InterOil (IOC) has been among the most intriguing opportunities I have encountered since I first met Phil Mulacek while managing money for a large hedge fund in 2006. Subsequent to the Antelope reef discovery in 2009, I have spent hundreds of hours analyzing the company's reefal discoveries, consulted with prominent independent petroleum engineers (one of whom is a former colleague of GLJ's David Harris), and sent analysts to Papua New Guinea to consult with experienced PNG hands, government officials, and InterOil personnel.
It appears the E&P majors overlooked InterOil's extensive plot of acreage in the Eastern Papuan Basin that is rapidly emerging as one of the most prolific sources of low cost natural gas and condensates in the world. Last week, InterOil released a new upstream presentation, which demonstrates how the paleogeograpic model developed by the industry in the 1950s, which would have predicted deep water limestone, was invalidated by the shallow water reefal discoveries of the Antelope and Triceratops fields. Additionally, extensive new seismic data collection in the Basin proved out a chain of onshore shallow marine carbonate build ups that act as traps and reservoirs for hydrocarbons.
Over the past three years, InterOil's exploration success has been virtually unparalleled. The company's Elk and Antelope fields contain C2 resources of 8.59 Tcf of recoverable natural gas and 128.9 MMBbls of recoverable condensate despite only 5 wells having been drilled (GLJ Petroleum Consultants Ltd. reserve evaluation) and its recently drilled massive Triceratops reservoir has a seismic closure of about 125 square kilometers, approximately double that of Elk/Antelope (the structure is still open ended in two segments), and a vertical carbonate thickness in excess of 3,500 feet.
InterOil is close to consummating a deal to sell-down a significant stake in Elk/Antelope, a process for which it engaged three prominent investment banks over the past year. It has now been confirmed both by the company and several external sources that there is an exceedingly high level of interest to buy into the Gulf Project and that up to 6 separate bids have been received. According to InterOil CFO Collin Visaggio, at least two supermajors have submitted bids for an operating stake of the Gulf LNG project. It has also been independently confirmed that JKM, which comprises Korea Gas, Mitsui, and JAPEX has submitted a bid, and a Korean government official has confirmed Korea Gas' keen interest in participating in the upstream and downstream phases of the Gulf LNG Project.
With bids having been received and pervasive interest in InterOil's resource confirmed, the market is severely undervaluing the company's assets. InterOil's F&D and project costs are significantly less than those of virtually any other natural gas resource and LNG development operation in the world. Its upstream Elk/Antelope project will require less than 11 wells in aggregate to be drilled as a result of its prolific flow rates and required dry gas pipeline length of only ~120km. The company's expected operating expenditures for an 8 Mtpa liquefaction plant are expected to be only $0.38 per mcf, substantially lower than those of virtually any other LNG project in the world. Its anticipated capital expenditures are only $1.16 billion per Mtpa while those of Exxon's (XOM) PNG LNG Project, for example, are $2.272 billion per Mtpa.
The most relevant recent LNG transaction to the impending sell-down of Elk/Antelope 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 approximately 5X InterOil's current valuation, excluding Triceratops, its remaining exploration acreage, and its downstream assets. According to Bernstein and Woods Mackenzie, PNG LNG has an ~$8 per mcf breakeven FOB gas price to yield a 12% IRR. After thoroughly modeling Liquid Niugini's FOB costs, which contemplate an interest expense on debt funded CAPX that exceeds LIBOR by in excess of 600 bps, I very conservatively estimate a ~$3 per mcf breakeven FOB gas price is required for InterOil's project to yield a 12% IRR. Assuming similar LNG capacity figures for the two projects, InterOil's average startup year occurring four years later than that of PNG LNG (despite first gas from Liquid Niugini being produced as early as 2015), and a 10% discount rate, I model the value of InterOil's project to be 68% greater per mcf than that of PNG LNG. This equates to ~$5 per mcf based on what Marubeni paid for its stake in PNG LNG. Unfortunately, there is no precedent for an LNG sell-down as high as $5 per mcf (or >$500 per share), so the winning bidder(s) will undoubtedly purchase a stake at a bargain price and anomalously high IRR.
At the lower end of the recent sell-down spectrum, Shell (RDS.A) and PTT 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. 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 some 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. Accounting for the timing and cost differentials on a 10 mtpa liquifaction project, InterOil's resources would very conservatively be worth well in excess of 50% more than those of Cove on a per mcf basis. There are several 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 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. Also, Wood Mackenzie estimates a two-train, greenfield LNG development in the region will cost at least $25bn, multiples of InterOil's projected project cost. Assuming a 15% 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 over 100% more per mcf than those of Cove, or >$2 per mcf. Had Cove waited for resource certification to be completed in 2013, environmental impact approval, and a project agreement, its resource would have been substantially derisked and would likely have fetched a higher valuation.
These comparative analyses yield a valuation of well in excess of $200 per InterOil share just for its stake in Elk/Antelope. One of the reasons for which the significant discount in the market's valuation of InterOil relative to its NAV exists is the lack of sell-side coverage to assist investors in assessing the resource. Raymond James & Associates, the only sell-side firm actively publishing research on InterOil, indicated the following justification for its price target: "Our target price is $100, in line with the NAV. To restate an important point we have often made in the past: the resource value embedded within the NAV ($1.00/Mcf for the Elk/Antelope field's gas resource) is a largely hypothetical "guesstimate" that reflects the absence thus far of tangible market multiples for Elk/Antelope. Once the partnership and associated resource sell-down are announced, we will be able to "mark to market" our NAV accordingly." Hence rather than predicating its NAV on appropriate comparable transactions, Raymond James imputed a conservative and arbitrary per mcf value and openly set the stage for a significant positive revaluation upon the consummation of a deal. Also, the investment bank seems to ascribe no value to either the massive Triceratops structure, which could have more gas and significantly more condensate resources than Elk/Antelope, or to the company's remaining exploration acreage.
The final element of the deal process that must be completed before InterOil accepts the bid for its resource and consummates a deal with a world class LNG partner is National Executive Council (NEC) approval for its Gulf LNG Project. Subsequent to the elections two months ago there have been very few NEC meetings as a result of Prime Minister O'Neill's extensive travel schedule and several weeks required to swear in the elected ministers. The prime minister and other NEC members now seem to have settled in Port Moresby and the opposition's criticism of the PM's travel schedule will likely result in a more productive NEC in the coming days and weeks. InterOil recently conveyed that it expects project approval imminently, the Prime Minister has made it clear that expediting the Gulf Project is a top priority for the new administration, there seems to be complete alignment between InterOil's plan and its 2009 Project Agreement, and the Department of Petroleum & Energy has been very supportive of InterOil subsequent to the elections. Upon the NEC approval catalyst transpiring, the only remaining question of any significance in determining InterOil's stock price will be the value of the leading bid, which will undoubtedly value the company at a multi-billion dollar premium to its current market capitalization.
The recent Triceratops discovery accompanied by new gravity and seismic data confirms an extensive shallow marine carbonate trend onshore in the Eastern Papuan Basin, and just like the frenzy that has developed in the offshore gas fields in East Africa, the Basin is attracting the attention and capital of the majors. A takeover of InterOil has become a much more likely near-term outcome with the company's recent replacement of CEO Phil Mulacek with Gaylen Byker as the Chairman of the Board of Directors. According to a recent article in PNG Industry News, "The CFO said the shortlisted parties were not legally prevented from making a friendly bid for InterOil. Visaggio also indicated what would happen if a supermajor outside of the Gulf LNG bidding process made a hostile takeover attempt for InterOil. "If it's someone who is not involved in the process we can release the existing shortlisted bidders to make a bid should they wish - that's the white knight story." Such a move would surge InterOil's share price upwards and could thwart a hostile takeover." With InterOil shareholders becoming increasingly frustrated with the delayed timeline in concluding a sell-down and reaching FID, this would be an opportune time for a major to bid for the company and secure a carbonate trend that could support an steep growth trajectory of LNG supply to Asia over the course of decades to come.