Since the last time we wrote here about IOC a month ago (May 5) a lot has happened (apart from the share price rallying 30+%), so a revisit is warranted. I think that a lot of uncertainty is being taken out as we speak, and the upside is now very, very significant.

Refinanced
The outstanding loan to Merrill Lynch and Clarion Finanz ($130M) was settled by two deals. Clarion agreed to a straight debt for equity swap of their part of the loan ($60M). InterOil issued 2.7M shares at $22.65 (which was about a dollar higher than the market price when the deal was announced, and probably quite a bit more when it was negotiated).

The remaining $70M was owed to Merrill Lynch. They apparently did not like the conditions Merrill Lynch were setting, so they went around with their hat, and hey presto, ended up with $95M in it. This is a pretty bullish sign to get that much at such short notice at these conditions, and the market took it as such.

Elk4 DST #1 and 2
We now had two DST tests, you can read the full results in the pr’s, PR1 and PR2. There are a couple of noteworthy points.

1) Flow rates increased with depth, from 8.3MMcf/d to 14.1MMcf/d
2) Flow rates have been negatively impacted by heavy skin damage resulting from:

“kill operations using heavy mud and lost circulation material. The calculated stabilized flow is the rate expected at the sandface of the reservoir if all the skin damage is cleaned up, which is a relatively simple operation in limestone reservoirs.” (PR1)

Although the calculated flow rate with zero skin damage (+/- 500MMcf/d!) is a little bit of a gimmick, they are right that heavy skin damage will severely reduce gas flows and that skin damage can be cleaned up relatively easily.

3) Apart from heavy skin damage, flow rates in the second DST test were also limited by “the capacity of the Drill Stem Testing equipment at surface” and “tubular constraints” (which suggest they’re using a very small pipe, using a bigger pipe would significantly increase flow rates).

Matrix porosity?
The heavy skin damage also indicates the existence of matrix porosity. In the words of Wayne Andrews (analyst at Raymond James, in an update May 14):

First, the company described pumping heavy mud with Lost Circulation Material (LCM), to stop the flow of gas and liquids into the well bore. The LCM works to seal porous formation, but depending on the type of material may not be as effective on fractures. The fact that the LCM was effective is a potential indicator of real matrix porosity, a very positive sign for reserve potential. However, and more importantly, the heavy mud probably caused near well-bore formation damage which may have hampered the flow rate of the well in addition to the drilling fluids that were being recovered during the test. Both of these give us confidence that the well will be capable of flowing at substantially higher rates.

It’s not the only indicator, as he argues elsewhere in the same update:

the visible matrix (vugs, chalky limestone) and fracture (visible micro-fractures) porosity along with shallow marine fossil evidence observed in cuttings from the well within the recently tested limestone reservoir.

Now, Wayne Andrews argued previously (RJ 11/04/07 p3), when discussing the Elk resource estimate (3.1-15.7Tcf at that time, increasing to 3.5-18.8 after Elk2):

The low end of the range assumes only fracture porosity contribution to reserves and excludes matrix porosity. The high end als includes matrix porosity.

So, if these multiple signs of matrix porosity play out, expect a BIG increase in the resource estimates.

Resource thickness keeps increasing
One has to remember that Elk1 (the discovery well) was not drilled to a finish, as the ELK1 did not drill the entire ELK formation as the well was not initially designed for drilling a very permeable high pressure gas formation. Elk1 was drilled to 1983m (6506ft), with a pay zone of about 1100 feet thick.

In a recent update (June 11 2008) after the second DST at Elk4, Wayne Andrews said:

This latest test has established a new Lowest Known Gas (LKG) level at 7,586 feet, confirming a substantial gas column height of 1,948 feet.

And:

Given our belief that both Elk and Antelope are part of the same structural complex, further testing and the confirmation of hydrocarbons at this level and deeper should result in a meaningful increase in the lower-end estimate of the resource in place and provide confidence to move ahead with LNG plans.

This is saying the pay zone of Elk has been increased from about 1100 feet thick to about 1900 feet thick. And since InterOil has already cored until 7815ft and still hasn’t encountered the water contact (they are executing DST #3 these days), it keeps getting bigger. This is another reason we can expect a big increase in the resource estimate.

Condensates

According to Wayne Andrews (June 11 update):

the condensate to gas ratio continues to rise – coming in at 12.4 Bbls/MMcf in this second Elk-4 DST, up from 11.2 Bbls/MMcf in the first Elk-4 DST and 5 Bbls/MMcf in the first Elk-1 DST. This higher liquid content suggests increasing condensate with depth, consistent with findings in gas caps on oil reservoirs and increasing the probability of encountering an oil leg with further drilling.

And indeed, in the second Elk4 DST, the condensates level increased further from 82 to 175 barrels a day. After the first DST test, Wayne already allowed for condensates to be included in his valuation of IOC:

Based on the estimated liquids content given the initial Elk-4 results, we are adding incremental value for liquid resource potential (69 MMBbls at $15.00/Bbl, risked at 50%) into our risked NAV, which essentially offsets the increased share count from the recent equity offerings.

These condensates can be used directly in InterOil’s refinery, providing instant cash-flow.

Oil?
As we have seen above, the increasing condensate level with depth (not only increasing depth within Elk4, but one also has to realize the payzone at Elk4 is a lot deeper than at Elk1) certainly point to the possibility of an oil leg.

Further, lab analysis of the specific gravity of the condensate, at room temperature rather than the heated temperature from the well bore, indicated 48 degree API, very close to crude oil. The fact that the specific gravity of the condensate is increasing with depth increases the probability of encountering an oil leg as the company deepens the well.

Valuation
Wayne Andrews first calculated the value of Elk by taking:

• 6.9Tcf, the midpoint of the then reigning recoverable resource estimate
• Value it at 75 cents per Mcf and risk it at 50%, effectively valuing it at 37.5 cents per Mcf
• Deducting third parties’ stake and applying 10% discount factor for cashflow.

Now, consider the following:
1) At the time of that valuation, gas was trading at $4, now, in Asia, it trades at close to $20

2) The 37.5 cent per Mcf valuation will have to increase as a result of a quadrupling in gas prices. But not only that, risk will also be removed when Elk4 completes and an independent third party assessment of the Elk/Antelope resource comes out.

3) From a story by Bloomberg: Petronas yesterday agreed to pay A$4.91 a gigajoule for proven and probable coal seam gas reserves from Adelaide-based Santos, which Santos Acting Chief Executive David Knox said sets “a new benchmark” for reserves valuations.

Calculating it back to US$ and Mcf, that’s a valuation of US$4.75 per Mcf. That’s 13 times the valuation Wayne attached to InterOil’s resource. Now, before we get too excited:

• These Santos reserves are proven and probable reserves. InterOil isn’t as far so a difference in valuation is warranted at the moment. However, they will be a lot closer with Netherland Sewell report and Elk4 concluded, which will move a lot of risk, and thereby reduce the risk factor and hence increase the resource valuation
• On the other hand, coal seam gas is more difficult and costly to extract (which is why, until recently, there wasn’t a lot of interest in doing it)
• The fact is, Santos also needs to build an LNG facility, they’re planning one. The first gas is expected to be delivered in 2014 (PR p15). So this is not unlike InterOil’s situation.

3) That valuation did not contain ANY provisions for oil, or any of the other 40 drilling prospects on 8.8M acres IOC has licensed in PNG. In a the latest update, some provision is being made for the liquids, but this is crossed out by the increasing share count as a result of the financing, leaving the NAV estimate essentially unchanged.

Shares short

InterOil historically has had a very high short count. The shorts have been there way before the Elk/Antelope discovery, and that is somewhat understandable. Exotic country, unknown company, lossmaking refinery. However, not only is the refinery slowly improving, the company has changed with the discovery of Elk/Antelope.

We’re now close to proving a resource. The shorts are still there because they didn’t believe this would be possible and it’s very difficult for them to get out without inflicting heavy losses on themselves. IOC has also been for 448 consecutive days on the naked short list, which is all but proof of foul play.

Other possible catalysts
The following items are set to propel the share price higher pretty soon after Elk4 has been completed:

• 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.