The casual observer might find the amount of shares short in InterOil (IOC), the latest figure is close to 12M (more than half the float!) difficult to fathom. After all, this is a company which looks on the brink of a second major gas find in times where these kind of big energy finds are scarce and energy, especially clean energy like gas runs at a premium, especially in Asia. So, what’s behind this? Do the shorts know something we don’t?

History

In order to answer that question it’s important to go back into history a little. We think that the single most important element in understanding why there is such a large short position in InterOil has to do with the fact that they have been there for a long time.

The large short position predates their first big natural gas find at Elk1. Like we argued in a SeekingAlfa article, shorting InterOil before their first big gas find was understandable, sort off:

• Exotic country
• Unknown company
• With no resource finds before 2006 despite drilling quite a bit there
• Having a loss-making refinery.

Although it would have depended on the exact price, but hey, with these basic features, we might even have been short at that time. However, there are two fundamental developments that went against the shorts in a big way:

• InterOil discovered a really big amount of natural gas at Elk1 in 2006
• Energy prices started to climb in a most spectacular fashion

Combined, these developments basically pulled the rug underneath the shorts. But this happened in slow motion, sort off.

Why didn’t they cover?

If that is the case, one might wonder, why didn’t they just cover and moved on? Although we cannot creep into the mind of the shorts, we can recreate some of the logic that must have been at work:

• They apparently refused to believe Elk1 was for real
• Covering would be expensive
• One well doesn’t prove a resource
• Precarious financial position
• Even if there is a resource, it could very well be ‘stranded’.

Let’s go through this little list one by one.

First, we have heard a rumor (we do not know whether it’s true) saying that the shorts just flatly refused to believe it (Elk1) was real. Some of this might have been based on a mythical Ross Smith report that the shorts themselves commissioned, in which the initial argument was that Elk1 was build on a major fault line, and that explained the high fracture porosity, but it would be a one-off.

We have also heard that Ross Smith had to make a rather embarrassing retraction considering the flow rates at Elk1, and no parts of that report has appeared in public, not even on message boards. If anything, subsequent wells have burried this fault-line thesis, but it might initially have contributed to the refusal of the shorts to cover.

Covering would be expensive. We think this is a main reason why they haven’t done it. The short position has been very large for years, on average it would be at least 8M shares (presently, it’s almost 12M). Covering such a large short position would drive the stock price way higher, especially after very favourable fundamental news, would not only validate that news (“look, even the sceptics believe”) and attract a lot of additional buying.

In fact, by keeping their position they not only spared themselves immediate pain, they also kept the believe alive that something was amiss at InterOil, quite likely convincing some not to buy. Such a large short position can easily intimidate prospective buyers into thinking, “perhaps these guys know something we don’t”..

These beliefs gained further currency when Andrew Left, the person behind Citron (formerly Stocklemon), predicted gloom and doom for the company in 2006. It is quite noteworthy that Left has not written about InterOil for one and a half years already.

Time. The shorts also had quite a bit of time to wait for an opportunity, and to see whether things would run aground. After all, one well does not prove the presence of a resource, further appraisal wells had to be drilled. Things could go wrong. These appraisal wells might not confirm the first find, or they might show the resource is smaller than previously thought, not enough to support the plans for an LNG facility.

Also, drilling is expensive, and InterOil has been dependent on outside financiers as the refinery and the retail business do not provide enough cash flow to finance the expensive drilling program. Citron especially best the drum on InterOil’s financial weakness in 2006 and argued the company might not make it through the end of that year.

How this logic played out can be seen in the rather spectacular events of July 2007, when the results (even before they were out) of the first appraisal well seemed inconclusive, and the shorts grabbed their chance to half the stock price in three days.

When the results did come out, they showed that fracturing did exist, the resource flowed (40000 barrels of gas saturated water, to be precise), but the limestone holding the gas was under the waterline (Elk2 is right on the edge of Elk, and the limestone tapers off into the depth there).

Although providing a chance for the shorts, as the results seemed disappointing for those that expected similar huge gas flows as the ones that Elk1 produced. They were good enough for T Boone Pickens though, as he bought 3M shares after these results. It also was the definite nail in the ‘fault line’ theory.

Stranded gas? Two arguments were taken up by Andy Left in his Citron were the financial problems and especially the stranded gas thesis. According to the latter, even if InterOil would discover a huge amount of natural gas, it wouldn’t matter as natural gas either needs a pipeline or an LNG facility to liquify it in order for the gas to be sold to end markets.

Citron feasted on the scrapping of plans to build a pipeline from PNG to Northern Australia, but this never made sense in the first place. Anyway, with two, possibly three prospective LNG facilities in the making, the argument of stranded gas has been considerably devalued, if not completely eliminated.

Since one needs a subscription for that link, we provide some useful quotes:

The PNG pipeline’s most passionate backer, Oil Search, has now conceded that LNG is a much more attractive option for commercialising PNG gas. Piping gas across the seabed into one of the world’s cheapest gas markets always seemed to be a marginal proposition, and it is clear now that the pipeline’s backers failed to understand the potential of Queensland’s coal seam methane blocks.

“The remoteness of the gas field from a suitable plant and marine terminal site will add to costs and the initial sizing of an LNG plant will be limited to a single train by currently available reserves,” said ExxonMobil. Botten himself has previously conceded commercialising Highlands gas via LNG would be difficult. “An LNG project without other projects coming to help the infrastructure will always be a very, very tough business in PNG,” he said last August.

But Oil Search has a rival that is planning to develop lowland gas fields for shipment from Port Moresby in southeast PNG.

PNG LNG, the privately held company that will develop the $US4-6 billion LNG project, has set itself a schedule that could see two LNG trains built at its proposed site in Port Moresby, with the first LNG shipment ready by 2011.

Set up by project partners InterOil, Merrill Lynch and Clarion Finance, PNG LNG has had a coup in recruiting former North West Shelf director Jack Hamilton as its chief executive.

While other players in the region such as Oil Search, ExxonMobil and Santos have LNG project studies underway, PNG LNG is the only company to be moving on a plan. InterOil will start upstream work at Elk at the same time. The plant will be built next door to InterOil’s 30,000 barrel a day oil refinery at Port Moresby, negating any landholder issues and providing access to infrastructure.

From these quotes a couple of interesting points emerge:

• Elk/Antelope is lowland gas, while it’s rivals have gasfields (the Hides and Kubutu fields from Oil Search) are in the much more remote highland area
• While InterOil has much infrastructure ready, rival plans are less favourably placed.

So, InterOil’s LNG plans are likely to be significantly cheaper, yet Exxon and Oil Search are moving ahead with theirs, both valuating the argument for LNG and severely devaluating the value of the ‘stranded gas’ thesis.