1998.
Unlike Exxon's sandstone reservoirs, InterOil's carbonates reservoirs are more heterogeneous and complex. So while hydrocarbons have been found in PNG's carbonate reservoirs (like Elk and Antelope), they have never been found in commercial quantities despite a number of wells drilled over the decades. The problem is that the rock in the area is heavily fractured, which can contain sizable quantities of gas that will rush to the surface, but may not be sustainable as the porosity is low. This explains why the initial flows are so strong at both IOC's acreage and some of the early wells drilled in the area. Only an extended well test (over a period of weeks) would provide enough information to confirm that this is a commercial discovery. IOC has not conducted these simple tests. IOC's own geologist states that "fracture characterization of the reservoir has been a challenge" and that "porosity is relatively low" in a 2007 article for the Australian Society of Exploration Geophysicists (a copy can be purchased at http://www.publish.csiro.au/paper/ASEG2007ab045.htm).
Bullish Arguments That Say The Reserves Are Legitimate
Much of the bullish arguments are not conclusive in my opinion. The following are the three biggest reasons that one might purchase IOC:
1. Oil And Gas Partners Validate The Wells' Value
The bulls will say that Pacific Rubiales (PEGFF.PK), a $7 billion oil and gas company, bought an interest in IOC's reserves which gives IOC credibility. IOC sent out numerous press releases on this deal, and it made some believers. However looking deeper, the deal is not very solid. The initial upfront funds by Pacific Rubiales was only $20 million, which is peanuts to a $7 billion company, and it's refundable.
As shown here, the "The transaction is subject to the satisfaction of closing conditions by June 15, 2013, or Pacific Rubiales will be reimbursed out of future upstream production proceeds."
This means that if the closing conditions, i.e. getting the gas fields closer to working order, don't come to fruition, then the $20 million will be reimbursed to Pacific Rubiales out of InterOil's future oil revenues.
In April, 2010, InterOil made a condensate stripping deal with Mitsui. Although Mitsui has contributed some funds, the deal is still only an option for it. IOC surely gave away this option to Mitsui to demonstrate the value of its wells. However, Mitsui is under no risk and, under the JV agreement, it has many outs.
Similar to the Pacific Rubiales deal, InterOil is required to refund all of Mitsui's contributions within a specified period if a final investment decision (FID) isn't made by Mitsui. InterOil must provide "reports and other information which demonstrates that the Elk and Antelope Fields are of a sufficient scales so as to be able to supply Feed Gas." InterOil has not done this yet, and Mitsui will only participate if there is sufficient gas. Furthermore, Mitsui isn't even claiming that there is sufficient gas.
2. Third Parties Confirm The Wells Contain Gas
IOC's resource report by GLJ says:
"That a personal field inspection of the properties was not made; however, such an inspection was not considered necessary in view of the information available from public information and records, and the files of InterOil Corporation."
Why wouldn't InterOil take a few weeks to have a full inspection done to clear the air? It is, after all, the first company to supposedly find a commercial quantity of gas in the region.
Morgan Stanley had an analyst visit the fields and saw a gas flare in the well. That was enough proof for Morgan Stanley.
The whole basis of "proof" of the gas wells seems to be from InterOil's own incomplete research.
3. Big Players Are Investing In InterOil
Two names that have consistently popped up from longs as big investors are George Soros and Richard Chandler.
Last quarter, George Soros liquidated his entire $80 million stake in InterOil. If Soros thought a deal was coming up, why would he liquidate his stake? Rumor has it that the portfolio manager who started the position was fired by Soros earlier this year, and Soros would never have owned the stock by his own analysis.
Richard Chandler has had a lot of success in the past, making him a billionaire, but he's also been blown up before. He owned Sino Forest, buying shares up until it got delisted, even after John Paulson liquidated his stake, Chandler kept buying.
Chandler also invested about $100 million in a company called Energy World (EQCLY) in 2011. It has been raising money since 1997 with lots of promises of an LNG plant. However, to this date it has nothing to show for it. This sounds similar to InterOil.
To conclude, I believe there are no more outs for InterOil at this time. The PNG government has pressed it to find a major partner, the company appears to be trying, but delays continue. It should give an investor no comfort that the PNG government continues to support InterOil. InterOil is the only oil and gas company they have to work with in the Puri Creek areas. It's like if you had someone around to clean your yard and he was doing a bad job, but you had no one to take his place. You would have no choice but keep him around. InterOil has reached it's peak, got everyone excited, including the media, only to let everyone down with a thud. As more and more IOC investors start getting skeptical, you can expect the stock to slowly drift down from here.
Disclosure: I am short IOC.