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INTEROIL (IOC) – THE STAGE IS SET FOR THE NEXT LEG UP

In conclusion, there hasn’t been a single argument submitted over the past few weeks that has altered my thesis on the value of the company’s gas and condensate in Elk/Antelope being in the vicinity of $300 and $40+ per share respectively and on the exceedingly high probability that the company’s resources will soon be converted into reserves as the it monetizes its gas and condensate this year and strikes offtake agreements with LNG consumers.  The simplified details of my valuation arithmetic is contained in the following post, http://seekingalpha.com/instablog/596886-thomasnoble/59320-riding-the-lng-wave-buy-interoil-ioc.

With government approval for the liquefaction facility having already occurred and a confirmatory positive resource assessment by both Knowledge Reservoir and GLJ Petroleum Consultants indicating sufficient quantities of low cost gas to support a 2 train liquefaction facility (the last published 2C resource estimate by Knowledge was 6.7 tcf, which doesn’t incorporate Antelope 2 results), InterOil has for the first time in its history emerged into more of a world class asset play than an execution story. 

To demonstrate the magnitude and potential value of InterOil’s resource base, let’s contrast its 873.2 MMBOE of net best-estimate contingent resources to CNOOC’s total net proved reserves of 2,658.4 MMBOE at year-end 2009 (I used CNOOC as an example because of the interest expressed by the company in the past in working with IOC – www.bloomberg.com/apps/news?pid=20601072… ).  CNOOC sports a $79 billion market cap while IOC’s slightly exceeds $3 billion.  CNOOC could purchase IOC for a substantial premium, fund the equity portion of the liquefaction facility with a fraction of its ~$10.4 billion of current assets, and take 100% of the LNG offtake to feed the LNG regas terminals that are mushrooming around China’s coast ( www.foxbusiness.com/story/markets/indust…;). 

The characterization of InterOil’s gas as contingent resources as opposed to proved reserves is a function of its commerciality, which would be addressed by CNOOC’s FID in this example.  Hence even if CNOOC were to pay a 200% premium for InterOil (~$220 per share), it could increase its proved reserves by in excess of 30% in return for an investment of just 12% of its market cap.  CNOOC and other cash-rich prospective partners in LNG importing nations like Japan, South Korea, Thailand, and India could probably facilitate a value accretive acquisition of InterOil at a huge premium and facilitate the commercialization of its resources without any external support.  This is a new phenomenon for InterOil that materialized subsequent to its third-party resource evaluations and government project approval, and it greatly diminishes the company’s execution risk as it provides a comfortable cushion on which to fall back.

The recent barrage of attacks against InterOil have attempted to instill fear about the quantity and quality of the company’s resources as well as managements’ credibility and the potential repercussions of a legacy legal issue that is likely completely immaterial to InterOil shareholders.  Let’s begin with an assessment of the molecules.  As noted above, both GLJ Petroleum Consultants and Knowledge Reservoir have provided robust assessments of InterOil’s resources.  GLJ is one of the largest Canadian reservoir engineering firms with >100 people on staff and it has been in business for almost 4 decades. 

It evaluates projects all over the world and provides certified resource estimates for Suncor, a $55 billion market cap integrated energy company based in Calgary.  The tight dispersion of GLJ’s resource estimates is a testament to its level of confidence in the quantity of gas in the reservoir.  Anecdotally, I’ve heard from people unaffiliated with InterOil that the reservoir evaluator who has spearheaded the certification process is a Senior Vice President named Dave Harris who has been with GLJ for over 20 years, is widely respected, and is known to be exceedingly conservative with his resource estimates. 

I’ve also heard that Jim Jarrell, President of Ross Smith Energy Group whose tenure at GLJ earlier in his career coincided with that of Dave Harris, transitioned from having a minimal resource estimate for Elk/Antelope during the period in which the Elk wells were drilled to being constructive on the size of the resource subsequent to the Antelope reef discovery. 

Lastly, I’ve heard that Ryan Todd, a research analyst who works on Evan Calio’s team at Morgan Stanley, was a reservoir engineer for Exxon earlier in his career and developed a constructive stance on InterOil after spending time in PNG conducting thorough due diligence.  Knowledge Reservoir is a Houston based reservoir engineering  consultant that specializes in field modeling and was hired by InterOil to model the Elk/Antelope field and estimate the size of the resource; the following link provides a list of clients for which it provides services – http://knowledge-reservoir.com/about_clist.htm. 

Henry Aldorf, who spent 32 years with Unocal and Marathon, was the President of Marathon International and is widely respected for economically and expeditiously facilitating Equatorial Guinea’s LNG project from scratch, was recently appointed President of Pacific LNG, which owns 47.5% of Liquid Niugini.  If he didn’t believe that InterOil unequivocally has adequate resources to support the 2 train ~8 million metric ton liquefaction project that he’s in the midst of trying to facilitate, it’s doubtful that he would have been compelled to join the venture.  

Despite the uniformly constructive comments and evaluations by credible third-party engineering firms (Knowledge and GLJ) and potential strategic partners (GAIL, CNOOC, PetroChina, etc…) that have had access to InterOil’s data including production log results, hundreds of core samples extracted from the Antelope reef, detailed observations of DST and flow test results including pressure plot data, and hundreds of miles of deep density 2D seismic data, the community of skeptics who haven’t even been to PNG seems louder and more pervasive than ever. 

In Morgan Stanley’s initiation note, it noted that “some 70 parties made initial contact to enter the data room, which began in March 2009”.  Why would these parties continue to express interest in partnering with InterOil if there were any doubt about the quantity and quality of the resources?  Weatherford facilitates InterOil’s flow test calculations and managed pressure drilling while Schlumberger facilitates its coring and logging.  My perspective on the skeptics’ arguments is that they revolve around arbitrary extrapolations and innuendo that circumvent addressing the attributes of InterOil’s world class reefal Antelope reservoir and instead focus primarily on drawing irrelevant analogies to dissimilar structures.

Some skeptics contest that prior exploration failures in the Eastern Papuan Basin elicit doubt about the attributes of InterOil’s reservoir.  Although there has been some drilling activity over the past several decades, the area was lightly explored with a well density of only ~1 well per 400,000 acres. Substantial oil seeps were reported in the Eastern Papuan Basin as early as 1911, but the perception about poor reservoir quality resulted in a lack of drilling activity in the region for over 3 decades. 

Onshore fractured carbonate reservoirs in the Eastern Papuan Basin including Kuru 1, Puri 1, and Bwata 1, all of which were drilled in the late 1950s, did not produce sufficiently robust hydrocarbon flows to materialize into commercial discoveries. Comparing these reservoirs, however, with the Antelope reef is like comparing apples and oranges. 

Antelope is the first onshore reef discovered in the Eastern Papuan Basin, extending a known trend of reef development from offshore into InterOil’s onshore acreage.  Both ends of the reef have been pinned down with the successful drilling of Antelope 1 and Antelope 2, which are 2.3 miles apart from each other. 

Antelope 1 has a 2,425 ft hydrocarbon column with a net dolomite reservoir of 746 ft that contains average porosity ranging from 13% to 30%.  The porosity of the limestone and upper and lower transition zones is much lower, but the quantity of high porosity dolomite make Antelope 1 an exceedingly prolific well.  The well flowed at 382MMcfd and 5,000 BCPD with increased condensate yields at lower intervals.  Antelope 2 has a hydrocarbon height of 1,729 ft, an AVERAGE porosity of an astounding 13% which is 48% greater than that of Antelope 1, and very high productivity across the pay zone with a net to gross of 70.7%. 

The well flowed a world record 705 MMcfd along with 11,200 BCPD.  Antelope has displayed consistent matrix porosity and robust permeability across the hydrocarbon column.  This is in stark contrast to the substantially less porous Puri and Mendi limestone structures that have been discovered in the region. 

In a research paper named “Characteristics and Hydrocarbon Potential of the Fractured Puri and Mendi Limestone Reservoir in Papua New Guinea”, written by several geologists including David Holland and Rodrigo Heidorn, they cite the lower porosity of the Mendi-Puri sequence, but they also acknowledge the “good reservoir properties” of fractured limestones that make them “attractive and viable hydrocarbon exploration targets” and the higher porosity and permeability in areas of increased dolomitisation:

“The Puri-1, Bwata-1, Kuru-1 and 2, Moose-1 and 2 and Triceratops-1 wells have shown that fractured limestones exist, have good reservoir properties and represent attractive and viable hydrocarbon exploration targets. Given that fractures and faults have acted as fluid migration conduits, and have been the principal storage sites; fracture orientation, spacing and aperture have been quantified in surface and subsurface intervals of the Mendi-Puri sequence.

Results from surface studies indicate a primary bimodal ENE and NW- trending fracture distribution, with a corresponding approximate calculated porosity of <5% and permeability of <180md. These data are comparable to calculations made directly on core from the Moose 1 and 2 wells, which yielded approximate calculated porosity of <7.3% and permeability of <136md. Core data has identified high and low angle fracture sets, with porosity and permeability increasing in zones of increased dolomitisation.”

The audacious claims of the skeptics insinuating that the third-party engineering firms who have conducted the resource evaluations for InterOil haven’t considered the attributes exhibited in fractured carbonate systems in the Eastern Papuan Basin are ludicrous.

Notice that the sources of skepticism towards InterOil’s resources are predominantly the company’s “competitors” (I don’t really perceive them as competitors since the opportunity to develop conventional LPG-rich LNG projects is so great, but some seem to exhibit hostility towards InterOil), short sellers who haven’t even been to PNG, or PNG old hands who haven’t had access to InterOil’s data room and may have witnessed disappointments in other carbonate structures that bear little resemblance to Elk/Antelope given the unique attributes of the Antelope reef and the tremendous dolomitised section of its pay zone. 

GLJ and Knowledge would not have provided such robust resource estimates if they thought that a long-term flow test were necessary to confirm that the pressure and flow rate of the structure are sustainable for a prolonged period of time.  The magnitude of the reef and extensive dolomitisation as confirmed by matrix porosity across hundreds of core samples and extensive logging data provides more than adequate assurance that the structure will generate sustained robust productivity.  Also, as Wayne Andrews indicated in a recent interview by PLS, “We flowed the well (Antelope 2) at various rates and chokes over a four day period to get information on some basic reservoir qualities. For example, even for the high flowrate test, the FTP was 1,254 psi, and upon shut-in, the pressure rebuild was almost immediate—back to the original SITP.”

Finally, I addressed the Peters case and insider selling in detail in my previous post (http://seekingalpha.com/instablog/596886-thomasnoble/61159-interoil-ioc-time-to-double-down ).  The  bottom line is that InterOil’s lawyers’ assessment confirms that it should be very difficult for the Plaintiffs to be awarded substantial damages (let alone the exaggerated derivative award that they’re seeking), as all but one partner who comprise the Plaintiffs have already signed partnership amendments fully releasing all claims against Phil and InterOil, and they’re now trying to rescind their agreements in conjunction with a bunch of contingency fee lawyers.

Also, the statute of limitations in Texas is 4 years, and the Peters filing occurred several years beyond this period.  The Bankruptcy Court Judge in the Nikiski case also acknowledged that the Peters case should not have an impact on InterOil – “Much as the change in percentage ownership occurred with the Martin settlement; after the Martin settlement Mulacek owned less, others owned more, InterOil was left unaffected under the evidence that I have before me … it’s also true that the lawsuit, reviewing the totality of the evidence, would more likely result in a change in the percentage of ownership of InterOil rather than somebody seizing the assets of InterOil.” 

I think that this is an ancillary issue that is distracting investors from focusing on the fundamentals of the business. As the following article states, “Nearly 90 percent of U.S. corporations are engaged in lawsuits. At any one time, the average $1 Billion Company in the U.S. faces 147 cases.” ( http://my.advisor.com/doc/17319 )  The Peters case is the only case that’s still pending under the “Legal Proceedings and Regulatory Actions” section of InterOil’s most recent annual report.  I don’t think that it would be too difficult to exaggerate the severity of most cases listed on companies’ annual reports by only presenting the allegations without the accompanying defendants’ arguments, especially given that parties involved in litigation are restricted in what they can say while legal proceedings are pending.

I strongly believe that InterOil’s stock is in the midst of its next leg up, as I anticipate current deal negotiations will translate into monetization of its resources at valuations that make the stock at current levels a tremendous bargain.