IOC`s 4Q08: Independent Review Confirms Multi-Tcf..

Resource Base
♦ InterOil reported a 4Q08 net loss of $0.96 per share, broadly inline with our estimate of a loss of $0.91. The loss was consistent with the preannouncement of February 23. Recall, the loss resulted from a price related inventory writedown, partly offset by hedging gains. The full-year net loss of $11.8 million narrowed by nearly 60% from 2007’s loss of $28.9 million, driven by healthy profitability achieved in 2Q08 and 3Q08.
♦ Despite the tough 4Q08, the refinery achieved a full-year EBITDA record of $25.5 million (up 39% y/y). The downstream segment’s fullyear EBITDA of $5.8 million was down 54% y/y but remained positive. Based mainly on updated margin and cost assumptions, we are adjusting our 2009 and 2010 EPS estimates as shown below.
♦ Of far greater long-term significance is InterOil’s first-ever independent reserve report, completed by GLJ Petroleum Consultants, a leading Canadian reserve engineering firm. As detailed on page 2, InterOil’s net resource is estimated at 1.3 to 2.6 Tcf of gas and 20 to 49 MMBbls of condensate, with the “best guess” being 1.9 Tcf and 33 MMBbls (2.1 Tcfe). The low end of each range corresponds to reserves with a 90% probability, which would generally be called proved reserves. However, the reserves cannot be classified as proved until there is a formal plan of development (e.g., a liquids-stripping plant). Importantly, this reserve report is as of year-end 2008, which means it does not take into account the most recent data from Antelope-1 (the record-setting flow test of 382 MMcf of gas and 5,000 barrels of condensate per day) nor the currently drilling sidetrack. So while the new reserve figures are towards the low end of earlier in-house estimates (in addition to “whisper numbers” heard on the street), InterOil is still in the early innings of evaluating this world-class resource.
♦ We reiterate our Strong Buy rating. Our target price of $45.00 is based on a ~80% multiple applied to our risked net asset value estimate of $55.93 per share, which is detailed on page 4.

Reserve Report
Concurrent with its year-end results, InterOil released the long-awaited independent resource assessment, prepared by the leading Canadian reserve engineering firm GLJ Petroleum Consultants. After analyzing the well data compiled from the Elk/Antelope field through year-end 2008, the third-party report estimates gross resource to be in the range of 2.5 to 5.3 Tcfe. This figure compares to InterOil’s previously disclosed inhouse gas resource estimate of 2.5 to 11.3 Tcf. Assuming full exercise by the indirect participation working interest investors as well as the PNG government after the granting of the Production Development License, InterOil’s net working interest would come out to 55.67%. As such, InterOil’s net resource for the Elk/Antelope field is estimated at 1.3 to 2.6 Tcf of gas and 20 to 49 MMBbls of condensate, with the “best guess” being 1.9 Tcf and 33 MMBbls or 2.1 Tcfe total (illustrated in the table below).

The “best guess” estimate is, by definition, the most reasonable estimate of the reserve quantity that will actually be recovered; it essentially has a 50% probability of being too high and 50% of being too low. This can be loosely thought of as proved plus probable (2P) reserves. The low end of each range corresponds to reserves with a 90% probability, which in the “oil patch” would generally be referred to as proved reserves. We would point out, however, that the reserves detailed in this report cannot be classified as “proved” until there is a formal plan of development (e.g., a liquids-stripping plant). The high end of each range, with a 10% probability, represents a fairly aggressive scenario.

Upstream Update
Earlier this month, InterOil announced a flow test from its Antelope-1 well totaling 382 MMcf of gas and 5,000 barrels of condensate per day – a new record level for PNG. Importantly, as we illustrate in the following table, this flow rate is more than three times greater than prior tests at Elk-1 or Elk-4. The net productive reservoir at Antelope-1 is believed to be in excess of 2,000 feet – a net to gross ratio of 90% – which is over 12 times the thickness intersected in Elk-4. Also, the flow test was performed with only 30% of the choke capacity open. Antelope-1 and prior wells confirm a combined productive capacity in excess of the amount needed to support a single LNG train (500 MMcf/d). The continued boost in deliverability from the Elk/Antelope structure has only enhanced our thesis that InterOil has discovered several billion dollars worth of hydrocarbons.

Looking ahead, InterOil is currently side-tracking the Antelope-1 well in order to test the lower zones of the reservoir. During earlier discussions, the company is planning on performing four drill stem tests designed to confirm the possible light oil zone in the lowest section. This is particularly important in terms of the potential development strategies for a liquids-stripping facility. After a final project decision is made, there is a roughly 12-18 month lead time for the facility. Following completion of the sidetrack, the company plans to move the rig to the Antelope-2 location (shown in the adjacent structural map). Future drilling prospects under consideration include Mule Deer, White Tail, Wolverine, and Raptor.

InterOil is still in the early innings of evaluating this world-class resource. Following a multi-phased transaction with one or more strategic partners, which includes the sale of interests in the Elk/Antelope field and the LNG project along with associated off-take agreements, we believe InterOil would have sufficient capital to fund further exploratory and development drilling operations for the next several years.

Additionally, this transaction has the potential to create an implied “industry” valuation several-fold higher than the market’s current valuation of IOC shares. In our view, further appraisal of Elk/Antelope should improve the likelihood of the company receiving a sales price comparable to recent transactions in the region, which have valued reserves in the ground on a 3P (possible reserves) basis in the range of $1.60-2.50/Mcfe.

For reference, the benchmark transactions came from ConocoPhillips (COP/$40.33), which purchased an interest in Australian-based Origin Energy; as well as the recent sale by Australian-based AGL Energy of its 3.6% interest in the ExxonMobil-led (XOM/$69.98) PNG LNG project. We should also gain greater clarity into the various monetization options for the high condensate levels encountered in the Elk and Antelope fault blocks, namely the prospects of a liquids stripping facility. Compared to a projected 2013/2014 timeframe for completing the LNG project, the construction of a liquidsstripping plant (with a 12-18 month lead time) would greatly accelerate near-term cash flow.

Midstream and Downstream Update
While our investment thesis on InterOil has never been focused on the company’s refinery and downstream network, we believe that these two segments are well positioned for future success. While 4Q08 bucked the positive earnings trend exhibited over the prior two quarters due to non-cash inventory charges related to the sharp decline in crude oil prices, the cost reduction steps taken by InterOil over the past few years have transformed the refinery and downstream network into sustainable cash-generating business segments (as shown by the positive EBITDA trends in the charts below, with 4Q08 being an obvious outlier).

Risked NAV Calculation
While the progress within the company’s two cash-generating business segments – midstream (the refinery) and downstream (the distribution network) – points towards a “base case” valuation of roughly $12 per share, our investment thesis on InterOil has obviously emphasized the potential value creation in the upstream segment. Following the year-end 2008 independent reserve report, we are updating the risked resource calculation in our NAV analysis. Previously, we had been using the company’s in-house estimate, with a relatively steep risking factor. We are now shifting to using the third-party data, with a commensurately less steep risking factor. Specifically, we are now using the following assumptions:

• 2.32 Tcf of recoverable gas and 36.7 MMBbls of recoverable condensate (the “low end” of the estimated resource range), unrisked
• Plus: 1.11 Tcf of recoverable gas and 22.6 MMBbls of recoverable condensate (the difference between the “low end” and “best guess” cases of the estimated resource range), risked at 50%
• $1.00/Mcf reserve valuation for gas and $10.00/Bbl reserve valuation for condensate
• 56% working interest attributable to InterOil

While recognizing that the reserve report came in towards the low end of the previous in-house range, this report serves to de-risk a portion of the resource estimate by providing the “seal of approval” from independent, third-party experts. All-in, with a somewhat lower resource figure but also a less steep risking factor, our risked NAV estimate changes only minimally – going from $55.52 per share to $55.93 per share. We would again underscore that our NAV does not include any credit for resource potential at prospects other than Elk/Antelope, nor does it give any credit for a potential oil leg at Elk/Antelope.