Markedly positive on the refinery and downstream operations..

IOC Stays Profitable in Q309 Despite Unfriendly Refining Backdrop

• InterOil posted 3Q09 operating earnings of $0.07 per diluted share, broadly in-line with our estimate of $0.06. Stronger-than-expected downstream results, lower interest costs and some non-operating items were largely offset by weaker midstream results and higher SG&A expense. Reported net income of $0.18 per share included a $4.6 million asset sale gain.
• Adjusted companywide EBITDA totaled $10.0 million in the quarter, falling shy of our estimate of $12 million. Looking ahead, we are slightly raising our EPS estimates (shown below) as we take into account continued strength (margins and volumes) within the downstream segment, partially offset by a reduced Singapore crack spread assumption. While the refining industry continues to face weak (albeit stabilizing) global petroleum demand, we would underscore the benefits (particularly with regard to sustained profitability) stemming from the company’s exposure to the niche PNG market.
• Turning to the balance sheet, InterOil’s liquidity position remains firmly intact. The company exited 3Q09 with cash on hand totaling $60.7 million (plus $27.9 million restricted). While operating cash flow nearly covered exploration spending during the quarter, the decline in the cash balance of over $35 million was exacerbated by working capital fluctuations. All-in, debt-to-cap sits at a comfortable 12% – less than a third of its 43% level in mid-2008.
• Drilling at Antelope-2 is on track, notwithstanding a recent operational glitch. After taking the well down and testing (combination of DST and full flow test) the base of the gas column, InterOil plans on casing this upper section (essentially isolating it) before drilling out of the bottom and into the more condensate-rich zones, including the potential oil leg.
• The extensive testing of the liquids zone is a critical aspect of understanding the value of the reservoir – something we’re sure the potential strategic partners (and investors) will be keeping a close eye on. In terms of timing, we believe it is realistic for initial testing of this bottom section of the reservoir to be wrapped up by the end of the year.
• As InterOil moves into its next growth phase, balancing exploration with commercialization efforts, there will undoubtedly be more milestones to come – look no further than Antelope-2 in the near-term. In fact, we readily acknowledge that the confirmation of a commercial oil leg could lead to meaningful upstream earnings in the relatively near term versus the extensive timeline set forth for the proposed LNG facility – with first production not expected until at least late 2014. That said, the pending execution risks inherent in the company’s monetization efforts of its significant gas resource base, combined with the hefty recent gains in the stock (now sitting just slightly below our “de facto” proved NAV estimate of $48.58), keep us on the sidelines for the time being. We maintain our Market Perform rating.
• 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 profitability.
• Other than the 4Q08 blip, in which the net loss was driven by 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). Furthermore, we believe the company has the capabilities to carry forward the positive earnings trend (not just EBITDA). While there is no denying the near-term headwinds facing the global refining complex, the benefits of InterOil’s exposure to the niche PNG market, with its Import Parity Pricing (IPP) arrangement, should continue to drive profitability within the refining segment (as evidenced the past two quarters in which Singapore crack spreads have been markedly weak). Moreover, we are encouraged by the company’s focus on export opportunities for its refined product slate, which has the potential of meaningfully boosting refinery utilization above and beyond levels of PNG’s domestic consumption.