Description

Merger security with an attractive risk-reward profile.

Long InterOil (IOC) gets you US$45.00 in Exxon Mobil (XOM) shares plus a merger security, a Contingent Resource Payment (CRP). 

The CRP is worth $0.00 - $27.00 per IOC share, with my best estimate expected value range of $8.50 - $12.75 per share. 

Buying IOC at $48.95 ($3.95 per CRP) results in an estimated IRR of 48% - 90%.

History

                InterOil (NYSE: IOC), along with joint venture partners Total SA and Oil Search, owns an interest in the Elk-Antelope gas field (within PRL 15) in Papua New Guinea. 

                The resource was discovered in 2006 with the drilling of the Elk-1 well, which tested at 21.7 mmcf/d. The Elk-2 well further delineated the structure.  The Antelope structure was discovered in 2008 with the drilling of Elk-4 (aka Antelope-1). The  Antelope-2 well was drilled in 2009, resulting in the world record for highest flow rate from a gas well at 705 mmcf/d:

http://www.guinnessworldrecords.com/world-records/highest-flow-rate-from-a-vertical-gas-well

https://www.youtube.com/watch?v=H7ezUFVIvm8

                The Antelope-3 appraisal well was completed in 2013, followed by Antelope-4 and Antelope-5 in 2015, then Antelope-6 in 2016.  Antelope-7, in which Oil Search believes could add 1-2 tcf of resource if successful, is expected to be drilled in late 2016 / early 2017. 

                Total SA and Oil Search joined as partners of InterOil for the development of the Elk-Antelope field in 2014.

                On May 20 2016, Oil Search (backed by Total SA) announced the friendly acquisition of IOC in an all-share transaction, plus a Contingent Value Right (depending on resource size of Elk-Antelope), representing a 27.2% premium and an enterprise value of $2.2bn.

                On July 17 2016, Exxon Mobil announced an overbid for IOC at $45.00 in XOM shares plus a Contingent Resource Payment (CRP).  The deal represented a 42.6% premium and is valued at $2.5bn.  Oil Search / Total SA declined to match XOM’s offer.  XOM and IOC signed a definitive arrangement agreement on July 21 2016.

The Deal

                On July 21 2016, IOC and XOM entered into an arrangement agreement, structured as a Canadian plan of arrangement under the Business Corporations Act (Yukon).  This is similar to a merger structure in the US.  The transaction attained unanimous board approval of both companies.  The key condition is a 66 2/3 vote (of shares voted, not shares outstanding), which is set for September 21 2016 (record date is August 10 2016).  The vote risk is minimal and the deal should close shortly thereafter.  The companies have guided to a September 2016 closing.

                MAC carve-outs: change affecting industry, economic, regulatory, financial, credit, F/X, securities markets, oil, natural gas, commodities prices, political conditions, terrorism, war, natural disaster, stock price, failure to meet projections.  Parties shall use commercially reasonable efforts to satisfy all conditions precedent.  Parties entitled to specific performance.  There is a dual $67mm break fee.

The consideration for one IOC share is US$45.00 in XOM shares (exchange ratio based on 10-day VWAP before closing) plus a Contingent Resource Payment (CRP), representing an additional cash payment of approximately $7.07 per share for each tcfe gross resource certification of the Elk-Antelope field above 6.2 tcfe, up to a maximum of 10 tcfe. 

                The CRP would be paid on the completion of the certification process expected mid-2017, which would include the Antelope-7 appraisal well. The CRP would not be transferrable and would not be listed on any stock exchange. 

Historical Resource Estimates

                Historically, IOC has had GLJ Petroleum Consultants evaluate the resource.  GLJ’s latest  2C resource estimate is 10.0 tcfe.

                Oil Search has used Gaffney Cline & Associates (GCA) and Netherland, Sewell & Associates (NSAI) to evaluate the Elk / Antelope resource.  GCA and NSAI’s latest 2C resource estimates are 6.8 and 6.1 tcfe, respectively.

“The Antelope 7 well, which is expected to spud in the third quarter of 2016, will test 1-2 tcf of upside in the Elk-Antelope fields.” – Oil Search, July 15 2016

Valuation

The Elk-Antelope resource certification, which will determine the value of the CRP, will be determined by averaging the 2C (contingent resource) estimates of two reservoir appraisal firms.

My resource estimate averages the latest two estimates (GCA at 6.8 tcfe and NSAI at 6.1 tcfe, or 6.43 tcfe average) and adds the low and mid-range of the estimated Antelope-7 resource (1 tcfe and 1.5 tcfe). 

This estimated resource range of 7.4 – 8.0 tcfe results in a CRP payment range of $8.50 - $12.75, yielding an estimated IRR of 48% - 90%.

My model assumes the XOM deal closes September 30 2016 and the CRP is paid out June 30 2017.

Note that GLJ’s estimate of 10.0 tcfe would result in a upside case CRP value of almost $27.00 per share.  NSAI’s latest estimate would result in a CRP value of zero. 

I think the worst case scenario for the resource estimate is the 6.43 tcfe certification (GCA and NSAI average) announced by Oil Search on July 15 2016, plus zero tcfe for Antelope-7.  This would result in a downside case CRP value of about $2.00 per share.

The Bear Case on IOC

                There is a very well-reasoned and subsequently successful short pitched by hawkeye901 on VIC on August 14 2012 at $85.00. Business Insider also covered the bear case in 2010:

http://www.businessinsider.com/interoil-ioc-major-momentum-or-just-a-castle-in-the-air-a-new-investigation-2010-4?op=1

The short was based on the following points (none of which are relevant anymore):

• Stock was overvalued at $85.00 – This was proven correct as the stock corrected 42%.

• A highly promotional founder / CEO – Phil Mulacek was replaced a few years ago with Mike Hession, a legitimate CEO.

• Shady characters promoting stock – including Carlo Civellli (convicted stock fraudster), John Thomas Financial (shuttered bucket shop brokerage firm whose founder Tommy Belesis was thrown in jail.  Note he was in Wall Street 2 the movie), Shia Lebouf (C-list actor), street analysts, Yahoo! message board cronies

• Skepticism regarding resource estimate – Bears were skeptical of the resource, well tests, sustainability of production and ability to support LNG development (stranded resource).  IMO this has been put to rest.  The third parties with the best data here would be Exxon, Oil Search and Total, who have all put their money where their mouth is and put >$2.3bn on the table for the asset.  The resource has also been verified by reservoir appraisal firms GCA, NSIA and GLJ.

Conclusion

                Long IOC at $48.95 (representing the CRP price of $3.95). I believe the CRP merger security will be worth $8.50 - $12.75, resulting in an expected IRR of 48% - 89%.

Risks

                Deal risks and resource risks.  This investment is speculative and should be sized appropriately. 

Catalyst

Deal closing

Certification of resource