Finally…
Investment Thesis

The value of InterOil’s (IOC) massive 9.1Tcfe of gas (independently confirmed) will be unlocked via numerous near-term catalysts that are likely to occur in 1Q2011 and 2Q2011. These catalysts will provide upside of 100%-200%+ to IOC’s current share price over the next 12 – 24 months. We fully recognize that stating an upside of 100%-200%+ elicits immediate skepticism. Initially, we were quite skeptical as well. However, we believe that if you spend some time working through the analysis, you will concur with the conclusion.

InterOil (IOC) is extremely well-positioned to meet the sharply increasing liquid natural gas (LNG) demand in Asia Pacific. Demand for LNG in the Asia Pacific region is forecast to grow from 7.8 Billion cubic feet (Bcf)/day in 2010 to over 25 Bcf/day in 2015 (26.6% CAGR). LNG demand is being driven by the rapidly growing power generation needs of India, China and the other Asian countries and the need to reduce pollution by moving from coal-fired to gas-fired power plants. Polluted water is inhibiting growth in China and other Asian countries. We believe that IOC has the lowest cost gas in Asia Pacific. In a commodity business like LNG, having the lowest cost position is the key to having a sustainable competitive advantage.

Company Description

InterOil (NYSE: IOC) is a Canadian integrated oil and gas company. The company’s upstream activities are conducted on 3.9mm acres of petroleum prospecting licenses in Papua New Guinea (PNG). The key asset is their Elk/Antelope fields, which have obtained a resource estimate of 9.1Tcfe from third party assessor, GLJ.

Papua New Guinea is an under-explored frontier with world class assets strategically located on the doorstep of Asia. PNG has been a country active in exploration of oil and gas with current investments by Exxon Mobil, Talisman, and Oil Search.

IOC Assets

IOC has 3.9mm acres in PNG. The first site being developed in IOC’s 3.9mm acres is called Elk/Antelope. IOC owns 58.6% of the Elk/Antelope resource (PNG government owns 22.5% and some outside investors own the remainder). As of the end of 2009, the GLJ estimate of the Elk/Antelope resource was 9.1 Tcfe, which is 1.52 Billion Barrels Oil Equivalent (BOE). When one includes the 2010 drilling results, which expanded the resources depth and boundaries, we believe that the 2010 resource estimate will be approximately 12Tcfe.

Additionally, there are 40 other exploration targets identified within IOC’s 3.9mm acres and 4 of these other 40 targets display reefal properties (see next section for significance of reefal properties). For conservatism, we are assigning zero value to these other 40 targets. That said, initial seismic results are promising for the 4 reefal targets.

IOC’s Ultra-Low Cost Position

IOC is well-positioned given that it has the lowest cost gas in Asia Pacific. First, the company has spent approximately $430 million in exploration which has resulted in 9.1 Tcfe, or 2C resource finding costs of less than $0.05/Mcf. Second, very few development wells will be required to extract the gas. This is due to the fact that the Elk/Antelope is a reefal structure that is comprised of dolomite with high porosity (8% – 14%). The Elk/Antelope structure is located in the lowlands of PNG, which is quite near the port. IOC’s breakeven price (FOB) is $0.70 per mmbtu (assumes 12% discount rate). Note: 1mmbtu is roughly equivalent to 1mcf. $0.70/mmbtu is among the lowest cost (FOB) in the world, which is just above Qatar at $0.40/mmbtu. The spot price in Asia is around $11.00/mmbtu (over 1500% higher than IOC’s breakeven FOB cost). For reference, previously built LNG projects have a FOB breakeven price of $2.00 – $8.00/mmbtu and new proposed LNG projects are even higher. Even if LNG demand were to slacken and spot prices in Asia fell from $11.00/mmbtu to $5.00/mmbtu, the higher cost LNG projects would be the ones that would become uneconomic. IOC’s project would still have extremely attractive economics even in that downside scenario. Having the lowest cost position is IOC’s key strategic advantage.

Recent Accomplishments

August 2010 – IOC and Mitsui enter into Joint Venture Operating Agreement for a condensate stripping plant. The gas in Elk/Antelope contains about 20 barrels of condensate for every million cubic feet of gas. These liquid condensates sell at a premium price to crude oil and are key feedstock for the production of numerous petrochemical products. As of the end of 2009, it is estimated that Elk/Antelope holds more than 156mm barrels of condensate liquids. Mitsui desires these condensates for its chemical businesses. The deal dictates that Mitsui contributes $550mm to build the condensate stripping plant and can convert that $550mm investment into 2.5% ownership in the Elk/Antelope structure and the LNG facility. The conversion option implies a value of $2.41/mcf. The condensate stripping plant is to be operational before 1H2013. Next step: Final Investment Decision (FID) expected before end 1Q2011.

September 2010 – Energy World Corporation (EWC) and IOC enter into a heads of agreement to construct a 2mpta (million ton per annum) land-based LNG facility in PNG. EWC contributes $910mm in capital for 14.5% of the first 1.5Tcf of gas extracted. Implied price paid by EWC is $3.64/mcf. Next step: FID expected before end 2Q2011.

November 2010 – IOC completes a $280mm capital raise at $75/share. Management and insiders buy $44mm of the deal. IOC now is 100% financed and has all capital needed to meet FID requirements for Mitsui and EWC deals and to fund E&P of Wolverine, MuleDeer and Bwata (next high value targets).

Upcoming catalysts (1Q2011 and 2Q2011)
1)   Partial Sell-Down (2.5%) and Offtake Agreement (1Q2011 and 2Q2011). Company has stated publicly that they expect to conclude a partial sell-down of the Elk/Antelope resource. The sell down will likely take the form of a 2.5% sell down (putting $500M-$600M cash on the balance sheet as the project reaches production) along with a 10 – 15 year offtake agreement (approx 1mm tons/yr).
2)   Floating LNG Partnership (before end 1Q11). We expect IOC to announce a floating LNG deal before end of 2Q2011. Partner (Daewoo or Flex LNG/Samsung) would contribute the LNG ship for a portion of the LNG production – expect there would be minimal cash cost to IOC. http://www.businessweek.com/news/2010-09-15/daewoo-ship-venture-may-beat-shell-to-floating-lng.html
3)   Final Investment Decision (FID) and finalized condensate agreement with Mitsui (before 1Q2011)
4)   Energy World Corporation FID (before 2Q2011)
5)   End of year 2010 resource estimate update from GLJ (1Q2011) – we believe that the 2010 resource estimate will be increased from 9.1 Tcfe to approximately 12 Tcfe (based on 2010 drilling results).
Valuation

IOC is trading at an enterprise value of $3.2 billion (at $74/share). Assuming that Elk/Antelope contains 12 Tcfe, dividing the enterprise value by IOC’s ownership portion of only the Elk/Antelope resources equates to just $0.46/mcf. This is a massive and unwarranted discount to recent Asia Pacific natural gas transactions.

Recent Asia Pacific natural gas transactions for the sale of gas resources have averaged $2.22/mcf. The $2.22/mcf average includes transactions for less attractive coal seam resources that typically sell for around $1.00/mcf. As mentioned above, the Elk/Antelope resource is extremely low cost due to its dolomite composition and the site’s close port proximity. Hence, Elk/Antelope resources should sell for at least the $2.22/mcf average (likely higher). As a reference point, Energy World is paying an implied price of $3.64/mcf for its investment.

Assume 12 Tcfe in Elk/Antelope – 12Tcfe x $2.22/mcf = $26.6 billion…$26.6 billion x 58.6% = $15.6B – value of IOC’s portion is $328/share (343% above current price of $74). Using the price of $3.64/mcf from the EWC transaction yields a value of $538/share. A sensitivity table is included below. Please note: given that the $/mcf amounts are present day transaction prices, the calculation already reflects a NPV adjustment.

The above math assumes ZERO VALUE for the other 40 drilling prospects – MuleDeer, Wolverine, Bwata are 2011 targets and initial seismic analysis is encouraging. We believe that Morgan Stanley (Evan Calio) is the most rigorous sell side analyst on IOC. Morgan Stanley’s current risk adjusted price target is currently $135/share and his Net Asset Value is $225/share.

Weak Bear Case (and getting weaker)
1)   Company has no “proven reserves “ – We agree. “Proven reserves” is merely a technical classification term. IOC has a contingent resource estimate. According to the Canadian Oil and Gas Evaluation Handbook (COGEH), Section 5.3.2, the commercial status of the project differentiates proven reserves from contingent resources. When the Mitsui and EWC deals reach positive FID, we expect the classification of IOC’s resources to change from “contingent resources” to “proven reserves.”
2)   Company has not produced any free cash flow yet – IOC is an E&P company. IOC is now moving from exploration phase (which has taken 11 years and $430mm) to harvest phase.
3)   Bears believe that IOC will not get a sell down and/or offtake deal done – Given IOC’s low cost position, the richness of the condensates, the increasing LNG demand in Asia, the amount of due diligence done by Mitsui before entering into the JVOA, and the experience/history of the deal team…we feel confident that IOC will close a transaction.
4)   Vocal IOC Bear Whitney Tilson (see point 3 in the next section)
–   Sept 10, 2010 – “We’ve Never Had More Conviction and IOC is our largest bearish position“ http://www.businessinsider.com/whitney-tilsons-latest-letter-weve-never-had-more-conviction-in-a-short-2010-9
–   Oct 27, 2010 (just 6 weeks later) – IOC does not appear in his top 12 short positions