It depends how soon you need your money, and it depends on your view on the world economy. Sooner or later, more normal conditions will return. Some observations on the sell-off in InterOil (IOC).
We start with an apology. People lost real money these days and we don’t feel comfortable with that. However, we firmly believe that everything we have said about InterOil the last couple of months (and quite a few things we didn’t say), is true and continues to be true.
Now, some observations.
Is the sell-off specific for InterOil?
- No, we don’t think so. Not business wise. It’s down comparable to similar companies, we re-published an article that appeared in the WSJ over the weekend here. It shows that relatively small exploration companies, especially those dependent on external financing were down 50% on average, and this was before today (even half an hour seems to be able to make a big difference, these days)
- Having said that, InterOil has a specific situation in the form of it’s large short (and naked short) count. We’re sure they cannot believe their luck. After two big gas finds, a gas shortage in Asia (witness the premium prices), the turn-around in the refinery and the imminent spudding of Antelope1, not to mention a third party report coming out by the end of the month and deals in the making to finance the LNG facility, they were running rapidly out of time and options. And for a while, it looked like the SEC was going to throw some sand in their wheels, frustrating their rampant illegal practices of naked shorting (this might still happen, as it’s mostly a question of enforcement, by the way).
- That was then, this is now. The shorts have been handed a very timely gift through an unprecedented bad market. But even they have a limited time frame to profit from this, and what’s more, the closer we will get to the end of that time frame and the lower the stock price, the bigger the incentives to cover.
- But that’s only true if InterOil’s business model is not affected by what is going on. This is therefore, in our view, the most important question.
Is InterOil’s business model affected by what is going on?
- We do not believe so, but the fall in the stock price hasn’t strengthened IOC’s hand. A simple truth is that you negotiate better when you have alternatives, and these alternatives (issuing new shares) are becoming less attractive as we speak.
- However, Asia is not nearly as affected by the global crisis as the US or Europe.
- Indonesia, the biggest gas exporter in the regio, isn’t suddenly going to flood the market with LNG
- Asian (probably Japanese and Korean) utilities trying to secure long-term gas supplies are little affected by the credit crisis, and their gas needs are not diminished.
- Apart from Asian utilities, the other kind of party which InterOil is likely to do a deal with is an Oil major. These have two characteristics, apart from not being affected by the credit crisis. They are awash with cash, but short on new drilling prospects and ways to increase their reserves. The situation of InterOil is almost exactly the opposite, so matching up to an oil major is very natural. That logic still holds as strongly as a week or a couple of months ago. All signs are that Antelope is massive. The gas pressure even in a periferal spot is at record highs.
What if energy prices retreat further?
- This is another risk. However, we think demand for LNG will remain strong. This is reflected in the fact that It’s growing at a much higher rate compared to oil (7-10% per year, versus a couple of percent for oil). LNG demand is set to double between now and 2015. Slowly but surely, clean energy will drive out dirtier energy. The question is, can supply keep up with that?
- In fact, it is not unlikely that lower energy prices, combined with tighter credit will push marginal projects over the edge. We don’t believe InterOil is such a marginal project, just because the gas flows so profusely, making it cheap compared to other proposed projects.
- Compare it to coal seam gas from Australia, one of it’s closest competitors. We have explained that coal seam gas from Australia is much more expensive to produce compared to the gas from Elk/Antelope (tens of thousands of wells have to be drilled, treated, and manned). Some of these projects might very well become uneconomical in the short-run if energy prices continue to go down.
- Rather than a bad thing, this will be a good thing for InterOil. InterOil, we cannot stress that enough, is planning LNG sales way into the future (2013-14). If less LNG projects come online by that time because of falling energy prices and tighter credit now, it tightens supply.
- Just because we are talking about the future, it is very unlikely that the Asian utilities with which they are negotiating are not taking a long-term view. Unless people expect a world recession lasting that long, the world economy will be up and running again, with energy supplies, especially clean energy like gas, will be once again in short supply, even more so if investing in new capacity has been impaired by the recession in 2008-9.
- So, the upshot is, if tighter credit and lower energy prices today push marginal projects over the edge less supply becomes available in the future and that will set us up for an even worse energy crisis once the world economy recovers.
- That is the long-term view that matters. The question is, can the relevant parties involved in the InterOil dealmaking afford such a long-term view. We just tried to explain that in our view, they can.
What will happen next?
- As we just argued, business wise, we don’t think InterOil is worse of than a couple of weeks ago in a material way. It’s negotiating position might have taken a little hit, but the parties it is likely to negotiate have the means to afford to take the required long-term view.
- The shorts, legally or illegally, might drive the price down further, helped by a primal fear and redemptions and forced liquidations in the markets. However, if we are right in our assessment that InterOil’s business model has been little affected by this all, then the things that are supposed to happen will, in all likelyhood, happen. These are:
- The spudding of Antelope1
- A third party report taking away uncertainty as to the viability of InterOil’s gas property
- Conclusions of negotiations with parties interested in securing long-term LNG supplies.
And also this:
- Antelope1 will, unlike the periferal Elk4, drill right into the center of Antelope, at least as it manifests itself on seismic studies. At 1500 meters, the pay zone starts. That can be reached in 6-8 weeks and since we believe spudding of the well is imminent, that opens the following scenario in two months or so:
- Having already been vetted by a couple of Tcf’s by the third party report, what will happen if they experience the first gas kick in Antelope1 just after entering the pay zone.. That will remove any residual uncertainty as to whether there is enough gas to support an LNG facility (if the third party report hasn’t convincingly done that already). We don’t think they even have to measure the gas pressures anymore if that happens, because it will show Antelope is big.
- And this gas will be way cheaper to get out compared to virtually all other gas projects under construction in the regio. Once any residual uncertainty on the question whether there is enough gas to support an LNG facility has been answered, that will be enough to get funding for it.
With share prices gyrating tens of percentages within hours, two months or so may be a long time, and fear reigns supreme in the meantime. But if you can hold on that long we still think it will be worth it.
Disclosure: Author holds a long position in IOC