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InterOil (IOC): A Crystal Clear Opportunity

|Includes: InterOil Corporation (IOC)

Although I’m typically averse to disseminating my thoughts on stock ideas, the misevaluation of InterOil has become so egregious that I felt impelled to make an exception.  InterOil has discovered in excess of 8 tcf of certified 2c conventional natural gas resources after having only drilled 5 wells in a massive structure with exceedingly high pressure, porosity, and permeability that facilitates world record flow rates and the lowest cost production in several decades at under $0.018 per mcf.  GLJ Petroleum Consultants Ltd., which also evaluates and certifies major energy companies such as Suncor’s resources (http://www.suncor.com/pdf/ic-AnnualInformationform2009-e.pdf - see pg. 29), has certified Interoil’s resources, which will only appreciate as the next two Antelope wells are drilled.   There’s a very misleading and ominous argument being put forth by uninformed skeptics that the company does not have any proven reserves and hence it’s overvalued.  As per world-pertoleum.org “reserves are defined as those quantities of petroleum which are anticipated to be commercially recovered from known accumulations from a given date forward” while “contingent resources are those quantities of petroleum which are estimated, on a given date, to be potentially recoverable from known accumulations, but which are not currently considered to be commercially recoverable”.  The lack of commercial recoverability of InterOil’s natural gas revolves not around its structures’ productivity, but simply around the timing of a deal in place to build a proposed liquefaction terminal that will enable it to convert its gas into LNG and ship it overseas to markets that are dependant upon gas imports.  The major obstacles towards achieving this goal have now been overcome, however, as certified resources finally comfortably exceed the threshold necessary to underpin a 2 train liquefaction facility and the government of PNG has signed InterOil’s LNG project agreement.  For illustrative purposes, Marathon started its Equitorial Guinea project with 1.5 tcf and the massive ~$10 billion Pluto liquefaction project was initiated with only ~5 tcf of starting reserves.  So the question is whether the company will now be able to sign a deal to commercialize its resources, and the answer seems to be unequivocally affirmative. 
 
PNG is a stable parliamentary democracy with a very benign fiscal policy that has drawn billions of dollars of investments from major resource companies such as Exxon, Oil Search, Santos, and Barrick Gold.  Talisman, a nearly $20 billion independent energy company, recently purchased Rift Oil Plc., joint ventured with Horizon, and has indicated an intent to accumulate exploration permits in PNG and pursue a drilling program that will enable it to accumulate enough resources to underpin a liquefaction facility.  The interest in investing significant investment capital in PNG is only increasing, as major resource companies recognize the unexploited potential in such a resource rich and politically stable country.  Although the bears often cite isolated incidences of corruption in the country, these occurrences happen throughout the world, but the overall trend is towards attracting more foreign direct investment and improving the lives of the country’s citizens.  Here’s a very recent example related to Exxon’s venture that confirms this argument - http://www.postcourier.com.pg/20100305/frhome.htm.  Also, InterOil’s project plan should be relatively simple to facilitate, as the proposed pipeline is just slightly over 200 miles long (approximately a third of the length of Exxon’s proposed pipeline) and only about a third of it is onshore (implying much less risk associated with landowner conflicts).  InterOil’s relationship with its landowners is very benign and the landowners will retain a fractional stake in the project (2%), so they have an incentive to help facilitate the construction phase of the project to start reaping the benefits of production being initiated.  The company has chosen a site on already leased land for the liquefaction terminal that’s adjacent to its refinery in Napa Napa with an established deep water jetty system and other required infrastructure.  Even if some of the proposed liquefaction projects in the world don’t materialize, Interoil’s project has some significant advantages over any other project in the world.  Firstly, its conventional gas flows at world record flow rates with only a few wells needed to supply an entire train.  Its F&D and production costs only amount to approximately $0.10 to $0.15 per mcf while Australia’s CSG is mined for approximately $2/mcf, which in conjunction with acquisition costs and other operating expenses, builds towards $3.50 to $5.00 per mcf.  This cost profile disparity is a tremendous competitive advantage for InterOil over competing Australian projects and implies a much higher resource value.  Also, the country’s proximity to Asia even exceeds that of Australia.  Lastly, InterOil is offering partners a very unique deal in which they will be able not only to secure offtake of LNG from the project, but also to invest in the upstream to hedge their costs of doing so. 
 
So what are the molecules worth?  Page 16 of the following Gastar Exploration presentation lists transaction values on 2P reserves (recall that upon striking a deal with partners to commercialize its gas, InterOil’s resources will be recharacterized as reserves shortly thereafter), of which the median was $1.51 per mcf and the high exceeded $3 per mcf - http://files.shareholder.com/downloads/GST/0x0x299529/3754582d-3abd-46f4-9923-13973f71243e/Gastar_Exploration_AGM_June_2009.pdf).  Logically, Interoil’s gas should sell for a substantial premium to these CSG deals, as its production costs are substantially lower and these deals were generally struck at the trough of the global economic cycle in 2008 and early 2009.  If IOC’s resources attract a price of $2 per mcf, its natural gas resources alone would be worth in excess of $9 billion net to the company (as it owns 57.5% of the resource) or approximately $200 per share.  The company also has certified condensate resources of 156.5 MMBbls that have a higher API gravity than light sweet crude and can be mixed with cheaper heavy crude to produce light sweet that can be processed in its refinery.  Condensate is an obscure term for many investors, but the type that InterOil discovered actually sells at a premium to crude oil.  Ironically, if it were called crude oil, the stock would probably be substantially higher.  If the condensate resource is worth $20/bbl in the ground, it implies a value of another $1.8bn, or >$40 per share net to InterOil.  These analyses exclude the potential value of the company’s other exploration prospects, potential oil, its stake in Liquid Niugini, the refinery and downstream assets.  My interpretation of the negative arguments that are suppressing the stock price is that they circumvent the most important facts and create abject fear among investors.  They typically revolve around a promotional management team and instances in which expectations were set in the past that weren’t delivered upon.  My perspective is that this management team is one of the most diligent, efficacious, and honest of any that I have encountered in my career.  They’ve made monumental strides, but I acknowledge that they’ve sometimes allowed their excitement to create expectations that weren’t delivered upon in the timeline that was set forth.  Frankly, I believe that anyone would have been susceptible to such mistakes if they were managing such a dynamic entity that made such tremendous progress over such a short period.  Also, they ultimately delivered upon and even exceeded initially established expectations, and an objective analysis of their current situation clearly indicates that the obstacles preventing a condensate stripping and natural gas liquefaction deal from occurring no longer exist with the recent government approval and step up in certified resources. 
 
This is just such a clear situation if you can segregate the noise from the important facts, and I think that investors will be rewarded tremendously this year.  I’m obviously not the only one who believes this, as Henry Aldorf, one of the most successful deal facilitators in the LNG industry, recently joined the Liquid Niugini venture to assist in closing a deal.  Henry was responsible for the development of the greenfield multi-billion dollar LNG project in Equatorial Guinea for Marathon, and after being courted by InterOil for years, he finally was sufficiently impressed with the resource and project plan to come onboard following the success of Antelope 2.  He’s clearly a tremendous addition and his joining is a testament to his level of confidence that InterOil’s plan will successfully materialize.  The exploration risk and government approval risk have now dissipated, and InterOil has transitioned into a simple story with an exceedingly high probability of success that is being completely underestimated by the market, as market participants allow the noise evoked by those who have no real understanding of the story to obscure the value embedded in the company’s highly coveted assets.  As the company strikes deals to monetize its gas and condensates, resources will be converted into reserves and its gas and condensate will be revalued multiple-fold from their current deeply discounted valuations.

Disclosure: Long IOC common stock, Long IOC call options