It has it all, a gripping story that is about to unfold, a company bold enough to move a whole refinery to the other side of the world, an industry legend billionaire investor taking a 10% stake, a massive natural gas find, now possibly another, even much bigger one, a highly respectable analyst putting a target price four times the market price, disbelievers, believers, a record listing on the regulation SHO list, and, not to forget, a near foolproof way to make money. (revised edition)  

We’re talking about InterOil, of course. They had a massive natural gas find (“Elk1“) in 2006 in Papua New Guinea, where they also have a refinery and a near monopoly in gas stations. On Thursday, they announced a second gas find in an adjacent (but connected) field, Antelope (at their Elk4 well, they’re currently almost completing).

According to Wayne Andrews, the respected analyst from Raymond James this morning:

“Elk is a sliver of limestone thrust upon the much larger Antelope structure.”

So it’s entirely possible that there is a whole lot more gas at Antelope then at Elk itself. However promising this looks, no DST test has been performed yet, but before they do, this might provide an extremely good entry point.

We’ll leave the gripping story for another time and concentrate on the immediate prospects, which are dominated by two uncertainties which, combined, give an interesting matrix of possibilities and opportunities:
∙ We are close to the conclusion of the drilling of Elk4
∙ IOC has an outstanding loan ($70M) from Merrill Lynch due May 12th (originally May 4th, but extended yesterday)

Let’s discuss the drilling first
InterOil’s Elk prospect is currently estimated to contain between 3.5 and 18.8 Tcf of natural gas. They’ve drilled two wells so far, Elk1 was the discovery well, and Elk2 the first appraisal well.

While the first (Elk1) was a runaway success (measuring pressures of 100MMcf+ through a 5 inch tube), the second well (Elk2) was, somewhat unfairly, seen as a failure by the markets.

That failure becomes relative if you consider that the resource estimate actually went up, and T Boone Pickens (who happens to hold a masters in geology), both privately and through his fund, took a 10% stake. Wayne Andrews, analyst at Raymond James, argued that the positives outweighed the negatives, and upped his target to $65. Apparently, there must have been something to like.

A DST test showed the well flowed 40.000 barrels of (highly gas saturated) water (the limestone is a lot deeper at Elk2 compared to Elk1, so it was below the water contact). Hardly the dry hole the shorts claimed it was. More importantly, that flow indicated the all important good porosity and permeability, hence the increase in the resource estimation (the limestone containing the gas is also thicker than previously estimated) and Boone’s buying.

As a side note, we have to say that InterOil’s CEO Mulacek argued that Elk2 showed that there is enough gas for not one, a two train LNG facility they are currently in advanced state of planning (together with Merrill Lynch and Clarion Finanz) through a vehicle called Liquid Niugini.

Elk4/Antelope
Now, in a brief PR on Thursday, the company announced the following:

“The Elk-4 well has successfully penetrated the Antelope structure, a new discovery which will significantly augment the gas found at the Elk-1 discovery well. Drilling operations experienced a gas kick and a flow of gas and gas liquids to surface which was circulated and flared. The well is now being prepared to drill deeper under pressure followed by comprehensive evaluation.

“This well confirms the presence of hydrocarbons in the Antelope structure,” said Mr. Phil Mulacek, CEO and Chairman of InterOil. “We are very excited about this early result and we look forward to drilling ahead to establish the commerciality of this discovery.”

It might be somewhat confusing that they are talking of Antelope while the well is called Elk4, but one has to realize that it’s a connecting field. No DST test was performed yet, but having to flare gas against heavy mud pressure sure looks very promising.

One has to realize that at their initial big discovery well, Elk1, a similar event took place (in fact, the gas pressure was so high that they almost blew the well, and CEO Mulacek likened the fight to control it to “stemming the tide of the Mississippi”). The DST test to prove Elk1 was perfomed considerably later.

Performing the DST test at Elk4 will take some time (although not as much as at Elk1 were they had to fight to stabilize the well), giving investors a unique opportunity as the price reaction to the news is still somewhat muted.

If a DST test proves what InterOil announced today, then resource estimates will go up, as Antelope now turns out to be a second (but connected) field containing natural gas.

And it doesn’t even have to stop there. There could also be oil. There have been indications of oil before, and every oilfield in PNG has natural gas, so they seem to come as a package deal. Both Elk1 and now Elk4 contain liquids (which, if in sufficient quantities, can also be used in InterOil’s refinery, providing almost immediate cashflow).

A popular argument used by the shorts is that no matter how much gas, it’s stranded, strikes us as particularly nonsensical. The demand (and price) for LNG is exploding, more especially in Asia, were it trades at a very significant premium and big producer Indonesia is diverting gas away from export towards domestic use.

The odds have improved that there is more than enough gas at Elk/Antelope to supply such an LNG facility. There are plenty of Asian parties interested in financing it. And InterOil is in talks with quite a few already.

As promising as it looks today, we need a DST test to nail it and there is another outstanding issue that has to be settled though.

The Merrill Loan
The second issue deciding the immediate fate of InterOil is a bit of a dark horse. A loan from Merrill Lynch ($70M approximately) was due May the 4th, after the Antelope find it has been extended for just over a week to May 12.

The outcome of these negotiations are, not surprisingly, difficult to gauge. Here are some of the ingredients that have a baring on it:

• ML is 1/3 owner of Liquid Niugini, the outfit that is planning the LNG facility next-door to the refinery in order to process the gas from Elk/Antelope (the other owners are InterOil and Clarion Finanz)
• ML did take $15 from an IOC private placement last November
• ML has been very accomodating with this loan in the past. Last year, they continued the generous 4% interest rate it carries until early May, no doubt to give IOC enough time to finish Elk4 and prove the resource.

So, they do have a common interest, and it would seem odd for Merrill to get tough with IOC now that we are on the edge of getting the Elk4 results. However:

• Merrill’s financial position has worsened considerably
• Merrill does seem to have a pretty strong bargaining position in the short-term
• It might want to exploit that in order to grab a bigger slice of the Elk/Antelope booty.

This issue complicates an otherwise rather straightforward investment thesis. On Elk4 alone, a stangle would have been almost guaranteed success. Either it is a success (which it now very much looks), or it isn’t. Either the stock price shoots up, or it falls. There’s hardly room in the middle.

But the whole Merrill loan issue is clouding that a little. There is now a matrix of possible outcomes:

• Elk4 a success, Merrill refinances. IOC will shoot up
• Elk4 a success, Merrill doesn’t refinance. IOC will, well, that depends, I’ll discuss this below
• Elk4 a failure, Merrill refinances. The stock will go down
• Elk4 a failure, Merrill doesn’t refinance. IOC will crater.

The chances that Elk4 will be a failure seem to have reduced considerably with the news on Elk4 Thursday, but well have to wait for the DST results to nail that.

The degree to which the Merrill loan issue is a problem depends on IOC’s capacity to organize alternative finance at good conditions at relatively short notice, but this itself is depending crucially on the Elk4 outcome.

Merrill will realize this so it might all be a bit of brinkmanship, it’s leverage is weakened with Thursday’s promising news.

Also, one has to realize that, depending on the success of Elk4, there are other possible catalyst to propel the share price higher:

• Netherland Sewell, a world-class engineering firm, will perform an independent audit of the Elk property
• An agreement with the PNG government about the LNG facility, giving Liquid Niugini (of which IOC holds a third) an almost unassailable lead over competing LNG projects.
• An agreement with outside (Japanese, Korean) investors for a participation in the LNG facility.
• The active negotiation with a strategic partner for the sale of a 10% interest in Elk, which has the potential to create an implied “industry” valuation several-fold higher than the market’s current valuation.
• The possibility of farm-out opportunities to industry partners, which could further accelerate the exploration of the company’s extensive acreage position.

We give you another quote from Wayne Andrews from Raymond James (15 Nov 2007):

“We are increasingly confident that $66.18 [which constitutes RJ’s total NAV value for the whole company, shareholdersunite.com] should be seen as the floor for InterOil’s value, not a “best guess” and certainly not a ceiling”

If one combines that with the quote from this morning about Elk being just a sliver of limestone thrust upon a much larger Antelope structure, and if you keep in mind that when Wayne arrived at his $65 price target LNG prices in Asia were a lot lower then today, this sure seems a pretty good opportunity.

And, not to forget, 10M shares short (almost half the float!) that will have to be bought back at some time. Those are mostly remains from before the Elk1 discovery, which they never seem to have taken too seriously (and the alternative, covering, would have inflicted rather substantial losses upon themselves, imagine what buying 10M shares would do to the stock price). They might pay a heavy price for that.

Interesting times seem virtually assured, although we are fundamentally long, some hedging with May, June, or September options seems to be the best way to play this.

There is a host of background material on the InterOil situation at http://shareholdersunite.com