By William Lobdell
So close.
For a decade, InterOil Corp. (NYSE: IOC) has peddled the so-close narrative to investors: the company is so close to discovering commercial oil or gas in Papua New Guinea, so close to releasing an independent evaluation of its oil and gas finds from international heavyweight Netherland Sewell, and so close to announcing significant funding for its proposed liquefied natural gas (LNG) plant on the Papua New Guinea coast that InterOil says will cost a bargain-basement $5 to $7 billion.
This storyline of so close has served InterOil extraordinarily well, pumping up its stock price to dizzying heights (it closed at 68.70 Wednesday) even though the company has zero proven gas or oil reserves, leadership of questionable integrity, a long record of unfulfilled promises and missed deadlines, and (if commercial gas or oil is ever discovered) the need to build a 250-mile pipeline through dense jungle and a multi-billion dollar LNG plant though InterOil had trouble putting back together a tiny oil refinery.
InterOil promoters have clung to the so-close storyline like a lifeline, unwilling to be swept away into the river of historical and current evidence that shows exactly how risky it is to invest in this inexperienced company that has burned through hundreds of millions of dollars in cash and drilled more than a dozen wells in Papua New Guinea that have produced no proven oil or gas reserves but helped propel the storyline forward.
But, InterOil backers argue, the company’s latest two wells—these in the Antelope field—are different. And InterOil is so close to proving it.
Lately, a case can be made for an alternative so-close narrative: the company whose stock price has jumped in the past 12 months from 24.35 to 84.05, may be so close to having to give up its 10-year-old storyline of imminent riches.
iBusiness Reporting has assembled 10 signs that suggest, at the very least, InterOil is a company living on the edge and undeserving on its sky-high stock price that implies InterOil is a sure bet.
1. GLJ and InterOil have been (way) wrong before.
Much of the recent credibility given by investors to InterOil’s Antelope gas finds comes from two reports produced by Calgary-based GLJ Petroleum Consultants. In its latest evaluation, GLJ’s "best" estimate was the Antelope field held 873.2 million barrels of oil equivalents. (The reserves were classified as contingent, not proven reserves.)
Maybe GLJ or InterOil should have put an asterisk next to the findings. Though respected for its work with Canadian companies, GLJ has overestimated gas or oil reserves three times in recent years, underscoring the tricky nature of determining the size of resources under the ground.
Mistake No. 1: In 2003, then-named Gilbert Laustsen Jung Assoc. estimated that Ivanhoe Energy had 15.6 million barrels of "proven" oil reserves at a field near Shanghai, China. Ivanhoe had only pumped 235,000 barrels of oil from its wells before GLJ’s revised its estimate downward by 1.4 million barrels or 9% at the end of 2004, according to Ivanhoe's annual report.
About one year later, Ivanhoe announced it would stop the drilling and that the "proven" reserves had been overestimated by a whopping 79.6%. The error blamed only "lack of continuity in the reservoir … and also changes in the porosity and permeability of the reservoir as interpreted from the original logs," according to an Ivanhoe SEC filing.
Mistake No. 2: In January 2006, GLJ estimated Canada Southern Petroleum had "proven" reserves of 1.5 million barrels of oil equivalents. Ten months later, GLJ had to revise that number down by 19.8% (8.3% of which were due to "technical revisions") when Canada Southern went to sell those reserves.
Mistake No. 3: On Dec. 2007, GLJ estimated Canadian Superior Energy’s probable gas reserves at 8.7 million MCF. A year later, GLJ lowered the estimate by 12.6% because of a “technical revision.”
There's no way, for now, to check the accurancy of GLJ's analysis of InterOil's contingent reserves, but investors should know that GLJ has overestimated both proven and probable reserves in the past.
And then there’s InterOil’s 10 years of hyping gas and oil fields in Papua New Guinea that have never produced any commercial gas or oil. (Backers of InterOil always seem to skip over this sobering fact because it would break the narrative.) For instance in 2002, InterOil released a press release stating it "believes it has discovered a new oil system in the Eastern Papuan Basin, based on the presence of hydrocarbons in Pale Sandstone cores from two stratigraphic wells." Turned out, that "oil system" didn't exist.
The list of wells that InterOil has drilled, often hyped and then abandoned include:
- Stanley-1: "The well identified 12 to 13 metres of gross pay of which 9 to 10 metres (31 feet) is considered to be net pay of good reservoir quality and potential deliverability."
- Triceratops: In December 2005, Interoil stock skyrocketed 50% on positive drilling prospects on the Triceratops well. Three weeks later the well was plugged and abandoned and the stock dove 40% in a day. (Source here.)
- Subu.
- Subu-2.
- Moose-1: "The contingent resource best estimate is 118 million stock tank barrels of oil ..."
- Moose-2: "... will be used to appraise the previously identified limestone target where multiple oil shows ..."
- Rhino: "... potential of 1,000 million" bls.
- Sterling Mustang: "... need a bigger rig."
- Black Bass: "... very encouraging gas flows during drilling."
- Elk-1: "We are very encouraged by these early test results..."
2. InterOil’s Netherland Sewell report is MIA.
GLJ's past mistakes might not be that much of an issue if it weren't for the "Case of the Missing Netherland Sewell Report."
In March 2007, InterOil CEO Phil Mulacek told attendees at a Raymond James conference in Orlando, Florida that three "world-class" firms were in the process of performing reserve analysis on InterOil gas fields. Mulacek named one firm, the iconic Netherland Sewell, stating that InterOil had hired the company, according to a reliable source.
This news of an imminent evaluation from Netherland Sewell was frequently mentioned in fawning investor reports by Raymond James and on blogs and message boards promoting InterOil.
But the report never came.
About 17 months later, Mulacek indicated in a conference call to investors that an international firm hired by InterOil would finish its reserve analysis report by the end of October 2008.
Again, the report never came.
So what happened to the Netherland Sewell report? Netherland Sewell nor InterOil will comment. And since InterOil is never shy about releasing good news, this should be worrisome to investors.
3. Cash is running out. Fast.
By Dec. 31, 2009, InterOil had just $46.5 million left in cash and equivalents, not a lot of cushion for a company that has burned through hundreds of millions of dollars trying in vain to find commercial gas and oil in the remote jungles of Papau New Guinea.
Drilling with a single rig, InterOil spent $91.7 million in 2009 for "expenditure on oil and gas properties," according to its annual report. In its current gas field, InterOil has spent about $107 million drilling just two wells between October 2008 and December 2009, according to company filings. That’s more than $53.6 million per well, making them two of the most expensive standard onshore wells ever drilled.
There’s other evidence that the company is strapped for cash. In recent court testimony, InterOil CEO Phil Mulacek and his attorney said that even a $50 million judgment in a massive fraud lawsuit against him and the companies he controls would be "devastating" and spell the end of InterOil.
In InterOil’s 2009 annual report, it stated that revenue from its refinery and other operations "will not be sufficient to facilitate further development of the Elk and Antelope fields, condensate stripping plant development, and the liquefaction plan development. Therefore the company must extend or secure sufficient funding through renewed borrowings, equity raising and/or asset sales to enable sufficient cash to be available to further its development plans."
Adjusting for one-time accounting measures, InterOil is averaging a cash-flow burn of about $15 million per quarter, meaning that without new sources of cash, the company will run out of money before the year’s end.
4. Morgan Stanley, a major backer of InterOil, says now is not "an ideal time" for new LNG plants.
Though Morgan Stanley analyst Evan Calio has become one of the largest promoters of InterOil stock, his company's own gas analysts covering the Asia/Pacific region say now is NOT the time to build in liquified natural gas (LNG) plant, which is needed for InterOil to monetize any gas it may find.
"Unfortunately, the global gas market is glutted, and this heightens valuation risk for undeveloped gas. In our view, this is not an ideal time to be launching new [LNG] projects, and either prices or volumes will have to give ground," wrote the gas analysts at Morgan Stanley in a report titled "Australia Oil & Gas."
They continue: "Global gas markets are glutted and, in particular, there is a large amount of LNG floating around that is not backed by bespoke utility buyers. In our view, it is not an ideal time to be launching new projects and would-be developers face more competition today than they did a few years ago."
And there's this from another natural gas expert:
Chakib Khelil, speaking before a meeting in Oran of the Gas Exporting Countries Forum, of which he is president, said the glut had led to a drop in prices to which the group was trying to find solutions.
Amid a recent drop in demand, "the spectacular development of non-conventional gas production...[in North America] seems to be sustainable" due to technology, Khelil said. This will "generate idle capacity in regasification."
He added that new LNG capacity "will clearly contribute to exacerbate the excess of LNG already in the market," and singled out Australia as adding to this new capacity.
Qatar has also expanded its LNG market share in Europe thanks to new production.
Khelil said the ramp up in LNG and US non-conventionnal gas came as "demand in major consuming countries has for the first time in recent history dropped significantly in 2008 and 2009."
"Forecasts for the next five years are rather worrying as they display only very weak growth," he said.
By the way, in his April 15 report, Morgan Stanley's Evan Calio listed reasons why he believes InterOil's stock is undervalued. He wrote (emphasis added): "Largest exploration land position in PNG with over a decade of drilling experience." Is Calio referring to InterOil's "decade of drilling experience" that has turned up no commercial oil or gas as a strength? He is kidding?
On the risk side, Calio fails to mention the massive fraud lawsuit against InterOil CEO Phil Mulacek and the companies he controls that so worries Mulacek that he recently filed for a bad-faith bankruptcy in an attempt to derail the litigation (here and here).
5. InterOil hasn't been able to find a partner for its proposed LNG plant willing to put up significant cash to get it built.
Since 2005, InterOil has talked about plans of building a liquefied natural gas (LNG) plant in Papua New Guinea in order to monetize any gas find. Using unnamed sources, news articles and Internet sites have repeatedly reported that InterOil was so close to signing LNG partnerships with various countries and/or world-class companies.
But a half-decade after first floating the idea (and in a year that InterOil is running out of cash), the company has landed no signficiant cash deals from an LNG partner.
6. New tough questions from old friend.
Earlier this month, InterOil did sign a deal with Japanese giant, Mitsui, to "jointly operate and fund the preliminary works involved to develop a proposed condensate stripping facility ... at InterOil’s Elk and Antelope field site."
If Mitsui decides by Dec. 31 not to continue the partnership, InterOil will have to pay back all of Mitsui's costs. No cash for InterOil; no risk for Mitsui.
Wall Street didn't think much of the long-awaited agreement; since April 15 when the deal was announced, InterOil's stock has dropped 15%.
Raymond James, one of IOC’s biggest cheerleaders over the years, put out a report April 21 to investors that poses four tough questions about InterOil’s agreement with Mitsui.
- Will there be a firm agreement?
- What multiple will be placed on the resource?
- Will InterOil receive cash upfront?
- What are the partner’s capabilities?
To us, this represents a new cautiousness in Raymond James’ coverage of InterOil. In the past, it's been so relentlessly flattering that one analyst covering the company was hired a few years ago to be InterOil’s director of investor relations.
7. InterOil has included an ominous new warning in its most recent annual report.
Papua New Guinea is one of the world's most corrupt countries, according to Transparency International, more corrupt than Ethiopia, Columbia, Zimbabwe, Pakistan, Kazakhstan and 150 other countries. Even Venezuela, whose government nationalized the oil industry, ranks only slightly more corrupt than Papua New Guinea.
Now, InterOil warns in its latest annual report that the company needs to worry about "landowner disturbances" on its property (new language in bold), a problem encountered by other oil and gas companies doing business in Papua New Guinea.
While we believe that we have satisfactory title to our properties, some risk exists that title to certain properties may be defective or subject to challenge. In particular, our properties in Papua New Guinea could be subject to native title or traditional landowner claims, which may deprive us of some of our property rights that consequently may have a material adverse effect on our exploration and drilling operations and our development projects. In addition, landowner disturbances may occur on our properties which disrupt our business in Papua New Guinea.
8. If InterOil finds commercial gas, its business plan calls for the construction of 250 miles of pipeline through some of the densest jungles on Earth and an LNG plant it says will cost just $5 to $7 billion.
In recent court testimony, InterOil officials said a 250-mile pipeline through the jungles of Papua New Guinea would cost nearly $1 billion. And that's not taking into account what could happen with "landower disturbances."
And then there's InterOil's proposed LNG plant, which InterOil projects will cost between $5 and $7 billion. (Exxon and its partners estimate the price of its LNG plant in Papua New Guinea will be $15 billion.) InterOil claims it can build its LNG at less than half the cost of Exxon's because of location and infrastructure advantages.
Will InterOil be able to construct, on time and budget, a 250-mile jungle pipeline? And how credible is InterOil's plan to build an LNG plant at less than half the price of Exxon's? We can only go by InterOil's track record.
InterOil has had experience with its small oil refinery. In 1994, Phil Mulacek got some investors to pony up $2 million to buy a shuttered refinery in Alaska that Chevron deemed obsolete and basically unsellable. In Mulacek's prospectus, he said that the refinery could moved to another county and be running by the end of 1995.
"As proposed, this should allow the recapture of all project equity within one year of start-up operations," he promised, and after after two years, the $2 million investment could be "worth up to $118 million."
It wasn't until 2002 that the first pieces of the refinery even arrived in Papua New Guinea, and the refinery didn't produce its first drop of gasoline until 2005, nearly a decade late. In the meantime, InterOil had lost tens of hundreds of millions of dollars.
9. For InterOil's story to be true, more experienced companies would have had to miss or pass on these "world-class" finds.
Over the years, oil and gas companies have held the leases to the same land in Papua New Guinea where InterOil claims to have made “world-class” discoveries. How did InterOil find commercially viable resource that other companies—with far more experience—overlooked?
There are a couple of explanations. First, it could be that InterOil hasn’t found any commercial gas, as it happened with the company's first 10 tries. Many critics believe that while natural gas is plentiful in Papua New Guinea, commercial gas is a much more rare commodity—and that InterOil's 12 years of drilling have demonstrated this.
Second, the other exploration companies found a healthy supply of natural gas, but getting that resource out of a remote jungle 250 miles from the coast didn't pencil out. Again, many of InterOil's critics believe its doubtful that InterOil can find enough commercial gas to make the construction of the 250-mile pipeline and multi-billion-dollar LNG plant economically viable.
You can read more here.
10. Insider selling was brisk last month.
At a time when InterOil is so close to making huge news (confirmation that its sitting on a world-class commercial oil field and signing of a major partner that brings cash to build the LNG plant), there sure seems to be a lot of insider selling. Canadian security filings show InterOil insiders dumped $9.7 million in stock last month. The timing is curious.
Disclosure: After uncovering information contained in this story, William Lobdell took a short position in InterOil. All facts in Lobdell's InterOil stories have come from public information.
Friday, May 14, 2010 at 08:45AM 
To see a large version of this graphic, just click on it.Since InterOil Corp.'s (NYSE: IOC) inception in 1997, Chief Executive Officer Phil Mulacek has made a habit out of doing business with family members and leaving many of the relationships undisclosed.
Despite InterOil doing $1.8 million with DESC and eventually buying the company, InterOil filings never disclosed that Christian Vinson is Paul Mulacek's brother-in-law and that Pierre Mulacek, Phil's brother, served as DESC's vice president and director.
