It’s not based on any new fundamental news but nice nevertheless. How to play this?

Yesterday, InterOil offered possibly one of the most inscrutable PR’s ever. Even highly trained petroleum engineers who are familiar with the story couldn’t make much of it (here and here). It was actually curious that there wasn’t a sell-off on the PR, as it seemed to contain at least two bad news items:

1. No oil flow from the vertical well
2. A much reduced thickness of the oil leg as the water contact was quite a bit higher than expected (see our post yesterday).
3. It also remains to be seen whether the 7% porosity they’re likely to encounter is good enough for a meaningful oil flow.

Later in the day, we think management realized the situation needed clarification so this morning they came out with all guns blazing, telling the story with the help of a conference call organized by Morgan Stanley. Morgan Stanley gave an update (see below). What do we conclude?

1. The fundamental story is intact (we never doubted that for a second).
2. InterOil’s shares are trading a little above MS’s distressed sale price for stranded gas and at a 50% discount to their unrisked NAV base case and a $49 discount to their 2010 price target ($115)
3. Between the lines one can read that the prospects for a commercial oil leg are reduced, but not gone
4. We believe that there won’t be any news for quite a while, possibly a month. We previously thought that the Mitsui deal could be signed any moment but according to MS that is dependent on the outcome of the horizontal drilling (see below in bold letters).
5. That could very well mean that after an intial pop today, the shares start to drift lower a bit while we waiting for the news. This often happens to InterOil’s shares.
6. So if one is patient, just stay put. For traders there seems to open up some trading opportunity for part of their shares.

Morgan Stanley: February 1, 2010 InterOil Corporation Pull-back Represents Buying

• Opportunity Supported by Gas and Condensate Value Investment opportunity in IOC. Despite 2009’s defining events that included the Antelope natural gas discoveries and successful early developments in the monetization efforts (PNG approval of IOC’s LNG facility and execution of the key terms agreement with Mitsui for the liquid stripping facility), investors continue to doubt IOC. We believe the pullback is an opportunity for investors that missed IOC’s first run on the Antelope discovery to participate in the next move relating to further definition of IOC resources and monetization.
• IOC is now trading modestly above our distressed sale price for its stranded gas/condensate, over 50% discount to our un-risked, base NAV and $49 discount to our 2010 price target with several material catalysts in 1Q2010 – all of which assume no value for oil potential.
• Today’s update. We view today’s drilling update as positive with an increase in porosity in “zone of interest” where a horizontal test in March will provide results on any oil potential. However, at $62, we see little “expectation for oil” and find significant value on gas and condensate resource and monetization thereof. We believe that the recent focus on oil potential has overshadowed the core value proposition of gas and condensate monetization.
• Why the pullback? In the last several weeks, IOC has reverted to its pre-Antelope volatility levels where, in our view, the recent sell-off has been excessive and primarily attributable to market factors, negative press, and a reduction of oil expectations. New personnel additions are positive. On January 18, 2010, Henry Aldorf, formerly the President of Marathon International, joined an IOC affiliate. We believe he augments IOC’s LNG execution skill-set (prior EG LNG responsibility) and provides another material vote of confidence in IOC and its planned LNG and liquid stripping projects by an industry executive.

Price Target $115 Derived from our base case. Bull Case $165

• Assumes $85 oilprice (perpetuity)
• Exploration Upside; Oil in Antelope Oil discovered in Antelope-2 and higher year-end resource estimate (gas to 8tcfe and condensate to 160mmbbls), 100MMbbls of recoverable oil (gross); $3.6 billion sale price of IOC’s interest (includes value for oil), 90% risk factor on upstream, 15% NAV discount; $6 per Base Case $115 Assumes $85 oil price (perpetuity) Joint Venture Partnership is Signed Assumes 120MMbbls of condensate, $2.35 billion sale price of IOC’s interest. Upstream gas risked at 85% and condensate at 90%; shares targeted to trade at an additional 15% discount to risked NAV.

Bear Case $55

• Assumes $75 oil price
• No LNG JV Signed, Resource Estimate Lower
• Assumes no LNG development JV; a lower resource estimate (5tcfe gas); no commercial oil found at Antelope-2; a $75 oil price; a condensate stripping facility is built ($8.50 per share); and IOC exploration resource and stranded gas is sold at $46/sh ($.6 per mmcfe).

Potential Catalysts/Key Value Drivers

• Liquid stripping commercialization agreement (~$450m credit facility) probable during early 1Q10.
• Antelope-2 horizontal drilling (higher flow rate potential) March 2010.
• GLJ/Knowledge Reservoir Resource improvement due in February/March 2010.
• Antelope-3 results expected late 2Q/early 3Q 2010.
• LNG Partnership/upstream sell down expected in 1H10 (fully fund development and future exploration).
• Additional Exploration as we believe IOC will likely test another structure within its exploration portfolio by year-end.

IOC Pullback

• The recent pull-back represents an investment opportunity in IOC. Despite 2009’s defining events that included the Antelope natural gas discoveries and successful early development in the monetization efforts (PNG approval of IOC’s LNG facility and execution of the key terms agreement with Mitsui for the liquid stripping facility); investors (both bears and bulls) continue to doubt IOC. We believe IOC remains a  non-consensus stock pick, particularly among institutions, and developments that we expect to occur in 2010 will mark the transformation of a company from a frontier exploration story to a fully funded hydrocarbon explorer with developments toward production and un-lock significant asset value.
• We also believe the pullback is an opportunity for investors that missed IOC’s first run on the Antelope discovery ($35-85) for the next move relating to further defining the resource base and its monetization. IOC is now trading at our distressed sale price for its stranded natural gas and 50% discount to our un-risked, base NAV, $49 discount to our 2010 price target with numerous, material catalysts in 1Q10. Why the pullback? In the last several weeks, IOC has reverted to its pre-Antelope volatility levels. In our view, the recent sell-off is excessive and attributable to the convergence of several factors:
• (1) the market correction and broader beta sell-off,
• (2) emerging market led sell-off (China matters to IOC),
• (3) relatively large recent stock gains since IOC’s March lows,
• (4) some modest delay in results versus expectations (condensate DST and oil test),
• (5) the atypical manner of the “oil discovery” disclosure due to Petromin disclosure; and
• (6) a renewal of negative coverage on IOC.
• The most fundamental change is the emerging markets pullback, where, China, in particular represents the primary potential buyer of IOC’s LNG. We believe the Chinese market consolidation is just that – a market related pull-back – and not a material change to China’s growth demand that could potentially alter its future natural gas and condensate demand. The increase in negative press or “fraud” claims contain no original insights into PNG or IOC’s assets versus those we addressed in our initiation at $35.
• The positioning of the company with resource, geologic data, and sell-down process and liquid stripping key terms agreement represent fundamental differences from prior two major stock pullbacks (2005 and 2007 price consolidations). What will drive sustainable stock gains in 2010: context.
• There has been a lot of focus on many tangential issues in the IOC story. What matters in 2010 and what should drive stock outperformance, in our view, is the following, in order of materiality:
• (1) a signed LNG agreement and upstream sell-down (gets our $115 target price on gas and condensate alone),
• (2) the natural gas and condensate resource upgrade (March – both GLJ and KR updates on 12/31/09 resource updates incorporating Antelope-1 and 2 well results – could also improve the upstream sell-down price),
• (3) Oil or no-oil (already priced in as “no-oil,” in our view),
• (4) signing final liquids stripping agreement with Mitsui,
• (5) Antelope 3 well results, and
• (6) other exploration wells/new drilling rig (post sell-down financing).
• A delay in a DST, lack of material oil, or an immediate catalyst should not be as critical to the ultimate value proposition at current levels. Today’s drilling update. The company provided a drilling update today that provides a reminder of the success of the Antelope-2 well to-date (gas and condensate) as well as some incremental drilling data. Since the 1,224 ft successful open hole test (702mmcfd flow rate), IOC cased the 1,224 ft gas section, drilled an additional 338 feet and conducted DST-2 over this section. DST-2 yielded a 15% increase in condensate ratio (down to 7628 ft). Following DST-2, IOC drilled another 132 feet where it conducted DST-3 and 3-A, after which it drilled an additional 327 feet to well TD.
• The water level appears to be at levels of DST-3 (7760 ft) and the “area of interest” appears to be the potential oil zone where they observed a 34% increase in porosity over Antelope-1 that we believe indicates approximately 7% porosity. Sufficient for oil flow yet lower than dolomitized portion of the reservoir. IOC is currently determining where to target its planned 1,000 ft horizontal extension and evaluation. We see the potential for an uptick in porosity into a horizontal leg as the company will likely drill in the direction of the reefal tilt where porosity should increase.
• We still see the possibility of an oil leg yet at $60 see significant value underpinned by the gas and condensate resource.
• Further, we believe the oil determination (either way) will clear the way for the Mitsui agreement to be signed and the LNG/upstream sell-down to proceed. New personnel additions: Improve execution ability and support story credibility.
• On January 18, 2010, Henry Aldorf joined as the President of Pacific LNG and a Director of Liquid Niugini Gas Ltd. Pacific LNG owns 47.5% of Liquid Niugini with IOC.
• We believe this addition greatly augments IOC’s LNG execution skill-set and provides another material vote of confidence in IOC and its interest in a planned LNG project by a senior oil and gas professional. Mr. Aldorf was most recently the President of Marathon International and Vice-President Global Upstream of Marathon Oil. Mr. Aldorf has 37 years of experience in the petroleum and chemicals industry, the last nine of which have been with Marathon Oil. Prior to his most recent role with Marathon leading worldwide upstream business development, including upstream commercial strategy and negotiations, Mr. Aldorf held the positions in Marathon Oil International of Senior Vice President International Business Development, Senior Vice-President West Africa, Middle East and Asia Business Development, and Senior Vice-President West Africa Business Development . In the latter position, Mr. Aldorf was responsible for Marathon’s EG LNG project in Equatorial Guinea and was the first Managing Director of EG LNG Co. Mr. Aldorf is reunited with his former Marathon Equatorial Guinea LNG team members, Mr. Andy Mitchell and Mr. Wayne Hamal, both currently with Liquid Niugini Gas and InterOil. They were all part of the team responsible for designing, partnering, and executing the Equatorial Guinea (EGLNG) LNG plant. The EG LNG development was completed in the shortest time ever for an LNG project.