Is Shell Trying To Muscle Into InterOil's LNG Project?

Includes: IOC, RDS.A
by: Shareholders Unite

Royal Dutch Shell (NYSE:RDS.A) is making a backhanded attempt to shake InterOil (NYSE:IOC) loose of its $100B Elk/Antelope resource, or at the minimum, become its LNG operator, according to The Sunday Chronicle, a newspaper in Papua New Guinea (PNG).

InterOil is an integrated oil and gas exploration company operating on PNG. It operates a refinery and has found a substantial gas and condensate resource, Elk/Antelope. This contains 8.57Tcf of gas and 129Mmbls of condensate, according to third-party engineering bureau GLJ, which has vetted the resource three years running.

The Elk/Antelope resource is also very prolific (especially the larger Antelope part). Consider the following details of the two Antelope wells:

  • 382MMcf/d and 705MMcf/d flow rates
  • 2277ft and 1175ft of net payzone
  • 8.8% and 14% average porosity

By any means, these are monster wells. The field can be completely developed by 6-10 wells. InterOil argues that it can provide two planned LNG plants (one 3mtpa build by EWC, the other a 2mtpa floating LNG plant build by Flex of Norway and Samsung) from the four existing wells (apart from the two Antelope wells, there are two Elk wells).

With demand skyrocketing and prices for LNG in Asia in the $15 per Mcf area, this is a $100B+ resource. We're not even counting the condensates or any of the other 56 prospects with 14 possible reefs identified (a reef is the type of porous and permeable resource that makes Antelope flow so profusely).

One of these prospects, Triceratops, is the next one to be drilled (before year's end); gas is known to be there, and a large reef was identified on seismics. If that pans out, it could be as large as Antelope.

Needless to say, this is a big prize by any means. Big prices attract big investors, but also something else:
After an earlier attempt to hold InterOil in breach of its December 2009 agreement with the PNG government (which was shot down by PM O'Neill), energy Minister Duma was at it again. This time it sounded even more scary, and no doubt the headlines in the international press resulted in a sell-off during the day.

It turns out this National Executive Committee meeting happened on Wednesday, September 21, which explains the rather large sell-off in the shares the next day, although most energy explorers had a rough day that day.

However, on closer inspection, there is considerably more to this story than meets the eye. Much more detail was available in an article in the The Sunday Chronicle dated Sept. 25. We'll give you the first bit:

Meetings are to be scheduled over the next seven days to avert sending out a potentially damaging sovereign risk signal to the foreign investment community. the move will also distance the government from the stigma of a potentially corrupt inducement money totaling $US100 million promised by a multi-national company to shaft the second LNG developer.

The second LNG developer is Liquid Niugini Gas Limited, a joint venture entity jointly owned by Interoil and its partner Pacific LNG Limited.

The $US100 million offer is payable after dilution of Interoil's project equity, cancellations of Interoil's project agreement with the State signed in December, 2009 and the company's present PRL-15 over Elk/Antelope and dispossession of its exploration acres in Gulf Province.

The offer was made in writing April 21 this year by Shell Exploration Company BV to investment bankers - Lazard Freres based in Paris and to New York based Ambata Capital Partners - who were appointed by Petromin PNG Holdings Limited to act for them. Petromin is the custodial nominee company appointed by the State's 20.5 per cent equity in the second Lng Project.

This is pretty serious stuff. We have no way of knowing whether the facts in this newspaper article are true, but at least it has the merit of offering an explanation of a rather spectacular 180 degree change in position of Energy Minister William Duma. Here's what Duma said last Tuesday about InterOil's plans to partner with EWC of Hong Kong building a modular LNG plant, with Mitsui building a condensate stripping plant and with Flex/Samsung building a floating LNG plant (FLNG). And this is what he said last February.

It really is hard to explain such a spectacular about-face. Apparently, what he said Tuesday is in reaction to the revelations by The Sunday Chronicle, exposing him, state-owned and supposed InterOil partner Petromin, and Shell in a triumvirate to muscle Shell in as operator and loosen InterOil's grip on its assets.

If Duma was feeling exposed by that Sunday Chronicle article, one can perhaps understand his strong reaction; this could very well be a person fighting for his political life and/or reputation. Duma has one point though: Indeed, InterOil changed strategy. The original plan proposed a traditional LNG plant build at site next to InterOil's refinery at Napa Napa (with the CSP in the much closer to the resource Gulf province). However, building a traditional LNG plant takes a long time, and the gas would have had to be re-injected into the resource, a costly operation.

Partly because of that, InterOil changed track and went with modular LNG and FLNG (Flex/Samsung), all to be located in the Gulf province (cutting necessary pipelines by two-thirds in the process).

InterOil also got much better deals, as the modular and FLNG are to be build and financed by EWC and Flex. InterOil will not have to put up any up-front capital (apart from infrastructure), paying both companies 14.5% royalties out of LNG proceeds.

Everything seemed well and truly on track with a 1mtpa offtake deal (long-term LNG supply contract) with Noble Energy to reach final investment decisions by the end of the year and start-up of the projects in 2014. InterOil's board even authorized spending $100M for ordering long lead-time stuff like pipelines to make sure production starts in 2014.

Now, despite warm endorsement of these plans in February, all of a sudden the same energy minister, William Duma, is dead set against these plans and wants Shell to be the operator of a traditional LNG plant, according to the original plans.

Does Papua New Guinea stands to gain from this?

Notice the start-up date of 2018 of a Shell-operated LNG plant mentioned in The Sunday Chronicle. That's a four year delay, four years without revenues for PNG of one of the biggest projects on the territory. And we know that big LNG plants build at sight (logistical nightmares under the best circumstances) have a tendency of cost overruns and delays. Just ask Exxon/OilSearch (rival project at PNG) or any of the Australian projects under construction. PNG does not stand to gain from delays -- quite the contrary.

Needless to say there are bound to be a host of legal issues. InterOil claims the new plans are within the parameters of the old agreement with the PNG government. Shell's role could very well be in breach of laws. PNG state company Petromin, as well as Energy Minister Duma, might have legal issues. Not good. PNG's reputation as a friendly foreign direct investment destination could very well take a serious hit. That's not good either.

Would PNG be better off negotiating with Shell rather than InterOil? We doubt that very much. So the conclusion can only be that this isn't in the interest of PNG, although it could very well be in the interest of certain PNG politicians, or even companies, like Petromin. It certainly is in the interest of Shell, which might have a lot to answer for.

Where is this going?

Keep in mind that recently (as earlier reported), PNG Prime Minister Peter O'Neill has issued unequivocal support for InterOil's project and has spoken out, in no uncertain terms, against political and/or bureaucratic meddling in business as recently as September 9. Although not impossible, but it's nevertheless difficult to see him climbing down from such strong positions taken up only weeks ago.

At the time of writing, it's not even sure whether O'Neill was, in fact, present at that National Executive Council (NEC) meeting that concluded in slamming the InterOil project. He could very well have already been in New York for the UN meetings.

As analysts from Raymond James and Morgan Stanley argued, it's difficult to see a scenario in which InterOil is being expropriated. PNG is not Venezuela or Cuba. The worst case according, to them, is that InterOil will be forced to take Shell on board, and since the resource is significantly undervalued at 40 cents per Mcf, a deal with Shell could even give a boost to the stock price. They reissued their guidance, with $135 (NYSE:MS) and $80 (RJ) price targets.

We doubt whether it will come to even that. Now that it is out in the open, the story in The Sunday Chronicle is actually very damaging for Shell, Petromin and Duma alike. Shell might very well have a case to answer in the Netherlands over this. Despite numerous efforts, it's really difficult to portray this as if it is in PNG's best interest, and for Duma it's completely inconsistent with what he said only half a year ago.

Indeed, part of the strength of Duma's response was because it was in reaction to these allegations exposing him as scheming on behalf of Shell. Raymond James argued that he has issued press releases refuting portions of the article (although he didn't deny discussions with Shell) and InterOil has been contacted by other members of the PNG government claiming they're not on board with Duma's comments.

One thing does stand out, though: Shell's willingness to go to these considerable lengths points to the fact that InterOil is a big prize indeed.

Disclosure: I am long IOC.