Tilson on InterOil

[Gator]

Short Book
Here is the YTD performance of the three shorts I disclosed in my 2012 annual letter:
1. InterOil 25.2%
2. K-12 28.5%
3. Nokia -5.3%
Their performance was quite representative of the dozen stocks that comprise our current short book: while a few worked, many – especially those with a high short interest – jumped substantially. In the first half of the year, I saw more pain inflicted upon short sellers than at any point since the internet bubble in 1999 and early 2000. During times of complacency, momentum-focused traders and computer algorithms like to play the “squeeze-the-shorts” game, which can cause heavily shorted stocks to skyrocket. It’s irritating to be caught in such a squeeze, but I size short positions so that I can withstand run-ups. I know how this game ends – with a sharp decline in the stocks – but I can’t predict the exact timing.
Here are discussions of two short positions, my oldest (InterOil) and my newest (World Acceptance):
InterOil
I believe InterOil is one of the largest promotions of all time – but unfortunately (so far) for anyone short the stock, it’s also one of the cleverest. The company, which has all sorts of associations with questionable characters (and pretty much every other red flag a short seller looks for), has been drilling for natural gas in Papua New Guinea for well over a decade and has repeatedly claimed to have found the mother lode – only to disappoint investors again and again (see Appendix B for a remarkable and telling series of unfulfilled promises from the company and its founding CEO, Phil Mulacek, dating back to 2007). One would think investors would finally wise up, but to date they haven’t, as the company currently sports a $3.4 billion market cap.
This valuation is based on the expectation that InterOil has discovered one of the world’s largest natural gas fields and that current negotiations with ExxonMobil will result in an extremely lucrative deal for InterOil. I think the odds of this are close to zero.
To be clear, nobody – not InterOil’s management nor any outsider – knows with certainty whether the company has a real resource discovery or not. This isn’t a fraud like Bre-X (for those of you with long memories) because there really is some gas in InterOil’s fields, which makes it almost impossible to disprove the company’s claims. Instead, one has to analyze geological reports, look at the track record of the company’s promises, examine the background of the key people, and then apply common sense.
Here are the key facts: after 15 years of drilling, InterOil still has no proven, probable or possible reserves (nothing but a “contingent resource estimate” by a company well paid by InterOil); its founding CEO unexpectedly quit recently (when was the last time this event was followed by great news?); the company continues to burn enormous amounts of cash; and after hyping a bidding war among multiple major oil companies, is currently only negotiating with one, ExxonMobil (think about who’s likely to have the upper hand in those negotiations…).
Here is my analysis of what InterOil told its investors in a presentation at its annual meeting on June 24th:
 What the company said: “Monetizing sufficient resource to cover our share of infrastructure costs and fund exploration while retaining maximum upside for IOC equity interest.”
What I think it really means: ExxonMobil will take a huge amount of the upside from whatever InterOil might have in exchange for a small amount of money to cover InterOil’s ongoing “infrastructure costs and fund exploration.”
 What the company said: “Post-negotiations, InterOil and Pacific LNG have clear path to resource monetization.”
What I think it really means: ExxonMobil only agrees to pay InterOil anything material if it’s actually discovered a major field.
 What the company said: “There will be staged payments before and after production commences to compensate for resource revisions.”
What I think it really means: Nobody knows how much natural gas (if any) InterOil actually has so, again, ExxonMobil will only agree to pay InterOil anything material if it actually has a major find.
 What the company said: “The purchase of an interest in PRL 15 is not contingent on resource recertification.”
What I think it really means: ExxonMobil will take a stake in InterOil’s resource now, prior to resource recertification, most likely in exchange for a de minimis amount of money.
 What the company said: “The resource recertification will be used to determine the economic interest in the license and to allocate upstream capital costs.”
What I think it really means: There will definitely be a resource recertification and all of the economics of the deal will be contingent upon what it shows.
Overall, this makes it clear that ExxonMobil has little confidence that InterOil has discovered anything, but is happy to get a nearly-free call option in the (very small) chance that InterOil really has discovered a huge resource.