Description

South American Production Growth.

 

All amounts are converted from NOK to US at .1975.

 

Basic shares outstanding:  21.85 million

Market cap.  $149.2 million

Total liabilities – cash and oil receivables (as of March 31^st, 2008): $181.5 million 

 

Shares outstanding fully diluted (assumes conversion of $20 million debenture into 2.72 million shares, 656,245 out of money options and additional forecast option grants for 2008):  25.22 million.

 

2P reserves as of December 31^st, 2007:  15.9 million barrels.

 

Current enterprise value:  $330.7 million.

2007 EBITDA:  0

2008 forecast normalized EBITDA:  $65 million

2009 forecast EBITDA (ex Africa):  $89 million-$137 million.

 

I own shares of Interoil ASA a smallish E&P with production in Peru and Columbia.  The shares trade on Oslo, Norway.  On today's date, the share price was 34.6 NOK.  This equals $6.83 US.

 

An important exploration success in Peru has just been declared.  Development may be swift, cost effective and have meaningful implications for reserve and production growth.  Based upon estimated success, IOX production may average 3800 bpd net for 2008 and average 4692-5342 bpd in 2009.  Reserves could grow by 35%, to as much as 21 million barrels of 2P by the end of 2009. 

 

Full development of the discovery has the potential to drive annualized production to 10,000 bpd, by the end of 2010.

 

Company description. 

 

Interoil ASA was founded through an asset purchase of a private oil and gas firm with two small producing fields in Peru and Columbia in September 2005.   I owned a modest equity interest in the firm (Mercantile International Petroleum) that was sold to Interoil.  Private shareholders were in the process of floating an AIM listing on London but were pre-empted by a cash offer.  Stark Energy LLC, (the majority owner of Mercantile) opted for cash certainty.

 

Interoil subsequently listed its shares OTC Norway, where I repurchased a portion of my position.  The shares of Interoil started trading on the Oslo stock exchange in July 2006 and have largely marked time in a range of $3.50-10.48 US. Insiders currently control more than 32% of the outstanding shares.

 

The fields and my evaluation of reserves & production potential are as follows.

 

Peru:  Interoil holds a 100% operating interest in two production licences over the oldest established fields onshore Peru, known as blocks III and IV.  These blocks represent 660 square kilometres, or 164,000 acres.   Gross production in May was 2710 barrels, which equated to approximately 1360 bpd, net to Interoil.  Production on blocks III and IV is governed by an oil license that is unattractive in relation to newer agreements in Peru.  Interoil pays royalty rates of 49.8% of gross production to PeruPetro, the state oil company. 

 

The fields contain 11.8 million barrels of 2P reserves and encompass one of the first oil finds in Peru, known as the Portachuelo field (block III).  Other fields are named La Brea, Boca and Mirador.  The licenses represent the largest oil exploitation blocks by aerial extent outside of the jungles of Peru.  The fields were operated by Exxon until 1968, and subsequently PeruPetro until 1993.  Blocks III and IV were almost dormant by the time Mercantile assumed operations in 1995. 

 

Production licenses are due for renewal on March 4th, 2013.  Reserves are calculated to the end of the current production license.  In the event that a new license is granted Interoil, reserves could increase accordingly.

 

http://www.sedar.com/GetFile.do?lang=EN&docClass=13&issuerNo=00001909&fileName=/csfsprod/data55/filings/00760869/00000002/s%3A%5CMercantileIntnlPet%5CAnnReport.pdf

 

Productive formations are relatively uncomplicated sandstones. Horizons are located between 2500 feet-6000 feet below surface and oil is reasonably distributed throughout two large areas.  Historic data indicates that reserves in shallow formations averaged  100,000 barrels and Salinas wells (deeper) average 140,000 barrels per well. There are large variations per well and per field due to heavy faulting in the fields and the formation targeted.  While historic reserves per well seem modest, most wells in these fields were drilled long ago. Extraction techniques have improved greatly over the past 50 years.

 

Newly drilled wells in shallow formations generally start off with production rates of 50-125 bpd, and within a year, decline to rates of between 5-10 bpd.  While production per well is low, so are costs.  Most who have operated stripper wells will confirm that EBITDA returns soar when pricing is strong.  A 7 bpd producer that doesn’t require much maintenance, has the potential of delivering $100,000 per year of annual EBITDA for IOX, in this pricing environment.    Oil prices received are typically WTI less $7 for quality differentials.

 

At present, blocks III and IV contain about 350 producing stripper wells.  More than 900 wells have been drilled on these fields since inception.

 

Portachuelo was discovered in 1931.  Original oil in place of OOIP is estimated at up to 400 million barrels.  Less than 8% of the OOIP have been produced to date.  This suggests that primary production is still appropriate for many years to come.  Other fields (La Brea, Boca and various fields in block IV) are estimated to have as much as 150-200 million barrels of OOIP, with less than 10% of OOIP produced to date.

 

I have always considered blocks III and IV to be good assets with development potential. A perpetually cash strapped Mercantile was able to boost Peruvian production over its 10 year history using “spit and duct tape”.  The former CEO once wondered what would be possible if a few million could have been found back in 2000, to pay for some modern seismic maps. 

 

Post acquisition, Interoil has acquired highly current seismic on unexplored portions of these blocks.

 

Incidentally, significant amounts of natural gas are located in Block III.  2 wells drilled in the 1950`s and 1960s tested at 20 mcf/day and 40 mcf/day respectively.    Up to 610 bcf of gas resource are estimated in the license area, with almost 225 bcf considered already found.  Under the current royalty structure and if a market could be had, IOX could quickly book up to 113 bcf of resource for their own account.  At one point in the late 1990’s, a contract to sell gas to the Malacas 150mw power plant near Talara, was under negotiation.  This was never consummated.   Around 2000, discussions took place regarding a contract to sell gas to a proposed 250mw gas fired facility.  The plant was ultimately shelved in the early 2000’s as being uneconomic to build.  Since there were no other current markets for the gas, and no infrastructure existed to allow for transport, no gas reserves are currently reported by Interoil.

 

http://www.sedar.com/CheckCode.do;jsessionid=0000OJI-O1xCf3d5tciYPX-XZmQ:-1

 

Investors will have to decide for themselves, whether or not 225 bcf of known, but stranded natural gas represents a “hidden value”; for a company with just 15.9 million barrels of 2P oil reserves.

 

Peruvian oil production appears set to grow rapidly, as a result of a new discovery, ``La Isla``, at the southern margins of block III.

 

Olympic Oil & Gas (an unrelated company) announced excellent results from a discovery directly adjacent to block III.  Several wells were drilled into the Salinas Mogollon sandstone formation and are estimated to be producing about 300 bpd.

 

Interoil subsequently announced an intention, in early 2008, to drill at least two wells to the Salinas formation, on a 6 square km exploration area within block III.  This in close proximity to the Olympic discovery.  IOX’ first well has been declared a commercial success, and is probably producing about the 300 bpd level, consistent with the Olympic wells.  Drilling costs are about $1.2 million per well.  Even with the high royalty structure in place, full payback on a successful well should occur within four-six months.  It takes approximately 4 weeks to drill an Isla location.

 

http://www.newsweb.no/newsweb/index.jsp?messageId=213503&lang=

 

This exploration play is well defined with very modern seismic. Given the size of the prospective formation, the current level of production from the first well and appropriate spacing, it should be possible to drill more than 30 wells into the existing area.  Information is sketchy on the Olympic discoveries, but I take it that production declines are lower than expected.  Oil produced from this formation is generally 32-34 API.

 

I estimate that with one rig working year round, an 80% success ratio on further Isla wells, 150 bpd of initial net production per well and a 50% annual production decline rate, IOX net production in Peru could grow to an average of 2,792-3,042 bpd in 2009.  Production would be divided between Isla at 1392 bpd, with 1400-1,600 bpd coming from the remaining fields.  Workovers and limited development drilling have proven to be sufficient to maintain or modestly increase production at the existing Peruvian fields. 

 

Put another way, at an assumed cost of $1.2 million per well, Interoil may have to spend as much as $21.2 million of further capex at Isla through the end of 2009.  This could prove up at least 4-5 million barrels of 2P reserves.  At $115 per barrel of oil, the Isla field could add $58 million to 2009 revenues and $33 million of annualized EBITDA.  The discovery and exploitation appears to be highly economic. An enormous number of wells, in theory, could be punched into this formation.

 

Columbia fields have production upside.

 

Interoil has a production license which represents a 50%-100% working interest in two fields, Toqui-Toqui and Tortare.  These production contracts expire on January 1^st, 2012. 

 

The Toqui-Toqui field is jointly owned by Interoil (50%) and Ecopetrol (50%).  Production is shared equally and the Columbian government is paid an average 15% royalty on Interoil's net production. 

 

Reserves are estimated at 4 million barrels of 2P, based upon a contract expiration date of 2012.  Older reports issued by Mercantile`s reserve engineers suggested that 2P reserves could be at least 53-69%% higher, should a license be renewed.  It is estimated that original oil in place (OOIP) from the two productive formations in Toqui-Toqui could be as high as 150 million barrels. Only 4% of the estimated OOIP has been produced to date. 

 

Oil prices received are typically WTI less $10-11 per barrel for quality differentials.

 

Columbian production is set to climb, starting this month.

 

Interoil has commenced an extensive fracturing program to increase production from Toqui-Toqui.  Initial results from the 1^st two wells are promising and 10 wells are scheduled to be fractured.  8 shallow and 3 deeper wells are also to be drilled this year.

 

Columbian production averaged 1376 bpd in May.  Net of Ecopetrol’s interest and assuming a 15% royalty, production may grow to average 1900 bpd in 2008, and surpass 2300 bpd in 2009.

 

Interoil holds African exploration interests.

 

The firm has a 31.5% holding in an offshore Ghana concession “Tano Shallow”.  This is in reasonable proximity to the large Mahogany oilfield now being developed by Tullow and Anadarko.   Interoil and Tullow drilled into a gas structure last year, but came up dry.   The dry hole resulted in a $10 million + expense against EBITDA in 2007.

 

The next target to be drilled in Tano is “West Tano”.  Dana drilled this structure back in 2000, intending to explore a horizon at 12,000 feet.  Pressure problems forced Dana to plug the well at 11,500 feet prior to hitting target. The well was suspended at 10,143 feet.  An oil bearing sand at 8900 feet was encountered and tested 1,000 bpd of 28 API oil.  Due to the lack of infrastructure at the time, and low oil prices, Dana subsequently relinquished the prospect.

 

http://www.offshore-mag.com/display_article/74796/9/ARCHI/none/none/1/WEST-AFRICA/

 

Tullow ultimately added this concession to their inventory.  Interoil has since assumed a 31.5% interest by paying 37.5% of costs.   An appraisal well at West Tano is to be drilled late this year.   As this well will be close to the Dana exploration target, I think the odds of hitting something are slightly better than 50%. 

 

IOX also holds two concessions offshore Angola; blocks 5 and 6.  A 40% interest in block 5 is maintained and the operator is Vaalco energy (EGY).  Vaalco intends to drill in late 2008-early 2009.  At block 6, Interoil holds a 20% interest and Petrobras is the operator.  Petrobras wishes to appraise an old heavy oil discovery “Cegohna’  that may contain an estimated 135 million barrels of resource.  The field was originally discovered by Conoco and Total.  It was released back to Angola’s oil company some time ago when heavy oil was deemed uneconomic.  Petrobras is considered a first rate company insofar as offshore heavier oil development is concerned. 

 

A new onshore concession called Cabinda North is interesting for wildcatters. Interoil holds a 21% interest in an area which has not been explored since the 1970’s.  Several smaller discoveries have been made in the area of late.

 

I believe that Interoil needs to raise about $50 million this year at the explorco level, to fully maintain their African interests.

 

In 2007, Interoil expensed $23.15 million on African operations.  As the firm uses successful efforts accounting, this is a direct hit against EBITDA.  An additional $2.87 million was expensed for Africa in the 1^st quarter of 2008.

 

Offshore exploration is high cost and carries low probabilities of success.  Replicating the success of a Tullow oil is difficult in smallish independents, and Interoil has bitten off more than I would personally care to chew.  

 

Diverting cash flow from the myriad of promising opportunities in Peru and Columbia, to potentially blow it up on dry holes offshore Africa, does not sit well with me.  Evidently, I’m not alone in this view.  Accordingly, management intends to spin off the African assets to a stand alone company. 

 

1. Management intends to issue about 6 million shares of equity to raise a minimum of $30 million dollars.  This will probably be via a rights offering to existing shareholders.

 

2. Interoil Africa will then be listed, perhaps on AIM.  A partial flotation is logical to raise initial cash, with the remaining shares potentially being spun off to shareholders at a later date.

 

3. Interoil Latin America (Latam) will hold all current financial obligations and production assets in Peru and Columbia.  There will be no further obligation to supply capital to Interoil Africa.

 

Separation of the South American and African assets is very sensible.

 

$30 million of funding could provide a cushion that may carry IOX towards self sufficiency. At forecast production volumes and should oil prices remain above $100, I don’t envision a further need for further equity issues in 2009.   

 

However, there is no way that in its present form, IOX can spend an estimated $50-$60 million on South American capex in 2009, while also coming up with about $50 million towards African capex.  Credit markets are such that further debt financing is unlikely at the current production rates…nor would I consider adding more debt to be prudent.   

 

830+ bpd of oil has been hedged at $75 US through 2008, with a further 600 bpd through 2009.  I believe that the firm ran out of money in the 1^st quarter, and had to curtail most development work in Peru and Columbia to fund a $10 million loan repayment. 

 

The lack of development capital largely accounts (in my view) for a drop in oil production from 5020 bpd in January 2008, to just 4329 bpd in May 2008.  Management blamed 150 bpd-600 bpd of the drop due to flooding in Peru, wells being shut in for fracturing and natural reservoir declines.  I don’t fully buy into this, when considering that drilling is now progressing, only after the loan payment was completed in early May.  As I am certain that many long time oil investors are of the same mind, it is no wonder that the shares are 35% off from their 52 week high.

 

 

Apparently, management doesn’t think much of me either.

 

I have queried if Interoil intends to build out a market for their natural gas assets, which are quite close to a proposed gas line for Olympia wells. This could add substantial natural gas assets, not on the books, as a reserve asset.  My questions have not been yet replied to.

 

I have also pressed twice in the past 12 months, about a proposed royalty reduction agreement in principal. This was entered into between the Peruvian government and the predecessor company, Mercantile.  Under this agreement, Mercantile was to accelerate investments for drilling, well rehabilitation and work commitments.  In return, Peru was to reduce oil royalties on all production to no more than 20%, which would be in line with new contracts.

 

The program requirements were fulfilled by Interoil in early 2007, but so far, royalty relief has not been granted.  Such a reduction would be a material event, and could immediately add almost 800 bpd to net production.  Incremental production going forward basis would be much more profitable.  EBITDA at current rates could improve by at least $.66 per share per annum, using current oil prices.  Reserves net to IOX would increase as well.

 

My questions as to why royalties have not yet been lowered, have not been responded to.

 

That said, I now consider the shares to be a bargain.

 

The Isla discovery is a highly material event.  If junior oils are worth 3X-4X EV/EBITDA, a $24 million capex plan at Isla could add $33 million of additional EBITDA in 2009 and some decent longer life reserves.  This would be worth $3.5-$4.74 of incremental value for Interoil shareholders in about a year, even assuming 6 million more shares outstanding.   For a microcap, this could be a company maker.

 

I personally believe that royalty relief is pending.  This is a hunch on my part and might be entirely off base.  As the markets are presently building in no value to my hunch, I don’t mind sharing my views with VIC.  (Please don’t splash this report around the internet…many thanks).

 

Should royalties come down, EBITDA could improve by an annualized $20 million based upon current Peruvian production.  Any incremental Peruvian production would pay just a fraction of present rates (20% vs 49.8%), so forecast Isla volumes would be much more profitable. Based just upon current output, a 3X-4X EV/EBITDA multiple on current royalty savings adds incremental value of $2.15-$2.85 per share, on a 28 million share base.

 

I believe that the African assets hold value, but are being priced like a liability by Interoil shareholders.   A spinoff could be worth at least $1 per share, based upon the $26.15 million already expensed on African operations in 2007-2008. 

 

In my view, IOX has the potential to double in the next 18 months.

 

The production growth catalyst could become evident as soon as August.  Interoil announces production figures monthly.  Based upon several successful fractures in Columbia, new production from Isla and two other decent shallow wells recently drilled in Peru, July net production could rise above 3226 bpd, up from 3151 bpd in January.   With 11 wells to be drilled in Columbia in the back half of 2008, and an unquantified number planned in Peru, month over month comps should start to look very good. 

 

Peruvian natural gas is a complete wildcard for IOX that few are aware of.  IF BPZ can get funding for a gas plant, there seems to be no reason that other substantial stranded gas producers in this region can’t replicate such a feat.  Royalty relief is possible. Reserves, while entirely accurate as per filings, seem quite understated if licenses can be renewed, royalty reductions take place or if natural gas ever gets added to the mix.

 

Using the current royalty regime, I arrive at a 2009 production estimate of 4692-5342 bpd .  Revenue could be $153.4 million-$176.4 million.  EBITDA could be $90-$102 million.

 

Using the new royalty regime, I arrive at a 2009 production estimate of 6695-7087 bpd.  This works out to be $223.2 million-$236.4 million of revenue.  EBITDA could be $129.5-$137.1 million.

 

A 4X EV/EBITDA multiple produces a value of $7.25-$13.36 on 31.22 million shares.  This assumes that a $30 million capital placement occurs.  I also assume that the $20 million convertible debenture, at some point in my forecast period, goes ”in the money”.  The capital placement assumes a 20% discount from the current share price and expenses = 10% of gross proceeds.

 

Add in $1-$2 per share of value for African assets, and the total return could be 20.7%-124% by the end of 2009.  Personally, I’m not holding these shares to earn just a 16.7% basic return.

 

Should management elect to procure a second rig for Isla, my estimates might prove out to be conservative.  If oil prices remain above $100 for an extended period of time; a 4X EV/EBITDA multiple will probably start to look quite cheap.  Once again, this could make my targets seem conservative.   Reserve recognition of natural gas assets on block III might make my targets look conservative. 

 

While it pleases me to see that the African assets are slated for spinoff, many of the concessions are intriguing.  This combination rather reminds me of an older deal I wrote about…Lundin Exploration.  Lundin was ultimately taken over by Petro Canada and spun off a package of exploration properties without any production, valued at less than $.40 US per share. Lundin Petroleum AB now produces about 27,000 bpd worldwide and the spinoff has become far more than a “30 bagger”.

 

Interoil’s website is here

 

http://www.interoil.no/ 

 

An overview of the productive petroleum formations in Peru can be found here

 

http://pubs.usgs.gov/bul/2206/A/b2206-a.pdf

 

Investors looking to bone up on the stranded gas assets in block III should review SEDAR filings (www.sedar.com) for Mercantile International Petroleum.  The annual reports for 2003 and 2002 mention gas reserves as well as failed attempts to market the gas.

Catalyst

La Isla discovery may help to drive 95% production growth by the end of 2009. 35% reserve growth is possible by 2009. A proposed spin off of African explorco would eliminate heavy drag on expenses and EBITDA. Unbooked stranded gas has company making potential on its own. A potential major reduction in Peruvian royalties could permanently change the outlook for the better.