The Complicated Math Lesson Taught by InterOil

by Roddy Boyd - 9/21/2010 5:30:31 AM

* Editor’s Note: This story has been republished with permission from To access the original article, complete with links to numerous backup documents, click here.

In the world of finance theory, a company’s credible suggestion that it is being forced to raise cash at exorbitant rates – or that it is valuing its assets sharply below where the market has valued them – traditionally means a death sentence for the company’s stock price. The reasons for this are straightforward 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 (NYSE: IOC).

An international oil and gas producer that has been touting a potentially epic find in the wilds of Papua New Guinea for more than a decade, InterOil recently raised cash at exorbitant rates and appears to be internally valuing its assets well 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 normally obtain. Better still, the person pulling InterOil’s eyeballs out is its longtime 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 would seem to indicate otherwise. For example, Civelli rang the opening bell at the New York Stock Exchange – an honor normally afforded to a company’s CEO or founder – when InterOil was invited to kick off trading for the day.)

InterOil did not respond to multiple requests seeking comments for this story. 

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 sellers, critics 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 ones caught on the wire and dying in waves.

This may soon change.

On Aug. 11, InterOil issued a press release announcing a $25 million loan it had struck with Civelli’s Clarion. In 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 even taken as a vote of confidence by other investors.

The deal itself is cut and dry, charging InterOil 10% interest on a $25 million loan secured by a fraction of the company’s purportedly best assets. Though the interest rate seems high – since even single-B-rated credits, assigned to those with potentially dubious prospects, are selling debt at 7% these days -- it’s a private deal that was struck quickly, so it’s understandable if investors shrug it off.

But if investors dig deeply into details of the deal, as disclosed in a recent 6-K filing, they may no longer assume that it’s business as usual for InterOil. First off, the filing explains that an “upfront fee of $1 million is also payable to the lender.” At 4% of the face value of the loan, that fee looks unusually high – especially with the interest rate already a few hundred basis points above junk. 

Based on actual cost to the company, this fee markedly changes the loan’s expense profile. With the loan structured as two $12.5 million installments – one drawable in 134 days and the other in 153 days – investors can use an average loan duration of 144 days to convert the upfront fee when calculating the true cost of InterOil’s loan. Since the 144-day term represents 39.45% of the calendar year, investors can divide that figure by the 4% upfront fee to reach a new 9.86% rate – which results in a total annualized interest cost of 19.86% for the company.

There are, to be blunt, no companies with share prices 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 only able to 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, of course, include those supposedly historical quantities of oil and natural gas in its Papua New Guinea fields.

By using a 2.5% interest in InterOil’s Elk and Antelope fields – or 1.25% for each $12.5 million – as collateral, the loan implies a $1 billion value for those properties. That total falls well below InterOil’s current market value of $2.8 billion.

This is a problem for two reasons. The properties rank as InterOil’s most important operating assets, so the company’s market capitalization would obviously reflect the market’s assessment of their value. Plus, InterOil has every incentive to obtain maximum value when pledging those prized assets. 

As a result, investors can reach one of two conclusions. Either InterOil was so strapped for cash that it willingly acceded to any terms that Civelli demanded, or the company’s properties are actually worth this lower sum and investors have been mightily misled in some fashion.

Neither scenario is flattering.

That situation, if true, may not even matter. For investors, InterOil appears to be more of a religious proposition than an economic one. To be sure, the bull’s case is both elegant and obvious: If there is oil and natural gas 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 argument from the bulls suggests a corollary argument from the bears. No one much doubts that Papua New Guinea contains plenty of oil and gas. However, InterOil has never produced any despite numerous capital raises and years of trying. In short, the consensus holds that those resources – while there – will be hard to find and extraordinarily expensive for a company like InterOil, with limited funds, to remove. The fact that a man who has backed InterOil for years, and presumably still has plenty of “skin in the game,” is charging the company almost 20% interest looks like a rather bearish data point as well.

Naturally, the two biggest challenges that InterOil faces – assuming that there is oil and gas and plenty to be had – are the cash flow situation and the costs to drill and transport oil and gas in one of the most brutal environments in the world. 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, the picture is not pretty. No matter what happens – oil or no oil – InterOil will need a lot more cash, and fast. 

For years, the “IPI” column (an abbreviation for indirect participation interest) has lingered as a reminder of one of the most powerful selling points that InterOil ever had. It includes the accounting residue of a February 2005 $125 million capital injection from an impressive roster of capital markets luminaries, such as Morgan Stanley’s John Mack and Furman Selz’s Bernard Selz. Tracking that money through accounting statements over time and making headway of it, however, raises entirely new issues.

According to a series of company filings, the big InterOil investors -- including a group from Pequot Capital Management, a hedge fund very closely linked to Mack -- put their money in and received interests that were convertible into stock after the share price hit $37.50 or the company completed eight wells. (Only four have been drilled so far.) In December, the interests were converted into stock. Although the situation remains somewhat unclear to me (and the company did not comment), it appears as though InterOil booked about $32 million of this money as a cash-flow attribute. In practice, that would serve to artificially deflate the company’s growing free cash losses.

The cash flow issue, in turn, relates to the funding levels required to extract the oil and gas. 

There appears to be no good answer to this dilemma. If the pipeline extends the 250 miles that management has estimated – and pipeline costs run between $2 million and $3 million per mile – then InterOil will need to borrow a lot of money and 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. Chances are, plans made on Excel at InterOil’s headquarters will not 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 remains uncertain whether the company has any provable reserves. To date, InterOil’s financing activity has played a major role in keeping the wolves away from the door. Investors have also been exceptionally kind and patient, even as their shares have been steadily diluted.

The latter cannot be overstated: InterOil investors appear to be single-minded in their belief that a legitimately spectacular enterprise remains to be had.

A company that is paying twice the going junk-bond rate for money usually winds up on the Pink Sheets or in court – and quite often both – but InterOil’s fan base stands out as a valid rival to the Grateful Dead’s in terms of loyalty and sheer optimism. The fact that the object of that affection must issue more shares and pile on more debt will likely be forgiven. So, in all probability, will the issuance of additional press releases that detail – in rich, technical, scientific jargon – how very close the company is to success this time. 

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


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