Deal Time for InterOil

by: Shareholders Unite

InterOil's (NYSE:IOC) Elk/Antelope resource has 8.2 Tcf of natural gas and 156 MMBbls of condensates. Is that enough for the resource to be developed? We're sifting through the evidence ...

Such a judgment is based on answering the following four questions:

  1. Is Elk/Antelope an economic resource?
  2. Is there enough future demand for LNG?
  3. Are there enough interested deep-pocketed third parties?
  4. Are there concrete signs of interest from such third parties?

Is Elk/Antelope an economic resource?

  • The latest independent resource appraisal argues there is 8.2 Tcf of gas and 156.5 million barrels of condensates. While this is an ongoing process, this should in principle be enough for a two train LNG plant, and at the minimum enough for the initial liquids stripping unit (which has 9700 barrels per day of capacity).
  • If one compares total project cost, the indications are strong that InterOil once again is the lowest cost project. Its LNG plant is budgeted at $5-7 billion, while other projects in the region are at least double that. Exxon (NYSE:XOM)/OilSearch is budgeted at $15 billion. Some of the Australian projects have an even higher projected cost (Gorgon is budgeted at $50 billion). These costly estimates are not surprising. Australia is a high cost location compared to PNG, and the gas resources are either coal seam gas (where wells don't flow and thousands have to be drilled, treated and manned to supply sufficient gas to feed an LNG plant), or expensive offshore projects like Gorgon.
  • InterOil holds further advantages in that it has a single resource in the lowlands as opposed to six scattered resources in the highlands, which total almost three times the distance of OilSearch's proposed LNG plant. They also have to construct more pipeline and in much more difficult terrain.
  • InterOil also has considerable infrastructure already in place. According to Wayne Andrews:

We have very high productivity wells. We’ve got the land ready to go to build the LNG plant. We own, we have a 99-year lease on the former Australian Naval Base in Papua New Guinea because so have no landowner rights issues, nothing that’s stopping us. We have a jetty system there. We own the harbor rights. We’ve got a deep-water forest. We’re taking tankers now to bring crude oil into our refinery. All that’s ready to go with low cost gas.

  • So since these locational and infrastructural advantages result in the project being basically half the cost of its rival project, led by Exxon/OilSearch, InterOil has a lot of leeway in terms of the number of wells needed. However, it very much looks like InterOil's wells are more productive, attributing it with a additional advantage.
  • Wayne Andrews, former analyst at Raymond James and now at InterOil, argued in a taped interview that InterOil's wells are three times less expensive and 20 times more productive compared to OilSearch's wells.
  • One has to realize the size of these wells, with not only the record flow rates being greatly different (382 MMcf/d and 705 MMcf/d for Antelope 1&2 respectively, compared to the Elk wellss already established flow rates of 102 and 105 MMcf/d), but also the sheer size of the payzone in the Antelope wells (see p.15 of the latest Investor Presentation), which have 2277ft and 1175ft of net payzones and average porosities of 8.8% and 14% respectively.
  • Despite all indications to the contrary, there could still be a theoretical possibility that the Elk/Antelope resource is not economical. If the resource is too compartmentalized it would lead to the wells depleting too fast and too many would have to be drilled as a result. There are several ways to look at this.
  • One way is to compare it with other Australian coal-seam projects (as we've done here). Coal-seam gas doesn't flow at all, it has to be made to flow, and the wells flow at such low flow rates (typically less than 1MMcf/d) and deplete very rapidly. Thus, thousands of wells have to be drilled, treated, and manned to supply an LNG facility. Yet there are many of these projects under construction or planned at the moment in Australia, which has a much higher cost location.
  • If coal-seam projects can be profitable supplying a (two-train) facility with 5000 wells over the lifetime of the LNG facility (the Conoco (NYSE:COP) / Origin (OTCPK:OGFGF) project needs 20,500 wells for four trains) and even assuming InterOil's wells would be ten times more expensive, Elk/Antelope would still be economical if it needed 500 wells. And as we have set out in this article, these assumptions are already quite generous.
  • InterOil holds several advantages over these coal-seam gas projects. It's gas is much cleaner (5-6% CO2, see p.25 here), doesn't have to treat the wells to make them flow (expensive and not environmentally risk free), it doesn't have to hook up so many wells at the same time as they are way more productive (leading to high infrastructure and manning cost), it produces very profitable condensates as a by-product, and it operates in a low cost environment, etc.
  • Another way of looking at this is that drilling 500 wells could amount to perhaps $10 billion in drilling cost, which would put the total budget for exploiting the resource at a par or slightly above of the Exxon/OilSearch project (which took the final investment decision in December last year).
  • We think the drilling cost of $20 million per well is rather onerous, as most of the present drilling costs are highly inflated due to (waiting for) extensive third party testing and meandering around at the bottom of wells ,which wouldn't be needed for production wells. InterOil also recently bought a more efficient rig.
  • The 500 wells would have to produce 8 Tcf over a 25 year period, that's 16 Bcf per well. Basically, these Antelope wells have to perform for less than a month. This is very unlikely considering the 1,000ft+ net pay-zones and average wells lasting 2-10 years. Not even the coal-seam wells peter out that fast.
  • If they cost $20 million to drill and produce that 16 Bcf, they would produce revenue of $160 million (providing a long-term off-take price of $10 per Mcf). Thus, we see that the drilling cost would still only amount to 8% of revenue, and that's not even taking into account profitable by-products like liquids (already embarking on FEED work for that), butane and propane.
  • We have seen no data at all which suggests that Elk/Antelope would be uneconomical, and multiple signs that Elk/Antelope is would be undisputedly profitable.
  • The quality of the rock (large stretches of dolomite reef), the size of the vertical pay-zones, and the world-record flow rates at the minimum suggest that this is a resource that is cheap to develop.
  • Further indication comes from Morgan Stanley, which calculated before Antelope2 the break-even prices for LNG projects in the region. IOC came out as the lowest, with $3.70 per Mcf, followed by Exxon/OilSearch with $5.05 per Mcf and the Australian projects with $6-8 per Mcf.
  • New Liquid Niugini CEO Aldorf has gone further than that after the very successful Antelope2 well, in stating the break-even price for InterOil is $2.25 per million BTU (roughly equal to 1Mcf), and citing a calculation from Wood Mackenzie showing the Exxon/OilSearch break-even price as $7.49 per million BTU.

Is there enough LNG demand?

Are there enough deep-pocketed third parties?

There are numerous deals in the region for more expensive projects, like:

Is there concrete interest from third parties?
There really is quite a bit of evidence of that:

  1. Part I including Petronet, CNOOC (NYSE:CEO), ENI (NYSE:E), PTT (OTCPK:PEXNY), and talks with 30 other interested parties.
  2. Part II including Petrochina (NYSE:PTR) and CNOOC, Petromin participation.
  3. Part III
  4. Part V
  5. Part VI
  6. Part VII
  7. Part VIII
  8. Ramond James email: 50 interested parties
  9. CNOOC deal with PNG government
  10. RJ interpretation

Apart from that, there is other evidence that work has already begun, not only by InterOil, but also by the provincial government:

  1. InterOil embarked on FEED
  2. InterOil ready to start
  3. InterOil MOU with Mitsui (OTCPK:MITSY)
  4. PNG province embarking on infrastructure investment for IOC's projects Feb2010
  5. PNG province part II Feb2010

Research firms take the LNG facility as a near certainty already. Morgan Stanley update on InterOil [Feb 16 2010 p.3]:

  • As such, rather than model an additional train or some type of FLNG off-take in our target price, we are de-risking the LNG partner risk in the asset today (to 90%). Meaning, we believe this higher resource in the Austral-Asian markets, increases the likelihood a deal is done and gets down in 1H2010. The higher resource estimate also lowers our implied price per mcfe in the sell-down process to $1.34 per mcfe vs. $1.75 for in-region, comparable transaction, where we see room to the upside.

Nataxis Bleichroeder went even further, in an update [Dec 1 2009], it arrived at a $98 target and said the following (p.1)

  • Complete De-Risking of LNG Business Marks Major Change in Valuation. Previous iterations of our IOC price target were at various risk levels of the company’s proposed LNG terminal materializing (50%, 65%, and a recent 75%). With the magnitude of natural gas and condensate tapped with the Antelope-2 well — which is about 2.5 miles from the Antelope-1 well — and the resulting likelihood of a growing attraction for the company and its assets to potential strategic partners, if not corporate buyers, we have now fully de-risked InterOil’s LNG facility, as reflected by the substantial increase in our previous $53 target price to $98 per IOC share.

Against that, the critics have come up with very little.

  1. They hired a geologist, Bertoni who argued (before Antelope2 was successfully drilled and tested) that it's too early to say and pressure depletion of the wells (as a result of resource compartmentalization) could be a risk. Bertoni didn't actually quantify this risk at all (apart from saying that it was 'non-zero'), but we've shown above (and here) that this is very unlikely to be anywhere near significant, and the Antelope2 results have further solidified the resource.
  2. Minkow's Fraud Discovery Institute (FDI) just took the Bertoni report as "evidence" that InterOil is a "Ponzi scheme" but we have shown that this is in no way substantiated by the facts. In reality, one has to make rather onerous assumptions to show that Elk/Antelope is not economical.
  3. And they go on to produce laughable stuff like this.
  4. How the FDI operates has been set out here.

So, all in all, while Nataxis Bleichroeder and Morgan Stanley give the LNG facility a 100% and 90% likelihood, we think that the present drilling-delay-related sell-off provides a nice buying opportunity.

Disclosure: Author long IOC

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