On Januari 11, the shares of InterOil, an exploration company operating on Papua New Guinea tumbled more than 10% on heavy volume, only to recover a good part of these losses later in the day after a couple of analyst (Morgan Stanley, Nataxis Bleichroeder, Raymond James) explained that the market had interpreted the DST results badly. Is there still value in these shares? We believe so.

What was wrong? The market zoomed in on the 11MMcf/d flow rate, which compared bleakly to the 705MMcf/d world record earlier from the same well. However:
– Gasflows were not the objective of this DST, the objective was the condensate/gas ratio, which came in at 20.7bbls/MMcf, which is 25% (not 15%, as the PR has it) higher than at the top of the payzone (16.5bbls/MMcf)
– The choke used in the DST was really minute (48/64 inch) compared to the 6 inch one used in the record setting flow test.
– The high porosity dolomized reef which produced the big gasflow was sealed off, the tested area has lower porosity.

Let us re-introduce the company and it’s main assets (we’ve written extensively about it before):
– It has a large gas and liquids field Elk/Antelope with the top two producing gasfields (at 382MMcf/d and 705 Mmcf/d, with 5000 bbls and 11,200 bbls/d condensate rates) in the world, Antelope1&2
– It has more than 40 other promising drilling sites on over 4M acres
– It has a 36,500 bbs/d capacity refinery operating at slightly over half capacity but still producing small profits
– It has a fuel distribution network on PNG that is a near monopoly that is profitable.

Changed company
Last year, the shares have been on a tear, rising over 500%. There are many reasons for that:
– The Antelope resource turned out to be quite another beast compared to the earlier Elk wells, with net payzones 15-25 times larger, porosity higher and rock quality much better (a reef with large parts of dolomization).
– They had their first official resource estimation from GLJ (3.43Tcf P2, although we have to stress that this basically excludes all data from the Antelope wells, so the real number will be several times that (expect an update in March this year)
– A second report from Knowledge Reservoir included the info from the first Antelope well and arrived at 6.7Tcf (P2).
George Soros took a large position at just under $35 and kept adding to that (he holds 2.8M shares)
– New analyst coverage with Morgan Stanly increasing it’s price target in steps from $65 to $115 a share recently and Nataxis Bleichroeder having an $98 target.
– After an initial scare in the summer, the PNG government approved the LNG plant proposal, which is budgeted at only half the cost compared to the Exxon/OilSearch one (the difference is due to infrastructure already in place, cheaper and more productive wells, InterOil being much closer to the LNG plant site and having a single resource in the lowlands, compared to scattered resources in the highlands for the other LNG project)
– Prime Minister Somare announced a MOU between InterOil and Mitsui about a liquids stripping plant which will give InterOil a significant early monetization opportunity. The final agreement is pending the ongoing testing at Antelope2.

Future catalyst
The rise last year was quite spectacular. Does this mean that there won’t be reasons for the stock to continue to go up? Well, not necessarily:
– any increase in the condensate/gas ratio at the (near) bottom of the Antelope2 well will have a significant impact on the economics of the stripping plant (see below)
– The signing of the liquids stripping plant deal (there is an MUO with Mitsui from Japan) is awaiting the well news
– At Antelope1 there was an oil leg below the gas but it was in tight rock. The chances of getting it out at Antelope2 are much better, as the reef dips down. Horizontal drilling will further increase the chances for a commercial oil leg.
– In February or March, there will be a resource upgrade year end report. Including the very prolific Antelope1&2 wells will increase estimations several fold
– Antelope 3 (between Antelope 1&2) will arrive in the second quarter
– After work at Antelope2 is finished, InterOil will continue to pursue a couple of deals: an upstream sell-down and an LNG partnership. These will give them funds to pay their part of the LNG plant and accelerate their exploration efforts applying multiple rigs.
– We can expect the first of the unexplored structures to be drilled in the second half of this year.

Morgan Stanley just increased it’s price target to $115 on the following assumptions:
1) Resources: 6.7Tcf of gas and 120MMbbls of condensate, although there is upside including Antelope2 data as the 6.7Tcf is Knowledge Reservoir’s assessment before Antelope2 was drilled. Antelope2:
– was found 345 feet higher, increasing the reservoir rock significantly
– proves Antelope to the south
– has 14% average porosity over an 1100ft net payzone

2) Sale price of $1.63 per Mcf for the upstream sell-down of a part of Elk/Antelope (35% max) of 6.7Tcf (there is upside to that, as this is the Knowledge Reservoir figure excluding Antelope2). This $1.63 is still below
comparable transactions like Nippon paying $800M ($2.16 per Mcf) for a small stake in the Exxon/OilSearch fields.

Liquids stripping
The liquids stripping plant is well supported by the new DST results, which came in 25% (not 15% as MS has it) above the figures from the DST at the top of the payzone (DST1). It’s perhaps best to quote the MS report at length for better understanding:

The impact of a higher condensate ratio reported today is twofold:
– (1) it increases the amount of condensate in the structure (have to wait for GLJ estimate to get the amount), and
– (2) could increase the producible rate in the condensate stripping facility.

The planned facility cost is $450MM for a 1 train stripping facility (approximately $220MM for facility, $100MM pipelines, and $120MM for drilling capex). The train is designed to strip condensate associated with 400mmcf/d of natural gas flow, so improvement in the condensate ratio, will also improve facility flow rate, cash flows, and the associated NPV.

We assume 22.4 bbls per 1mmcfe to yield 9mmbpd from the facility and the condensate ratio from today’s test at an adjusted 26 bbls per 1mmcfd represents potential upside to 10–11 mbpd. Each incremental 1 mbpd of processed condensate improves the NAV by approximately $1.50 per share (pre-sell down) on the same resource amount. Additional trains could be added at a cost of $220MM per train, so economics improve for each additional condensate train added.

On the MOU between IOC and Mistui, Morgan argued:

The agreement will likely also provide an off-take agreement for naphtha, a product of the condensate refined at IOC’s refinery. We believe the MOU is an important first step and a binding agreement will be executed in 1Q10. The key terms to be negotiated are likely the off-take agreement and whether and how the facility could be converted into an upstream interest when the LNG sell-down closes. We believe signing a liquid stripping facility financing and off-take agreement would have the following positive value implications:
(a) it would de-risk the liquid stripping value;
(b) it would support our increased price assumption on the upstream sell-down as the more immediate cash flow stream and liquids drive higher value in the sale,
(c) it would mitigate 2010 funding issues as the credit facility could fund associated Antelope drilling which preserves IOC’s $80MM cash for other exploration (effectively improving IOC’s leverage in its sell-down process), and
(d) it will improve the refinery profitability by increasing throughput by 9–12mmbpd without any additional working capital requirements (condensate production rate).

Oil?
Antelope1 showed oil, albeit in tight rock. The chances of getting the oil out at Antelope2 are higher, especially with the help of horizontal drilling. Antelope is roughly 12×4 miles, which yields 30,000 acres. Morgan assumes 20% of the acreage can produce oil and a 15-20% recovery factor, 5% average porosity and 80% saturation, which yield a possible 85-115MMbbls of recoverable oil. This would add $42 to their base ($115) share price target which doesn’t include anything for the oil. An oil recovery would also:
– de-risk the LNG/sell-off of a stake in Elk/Antelope
– force the street to assign some value for IOC’s exploration portfolio (over 4M acres).

Criticism?
Once, InterOil had over 11M shares short and up to 6M undelivered shares. It spend years on the RegSHO list. This is largely in the past, However, there is a small but voiceforous band of critics led by Barry Minkow’s “Fraud Discovery Institute”. They haven’t had the best of years, being short since the mid 20s. Morgan Stanley argued in their first report that it was “not meaningful” and we have previously busted their arguments (for a summary, see here, especially the rebuttal of what they caracterized as the prime risk, pressure depletion in the wells)