The P'nyang Paradox And Why Exxon Needs InterOil's Gas

| About: InterOil Corporation (IOC)

The PNG LNG project is a $19 billion Exxon Mobil (NYSE:XOM) operated 6.9 million ton per annum (mtpa) natural gas liquefaction project in Papua New Guinea (NYSE:PNG). Exxon and Oil Search, the largest independent oil and gas producer in PNG, own 33.2% and 29% of the project respectively. Oil Search recently reported that the PNG LNG project was over 80% complete and on track for first LNG sales in 2014. The project's LNG storage tanks and jetty can accommodate additional capacity, and the LNG precinct has adequate room for a total of eight LNG trains. Hence, with an economically viable gas resource to underpin PNG LNG's expansion, the marginal returns associated with adding new trains should exceed the project's already world leading economics, as most of the fixed infrastructure has already been constructed.

In its presentation at the Goldman Sachs Australasian Investment Forum in March 2013, Oil Search acknowledged that "expansion of PNG LNG is [the] highest value opportunity in [its] portfolio". ExxonMobil senior vice-president Mark Albers said at its recent analyst meeting that the company aimed to add to its resource base and that there was plenty of room on the LNG facility to add a "third, fourth and fifth train".

Exxon and Oil Search have recently conveyed that their P'nyang gas field, which lies 90 kilometers northwest of the Juha gas fields in PNG's highlands, may be large enough to underpin PNG LNG's third train. Evidence suggests, however, that P'nyang may not be an economically viable solution for the project's expansion, implying a need for Exxon to acquire a stake in InterOil's (NYSE:IOC) PRL 15 in order to ensure an adequate concentration of gas to supply PNG LNG's additional trains.

The initial P'nyang South-1 well successfully intersected a 184 meter gross gas column across the Toro, Digimu and P'nyang sands. The well was subsequently plugged back to a shallower depth and a side track was drilled downdip to identify the gas water contact in the well. The P'nyang South-1 sidetrack intersected the gas water contact and increased the vertical gas column by 200 meters to approximately 380 meters. Seismic data suggests further up-dip potential in the field, which if validated, could increase the total vertical gas column to over 650 meters.

Though the P'nyang South-1 sidetrack succeeded in significantly deepening the lowest known gas in the field, the aggregate resource accumulation in the structure will depend on its size and shape and on the variability of reservoir thickness across the field. Oil Search estimates total 2C gas resources in P'nyang of 2.5 - 3.0 Tcf, which it claims are sufficient to "underpin potential LNG expansion". Peculiarly, however, the Exxon-led PRL 3 joint venture has decided not to drill additional wells this year in P'nyang and instead to conduct a seismic program to assist in determining the location of any future wells. According to Oil Search's 2012 annual report, the joint venture will also "complete initial P'nyang design studies and, if viable, decide whether to commence FEED and marketing activities". If Exxon and Oil Search consider the expansion of PNG LNG's capacity a top priority and if they were truly confident of P'nyang's multi-Tcf size and economic viability in supplying an additional train based on the drilling results and seismic interpretation from the data acquired in 2011, why have they decided to refrain from drilling additional wells in the field pending further analysis?

Approximately 4 Tcf of gas is required to supply an additional LNG train for 20 years, so even if further delineation confirms Oil Search's 2.5 - 3 Tcf target size for P'nyang, the field would be inadequate by itself to underpin the proposed expansion at PNG LNG. P'nyang is far away from the other PNG LNG gas fields, and a 90 kilometer pipeline built to between P'nyang and Juha, which is part of the current PNG LNG development, would have to traverse very remote and rugged territory. Consequently, industry experts with whom I've spoken estimate that the development of P'nyang would add $1.5 -$2 billion to the cost of PNG LNG's train 3, taking the total budget for an additional train from $3.5 billion to $5 - $5.5 billion. Assuming 2.5 Tcf of gas is ultimately discovered in the P'nyang field, it would only supply an additional PNG LNG train for 12 years. Hence the PRL 3 joint venture's decision to refrain from drilling additional wells at P'nyang may be indicative of significant risk that the reservoir thickness will be inadequate to justify the cost of building additional infrastructure to supply PNG LNG's train 3.

It is therefore not surprising that with InterOil's 10.3 Tcfe of natural gas and condensate resources discovered in PNG's Gulf region, Platts recently reported that "there are obvious synergies for ExxonMobil in securing a stake in InterOil's gas resources as the US major is currently constructing the $19 billion PNG LNG project near Port Moresby". In fact, Platts reported that "the interested parties are understood to be ExxonMobil, Shell (NYSE:RDS.A) and France's Total (NYSE:TOT)" in InterOil's sell-down of its Elk/Antelope field.

The greatest synergies for expanded capacity at PNG LNG would be derived from a large concentrated gas resource that could underpin multiple trains. The PNG LNG pipeline from the highlands cannot accommodate gas for more than three trains, but the aggregation of resources in InterOil's Gulf acreage from its Antelope reef, its prospective Triceratops reef, and its extensive pipeline of additional reefal targets could easily justify the cost of building a brand new 250 mile pipeline between InterOil's Elk/Antelope field and the PNG LNG facility in Port Moresby. If the proposed pipeline were to connect directly to PNG LNG's offshore pipeline, it would span less than 100 miles to transport gas from Elk/Antelope to Exxon's facility. I estimate that at a cost of $4 million per pipe mile across relatively flat terrain, the capex required to transport gas from Elk/Antelope directly to PNG LNG would be $1 billion. Based on discussions with industry experts, the cost of additional trains at an existing liquefaction facility is estimated to be approximately $1,000 per ton per annum. If gas from Elk/Antelope or Triceratops were to underpin two additional trains at PNG LNG, the incremental estimated capex required to double the project's capacity would only be 42% of the capex that Exxon and its partners are spending for the facility's first two trains. Hence, Exxon has a significant incentive to buy into InterOil's resources in order to benefit from the economies of scale associated with its world class project, the construction of which is almost complete. Exxon's only other viable alternative is to hope for future exploration success in PNG, but there haven't been any significant discoveries outside of InterOil's acreage in recent years.

The synergies and consequently the extremely high returns on invested capital of channeling InterOil's gas to Exxon's PNG LNG project have very positive implications for the value and commerciality of InterOil's resources. With significant uncertainty around the size and economic viability of P'nyang, Exxon has a tremendous incentive to acquire some or all of InterOil's PRL 15 and PPL 237 to virtually ensure adequate gas supplies for its PNG LNG expansion. Between InterOil's 3.9 million exploration acres surrounding multiple confirmed reefs, its already defined concentrated resource of over 10 Tcfe at Elk/Antelope and Triceratops, seismic interpretations indicating additional reefal clustering, and what Pacific Rubiales' SVP of Exploration Jairo Lugo recently characterized as "in excess of 5 to 10 Tcf [for] every single opportunity", Exxon could be jeopardizing a transformational opportunity if it loses to another supermajor in trying to acquire a stake in InterOil's assets.

InterOil's stock is implying a valuation of under $0.65 per mcf of 2C resources, and I estimate that Exxon can generate an extraordinary return on its investment even if it pays several dollars per mcf for InterOil's PRL 15 at a conservative LNG pricing slope. With the PNG LNG project 80% complete and InterOil's recent Antelope-3 well having confirmed the reservoir continuity and size of its primary reef, the value proposition for Exxon of acquiring InterOil or a stake in its PRL has never been more clear.

Disclosure: I am long IOC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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