Last month, Royal Dutch Shell (RDS.A) CFO Simon Henry acknowledged on the company's conference call that it was in talks with InterOil (IOC) to buy into the company's resources. As cited by the author of a negative Seeking Alpha article last week, however, Mr. Henry reportedly subsequently indicated, "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 licence holder [InterOil] doesn't want to talk to you (Shell) about." The author then cited an anonymous hedge fund manager's interpretation that Shell's inability to access the data room was a function of a lack of compelling data. In order to grasp the nonsensicality of such an interpretation, let's take a step back to the end of last year.
In October 2011, InterOil hired three of the leading global investment banks, Morgan Stanley, UBS, and Macquarie, to manage the sell-down of the company's Elk/Antelope resource. If there were no compelling data in the data room, would these investment banks risk continuing their engagements with InterOil and jeopardize their reputations? In its first quarter press release, InterOil's CEO stated, "We have received conforming and non-conforming bids for the LNG partnering and sell down of an interest in the Elk and Antelope fields that we believe would be accretive to shareholders." Would formal bids have been received by "significant LNG industry participants" if they weren't allowed in InterOil's data room?
In discussing these topics with Wayne Andrews, InterOil's Vice President of Capital Markets and former Managing Director of Exploration & Production Equity Research at Raymond James and Associates Inc., on a call this weekend, provided the following clarifying statement:
We have provided unfettered data room access to qualified bidders with whom we have completed confidentiality agreements including a standstill provision. Many have accessed our data room and conducted thorough assessments. We are now working with a short list of parties capable of bringing an LNG processing facility to Papua New Guinea of a nature and in a manner which will be satisfactory to the PNG State. The parties with which we are dealing are very sophisticated, and it has been absolutely necessary to provide them with complete transparency.
Why then would Shell's CFO publicly indicate that the company is in discussions with InterOil to buy into its resources and subsequently blame InterOil for preventing Shell from accessing its data room? I believe that the only plausible explanation is that Shell did not want to lose the ability to pursue a hostile bid for InterOil by signing a restrictive NDA with a standstill provision that would have prevented the company from doing so.
After InterOIl gained the right to build a refinery in PNG, Shell would have found it difficult to compete in the local retail distribution business and agreed to sell its assets to InterOil and cease operations in the country. PNG Gulf Governor Havila Kavo argued against Shell's return to the country after its having betrayed it: "Ten years ago, Shell described PNG as a failed state, gave up its operations, sold it to InterOil and left… Now they have decided to come back. They ripped off the country and left. What infrastructure have they left and what positive development have they left before departing?...Such companies had no confidence in the country. Why allow them back?" While the majors had no interest in the Eastern Papuan Basin for decades, InterOil incurred an inordinate amount of risk and spent hundreds of millions of dollars drilling in the Basin, which was only sparsely explored following a lack of success beginning in the late 1950s.
The company hit the jackpot in 2009 with the discovery of the massive dolomitized Antelope reef, which contains the most prolific gas flow rate in the world (it's literally at the top of the Guinness Book of World Records). With the corresponding seismic work that was conducted on InterOil's surrounding acreage, it became evident that InterOil discovered not only a sufficient quantity of gas in Elk/Antelope to underpin a multi-train LNG facility but also potentially a rare cluster of gas and condensate rich onshore reefs clustered in close proximity to Antelope. In the context of the increased global LNG deficit and rising corresponding prices, such a discovery could not have occurred at a more fortuitous time.
At the end of 2009, InterOil's first independent resource appraisal was completed by GLJ Petroleum Consultants, whose clients include CNOOC (CEO), KOGAS, Suncor (SU), Talisman (TLM), and ConocoPhillips (COP). David Harris, who has 30 years of relevant experience and was described to me by a former colleague of his to be one of the most conservative resource appraisers in the industry, led the team at GLJ in their analysis of InterOil's reservoir. And, let's not forget, Petromin and the PNG government wanted a second opinion on the resource from one of the top global reservoir engineering firms in the world, Gaffney Kline, who is known for their diligent and conservative approach. InterOil is not allowed to disclose the report as it was not conducted under Canadian Resource Reporting Standard NI51-101 and they are only allowed to have one qualified resource evaluator (a rule enforced to deter cherry-picking from multiple resource reports). The report was provided to Petromin and the DPE under confidentiality, but nonetheless appeared on the internet shortly thereafter with the intention of discrediting InterOil as the resource estimate, as expected, was slightly lower. The effort to discredit InterOil failed and actually turned out to be a positive for the company as Gaffney Kline's conclusion, despite a more conservative view, is that there is more than sufficient recoverable gas for InterOil's proposed LNG project. That alone should shatter any recent and continuing arguments questioning the recoverable resource, a common theme in the short thesis.
InterOil's success clearly had a profound impact on Shell's plans in PNG, as Shell moved into an office in the Petromin Haus (Petromin is the PNG state petroleum entity) early this year and has reportedly been trying to muscle in on InterOil's project. Irrespective of whether these ominous allegations are true, Shell had clearly managed to emerge as Petromin and the DPE's favored operator and owner of InterOil's Gulf assets.
Following a chaotic year in PNG politics, however, Prime Minister O'Neill recently was reelected and formed the strongest coalition government in the country's history. PM O'Neill has been a strong advocate of integrity, morals, and the proliferation of resource monetization to support education and health, and he recently issued a powerful statement backing InterOil and insisting that the DPE work with the company to push the Gulf Project forward. Energy Minister William Duma has taken a much more benign stance towards InterOil following the elections, and after recognizing the company's efforts to comply with all of his demands pertaining to the project, he suspended a project cancellation notice that was served to InterOil three months ago. This is the most tangible evidence thus far of Mr. Duma's increasingly positive stance towards InterOil and his desire to help the company succeed in moving the project ahead. Mr. Duma also recently indicated that the choice of a major operator is InterOil's to make and that Shell is just one option for the company to consider in its commercial decision. With the integrity of PNG politics having clearly prevailed, Shell is running out of options to cheaply secure what may emerge as one of the most prolific series of onshore natural gas prospects ever discovered.
Shell's recent tactic to publicly express interest in InterOil's assets and subsequently blame InterOil for failing to facilitate access to its data room seems like a futile effort to make InterOil seem culpable of obstructing the process in order to keep Shell's dream to muscle in on the company's assets alive. With PNG's National Executive Council resuming its meeting schedule this week, final project approval for InterOil is likely imminent. With Shell running out of options, it may finally be forced to pursue a hostile bid for InterOil. The recent shuffle of InterOil's Board of Directors with the replacement of Phil Mulacek for Gaylen Byker may signal an increased willingness to consider any options that are accretive to shareholder value, so a Shell bid for the entire company at a high enough price could potentially be accepted. The value of InterOil, however, is so much greater than its current market capitalization that the premium would likely have to be very significant.
Shell recently engaged in a bidding war for Cove Energy, an East Africa focused independent E&P company with an 8.5% interest in Area-1 offshore Mozambique. After a prolonged competition with PTT that drove the price of Cove to parabolic new heights, however, Shell dropped out of the race. Cove owns interests in several concessions across Kenya, Tanzania, and Mozambique, and the company's valuation soared subsequent to a sufficient concentration of gas having been discovered in offshore Mozambique to underpin a world class 10 mtpa LNG project. The latest resource estimates for the Rovuma Basin Area 1 in which Cove has an 8.5% stake is 17 to 30+ Tcf of recoverable gas. At the midpoint, this implies that the £1.22 billion price tag agreed to by PTT equates to ~$0.96 per mcf. Although there are many similarities between Cove's offshore gas resources and InterOil's onshore gas and condensate resources in Elk/Antelope, there are also many differences that imply a significantly higher value for InterOil's resource.
According to Cove's most recent presentation, its total breakeven price equates to $5.80 per mcf including upstream and LNG plant costs. Based on its low cost finding and development costs and moderate infrastructure requirements, Liquid Niugini's FOB breakeven price is projected to be only $0.70 per mcf. Also, FID for the Rovuma Basin Area 1 Project is not anticipated until q4 2013 and first gas sales for Cove are targeted for 2018 while Liquid Niugini's first gas sales are targeted for late 2015/early 2016. Accounting for just the timing and cost differentials on a 10 mtpa liquifaction project, InterOil's resources would be worth in excess of 70% more than those of Cove assuming a 20 year project duration and a 15% discount rate.
There are many other differences, however, that would argue for the application of a higher discount rate to Cove's project relative to that of InterOil. InterOil has already attained its project agreement, the company has three confirmatory independent competent person reports (CPR) that certify its resources discovered to date, and it is likely only days or weeks away from being granted final project approval with the new pro-business and powerful administration that has taken the helm in PNG following the recently concluded elections. Cove is arguably in a much more precarious position than InterOil given that its FID is not slated until q4 2013 and the following necessary requirements to attain FID are still works in progress: certification of gas reserves, negotiation of market capture and arrangement of project finance, front end engineering and design work, site selection and acquisition and environmental and development permitting. Assuming a 10% discount rate differential between the two projects to account for their varying stages and the disproportionate number of obstacles ahead for Cove, InterOil's resources would be worth approximately 200% more per mcf than those of Cove, or approximately $3 per mcf (almost precisely what Pacific Rubiales agreed to pay to buy into InterOil's Triceratops reservoir upon a resource being defined). At $3 per mcf, InterOil's stock would be worth >$300 per share only accounting for its Elk/Antelope structure. With some assistance from several very credible petroleum engineers with whom I speak regularly, I intend to write an analysis of why the Triceratops reservoir could be significantly bigger and more valuable than Elk/Antelope, but that analysis is beyond the scope of this article.
Shell generated $12.6 billion of free cash flow in the first half of 2012, and it is hungry for acquisitions following the loss of Cove to PTT. As a Bloomberg article published early this month indicated, "Chief Executive Officer Peter Voser has signaled he's on the hunt for purchases, noting Shell sold $6 billion more in assets than it bought over the past 18 months. Shell's balance-sheet strength may embolden the company to go beyond the $5 billion peak it's spent on an acquisition, becoming more like rivals such as Exxon Mobil Corp. (XOM), which spent $35 billion buying XTO Energy Inc. in 2010." Shell likely understands that submitting a hostile bid for InterOil will result in a bidding war comprising many interested majors including Exxon. Exxon could divert InterOil's low cost gas to its PNG LNG liquefaction facility and expand to trains 3 and 4. It is common industry knowledge that the expansion projects generate higher returns due to the benefit of the infrastructure costs borne by the first two trains.
Shell's options have dwindled, and the company's tactics have become more transparent which should give InterOil bulls more confidence that the likely next move for Shell is a takeover attempt of InterOil. It may come sooner than we expect as InterOil is about to be revalued following formal project approval and a transformational deal with a strategic partner leaving Shell in the dust once again.
Disclosure: I am long IOC.