We think an oil disappointment is probable, but already priced in by now. It was never going to be the main value play for InterOil anyway.
We wrote yesterday about what is going on (see here). We did think InterOil had a good chance of getting oil flowing based on:
- Even Bertoni (the geologist paid by the shorts) acknowledged there is an oil layer below the gas (see p.12 of his report).
- There were oil shows in Antelope1, the problem was the rock, it was too tight at that depth.
- The quality rock dips down from Antelope1 to Antelope2 and in fact thickens (the dolomite is considerably thicker at the latter)
- The latest DST flew 11MMcf/d of gas. That quality of rock is good enough to flow meaningful quantities of oil from a vertical hole, and the flow rate can be significantly enhanced by horizontal drilling.
- Some sources have it that the 11MMcf/d was an understatement due to choke problems, and that the test was still executed in the dolomite. Although we can’t confirm that, it would be nice if true. However, dolomite is not necessary for oil to flow from a vertical well.
- So all we need is the rock quality over the tested zone to continue deeper. The drilling break they experienced at the bottom is a promising but hardly a conclusive sign.
- Even if not successful, the quality rock dips down so there are likely to be better places still for getting it out.
But the only way one can know for sure is to analyze the logs and to test. Now, considering all this, we arrive at the following conclusion. There are three possible explanations for the sell-off:
- Normal profit taking in a stock that has moved from $10 to $85 in a market that has shifted a way from risk
- Some aggressive shorting as a last dash effort by the shorts before any news on commercial oil and/or a deal with Mitsui is out.
- Disappointing well news.
We think it’s probably a combination of all three. We have never seen major price moves on high volume without some kind of news following, whether good or disappointing.
What do we mean by disappointing well news? Perhaps the quality of the rock at the bottom of Antelope 2 is not sufficient for oil to flow from the vertical well, and horizontal drilling is necessary to make the oil flow. But this will take time, and it produces disappointment, and there are no guarantees for success either.
Would the absence of commercial oil (for now) be a disaster? Not really. The gas is still there, the liquids are still there, we think a liquids stipping plant is coming (in fact, InterOil is already making preparations for that). Oil could very well still flow from a horizontal well, or if not since the quality rock dips downwards there are better places to get it out. But the excitement will wane a bit, that’s undeniable.