A Sober Look At InterOil's Deal With Total SA

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"In Philadelphia, it's worth 50 bucks."

- Pawnbroker, Trading Places

An old Wall Street adage is "Buy the rumor, sell the news." I have two problems with this advice. First, it is hard to apply in situations where the rumor mill has been in overdrive for years. Second, it assumes that an investor will be able to make an orderly exit once the "news" finally hits. Both problems were illuminated rather brightly this month in the case of NYSE-listed InterOil Corporation (IOC) and its long-awaited announcement of a strategic partnership with oil and gas major Total SA (TOT) of France.

In two prior articles (here and here) I summarized the seemingly endless stream of partnership discussions and transaction rumors that have swirled around InterOil for many years, only to end up in disappointment for the company's long suffering shareholders as one after another slipped into the abyss.

"The four most dangerous words in investing are: 'This time is different."

- Sir John Templeton

At the risk of dismissing yet another famous Wall Street axiom, this time really is different. On December 6, 2013, not only did InterOil announce a partnership, it actually inked a binding arrangement with one of the world's largest energy companies (Total SA). The deal calls for the sale of a majority stake in InterOil's primary asset, the Elk/Antelope natural gas discovery in Papua New Guinea and the potential for a future liquefied natural gas (LNG) project in the country.

"It ain't cool bein' no jive turkey so close to Thanksgiving."

- Prisoner, Trading Places

Expectations had been running high since IOC's third quarter conference call on November 12 during which InterOil's new(ish) CEO Michael Hession outlined plans to complete "this transformational deal" by the end of the year. The following are some snippets that were used to describe the transaction:

"capturing the upside"

"the transformational deal is underway"

"We have offers from a number of mega majors"

"we are in parallel negotiations with a number of mega majors. These parallel negotiations are reaching conclusion"

"That's what happens when you're in parallel negotiations with mega majors who do [covet] these assets, and there is a degree of competition"

"InterOil has found the biggest gas field in Southeast Asia for 20 years"

"And upside, yes, we're on the way"

Investors were well aware that InterOil had been seeking a strategic partner since the most recent process began in September 2011. In fact, the company told investors at its June 15, 2012 Annual General Meeting that "All Bids accretive to shareholders, top bids at a multiple to share value":

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Source: InterOil 2012 AGM Presentation

The day prior to that statement IOC closed at $58.72, so a "multiple to share value" must have sounded pretty compelling at the time.

With all of that interest, wildly bullish analysts (e.g. Evan Calio of Morgan Stanley re-initiated coverage with a $105 price target on November 15 of this year), and Dr. Hession's confirmation of an imminent "transformational deal," it seemed like a one-way bet. Buy the rumor. The market liked what it heard, and IOC shares soared, rising from the $67 level prior to the call reaching the $89 range by December 5.

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Source: Yahoo Finance

"Nothing you have ever experienced will prepare you for the absolute carnage you are about to witness"

- Louis Winthorpe III, Trading Places

Details of the transaction began trickling out of Papua New Guinea overnight on December 5 on Twitter and elsewhere. IOC put out a press release late in the evening of December 5, followed shortly by Total. Seeking Alpha contributor Chris Demuth Jr. provided a nice side-by-side comparison of the two press releases that suggested vastly different economics. Shares were down sharply in the pre-market and IOC appropriately responded with a conference call, and later in the day issued a "clarifying" press release and filed the entire 80-page Sale and Purchase Agreement.

While surely not helped by the confusion that morning, it was clear the market was expecting something far more lucrative from this "transformational deal." The agreement calls for further delineation work, a 2016 expected Final Investment Decision on an LNG project (IOC had previously claimed it was "FID ready"), first gas in 2020 or later, lower-than-expected pricing, and a significant portion of the potential consideration being contingent on both FID and certification.

Further complicating matters, the whole enchilada is contingent upon InterOil buying out its co-owners in PRL 15 (the license containing the Elk/Antelope discovery). Investors, it seemed, had not signed up for another couple of years of uncertainty and deferred gratification and the stock sold off sharply:

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"Hey, we're losing all our damn money, and Christmas is around the corner, and I ain't gonna have no money to buy my son the G.I. Joe with the kung-fu grip! And my wife ain't gonna f... my wife ain't gonna make love to me if I got no money!" So they're panicking right now, they're screaming "SELL! SELL!" to get out before the price keeps dropping. They're panicking out there right now, I can feel it."

- Billy Ray Valentine, Trading Places

Despite whatever rational or irrational investor exuberance occurred prior to the Total transaction, it is a good deal for InterOil. It also allows investors to better model the company's valuation, within the framework of the transaction (under which Total is acquiring a 61.3% stake in IOC's key PRL 15 asset). Investors seriously interested in going long or short IOC shares should pull down a copy of the SPA and read it cover-to-cover. I won't get into the minutiae but the following table summarizes the payment structure:

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The Interim Resource Payment is calculated on an escalating scale, with higher per million cubic feet (MCF) values paid on higher total certified resource quantity:

A deduction for carried resource evaluation costs (mostly drilling 3 wells) is also made. I estimate this amount at approximately $60 million as follows:

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I have modeled out several scenarios based on my reading of the SPA. I believe the calculations to be accurate as they are consistent with InterOil's "clarifying" press release that outlines total "Indicative Payments" at the various Tcfe certified resource levels. Before showing the analysis, some clarifying points:

• I have ascribed no value to the "Discovery Bonus" which would kick in if IOC and Total drill a successful exploration well in the license area. It is highly speculative, and an "unknown unknown" but there is a bit of option value here. However, it is likely to be a rounding error. As an example, if this well is as successful as IOC's highly touted "Triceratops" structure that was drilled in 2012 (and is outside of the PRL 15 license area), it would add approximately $43 million to the transaction. IOC's resource evaluator (GLJ) ascribed a best case 71.9 MMBOEs (or about 0.4 Tcfe). Ascribing a 50/50 chance that this well is as successful as Triceratops the expected value is about $20 million, or 40 cents per IOC share. I have safely ignored this but others may be more hopeful.

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Source: InterOil 2012 Annual Information Form

• For the sake of convenience and simplicity, and to focus on what really matters, I have assumed that IOC's midstream / refinery and downstream distribution businesses are worth perhaps enough to cover the company's long-term debt. The Midstream - Refining business segment generated EBITDA in the first 9 months to September 2013 of about $10 million, while the Downstream segment generated about $33M. Applying conservative multiples a sample valuation of these businesses is below:

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Excluding the working capital facility I roughly calculate approximately $340 million in LT debt:

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Source: IOC Q3 Report, $50M estimate on CS Facility

• I have not included any value for IOC's prospective acreage. While not worthless, markets and partners clearly do not ascribe meaningful value to such unexplored acreage. As a reference, New Guinea Energy Ltd. (Ticker NGE on the Australian exchange) holds 5 onshore Petroleum Prospecting Licenses (PPLs) covering over 29,500 square kilometers in Papua New Guinea and a royalty right in another 4,000 square kilometers in a PPL. It has farm-in partners in Talisman and Mitsubishi, and a royalty deal with Exxon and Oil Search. Its market cap is about $20 million. This may seem a bit harsh but note I have also not deducted any value for the company's corporate overheads either. Call it a wash.


• I have assumed that a Final Investment Decision (FID) is made with 100% probability, even in the case of a low (e.g. 3.5 Tcfe) certified resource amount. The theory being that Total could add gas from elsewhere (e.g. its joint interests with Oil Search in the surrounding area, or other PNG gas assets that could be drilled out or acquired). Nothing is ever 100% of course but it's the festive season and we should be optimistic.


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  Source: Total SA

The main takeaway from the above four points is that whether these items add or subtract a few bucks per share is immaterial in the context of InterOil's deal with Total. The factors that completely dominate the company's valuation are simply how much contingent resource will be certified in 2015 when the delineation wells are drilled and the resource evaluators do their work, and whether or not an FID is reached over the next few years.

Below is a series of scenarios. I have included all of the payment break points in the SPA (3.5 Tcfe, 5.4 Tcfe, and 6.5 Tcfe), as well as a 9.9 Tcfe scenario which is consistent with that given by InterOil's regulatory resource evaluator, GLJ. As a fifth and final scenario I show a calculation for what certified resource size is implied (under my assumptions) by IOC's current trading price of ~$53:

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You can see from all of the above scenarios that IOC's valuation under the deal framework swings enormously with the amount of certified resource that will be determined in 2015. At 9.9 Tcfe (GLJ's current estimate), IOC would be a compelling value at these levels (~64% upside to the current share price). However, using the 5.4 Tcfe on which Total based its payment estimate in its press release, there is downside from here (~40% to the low $30s).

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(Note the above estimate by Total assumes a subsequent 19.3% selldown)

At the 6.5 Tcfe level that is close to the 6.6 Tcfe level that Gaffney Cline reportedly estimated in 2012, there is still modest but meaningful downside (~20% to the $43 range). It should be noted that GCA's estimate was made prior to the drilling of Antelope-3 which added modestly to GLJ's estimates. In my fifth scenario, I back into the current share price and estimate that the market is currently pricing in about 7.3 Tcfe. Below is a summary of the results:

All we know for sure at this point is there is a wide band of outcomes. Elk/Antelope is a very large and complex resource. 3D seismic is not feasible given the terrain, and the 3 wells drilled into Antelope (where most of the resource is located) to date have been in the crest of the formation. What turns up when the delineation wells are drilled will have a material impact on the ultimate resource assessment (e.g. the first of 3 appraisal wells will be drilled 1.2km southeast of Antelope 2).

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Source: SPA (note red circles and X are my annotations)

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Source: Annex 2 to Interoil / Total SPA

InterOil's consultant GLJ estimated (in its 2010 full report released by IOC) Original Gas-In-Place (OGIP) of 11 Tcf (excludes liquids) with P50 recoverable raw gas of 9 Tcf. They estimated that over 80% of the gas can be recovered. This is a high level and may prove ultimately to be correct, but the delineation process needs to confirm both the OGIP and the recoverability of the gas which will rely on many factors such as rock quality, porosity, permeability, etc. in these undrilled areas of the formation. Buy the rumor?

"By the way, food and rent aren't the only things around here that cost money."

-Ophelia (Jamie Lee Curtis), Trading Places

Another large unknown is what it will cost InterOil to buy out its co-owners in PRL 15, the "Indirect Participating Interest" (IPI) parties. CEO Michael Hession has indicated that this buyout will be "deal neutral" but it's unclear if this ultimately means pass-thru economics to these investors, or if IOC will be buying them out of PRL 15 (and other licenses?) completely for some unknown consideration (i.e. cash and stock).

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Source: December 6 IOC conference call transcript

My analysis above assumes pass-through (i.e. "neutral") economics. If, however, IOC has to establish a price now to take out these investors completely it gets more interesting. If IOC believes the resource will ultimately be certified at 9.9 Tcfe, as ~25% (gross) owners in PRL 15, at pass-through economics these investors would be entitled to over $1 Billion in cash plus a retained interest in the resource. That $1 Billion is nearly 40% of IOC's market cap today. But if IOC is able to buy out these interests a price that proves out to be below the ultimate certified resource, it would be accretive.

It's unclear what will happen with these minority investors that own nearly a quarter of PRL 15. However, there is at least some evidence that at least one of them is not expecting to be taken out on the cheap.

In 2007 Helia Tec Resources, Inc. a unit of a South Korean technology firm, announced a transaction with Clarion Finanz whereby it would spend over $400M to acquire a stake in IOC's resources owned by Clarion. It's not exactly clear what ultimately transpired but it seems that Clarion's Pacific LNG unit transferred some of its IPI interest to Helia Tec and Helia Tec agreed to be bound by the IPI agreements according to later court documents (here and here).

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Source: Justia.com

According to the filings, the relationship between Helia Tec, its parent company, and various parties soured and in 2009 a Helia Tec director transferred the IPI interest back to Clarion (Pacific LNG).

Yada yada yada there were a bunch of lawsuits between Helia Tec, it's execs, its parent, Interoil, and Pacific LNG. You can Google "Helia Tec" and "InterOil" if you're having trouble sleeping and looking for a natural sleep aid. It's not important to today's discussion but I wanted to provide that background.

Why Helia Tec is interesting is that it filed for Chapter 11 bankruptcy protection recently (October) in Texas court (Bankruptcy Petition #:13-36251 in the Southern District of Texas (Houston).

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Source: Inforuptcy.com

Apart from a few dollars in cash ($4 - not even enough for a half-sweet non-fat no-foam peppermint latte), Helia Tec lists two assets in its Chapter 11 Filing:

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Source: Helia Tec Chapter 11 filing

Per IOC's Annual Information Form, this IPI group (a portion of the ~24% overall minority) owns 15.13% of PRL 15 (Elk/Antelope) on a gross (before govt back-in) basis.

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If Helia Tec is representing to the court that 1.2% of this amount is worth $9.2 Million, mathematically 100% of the IPI Percentage would be worth $763 million ($9.156 / 0.012). And as this block owns 15.13% of PRL 15, it implies 100% of PRL 15 is worth an almost even $5 Billion on a gross basis ($763/0.1513). Given IOC owns about 75.6% (gross) of PRL 15 currently, the read-thru value of IOC's stake is approximately $3.8 billion, or about $78 per IOC share - not far from the $70-$75 range where IOC was trading just prior to the bankruptcy filing.

This is only a single data point, and my math could be off without the underlying backup material, but it does suggest that IPI investors may be expecting full and "fair" value for their interest. InterOil's CEO has stated as much. Valuing the entire 24.4% minority interest on the same basis that used in the Helia Tec bankruptcy case would yield a total minority value of $1.23 billion ($5.04B x 24.4%). Under a 9.9 Tcfe scenario and pass-through economics the minority would get about 25% of $4.1 billion in total (undiscounted) cash of over $1 billion and retain a meaningful piece of the PRL.

It doesn't strike me as an unreasonable assumption that it could cost $1B to $1.2B get the minority to walk away completely now. The question of course is how IOC could fund such a large outlay at this time- it could use a portion of the $613M inbound cash from Total, but much of that is needed for drilling and debt repayment (e.g. the $70M convertible bond due in 2014). $1B in liquid IOC stock is nearly 40% of the current market cap which I assume is off the table. It's not clear what IOC can do and to what IPI investors are entitled. Perhaps IOC can arrange a "neutral" or pass-through scenario as the CEO suggested on the call and I have assumed in my analysis, or even take them out on the cheap which would be a boost for current IOC shareholders.

There are two huge "known unknowns" (minority buyout and certified resource quantity), only one of which (the buyout) will be clarified in the coming weeks and months. However, at a stock price in the low 50s the risks still seem to be skewed to the downside, pricing in resource levels about 35% higher than Total's publicly stated estimate. Drilling enormously expensive wells in the jungles of Papua New Guinea is risky and speculative. Of course the promise of "unlimited upside" can be alluring and IOC has earmarked a good portion of the inbound closing cash for drilling outside of PRL 15. There may be a time to buy the rumor, but not yet.

"Gold doesn't grow on trees like oranges"

- Randolph Duke, Trading Places

Source: A Sober Look At InterOil's Deal With Total SA

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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. (More...)

Additional disclosure: This article reflects my personal views only. I have no position, long or short, in InterOil or Total SA. All data and calculations presented are accurate to the best of my knowledge but have not been vetted, checked, proofread, or independently verified. This article should not be relied upon for any purpose other than for entertainment. I welcome comments and or corrections.

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