InterOil IOC S W
November 21, 2006 - 5:13pm EST by
2006 2007
Price: 22.33 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 750 P/FCF
Net Debt (in $M): 0 EBIT 0 0
Borrow Cost: NA

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I recommend a short position in InterOil Corporation (Ticker: IOC) and believe the stock could be worth $0-3/share over the next 12 months vs. its current $22 share price. This post is a follow-on to an original VIC posting I made on InterOil in August 2005.  The original posting was extremely detailed and I encourage readers to refer to the original posting as a starting point if they are unfamiliar with the InterOil story.  This post will update that original analysis for current events. 
IOC’s stock price has once again popped up on speculation about a natural gas find, taking IOC’s enterprise value back to $1.0 billion.  However, consider what has transpired since my last posting:
-    IOC burned $4/share in cash ($135mm) over the last 12 months (average ~$34mm/qtr)
-    Net debt has risen to $230mm at Q3 2006 from $95mm a year ago (Q3 2005)
-    The refinery results (negative EBITDA) have proven our thesis that the asset has little value and I believe it is likely that the company will need to write-down the value
-    The company has $31mm in cash left as of 9/30/06 versus its $30-35mm/qtr average cash burn rate, implying it will likely have to attempt an equity deal to remain solvent
-    IOC is committed to drilling 8 wells for the investors who funded $125mm drilling joint venture in Q1 2005.  IOC has only drilled 3 of these wells but has burned through around $90-100mm in capex in 2005-2006 YTD (this implies the average well is costing ~$30mm/well).  And they only have $30mm in cash remaining.  How are they going to fund the remaining obligation they have to the JV investors?  And furthermore, how are they going to raise capital when any new dollars coming in have to go to funding the remainder of IOC’s commitment to the joint venture investors?  Who is going to want to pay for someone else’s wells?  (IOC discusses this issue in their MD&A from Q3 2006, p. 21 of 24). 
-    IOC drilled another dry hole (Triceratops), worsening the company’s drilling success rate to 0 for 8 (before the Elk well they are currently testing)
-    IOC’s recent Elk well (their 9th attempt) is likely uneconomic – after taking 9 months to drill the well and spending $36mm year-to-date, IOC claims they have found natural gas (the well flowed natural gas over a very short test period that lasted a couple of days).  However, as we all know, the world is awash in stranded natural gas that has no market (and PNG already has over 10 trillion cubic feet of it sitting in the western part of the country that has been there for over 10 years because there is no market).  IOC is proposing building a $3 billion liquefied natural gas (LNG) facility to monetize the gas, which is absurdly premature given how little they know about the reservoir they might have encountered (see details below). 
-    The CFO resigned in August and an Audit Committee Director resigned in October
-    To justify IOC’s $1.0 billion enterprise value, they would now need to find at least 750 million barrels of oil equivalent (up from 500 million barrels of oil equivalent at the time of my last posting)
Summary of the original short thesis (from the August 2005 posting):  For all of the details, refer to my post from August 2005, but here’s the quick summary: 
Investors (based on management’s guidance) believed that IOC’s refinery would earn $60mm in EBITDA and was worth $15-$20/share, so you were getting a “free option” on exploration upside on IOC’s 8mm acreage position in the eastern region of Papua New Guinea.  Investors believed this acreage position had significant potential upside.
In contrast to management’s claims, our analysis concluded that the refinery had minimal earnings power and therefore little to no value (we estimated $0-$3/share at the time).  The bottom line is the refinery was a bad investment and the product pricing arrangement IOC had with the state implied the refinery would not earn anything near what management had promised investors. 
Backing out the $0-3/share of value for the refinery, the $25/share stock price at the time implied IOC’s E&P business was worth $22-25/share ($730-$820mm).  To justify that kind of valuation, we estimated that IOC would have to find around 500mm barrels of oil equivalent, which is highly unlikely given:  1) IOC’s abysmal drilling record (8 straight dry holes before their most recent Elk-1 well, which they are claiming is commercial);  and 2) the lack of any commercial discoveries in Eastern PNG (where IOC’s acreage is) despite 50+ years of drilling in the area by major oil companies all of whom have since abandoned the province (all of the discoveries made in PNG were in the western part of the country). 
Updates on the original short thesis
Update #1:  Refinery continues to lose money
The refinery has continued to lose money for IOC as we originally predicted.  YTD EBITDA from the refinery:
Q1:   $0.2mm
Q2:  -$8.3mm
Q3:  -$2.8mm (backs out $4.1mm in one-time foreign-exchange gains booked in SG&A, page 11 of 24 in the Q3 2006 MD&A)
Management’s promised revamp of the refinery hasn’t worked.  The revamp was completed at the beginning of Q3 2006 and the refinery still had negative -$3mm of EBITDA in the quarter.  Management is now saying that the reason they lost money is because the refinery was down for 25 days in the quarter (to finish the revamp).  However, this is a disingenuous explanation:  the refinery operated at 14,000 barrels/day in the quarter (vs. its capacity of 36,500 barrels/day).  However, management says total PNG demand is only 16,000-18,000 barrels/day (see Q3 2006 MD&A for detail), so unless the refinery can export product (which is uneconomic as we proved and management now admits in their MD&A) then the refinery will only operate 45-50% utilization going forward (in other words, it will produce no more than domestic demand).  This means that in any given quarter, the refinery will only need to run for 45 of the 90 days in the quarter to meet domestic demand. 
Furthermore, refinery inventories increased slightly to $103mm from $102mm despite a significant decline in crude oil prices in the quarter (crude fell 18% from the end of Q2 to the end of Q3).  Why would inventories be increasing if the refinery was underutilized in the quarter and prices fell?   (Note:  IOC marks-to-market their inventory using the lower of cost or market)
Update #2:  Cash position continues to deteriorate – IOC needs to raise equity
When I originally posted this idea, net debt for IOC was $95mm (Q3 2005).  This number has ballooned to $230mm as of Q3 2006, implying a $135mm cash burn over the last twelve months (average = ~$34mm/quarter):
                                          Q3 2005        Q4 2005        Q1 2006        Q2 2006        Q3 2006
IOC Net Debt                    $95mm          $113mm         $126mm         $176mm        $230mm
Quarterly Cash Burn             --                 $18mm           $13mm           $50mm          $54mm
IOC has fully-pledged all of its existing assets (working capital, refinery) and only has $12mm left on its unsecured facility (of which they have drawn down all $12mm in Q4 as per the MD&A).  It doesn’t appear to me that the company has any financing capacity remaining. 
Also as noted above, IOC has only drilled 3 of the 8 wells it is on the hook for to its joint venture investors and it has spent $90-100mm to drill those 3 wells ($54mm in 2005 on the Black Bass and Triceratops dry holes, and $36mm through 9/30/06 on Elk-1) despite management’s claim back in January that Elk would only cost $9mm (see attached link, page 7:  IOC discusses this 5 well liability in their Q3 2006 6-F (MD&A page 21 of 24). 
So any financing IOC raises from here (equity or debt) is going to have to go to funding the remaining 5 wells IOC owes its joint venture investors.  Who is going to want to finance this company so they can go and drill wells for the benefit of someone else? 
Update #3:  Does the Elk well really have any value?  I don’t think so
Management claims it has a major natural gas discovery at its recent Elk well.  They started drilling the Elk well in February (original targeted depth was 9,800’) but 9 months later they only made it to 6,500’ before the well started to collapse and they stopped drilling.  They recently tested the well over a two-day period and it flowed 22 million cubic feet per day (mmcf/d) of gas.  Remember this well cost them $36mm to drill ($3mm spend in 2005, $33mm spent YTD as of 9/30/06). 
Let’s take a step back:  stranded natural gas in the middle of nowhere with no access to a market has no value.  The world has tons of natural gas that has no market.  This well might have some value if it was drilled in Texas (where gas sells for $7-8), but in the middle of the Papua New Guinean jungle it has no value. 
But IOC is claiming they are going to build an LNG facility to monetize their gas, right?  And didn’t they sign Merrill Lynch as a partner?  A few thoughts:
-     IOC has refused to discuss the details of the terms of the Merrill Lynch relationship or disclose the contract in their filings.  Is Merrill actually funding the development expense, or is IOC simply allowing them to invest (or just market the gas) if the LNG project is developed (in other words, leaving IOC with all of the development risk and giving Merrill a free option)?  IOC won’t say.  Merrill Lynch is quoted (in a Bloomberg article dated 11/21/06) as saying they are in discussions with all of the PNG gas producers including Oil Search and not just IOC – so how committed are they to an IOC-operated project?  Or is this one way of getting involved in Oil Search’s LNG initiative (see below)? 
-     An LNG facility could NEVER be financed with out significant reserves behind the facility.  Oil Search has > 10 trillion cubic feet of known reserves in western PNG that have been stranded for 10+ years (see below for more discussion of Oil Search)
For lenders to ever contemplate committing $3 billion to a new LNG facility, they would need to see significant reliable reserves to ensure the facility had adequate gas supply.  So how reliable are IOC’s reserves?  This gets to the heart of the reason why all of the majors abandoned eastern PNG.  This is a somewhat technical discussion but I’ll keep it high level and if anyone wants to follow-up on specifics they can ask questions:
-     The reservoirs in eastern PNG (where IOC’s acreage is) are what are known as “fractured limestone” reservoirs.  What this means is that the reservoir rock has very low porosity (ability to hold oil/gas within the rock) and instead oil/gas exists in channels (fractures) that run through the rock.  Think of a really hard, impermeable rock (like a tombstone) with veins running throughout the rock – that’s what a fractured reservoir is like.  Oil/gas resides in the veins.
-     Contrast this with the sandstone reservoirs in western PNG where all of the country’s production currently comes from.  The reservoirs in western PNG are all highly porous sandstone reservoirs.  This means that the actual reservoir rock is saturated with oil/gas (the oil/gas resides throughout the rock vs. in fractures/veins).  The Hides field in western PNG (this is the big stranded gas field) for example has a porosity of 15%.  Compare this with the 1% estimate IOC management gave on the last conference call.  That’s the difference between a fractured limestone and a sandstone reservoir. 
-    What this all means:  when you drill a fractured reservoir, you often have very high initial flow rates (as the fractures drain and oil/flows very quickly to the well) but the wells then “can collapse to zero over dinner” (as one of my geologist friends likes to say).   This is the key reason I’ve been told that all the majors left eastern PNG and the key reason that Oil Search (see below) won’t drill there.  The “discovery” wells in eastern PNG ended up not being able to sustain production (for example:  IOC themselves cited on the last call a well drilled years back that was 16km to the north of them that flowed 1,600 barrels/day but then “depleted on test”).  This has been the story of all of the eastern PNG discoveries from the 1950’s onward – that’s why no one but InterOil drills there anymore, and that is why there is no commercial oil or gas production in eastern PNG.  The geology simply doesn’t work. 
Bottom line:  Given the fractured limestone reservoirs of eastern PNG, its hard to even say if IOC has a sustainable hydrocarbon find, not to mention the fact that it has little to no value because it’s natural gas.  In any case, it will take them multiple appraisal wells, long-run production tests, and significant capital to determine if they had a producible reservoir and enough gas to support an LNG project, and in a best case scenario the project wouldn’t come online for 6+ years.  So what is it worth today?  You do the math but the answer is very little. 
Update #4:  Valuation – how much oil & gas would IOC need to find to justify its $22/share value?
By my analysis, in order to justify its current valuation IOC would now need to find between 750 million and 1.5 billion barrels of oil equivalent vs. 500 million barrels at the time of my last report.  Here’s how I get there: 
The market is currently valuing IOC at a $1.0 billion enterprise value ($22.00/share x 34mm fully-diluted shares = $750mm market capitalization plus $230mm of net debt at Q3 2006). 
Oil Search (Ticker:  OSH AU, trades in Australia) is 20% owned by the government of PNG and produces 100% of PNG’s commercial production (current production is around 27,000 barrels/day).  Oil Search has an enterprise value of US$2.3 billion.  However, in contrast to IOC, Oil Search actually has real oil & gas reserves and is producing >$500mm in EBITDA.  At 12/31/05, Oil Search had 1.2 billion barrels of oil equivalent in total resource (made up of 250 million barrels of oil and 5 trillion cubic feet of gas).  So Oil Search trades at $2.00/barrel of oil equivalent (and remember its producing $500mm of EBITDA already).  In addition, Oil Search has three initiatives to monetize its stranded gas:
1)      Pipeline to Australia (partner:  ExxonMobil, Australian Gas and Light)
2)      LNG facility (partner:  British Gas)
3)      Petrochemical plants (partners:  Japanese companies Itochu and Mitsubishi Gas)
Let’s first take a step back and ask the simplest question:  How in the world can IOC be worth $1.0B when Oil Search is worth $2.3B (with 1.2B barrels of resource, $500mm in EBITDA, and three PNG gas monetization initiatives with highly reputable partners)?
We now value IOC’s refinery at $115mm (50% of invested capital), which could still be considered generous given that net working capital is only $65mm and the refinery is structurally cash flow negative (so perhaps its really a liability)?  When you add $50mm for IOC’s retail business, I come up with a total valuation of $165mm for IOC’s non-E&P assets. 
So the implied value of the E&P business is now $800mm ($1.0B EV less $165mm refinery/retail value).  Oil Search trades at $2.00/BOE and is producing $500mm in EBITDA with three (very real) gas monetization initiatives underway.  So being generous and giving IOC Oil Search’s multiple (a stretch for obvious reasons but let’s go with it for now), IOC would have to find at least 400mm BOE of net resource to justify its value.  But here’s where the story gets even more interesting.  For every barrel you find in PNG, the government immediately gets 22.5% of it in royalties.  In addition, IOC has also “pre-sold” 32% of the reserves they find to existing investors (through the drilling joint ventures) over the past few years to raise cash.  So out of the box, 47% of the reserves they find are someone else’s reserves.  So in order for IOC to have the minimum 400mm BOE it would need to justify its valuation, it would actually have to find 750mm BOE (400mm / (1-.47) = 750mm). 
But $2.00/BOE is probably way too generous given that Oil Search has already invested large amounts of capital in reserve development and is producing $500mm in EBITDA.  If we assume $1.00/BOE (50% of Oil Search’s multiple), then IOC would have to find 1.5 billion BOE to justify its value. 
As IOC continues to burn cash and destroy shareholder value, the hole gets deeper and deeper.  At some point, investors will realize “the emperor has no clothes.”  My expectation is that the date is sooner rather than later. 


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