Monness, Crespi, Hardt & Co on InterOil

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IOC Update

InterOil Corp (IOC – Buy – $74.74): The InterOil common shares have been under selling pressure as some holders take profit after the major price appreciation realized in 2009. The shares continue to be attractive based on impressive drilling results and major strides made on both the proposed LNG export facility and a natural gas liquids stripping plant. Investors should continue to accumulate the common shares as the profit potential continues to be impressive along with an exciting long-term exploration exposure.

The latest drill stem test at the Antelope II well was not well received. The reported daily flow rate of 11 million cubic feet of natural gas and a condensate ratio of 20.7 were disappointing to some shareholders. For our part, the 20.7 was well above the 16.0 barrels per million cubic feet reported earlier from the upper part of the Antelope II well. The reported natural gas flow rate relates to only a small section of the well and could have been impaired by some mechanical difficulty.

The Antelope II well has proved up a major resource of natural gas and is now approaching the most interesting sectors of the well. We expect another drill stem test in the next week or so which should reflect the normal trend of heavier condensates at the lowest part of a natural gas reservoir. Soon after completing the natural gas tests, the Antelope II well will probe the possibility of an oil leg at the bottom section of the well with total depth expected to be in the area of 8,300 feet. Any type of oil discovery would of course add an entirely new dynamic to the evolving InterOil situation.

While there is considerable current focus on near-term drilling results, investors should note that two proposed industrial facilities are fast approaching a final contract stage. The condensate stripping plant appears to have the more important near-term significance. We assume a stripping plant could be operational in about two years and would generate a very attractive return very quickly. We assume sufficient natural gas has been discovered to back up both a stripping plant and an LNG export facility. The stripping plant will extract all the liquids usually found with natural gas and the dry gas will then be reinjected into the original reservoir for productive use at some future date. InterOil and the PNG government have signed a deal with Mitsui, a large Japanese conglomerate to proceed with a stripping plant with the final terms to be fixed pending final determination of the volumes of NGL in the natural gas. Mitsui is committed to provide a credit facility that would cover the remaining costs of $440 million to build the complex. We estimate the pre-tax profit potential of this facility could exceed one or two hundred million per year based on anticipated production of 9,000 b/d of saleable liquids and current prices. Depending on future drilling results, the 9,000 b/d may well be exceeded and prices will no doubt continue to fluctuate.

The LNG plant is of course a much longer-term project. The PNG government recently issued a final project agreement and we suspect negotiations are underway with numerous interested partners that would like to own part of an LNG complex that should have the lowest costs of any comparable plant in the region.

We anticipate the transformation of InterOil that started in 2009 will continue in 2010 as the company becomes more of an industrial enterprise with solid earnings largely based on oil and gas production. The company’s small refinery has been a modest but steady source of earnings and cash flow with throughput in the area of 50-60% of capacity.  Numerous announced construction plans indicate that sometime in 2010 demand for oil products should jump as construction starts with a favorable impact on downstream earnings. A stripping plant could well be operational in late 2011 – early 2012 and an LNG facility in 2014-2015. Not a bad potential growth trend for a company that for its entire fifteen year life has reported only nominal earnings.

Despite all of the above prospective earnings prospects, the most exciting potential for InterOil could well lie in its exploration possibilities. To date, IOC has drilled only five wells on the Elk-Antelope structure and recorded four successes. The company has reported at least 35-40 additional geologic prospects that should be tested as more funds become available to the company. One or two additional discoveries could have a profound impact on the markets long term evaluation of InterOil. We continue to believe IOC is on a threshold of a new era that could be very profitable for both the company and its shareholders. Purchase is recommended.

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