|Shares Out. (in M):||48||P/E||nm||nm|
|Market Cap (in $M):||4,100||P/FCF||nm||nm|
|Net Debt (in $M):||100||EBIT||0||0|
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Last December, we posted a short idea on an energy company called Hyperdynamics, which at the time we compared with an earlier short idea we had posted on BPZ Resources. In both cases we noticed a similar fact pattern of deception, significant geological / operational concerns and investor complacency with highly theoretical reserve estimates. Since then, Hyperdynamics is down 80% and BPZ Resources is down 90%. In recent years, we have noticed almost identical characteristics present at other energy companies such as Houston American and Camac Energy (both down around 90%).
Enter, InterOil. InterOil (“IOC”) is perhaps one of the most hotly contested and highly valued energy stock promotions of all time. Never can we recall a company being given the benefit of the doubt like InterOil – we believe in recent years investors have lost sight of a disturbing pattern of events as management has cleverly engaged in convoluted transactions to give an appearance of substantial asset value. We recognize that InterOil is an extremely controversial name (both within the VIC community and elsewhere – please see previous posts by jaxson905), but with the stock at all time highs and the end of the promotion phase upon us, we belive InterOil is a fantastic and timely short opportunity.
To own InterOil stock is to trust management and the quality of their fields. Below, we first establish that the people involved here are simply not credible and then we establish the significant geological issues with their fields. Next, we will debunk the bull case that relies on irrelevant benchmarks and fuzzy math to justify a huge InterOil price. Finally, we will explain why we think the story at IOC has hit an inflection point as the company is now forced to move away from PowerPoint slides into being forced to proving commercial viability of their fields (again, I refer you to our Hyperdynamics post which reached a similar crossroads).
DISCLAIMER: We currently hold a short position in this security. We may change our position at any time without posting an update. The views expressed here are merely the opinion of the author. Please do your own research.
IOC was founded by current CEO Phil Mulacek and became a public company by merging with a Canadian shell company. The original project began in 1994 when Mulacek purchased an old refinery from Chevron inAlaskaand dismantled it with the goal of rebuilding it inPapua New Guinea(“PNG”). After numerous delays and disappointments, the refinery finally began selling product in 2004, nine years after Mulacek originally suggested (at the time of purchase, he told Platts that “the refinery could be processing crude early in 1995”.
However, the source of investor enthusiasm is IOC’s potential natural gas discoveries. The acreage that IOC is exploring has been drilled by a number of E&P companies over the years, with a pattern of initial excitement turning into disappointing non-commercial finds after extended flow tests were performed. IOC drilled eight wells on their acreage from 2001-2005, all of which were dry holes. Beginning in 2006, however, the company had some success. In 2006, IOC’s Elk-1 well discovered natural gas, but then was followed up by a dry hole at the Elk-2 well in 2007. Things turned around for the company with discoveries at the Elk-4 well in 2008 and both the Antelope-1 and Antelope-2 wells in 2009 (with Antelope-2 setting a “world record” flow rate for gas). On the basis of a non-SEC compliant contingent resource estimate from a Canadian firm called GLJ, the company has aspirations of a large-scale multibillion dollar LNG facility that would allow for the export of the gas produced in the Elk and Antelope fields. Simultaneously, IOC is also drilling a separate section of its acreage called Triceratops.
Now, after more than a decade of prospecting and three years since it drilled its last well in the Elk and Antelope fields, the IOC story is entering its final chapter in our view. Given all the delays and the painfully slow pace, IOC is being pressured by the PNG government to finally move the project forward by bringing in a credible international partner which we believe will finally force InterOil shareholders to move on from the company’s hype and deal with the reality of the acreage’s geological deficiencies.
The Individuals Involved with InterOil Cannot be Trusted
Given the IOC bull case basically rests on trusting statements from the company, we are amazed that anyone can get comfortable with the people involved with the company in what amounts to a complete leap of faith. CEO Phil Mulacek has constantly missed deadlines for the refinery, well results and the LNG project development. There are numerous ethical questions swirling around Mulacek as well. Past investors in an entity formed to raise money for the refinery venture, claimed that Mulacek purchased used equipment for the refinery worth $250,000 for $15 million to effectively transfer 5.1 million shares of InterOil to a company owned by his grandfather. Other allegations include diversion of shares for the benefit of Mulacek, his family and other insiders (with no consideration paid).
According to BusinessPundit.com:
In 2002, Mulacek contracted “unspecified ‘services’” to Direct Employment Services Corp., whose officers couldn’t be identified and whose services were nebulous at best. Said officers also happened to be relatives and/or employees of InterOil company. Does it sound convoluted? Well, the SEC’s interest was piqued when a contract was awarded to the tune of $1.8 million to a seemingly fictitious company. When the SEC came knocking on Mulacek’s corner office, he threw the cherry on top of the situation by pulling an Oliver North. According to court document transcripts of the recent SEC hearing, whose purpose was to “connect the dots,” InterOil’s connection with two companies came up. Despite being introduced to the fact that both Biltrust, Ltd. and Eurostar Fund, Ltd., list their addresses as the same as InterOil’s, Mulacek denied knowing them. Ollie North would be proud. (http://www.businesspundit.com/the-worlds-most-controversial-ceos/).
Carlo Civelli, who is Managing Director of Clarion Finanz (an IOC shareholder), has provided significant financing to IOC in the past and is a shareholder in the LNG project and the upstream assets through Pacific LNG (or “PacLNG”, an affiliate of Clarion Finanz that owns 47.5% of the LNG project). To put it mildly, Civelli has a checkered past. According to a NY Times article (http://www.nytimes.com/2007/01/21/business/yourmoney/21oil.html?_r=2&pagewanted=all), British officials investigated Civelli in 1994 for alleged insider trading. While he was never charged by the British government (and Vancouver Stock Exchange officials decided not to pursue an investigation), there is some indication that an old friend of Civelli’s (who turns out to have strong connections to Pacific Rubiales, one of IOC’s new partners) provided some assistance at that time. According to a 2009 Vancouver Sun article, a friend named Frank Giustra (who shared an office with Civelli in Zurich in the late 1980s) “in an attempt to calm troubled waters … took Civelli to meet then-B.C. Securities Commission executive director Dean Holley and VSE president Don Hudson. The exchange subsequently declared there was ‘no substance to the allegations.’” http://www2.canada.com/vancouversun/columnists/story.html?id=46a95d67-df38-42f5-a6e4-64c981872d0d. In addition, there are numerous companies with which Civelli has had involvement, many of which have been delisted and/or run into their own legal/ethical problems. For example, he was a director of Namibian Minerals (which Frank Giustra joined in 2001) when it traded as high as $10 (now delisted). He was CEO (and several other roles) at XLR Medical Corp in the early 2000s. The stock traded around $20 at that time but is now a penny stock. At Spatializer Audio Laboratories, Civelli was an executive and director in the 1990s (the stock was around $40) until he resigned from the board in 2007 (when it was a penny stock).
The Geology of InterOil’s Assets Cannot be Trusted
IOC has been drilling in an area of PNG around the Puri Creek which has been known to contain hydrocarbons. Below, you can find articles of a partnership between BP and a company called Vacuum Oil from 1958, which initially looked very encouraging.
However, after a few days the oil flows almost disappeared and a second nearby well proved a failure.
Another company called Kundu Petroleum drilled a well in the 1980s (http://news.google.com/newspapers?id=4CtWAAAAIBAJ&sjid=cOQDAAAAIBAJ&pg=2290,8055616&dq=kundu+petroleum+puri-2&hl=en) and eventually went bankrupt.
Finally, a Nevada-incorporated Canadian company called Cheetah Oil and Gas had a license to explore in a field that showed some gas from the 1950s, but that stock now trades at $0.02. (http://www.sec.gov/Archives/edgar/data/908821/000106299308002272/form10ksb.htm).
Aside from some of the examples above, much exploration has been conducted and wells drilled with no commercial success in the carbonate reservoirs around IOC’s acreage. Over the years, oil companies allowed their licenses to expire and moved further west to explore PNG’s sandstone reservoirs. It is in this area that the only commercial successes in PNG have occurred, with all of PNG’s current oil and gas production operated by Oil Search (OSH AU), Exxon’s partner in the LNG facility. Oil Search purchased BP’s E&P assets in PNG for $400 million in 1998. You can get a sense for the geography in the following map from Oil Search: http://www.oilsearch.com/media/images/120419%20PNG_WEB_Large-c1bb7ae7-4588-4733-8467-ffba83dee039-0-1200x850.jpg.
Unlike Exxon’s sandstone reservoirs, IOC’s carbonates reservoirs are more heterogeneous and complex. So while hydrocarbons have been found in PNG’s carbonate reservoirs (like Elk and Antelope), they have never been found in commercial quantities despite a number of wells drilled over the decades. The problem is that the rock in the area is heavily fractured, which can contain sizable quantities of gas that will rush to the surface, but may not be sustainable as the porosity is low. This explains why the initial flows are so strong at both IOC’s acreage and some of the early wells drilled in the area. Only an extended well test (over a period of weeks) would provide enough information to gain comfort that this is a commercial discovery. IOC has not conducted these simple tests. IOC’s own geologist states that “fracture characterization of the reservoir has been a challenge” and that “porosity is relatively low” in a 2007 article for the Australian Society of Exploration Geophysicists (a copy can be purchased at http://www.publish.csiro.au/paper/ASEG2007ab045.htm).
PNG has experienced one potentially commercial carbonate find in the Pandora field, owned by Talisman. However, we would highlight that the find is offshore in the Gulf of Papua (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ard0nlpYmtek&refer=canada) and that Talisman thought the field was “too small to monetise” (http://www.pngindustrynews.net/storyview.asp?storyid=1038157). It was only after they tried to sell the field and received offers that were too low that they decided to keep it and try to aggregate other assets in the country.
IOC’s resource report is written by a group called GLJ out of Canada, who acknowledged in the report (http://www.InterOil.com/faq/Elk_Antelope_Gas_Field_2009_GLJ_-_FINAL.PDF) that “a personal field inspection of the properties was not made” (emphasis added). Instead, they relied upon data provided by InterOil. Ironically, many IOC bulls are quick to point out that they have actually been to PNG and have seen the well flare and additionally are comforted by Morgan Stanley’s bullish stance on the basis that their analyst has visited the fields (the logic being if you see the gas flare, then the resource estimates must be good). Simply, the whole basis for IOC’s resource estimates are a few guys in an office in Canada crunching numbers provided by IOC that were generated with a few days of well tests.
The bulls will highlight IOC’s “world record” flow test on the Antelope-2 well. The problem with the excitement surrounding IOC’s discoveries is the fact that the company is unwilling to dispel the critics by performing extended flow tests that are absolutely necessary to truly assess the quality of the reservoir. In an April 2010 investor presentation, IOC shows they only test the wells for a few hours a day over a five day period (http://www.InterOil.com/presentation/2010-04-14_InterOil_IPAA_Presentation_final_.pdf, pages 15-16) . The geology around their fields is notorious for flowing really strongly at first, only to flame out. So, why hasn’t InterOil conducted basic extended flow tests necessary to better assess the full extent of the discovery? The answer to us is fairly obvious.
The key issue now is that no one on earth will commit the $10 billion in capital (or more) for an LNG project based upon brief flow tests by a group of people who don’t exactly inspire confidence. Also, if IOC is sitting on such a valuable asset, why hasn’t InterOil drilled a single additional well since that time to prove up the resource and likely achieve better valuation from any potential international partner? Again, to us, the answer is fairly obvious.
The Bull Case is Based on Irrelevant Benchmarks and Fuzzy Math
The InterOil bulls rest their case on three main points: (1) Exxon is doing a significant LNG project nearby, which clearly validates the potential for InterOil’s asset, (2) a deal with Mitsui values the field at a significant premium to where the stock is trading and (3) a recent deal with a company called Pacific Rubiales assigns a significant valuation to the exploratory Triceratops acreage, possibly setting a floor valuation for the Antelope and Elk fields.
One of the biggest bull arguments for InterOil has been the fact that Exxon has validated PNG’s resource potential by building an LNG facility there. The problem with the comparison lies in the fact that the Exxon project is a sandstone reservoir, which results in greater consistency throughout the reservoir than IOC’s carbonate reservoir, which as we described earlier is heavily fractured and has significant variability. We simply believe there is no read across whatsoever to InterOil from Exxon’s fields given the vastly differing geologies. One expert geologist in the region who is intimately familiar with both projects told us that Exxon “may as well be drilling in Alaska” as far as InterOil is concerned, highlighting how the geologies almost couldn’t be more different despite their proximity. We would also note a similar bull case that existed for Hyperdynamics where investors pointed to the nearby Jubilee field (which seemed nearby but had no geological similarity).
In April 2010, InterOil announced a deal with Mitsui for a condensate stripping plant (CSP). Condensate is a liquid at normal temperatures and pressures and the idea here was that it would be processed at the CSP with the dry gas reinjected into the reservoir for storage until the proposed LNG facility is constructed. The condensate would then be barged to the InterOil refinery in PNG for processing/sale. Under the terms of the JV agreement (which is filed with SEDAR), Mitsui will fund both its share of the project plus IOC’s share (with IOC’s paying L + 600bps to Mitsui on its share). As part of the deal, Mitsui can convert the total $550 million in capital it would advance (both its and InterOil’s share of the project costs) into a 2.5% interest in the LNG project and resource assets at the same valuation at which an international partner invests. On the surface this would seemingly strike a huge valuation for the projects as the bulls are quick to point out. However, this is purely an option for Mitsui and arguably an irrelevant valuation – IOC almost certainly gladly gave away this option to show a high value benchmark and Mitsui has nothing to lose by accepting it. Critically, under the JV agreement, Mitsui has many outs up until the final investment decision is made that we would again argue make the capital commitment thus far a non-event. Some of the requirements to the decision to proceed include requirements that IOC provide “such reports and other information which demonstrates that the Elk and Antelope Fields are of a sufficient scale so as to be able to supply Feed Gas.” Additionally, InterOil is required to refund all of Mitsui’s contributions within a specified period if a final investment decision is not made. Mitsui merely will participate if there is sufficient gas – they are not making any statement that in fact there is sufficient gas. We would also note that originally this decision was supposed to be made by the end of 2010 with the plant in operation by “no later than mid-2013.”
Earlier this year, a Canadian company called Pacific Rubiales (PRE) signed an agreement with InterOil to participate in 10% of an area covering IOC’s Triceratops structure. While IOC highlights huge numbers around the total potential value of cash payments plus carry ($345 million plus a “final resource payment”), the initial cash payment is only $20 million with termination provisions for PRE should they get unsatisfactory results along the way.
PRE seems to owe its existence in large part to Civelli’s friend Giustra (who we mentioned earlier). Guistra and his company Endeavour Financial Corporation (where he was Chairman) played a significant role in the company that became Pacific Rubiales. PRE was originally called AGX Resources Corp and changed its name after raising C$440 million in July 2007 to fund the acquisition of 75% of Rubiales Holdings. According to a Wall Street Journal article about former President Bill Clinton’s philanthropies, Giustra discussed the Pacific Rubiales deal with Colombian President Uribe (http://online.wsj.com/article/SB120296323202367961.html). Upon the closing of its private placement and acquisition of Rubiales, the company’s press release highlights that it paid GMP Securities and Endeavour Financial (again, where Giustra was Chairman) advisory fees of $3.8 million through the issuance of units and repaid a bridge loan of $15 million provided by Endeavour Mining Capital Corp (which announced that it was acquiring Giustra’s Endeavour Financial one month earlier in June of 2007). As part of the bridge loan, Endeavour also received warrants in PRE struck at C$1.05 per share. Upon closing the deal, Pacific Rubiales and GMP turned around and donated a combined C$4.4 million to the Clinton Giustra Sustainable Growth Initiative (see http://www.pacificrubiales.com/2007/35-24072007 and http://www.bnamericas.com/ten/articulo.jsp?idioma=I&documento=30). And for what it is worth, earlier this year, President Clinton played in the 2012 Pacific Rubiales Colombia Pro-Am (http://www.pgatour.com/2012/tournaments/h104/01/30/clinton/).
We find it concerning that Civelli’s PacLNG (which owns a small stake in Triceratops) will receive 25% of all payments PRE makes and will also receive a commission of 2.5% on the deal. We are unable to fathom how anyone could put any credence in this supposed “validation.”
On an amusing note to us, PRE also recently agreed to a partnership with BPZ Resources in April of 2012 (one of the other energy shorts we mentioned earlier that we wrote about on VIC). At a minimum, PRE has demonstrated an uncanny ability to associate with some questionable characters.
The End is Near
Given all of the delays and disappointments and lack of credibility in bringing a complex, multi-billion dollar project to production, it is no surprise that the political pressure on IOC has been building from the PNG government. Since May of this year, IOC has been in a six month consultation period with the PNG government whereby the government is demanding IOC bring in a large international partner. We believe the government is tired of IOC talking up the resource and is finally forcing them into action. While IOC should be able to strike some deal for a starter investment as many companies would likely risk a small amount of money on the option value (which IOC will undoubtedly try to trumpet as assigning some potentially huge value on the assets), no partner will risk any real amount of money without first doing the additional well tests and drilling to prove up the resource. When a credible oil company enters the equation, IOC will be forced to move from a concept company to a real company. As such, we believe the long saga of InterOil is finally drawing to a close and the company will soon be on its way to a hard-earned spot in the energy stock promotion graveyard.
And finally, even Shia LaBeouf has been drawn into the stock (a must watch)…
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