InterOil Increases Production...

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By Chris DeMuth Jr. :

InterOil Increases Production...

of press releases.

Since our note InterOil Produces , here is what has happened at [[IOC]]:

(click to enlarge)

We do not expect there to be enough gas to incent [[TOT]] to proceed with this project. TOT was wise in the way that they structured this deal. They will do their own work in evaluating whether it is worth proceeding. I prefer to think in terms of probabilities than in terms of predictions but here are two bold exceptions: I expect IOC to issue many more press releases and many many more shares. We think that the value of IOC is well beneath $50 per share and we would not be surprised if the market price reflects that before too long. When will facts indicate that we are right or wrong? If independent engineers certify that there is an economically viable amount of gas and if TOT ends up paying the $590 million contingent payment, then we will have been wrong. The more likely outcome is that IOC gets no contingency payment, engineering results lead TOT away from this project, IOC raises more equity, and the price of IOC shares converge with their value beneath $10 per share.

Here are our notes from this past April, which are still relevant today:

IOC is a gas and oil exploration, production, and distribution company located in Papua New Guinea. The company trades on the NYSE, has a market cap of $3.7 B, a current PE of 254, and a price to book of 4.88X This company has the financial and business profile that epitomizes a speculative investment. Its focus is clearly on locating huge gas and oil reserves covered by the exploration agreements that they have with the Papua New Guinea government. As with all speculative investments, the focus is not on what the company currently owns, but on the bet that what they own may be worth more than anyone currently has a reason to believe. This investment will remain very valuable and perhaps increase dramatically in price as long as the management believes and can convince investors that the value of what is behind the curtain is worth the bet. They hope to find gas and oil where no one else thinks there is any. They may very well do that. This investment is at the opposite end of the risk spectrum from a value investment. A value investment offers proven assets and cash flows at a discount to their market value. A speculation offers the thrill of being lucky enough to see assets that have little proven value turn into very valuable proven assets as the story unfolds. IOC is perhaps one of the most speculative investments available today.

The way to analyze the value of a company is to look to the balance sheet and see what assets support such an incredibly high price to book ratio. The assets that we are looking for are undervalued gas and oil leases, undervalued proven reserves to exploit, assets that are written down below current value from the financial crisis, or they could be contingent gains such as pending litigation or insurance claim recoveries. Finding this kind of value would make it a value investment. Without them, they move toward the speculative end of the range.

Their laundry list of assets does not appear to have much hidden value except perhaps in the oil and gas exploration rights. But that is where we would like it, leases just waiting to be drilled in the hopes of discovering massive as yet contemplated reserves. Looking into the detail of what the $515 M represents, we found the following.

IOC started investing in Papua New Guinea in the late 1990s. They started their relationship there by entering the refining and distribution business in the local economy. They purchased and moved refinery equipment from Texas to Papua New Guinea. Through 2005 they built the refining and distribution business. By 2005 they had lost money every year building up a negative accumulated deficit of -$110M. However, in this period they had also raised enough additional equity and debt to have a positive book value of $144M and total assets of $429M. Most of the money was invested in refinery and distribution plant and equipment (55%) while $93M (21%) was invested in distribution assets of inventory and accounts receivable. I am sure that this large investment in the local geography paved the way for them to secure the gas and oil exploration agreements that they have today. The right to exploit the hopefully rich gas and oil reserves is where the really big payoff may be.

Starting in 2006, IOC started investing in the oil and gas exploration segment of the business. For a company that started out in 2006 with only a book value of $144M, they raised debt and equity to fund investment in oil and gas exploration of $478M, bringing the book value of their oil and gas investment to a total of $515M. This was despite never having been able to book any proven gas or oil reserves after exploring and drilling for six years. Luckily for IOC shareholders, as long as they keep investing more money in the exploration process in these oil fields, they do not have to write off the majority of the exploration costs. They only have to write them off when they finally decide to give up on the fields. With the proven skills of the senior management team in raising money, there is no reason that they will ever need to give up. But, if they had decided to cut their losses at the end of 2012, the entire balance of $515M would have been evaluated for write down. If it had been write off, the price to book at today's stock price of $75 per share would have been 14.2X book value. The only assets on the balance sheet would have been the refinery and the distribution assets. These assets currently have the ability to generate enough cash to be self-sustaining, but not to fund much in terms of exploration or the infrastructure required to monetize the oil and gas presuming that they are eventually found.

So what is the Plan? IOC has three challenges to keep the hope alive in this speculative investment. First, they need to continue to investment money in development wells in order to sustain their exploration license from the government. So far they have drilled eight wells. They have declared two of those well "successful", but apparently they have not been successful enough to meet the criteria required to quantify that success with any "proven reserves". Secondly, they have to show progress in getting qualified partners that are capable of providing financing and industry expertise in order to build an LNG facility and a condensate stripping facility capable of processing and exporting whatever gas and oil they find. Third, they need to successfully negotiate the necessary licenses to develop and sell any oil and gas that they find with the Papua New Guinea government. All of this needs to be done without diluting the current equity investors to the point where there is little value left for them.

IOC is very open with their plans on how this will be financed. They will finance it by selling and trading equity in what oil and gas may be found for the money and partners required to continue exploration and development of the finds, building the LNG and stripping plant, and negotiating the development licenses with the government. Currently, they are evaluating proposals to participate in this endeavor. To quote their latest filing, they have authorized "unlimited shares" of preferred and common stock to use in procuring the financing to keep going. As yet there seems to be little indication of how much dilution will be required to finance the project through to the actual production stage of the business. Of course all of this depends on them ultimately finding developable oil and gas deposits.

As of today, an investment in IOC is the poster child of a speculative investment. No one knows if and when they will actually find proven reserves of oil and gas. Therefore no one knows how big or small the pot of gold is. We have been told that the development of the required processing plants and infrastructure will be "hundreds of millions of dollars". No one knows how much equity will be required to be sold or given to partners in order to finish the project. No one knows if they will actually be successful in getting the required licenses from the government while retaining any return at all for the current shareholders.

Disclosure: I am short [[IOC]]. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

See also Sleep Well At Night Owning This Hotel REIT on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

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