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InterOil: What The InterOil Math Teaches Us

InterOil: What The InterOil Math Teaches Us


In the world of finance theory, a credible suggestion that you are being forced to raise cash at exorbitant rates or are internally valuing your assets sharply below where the market appears to value them is traditionally a death sentence for your share price. The reasons for this are straight forward enough: Investors hate desperation but not as much as they hate making an asset play and being wrong on the value of the assets.

Then there is InterOil.

A Cairns, Australia- and Houston, Tx-based oil and gas producer that has been touting in one form or another a potentially epic find in the wilds of Papua New Guinea for more than a decade now, it recently raised cash at exorbitant rates and appears to be internally valuing its assets way below what the market appears to think they are worth.

Yet all is well in the share price department.

The story is none too complicated: InterOil, a company whose shares are seemingly made of titanium, is paying rates for cash that only credit cards aimed at those with bad credit can obtain. Better still, the person pulling InterOil’s eyeballs out is its long-time sponsor and key investor, Clarion Finanz AG and its controversial chief, Carlo Civelli.

[Civelli’s record as a broker, investor and promoter of a series of often troubled energy enterprises drives skeptics somewhere north of berserk. He and InterOil have loudly proclaimed that he is little more than an investor and advisor, although the power dynamics of this picture would seem to indicate otherwise. When having your company feted at the NYSE, it is customary to have the CEO or the company’s founder/guiding spirit ring the bell at the opening. Civelli, in the picture, is the one reaching over to ring the opening bell.]

To call InterOil a battleground stock is to be droll. The dispute over the proper level of its valuation and prospects in every sense of the word is analogous to the sanguinary trench combat of the First World War’s Western Front. Short-sellerscritics and investigative reporters raise more and more questions about management disclosures and candor but the stock continues to enjoy robust support. To follow through on the metaphor, the shorts have been the one’s caught on the wire and dying in waves.

This may change soon.

On August 11, InterOil issued a press-release announcing a $25-million loan it had struck with Civelli’s Clarion. Of itself, there is nothing alarming about a company striking a deal with a key investor for some ready cash–it makes sense in many ways, cutting down on possible shareholder dilution, for example, and saving time and money on due diligence. Often times, it is taken as a vote of confidence by other investors.

The release itself is cut and dry amounting to a 10% interest-rate on a $25-million loan secured by a fraction of its purportedly best assets. Though the interest-rate seems high–even single-B rated credits, whose prospects are traditionally held to be dubious, are selling debt at 7% these days–it’s a private deal and was struck quickly, so it’s understandable if investors shrug it off.

But once you dig into the details of the way the loan is structured in InterOil’s 6-K filing it becomes much less clear why anyone could assume it’s business as usual for InterOil.

First off, the filings describes an “Upfront fee of $1 million is also payable to the lender,” the 4% face-value of the loan fee is an unusually high amount of points for a corporate loan (especially one whose interest-rate is already a few hundred basis points above junk.)

In terms of cost to the company this markedly changes the loan’s expense profile.

Structured as two installments of $12.5-million, one drawable on August 11 and the other on August 30–or 153 days and 134 days, respectively–we can use an average loan duration of 144-days to convert the upfront fee into the true cost of InterOil’s loan.

As the 144-day term represents 39.45% of the calendar year, we can divide by the 4% upfront fee and we have 9.86% which gives us an annualized interest cost of 19.86%.

There are, to be blunt, no companies with a share price in the mid-$60 range that are paying what people who have no jobs and no real assets–and no real prospects of having jobs or assets–pay for loans.

It bears repeating: InterOil is able to only obtain secured financing from its biggest investor at credit card rates. While Civelli has been involved in the company for years, he preferred to avoid taking his repayment in stock. This is puzzling since InterOil is not shy about touting its own prospects which include supposedly historical quantities of oil and natural gas in its Papua New Guinea fields.

The use of 2.5% interests in its Elk and Antelope fields–or 1.25% for each $12.5-million installment–to secure the loan implies a $1-billion value for the properties ($25-million divided by .025% is $1-billion, sharply below the company’s $2.8-billion market cap. This is a problem since A) the properties are InterOil’s most important operating assets so its market cap would obviously reflect the market’s assessment of their value, and B) the company has every incentive to get maximum value for pledging them.

As such, we can conclude either InterOil was so strapped for cash that they willingly acceded to any terms that Civelli demanded or that the properties are actually worth that much and investors have been mightily misled in some fashion.

Neither scenario is flattering.

InterOil did not reply to repeated requests for comment. [I sent two detailed E-mails to InterOil’s investor- and public-relations several weeks back and never heard back. See here. I followed up with phone calls to its U.S.-based staff 's office and mobile-phones and those were not returned either.]

But then even if true, it is doubtful that it would matter. Investing in InterOil appears to be a religious proposition more than an economic one. To be sure, the bull’s case is both elegant and obvious: If there is oil and natural gas is in Papua New Guinea, and in the volumes suggested on the company’s properties, shareholders are in for an instant windfall to the tune of several dozen points worth of price appreciation.

Yet every bull datapoint suggests a corollary bear point. No one much doubts that there is plenty of oil and gas in Papua New Guinea, just that they haven’t produced any despite years of trying and numerous capital raises. Again, there is a consensus it is there but finding it and removing it is going to be extraordinarily expensive and InterOil has nothing like the money necessary; that a man who has backed them for years and presumably still has much “skin in the game” is charging them almost 20% is not a bullish datapoint.

Naturally, the two biggest concerns the company has—granting that there is gas and oil to be had in plenty–are the cash flow situation and the costs to drill and transport oil and gas in what is easily one of the world’s most brutal environments.

The corporate free cash flow story is crucial for InterOil since it represents the cash generation capacity of the company after its prodigious capital expenditure requirements. So far, its not pretty as this chart illustrates. The takeaway: No matter what happens, oil or no oil, they are going to need much more cash and fast.

The “IPI” column–an abbreviation for indirect participant interest–represents the accounting residue of one of the most powerful selling points InterOil ever had: The February 2005 $125-million capital injection from a roster of capital markets luminaries like Morgan Stanley’s John Mack and Furman Selz’ Bernard Selz. Tracking it through the accounting statements over time and making headway of it, however, is an entirely  separate issue.

According to a series of company filings, the big investors–including a group from Pequot Capital Management, a hedge fund very closely linked to John Mack–put in their money and received interests that were convertible into stock after either the share price hit $37.50 or eight wells were completed (only four have been drilled.) In December, the interests were converted to stock. It appears–it is not entirely clear (to me) and the company did not comment–that about $32-million of this figure was booked as a cash-flow attribute. In practice, it serves to artificially deflate the growing free cash losses.

The cash flow issue is in turn connected to funding the level of expenditure necessary to extract the oil and gas. There appears to be no good answer. If the pipeline is to be the 250-miles that the management has estimated, and pipeline costs run between $2-million and $3-million per mile, InterOil is going to need to borrow a lot of money and to dilute its investors sharply. That’s the best case. This isn’t tapping a well in Odessa, Texas though, but rather a well in a portion of the world where even bitter combat is less lethal than the climate. Plans made on Excel at headquarters are not likely to perfectly match up with the reality of capital projects in Papua New Guinea.

InterOil does have a remarkable ability to obtain financing even though it is uncertain, as this high-profile short-seller notes, that it has any provable reserves. As the chart above makes clear, financing activity is a major component of its ability to keep the wolves away from the door. Investors have also been exceptionally kind and patient as their shares have been steadily diluted.

This last cannot be overstated: InterOil’s investors appear to be single-minded in their belief that a legitimately spectacular enterprise is to be had.

A company that is paying twice the going junk-bond rate for money usually ends up in the pink sheets or court–and quite often both–but InterOil’s fan base is a valid rival to the Grateful Dead’s in terms of loyalty and sheer optimism: Here’s InterOil’s chart over five years. That the object of their affection is going to have to issue more shares and pile on more debt will be forgiven; So, in all probability, will the issuance of a slew of further press-releases that detail–in rich, technical scientific jargon–how very close they are this time.

But for the time being, to paraphrase Mr. Barlow, at least they are enjoying the ride.

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