It already seemed pretty good to us, and now it’s gotten a whole lot better still..

You might want to reflect on the latest news (see here):

• Flex LNG of Norway and Samsung Heavy Industries are going to build a 2mtpa floating LNG plant to liquify gas from InterOil’s Elk/Antelope.
• Operations will start mid 2014, that’s early monetization (compared with the traditional plans of a big land based LNG plant at Napa napa, next to the refinery)
• The Feed has already been completed
• The plant will be fully financed by, no, not InterOil but Samsung and Flex LNG and operated by Pacific LNG (that is, InterOil and Civelli’s JV)
• InterOil and Pacific LNG will receive options to acquire a stake in Flex LNG and shares on FID (15% stake)

Until now, the weak link in the monetization scheme has been the skepticism (whether warranted or not) towards EWC, on which InterOil’s modular LNG plan depends.

Unfortunately, judging by the market reaction to the news today, the same skepticism is apparent towards Flex LNG. The question is, is this warranted. We don’t think so (from the Flex LNG pr):

“Samsung Heavy Industries has agreed to restructure the commercial relationship between the two parties whereby, upon achieving FID, the intention is to transfer substantially all previous instalments paid to Samsung Heavy Industries under the existing four shipbuilding contracts to the single FLNG unit that is destined for the PNG project. FLEX LNG would retain its right to construct additional FLNG units at SHI.

FLEX LNG and Samsung Heavy Industries will be responsible for the design, engineering, construction and commissioning of the FLNG vessel. FLEX LNG will also be joint operator of the FLNG unit together with LNGL, which is a joint venture between InterOil and Pacific LNG. Construction of the FLNG unit will be fully financed until delivery. The equity already paid in by FLEX LNG to Samsung Heavy Industries will cover all payments to Samsung Heavy Industries until delivery of the FLNG unit, when one final instalment will be due. FLEX LNG will not require any additional working capital from its shareholders prior to reaching FID. FLEX LNG’s funding requirement between FID and delivery of the FLNG vessel is limited to general working capital and project management cost in the period.

This strongly suggest that the overwhelming majority of the financing burden of building the FLNG plant is on the shoulders of Samsung, in a kind of vendor financing. Difficult to argue that Samsung won’t be able to get this done.

What’s more, since most of Flex LNG’s financing obligations to Samsung have already been paid and are in equity, aligning the interests of Flex LNG and Samsung as the latter becomes a substantial shareholder in Flex LNG. Samsung will therefore also have an interest in the operation of the FLNG vessel, not just it’s construction. One could basically say that to a considerable degree, Samsung is Flex LNG.

InterOil and Pacific LNG act as guarantors for the last Flex LNG installment (but they also get an equity stake in Flex LNG for that). This last installment is due when the vessel is completed, and there can be little doubt Samsung won’t be able to do that.

In creating the vessel, it also generate the hard asset underlying Flex LNG’s value, and by extension, InterOil’s and Pacific LNG’s guarantee of the last installment, aligning the interests of all in getting it done.

What’s more, even if EWC will somehow not be able to get the modular LNG plant financed, there is now a Samsung financed/constructed alternative for handling the dry gas coming from Mitsui’s stripping plant. This should make Mitsui’s FID more certain (even if it might get delayed to synchronize with Flex/Samsung instead of EWC).

Why we think InterOil is a relatively low-risk investment, especially when set out against the possible rewards?

At heart, this is rather simple: InterOil has third party vetted resource in the ground. Unlike highly valued technology companies, that resource runs minimal risk of being outdated anytime soon, It doesn’t depreciate. It doesn’t rot or perish. It just sits there, it’s value not decreasing. In fact, it’s much more likely to get bigger and more valuable than it is to lose value.

Three ways InterOil can lose value

1) Resource gets partly or wholly expropriated
PNG could misbehave. Politicians might be tempted to appropriate more of the extraordinary value of the resource (and/or it’s monetization routes).

However, one should not forget that PNG already starts to benefit massively from the project, benefits (especially when other big investment projects on the island are considered) that probably go beyond the scope of the economy to absorb (just one of these LNG projects will more than double the economy over six years).

PNG is owner of 22.5% of the resource at pro-rata development cost (discovery and drilling) while enjoying all the benefits of other owners. It receives further income from taxation on numerous activities, although PNG has one of the best resource tax regimes in the world.

So far there is no indication that whole, or part expropriation is likely to happen. Relations between IOC and PNG are generally excellent. More importantly, it wouldn’t be in PNG’s interest to become an unreliable partner. That would scare away foreign capital, technology, know-how and investment, which they urgently need.

2) Demand for the resource falls away
Realistically, this can only happen if the world economy goes of the boil again. So far, there is favourable wind in sails because of the nuclear situation and strong emerging market growth.

3) Stockmarket crash
Unless accompanied (caused) by a world economic crisis and a fall in energy prices, this will have but a transitory influence on shareholders. As long as InterOil’s business model is not impaired (that is, as long as it can sell gas and liquids), it’s valuation will fluctuate but there will be a base value.

Reward

1) Resource gets bigger

• Bwata contains gas (per Bwata1 well from 1960)
• Seismics show it’s a lot bigger and (at places) much thicker (it has an ‘attic’)
• Seismics show there is a reef (see end pages of this presentation)
• InterOil is 100% (minus 22.5% PNG option) owner (no IPI parts here as Bwata has already been discovered so the well they’re going to drill isn’t a discovery well)
• Triceratops had oil shows
• According to the new seismics, Triceratops is part of Bwata
• So we know Bwata will add to the resource, the question is how much. If it is indeed a reef, this could even approach Antelope numbers, but there be a couple of Tcf’s at the minimum

There are plenty of other prospects (Wolverine, Mule Deer, Seismosaurus, etc.) with a couple of other possible reefs indicated by seismics to add further. You would think that if drilling confirms a reef at Bwata, the chances of these other prospects containing reefs increase. After all, InterOil identified the reef at Antelope before it was drilled, and this was heavily contested by Ross Smith Energy Consultants, who had to eat humble pie after drilling confirmed InterOil was right all along.

If Bwata indeed turns out to be a reef, that’s two out of two seismic interpretations right. The odds on further reefs will increase as not only InterOil’s interpretation turns out to be correct, but if there is one, or two reefs in the area the chance that there are to be more increases as well.

2) Resource gets monetized

InterOil’s gas is valued at approximately 70 cents per Mcf in the ground (actually, quite a bit less as we’re not even including the 128.9MMbls of liquids, the profitable downstream businesses, and the 4M acres full of promising prospects). In Asia, LNG can be sold for $10+ per Mcf in the market.

With 8.59Tcf of produceable gas in the ground, that’s more than $80B of potential value, although ‘only’ 5.03Tcf is net to InterOil.

Other parties will build and finance the necessary plant for that. InterOil needs infrastructure spending, but they already went to the markets for that (the share issue and convertible at $75). Cost: the 14.5% of LNG sales to EWC and Flex LNG for building the plants.

They could quite conceivably come to own the condensate stripping plant (build by Mitsui at an estimated $550M cost) if the latter exercises an option for a 2.5% stake in Elk/Antelope in exchange for the plant.

Now, what do we know about potential profitability of monetization?

• 90% of LNG in Asia sells in long-term contracts for prices starting at $10 per Mcf
• Because of the prolific nature of the wells (setting consecutive world record flow rates, having 2277ft and 1175ft of net payzones with 8.8 and 14% average porosity, similar pressure regimes and near instant pressure rebuild), extraction cost are amongst the lowest in the world at 70 cents per Mcf (see p.8 of this, and negative 87 cents if one include the jointly produced liquids, according to Macquarie)

The 70 cent per Mcf calculations include apex and opex. But InterOil has shifted the cost of the CSP (condensate stripping plant) and LNG plant to Mitsui and EWC, respectively. It already has most, if not all of the financial requirements remaining (infrastructure like pipelines and jetty) by means of going to the markets late last year (at a heavily oversubscribed $75 per share issue in which management participated quite heavily as well).

All this points to potentially very profitable projects.

• We forecast the project could expand to 7 mtpa of capacity at which point gross annual free cashflow would reach about US$2.5b. We forecast the first 2 mtpa of capacity alone will generate ~US$9 of our US$11.38 InterOil 2014 CFPS estimate. [Macquarie]

InterOil’s own calculations, as mentioned in a recent research report by Monness, Crespi, Hart and Co. mentions:

• At a recent investor presentation, management forecasted this entire complex could be in place about 30 months after signing and output over a 12 month period (2014) could generate cash flow in excess of $1.5 billion with IOC’s share about $800 million ($16.75 per common share).

The difference is likely to be the result of the extra 1mtpa expansion recently agreed between InterOil and EWC.

And now factor in the 2mpta from the Flex LNG deal, sharing much (if not most) of the infrastructure and the numbers will be a lot better still.

However, waiting remains for clarity about financing the Flex LNG and EWC projects.

Here is what we think could be the problem. There is little doubt that Flex LNG and EWC are financially weak partners, needing third party financing to be able to pull these projects off.

Although overall, producing gas and liquids from Elk/Antelope will be highly profitable (as explained above), but the weak financial positions of InterOil’s partners has created very favourable deals for InterOil, paying nothing up-front for both plants (and only 14.5% of gas revenues as a fee to using them).

So excellent deals for InterOil, but the economics of these projects from the perspective of Flex LNG and EWC is necessarily less attractive.

It could just be that InterOil, as the holders of the scarce resource taking full advantage of a strong negotiating position, has contributed to comparably mediocre deals for its partners and thereby making it more difficult for these projects to get financed.

We do think that will be resolved and Phil’s gamble will pay off handsomely for IOC’s shareholders, but in the meantime, they’ll have to do some sweating

There are several ways financing can be done though:

• Selling part of the resource (Mitsui has one option, another one in exchange for the CSP)
• Farm-out drilling prospects
• Off-take agreements for gas
• Vendor financing. EWC and Flex LNG provide similar, new concepts (modular LNG and floating LNG plants, respectively). They are eager to get a first commercial working example off the ground (another reason InterOil was in a favourable negotiating position) as this can be the first of many. But the same holds for important vendors on which the technology depends, like Siemens and Samsung. As it happens, Samsung is already financing the Flex LNG plant until operation almost completely (see the quote at the beginning of this article, or read the Flex PR).

Which is effectively saying that financing for the Flex LNG project is already in place, with the compliments of Samsung.