Description

Investment Thesis
- I recommend a short position in InterOil (Ticker: IOC) with a target price of between $3 and $9/share vs. the current stock price of $25/share.

Price: $25.00
Shares Outstanding: 33.1mm
Market Cap: $827mm
Net Debt: $120mm (excluding $125mm in cash for pre-funded exploration JV)
Enterprise Value: $947mm

- Long investors and sell-side analysts value IOC’s one oil refinery at $15-$20/share based on management guidance ($60mm in EBITDA / $44mm or $1.33/share in net income) and view the stock at $25/share as a cheap option on potential exploration success in the company’s remaining 7 well drilling program in eastern Papua New Guinea (PNG), where management has represented that the basin has the potential for world-scale oil & gas discoveries (i.e. you are only paying $5-10/share, or $165-$330 million, for the E&P optionality).

- However, I believe the earnings power of the refinery is significantly less than $60mm (I calculate $0-$10mm in EBITDA) based on my reading of the refinery’s pricing contract with the state of PNG (management has historically refused to discuss detailed terms of the contract, but it is available publicly in PNG and is attached below). In my best case scenario (laid-out below), the refinery is worth $0-3/share (net of debt).

- IOC’s refinery is currently operating at negative EBITDA and 60% utilization, a situation management blames on operational issues as the refinery ramps-up (it went into service in summer 2004). As recently as June 2005 management reiterated their long-term guidance of $60mm EBITDA / $44mm net income. After examining IOC’s pricing agreement with the state and analyzing regional refining crack spreads, I believe the refinery’s problems are not temporary operational issues: the refinery has no long-term earnings power given its limited product slate (it is a very low complexity refinery, discussed in more detail below) and a pricing agreement that does not yield IOC any material pricing benefits.

- If one values the refinery at $0-3/share and backs it out of the current stock price of $25/share, the E&P business is actually being valued at $22-25/share, or $720-$830mm, and not $5-10/share as the bulls/sell-side analysts seem to think. Based on comparable PNG E&P valuations (see detail below), a $22-25/share valuation implies that IOC has already found 450-620 million barrels of oil equivalent (whereas IOC has actually discovered no commercial oil or gas in the 7 wells it has drilled over the last 5 years). To put this quantity in perspective, in the history of PNG’s oil & gas industry there has been only one large oil field found in the country (the Kutubu field, which was a 300 million barrel field) and three commercial oil fields found in total. Kutubu was discovered almost 20 years ago (1986) and is located in western PNG (all of IOC’s acreage is in eastern PNG). The other two sizeable discoveries were Gobe (discovered in 1991) and Moran (discovered in 1996). Both Gobe and Moran (also located in western PNG) had 100-150 million barrels each. There have never been any commercial oil or gas discoveries in eastern PNG. Any gas discoveries would be uneconomic unless the gas is found in massive quantities that would justify a liquefied natural gas (LNG) or pipeline project to bring it to market (such as the one large PNG gas field, the Hides field (also in Western PNG), from which Oil Search is building a gas pipeline to Australia). Therefore, any gas that IOC might find will have minimal to no value unless it is a massive find.

- Is IOC’s E&P business worth $22-25/share ($720-$830mm)? This assumption is a stretch given: 1) management’s weak exploration track record (most recently a month ago but totaling 7 over the last few years – this company has never found any commercial oil or gas reserves. See the chronology of management’s drilling guidance and actual results below); 2) assessment from other large current and historical PNG operators (Oil Search, Chevron, BP) that Eastern PNG (where IOC operators) is not prospective and that the potential for large finds is very low (the reason why both BP and Chevron left PNG (BP exited in 2002, Chevron left in 2003), and Oil Search refuses to spend any more exploration dollars in the east); 3) the extremely difficult and high cost exploration/drilling conditions in PNG (very mountainous terrain, no infrastructure, inability to cost effectively shoot 3D seismic which leads to low success rates).

- Based on numerous sources and research (detailed below), I believe it is unlikely that IOC will find any commercial oil or gas in its remaining 7 well drilling program, which would make the E&P business worth $0. However, one would attribute some option value to the drilling program for the possibility that IOC has a commercial find. I would suggest a value of $100-$200mm, or $3-$6/share ($100-$200mm implies a 45-170mm barrel of oil equivalent find, see detail below). If you think the market is currently valuing the downstream business at $15-$20/share, then it follows given the $25/share stock price that the market thinks it is valuing the E&P option at $7-$8/share, so this only slightly above my $3-$6/share valuation. Combined with my $0-$4/share valuation of the refinery, I arrive at a price target of between $3 and $9/share for the stock.

- Given the current bull market in energy, it’s not surprising that these types of companies/management teams are coming into favor. Investors have forgotten the spotty drilling and execution record of this company during its 8 years of existence. In fact, Eastern PNG has become a magnet for similar start-up E&P companies, such as Cheetah Oil & Gas (Ticker: COGL) and Transeuro Energy (Ticker: TSU in Canada), because it is so easy (and cheap) to acquire acreage given that all the major E&P operators have shunned the play. The key question this raises is: if eastern PNG was truly a prospective E&P basin and given how easy it is to get drilling licenses there, why in a world of $65 oil is there not a single major E&P company with a proven track record operating there?

- Trading in IOC has liquidity surges as retail investors play a meaningful part in day-to-day trading. While liquidity over the last few weeks has been low (100,000 shares/day), trading goes up to 500,000-1.0mm shares per day around events (wells, earnings, etc). There should be ample liquidity to build a meaningful investment over time.


Company Overview
InterOil is an energy company focused on exploration & production (E&P) and oil refining in Papua New Guinea (PNG). The company has three key assets: 1) a 32,500 barrel per day simple distillation refinery that was completed in 2004 at a capital cost of US$230 million (the only refinery on the island); 2) exploration rights on 8 million acres in the eastern portion of PNG on which it has been exploring for oil & gas for the last five years; 3) a chain of 40 gasoline stations and 10 refined products terminals (“Downstream”) in PNG purchased from BP in 2004 for $12.5 million ($6.8 million of which was for refined products inventory), giving IOC 20% market share in retail refined products sales.

At 3/31/05, total debt is $132 million and cash is $137 million, of which $125 million was funded by institutional investors to purchase a minority interest in an eight-well exploration program (first well in this program was drilled in Q2 2005 and was dry). The $125mm funding is convertible at the investors’ option into 3.3 million shares but also gives investors the option to take a 25% working interest in any of the remaining 7 wells. Net of the $125 million in committed drilling funds in the joint venture, IOC’s net debt is $120 million.

IOC went public in Q2 1997 through a merger with a publicly-traded Canadian shell company with no assets and remained a penny stock (<$3/share) until January 2002, when IOC announced that they had “discovered a new oil system in eastern PNG” based on samples they took from two dry holes they drilled in 2001 (see press release hyperlinks below). Before 2002, IOC’s business was focused entirely on the refinery (the CEO purchased an abandoned Alaskan refinery that Chevron had built in 1963 and closed in 1991, dismantled it, and shipped it to PNG to be reassembled). After IOC came public, the stock rose to $10/share after the Company indicated that Enron and others were going to invest in the refinery and that the refinery would be completed by year-end 1998 (it was ultimately completed in 2004). After a series of upward cost estimates and project delays, Enron pulled out of the refinery in September 1998 and the stock fell to <$1/share. After Enron pulled out, IOC attempted to obtain third-party financing from private sources (they hired BT Alex Brown to raise the capital) but failed, ultimately doing a deal with OPIC (U.S. government) for a much smaller portion of the financing than originally indicated (they got $85mm versus the $130mm they targeted in the BTAB-led private placement). The stock remained at low levels (<$5/share) until the Company began promoting the E&P potential in 2002.

As many who are reading this posting probably already know, this stock has been very controversial for some period of time. The standard long thesis on the stock is that the refinery and downstream businesses are worth most of the stock price ($15-$20) and that you are getting a cheap exploration option. For example, Raymond James (the biggest bull on the stock with a $70 price target) values the refinery/downstream at $24/share. These valuations are based on the company’s guidance (reiterated as recently as 6/28/05) of $60 million in EBITDA and $44 million ($1.33/share) in net income from the refinery/downstream.

Shorts in the name have cited: 1) a promotional CEO who has indicated to Wall Street that IOC has the potential for Saudi Arabian-sized oil and gas finds in order to maintain his stock price and raise capital; 2) poor historical drilling results (IOC has been drilling on the acreage for the last five years with no success, most recently drilling a dry hole on 7/18/05); 3) an abysmal history of execution (first production from the refinery was originally promised in 1999 at a cost of $160mm -- first production was actually realized in 2004 at a cost of $230mm); 4) the fact that current and historical oil & gas operators in the country (Oil Search, Chevron, BP) have chosen not to pursue E&P in the eastern half of the island (where IOC has all of its acreage).

Given that the drilling history is well known to most who are familiar with the story, I won’t focus this posting on IOC’s drilling track record (however, to be complete, I have put together a chronology of the E&P press releases that compare the company’s claims/guidance to actual drilling results below with hyperlinks to the original press releases). Instead, I will focus this posting on valuing the refinery/downstream operations, which many of the bulls have taken for granted and instead relied on management’s earnings guidance.

In order to analyze the potential profitability of the refinery, I tracked down the agreement that governs the pricing of the refinery’s products in PNG. After analyzing the agreements as well as historical Asian refining crack spreads, my analysis indicates that IOC’s refinery will be permanently unprofitable and therefore has little to no value. When you back out real value of the refinery from IOC’s stock price to figure out what you are paying for the E&P upside, you quickly realize that the market is making heroic assumptions about what IOC will find in order to justify the current valuation.


1997 Contract with the State of PNG (Regulates Refinery Pricing)
The sales price for the refined products from IOC’s refinery are regulated by a 1997 Project Agreement between IOC and the government of PNG (referenced in IOC’s 40-F and filed on SEDAR in November 2004, although this filing excluded Appendix A which has the specific details of the pricing arrangement). The company has refused to offer the details of the agreement but (unsurprisingly) an agreement which regulates the price which consumers and businesses will have to pay for energy is typically in the public domain. A little digging in PNG produced the document (attached here [http://www.swimediaservices.com/1997pa.pdf]) and confirmed that the document is in the public domain. The exact formula for the pricing agreement is laid out in Appendix A (page 48).

In concept, the agreement allows IOC to price the products based on import parity. IOC is allowed to charge the Singapore posted price for any refined product sales plus a transportation differential that is designed to compensate for the full costs of transportation (tanker rates, insurance, ocean/inland loss, landing charges, additives, demurrage).

Currently, the transportation differential is around $3/bbl (see pages 2-4 of the attached pdf file for the exact calculation based on the formula [http://www.swimediaservices.com/interoil.pdf]) by my calculation. This is consistent with current tanker rates from Singapore to Papua New Guinea (the most recent tanker quotes for Singapore-Port Mooresby are Worldscale 220, which equates to $1.75/bbl. Insurance/loss provisions/etc makes up the difference. See page 4 for the detail).


The Refinery
IOC’s 32,500 b/d refinery is a simple distillation refinery that lacks any ability to process heavy or sour crudes (it can only run light, sweet crudes). The product slate of the refinery (from the company’s most recent management presentation) is:

38% diesel
17% naptha
16% gasoline
14% marine fuel oil
8% jet fuel/kerosene
4% liquid petroleum gases (LPGs)
3% process loss/refinery fuel

Management claims the refinery is capable of running at 36,500 b/d (vs. nameplate capacity of 32,500 b/d) and 96% utilization, implying that it can process 12.8 million barrels annually. Cash operating costs for the refinery (also from the management presentation) are $21.5 million ($1.70/bbl at full utilization).

The economics (EBITDA) of IOC’s refinery, then, should be:
1) the crack spread for the above product slate using light, sweet crude oil in Singapore;

2) Plus: the import pricing premium as per the 1997 Project Agreement (+$3/bbl)

3) Plus/(Less): the discount / (premium) for IOC’s purchased light, sweet crude to the Singaporean light/sweet crude benchmark (called Tapis). If IOC runs Kutubu (the local PNG light sweet crude that is equivalent to Tapis), it will gain a roughly $0.50/bbl discount to Tapis for its feedstock (over the last 10 years, Kutubu FOB Papua New Guinea historically sells for a $0.50/bbl discount to Tapis FOB Malaysia. This discount has widened out in the last few months to $1.50-$3.00/bbl due to the high naptha yield of Kutubu as naptha pricing has declined; however, my understanding is that IOC is not currently running Kutubu and is instead importing oil with lower naptha yield to feed the refinery, as the crack spread on Kutubu is currently worse than other crudes despite the more advantageous pricing of recent weeks (see attached pdf page 7 for a graph of the 10 year historical Kutubu-Tapis spread [http://www.swimediaservices.com/interoil.pdf]).

4) Less: cash operating costs ($1.70/bbl as per mgmt guidance)

So what is the crack spread for a simple distillation refinery like IOC’s in the current market? Currently, the crack spread (applying IOC’s product yield laid out above and using Tapis feedstock) is -$6.00/bbl (see page 5 of the attached pdf for the exact calculation using current product prices [http://www.swimediaservices.com/interoil.pdf]). The prices for IOC’s products and feedstock are posted daily on Bloomberg and are calculated using the yield slate that management indicated. The current -$6.00 crack spread, however, is abnormally low (crack spreads are very volatile on a week-to-week basis) and doesn’t represent a normalized spread. To assess normalized earnings power of the refinery (vs. at any given point in time), I looked at this spread over time (from 1995-2005) and it has consistently cycled between $0 and -$2/bbl (see page 6 of the attached pdf for a graph of historical crack spreads [http://www.swimediaservices.com/interoil.pdf]). In coming up with normalized economics for the refinery, I have assumed the midpoint of the range (-$1/bbl).

A negative crack spread isn’t surprising given the refinery’s lack of any complexity whatsoever (i.e. it has no ability to process heavy or sour crudes; as a pure distillation tower, it is the most basic and simple of all refineries). Distillation margins (as any refining industry analyst will confirm) have always hovered around $0/bbl and are even worse in Asia versus the rest of the world due to structural oversupply of distillation capacity. The margin in refining is made in upgrading (through catalytic crackers, cokers, etc).

To summarize on the economics of IOC’s refinery, IOC’s EBITDA per barrel will equal:
1) Singapore crack spread (-$1.00/bbl)
2) Plus: import parity premium (+$3.00/bbl)
3) Less: cash operating costs (-$1.70/bbl)
4) Plus: Kutubu oil discount to Tapis (+$0.50/bbl)

which equals $0.80/bbl. Multiply this times 12.8 million barrels processed and the result is a $10mm in annual EBITDA. This compares with management’s $60 million EBITDA guidance. It should be noted that management’s guidance also includes the Downstream business (they don’t breakout refining and downstream); however, given the $13mm price tag InterOil paid for its Downstream business it should be safe to assume that it does not contribute meaningfully to the $60mm in guidance (see further discussion below). To corroborate that point, note that in Q1 2005 IOC’s downstream business did $600,000 of EBITDA.

What’s worse is that this analysis assumes that all of the refined products are sold in PNG. If any of the product is exported, then gross margins deteriorate further (turn negative) due to the shipping costs of export (i.e. if IOC then had to ship any of its refined products to Singapore to market them, per barrel margins would deteriorate by another $1.75/bbl, or the cost of shipping product to Singapore). After all, why would it make sense to ship light sweet crude (in high demand currently) to a very small scale refinery in the middle of the Pacific Islands for processing to then be exported? The problem for IOC is that the domestic market can only absorb 50-60% of their output according to management. The remainder was optimistically targeted for export when the refinery was commissioned. Assuming real domestic demand for refined products in PNG grows at 5% per year, it would take 12 years before the refinery is fully utilized (i.e. before demand grew into the domestic capacity that IOC built). At that point, we could expect to see $10 million in EBITDA.

Given the above, it is not surprising that in Q1 2005 (the first full quarter of IOC’s refinery operations) the refinery and downstream were EBITDA breakeven. Furthermore, management stated in its June press release that the refinery is currently running at 22,000 b/d (60% of capacity) in Q2, on par with the same low utilizations achieve in Q1. My guess is that this may have more to do with the fact that exporting is not profitable than it does with the need to optimize the refinery operations. Furthermore, management’s claim that the current unfavorable crack spreads for naptha are also responsible for the refinery’s poor financial performance seems implausible given that: 1) naptha is only 17% of the output of the refinery; and 2) Singapore crack spreads for the fully refinery product slate have consistently been negative over the last 10 years (i.e. this is not a temporary situation due to abnormal supply/demand for one single product such as naptha).


Valuing the Refinery
Given the analysis laid out above, it appears to me that InterOil made a strategic mistake in siting a sub-scale, simple distillation refinery in PNG. It is unlikely that the refinery will be meaningfully cash flow positive over the next decade without major capex to add to complexity (something that doesn’t make sense on a small 36,000 b/d refinery in a remote market), and it is furthermore highly unlikely that management’s $60 million EBITDA guidance will be achievable.

If we were to be optimistic, however, and value the refinery on invested capital, one could argue it was worth $0-3/share. Invested capital in the refinery according to IOC was $230 million ($6,300/daily barrel at 36,500 b/d capacity). If we assume the refinery is worth invested capital of $230 million, then the asset is worth $6.95/share. Net of $3.62/share of net debt (excluding the $125 million in drilling financing) = $3.33/share of equity value for the refinery. Original costing for the project (also disclosed in the 1997 Project Agreement) was $162 million ($4,400/daily barrel). So the project ended up 42% over budget (which may have been the key reason Enron backed out of the investment). Regardless of IOC’s invested capital, a $230mm valuation is hard to justify based on cash flow multiples (a $230mm valuation equates to 23x the $10 million EBITDA run-rate we would expect to see once the refinery is fully selling in the domestic market). Using a more realistic number of 10x the $10 million EBITDA figure, the refinery would be worth $100 million ($3/share), or zero to the equity once the $3.50/share of net debt is taken out. Using IOC’s original cost estimate for the investment of $160 million, the refinery would be worth $1/share net of debt.

This is a far cry from the $15-$20/share valuation referenced by the bulls on the stock. At $15-$20/share (plus $3.62/share of net debt), the refinery/downstream business is being valued for $615-$780 million, or $17,000-$21,400/daily barrel of capacity. This is an absurd valuation relative to market: recent refining asset transactions (El Paso/Valero’s Aruba refinery deal, El Paso/Sunoco’s Eagle Point refinery deal) traded for $2,500-$4,000/daily barrel and both refineries were meaningfully more complex than IOC’s. Furthermore, Valero’s recent bid for Premcor (a high complexity refiner acquired in a corporate transaction for a 28% premium) went for $10,000/daily barrel. In addition, replacement costs for a greenfield high complexity refinery currently run around $10,000/daily barrel.


E&P
Ex-the refinery, IOC’s E&P business is an option (IOC has no reserves or other E&P assets of any material value). In my view, the two key questions to ask in assessing the value of the option are: 1) what is the likelihood this management team finds hydrocarbons? and 2) if they do find hydrocarbons, then how much can we reasonably expect them to find and what are the barrels worth?

In assessing the exploration capability of this management team, it is worthwhile going back and reviewing the chronology of IOC E&P press releases vs. the actual results. It is worth noting several of the dry holes (there were 7 in total) were preceded by press releases indicating major hydrocarbon finds, and in a number of instances the company raised significant equity financing in the wake of the stock price increase that preceded later announcements that the wells were dry (this is most notable in 2003/2004 – see the history below of the Moose-1 and Moose-2/Sterling Mustang wells).

Chronology of Company’s E&P Claims - See post #1 for details

Valuing the E&P Option – See post #2 for details

Catalyst