Bear Case – IOC

I have a funny feeling about IOC. The company and its critics are an assortment of characters that would make Damon Runyon envious.

Beneath this color is an analytical story more complex than the typical stock analysis, made more difficult because management can’t be trusted in my opinion. If management and its supporters are right it is a great buy and could quickly double from the current price of $62. If its critics are correct the stock could easily drop more than 50% in the same time frame.

Yes, there have been allegations of fraud. And yes these allegations have been guilt by association by one short seller, and a lot of hunch in another. What is surprising is the counter punching by the proponents of the company has not been exculpatory, but ad hominem attacks on the principals of those making the allegations. That raises my antennae.

Morgan Stanley enjoys real respect, but rather than refute the arguments of Fraud Discovery Institute (FDI), attacks FDI to discredit the principals rather than their argument or evidence. What I needed to see from Morgan Stanley was an explanation of why the geologists hired by FDI were wrong, not that the principals were reformed criminals. And I don’t want to hear that 70 firms entered the data room. What is important is how many come out of IOCs data room with a firm offer.

It had been my hope that some knowledgeable persons/entities would respond to the bear case with well reasoned arguments. For me personally it is a dangerous short. So I responded in a a way similar to Howard. On Friday afternoon I sold short and sold in-the-money puts to cover any possible losses up to $78.

The arguments that resonated the most with me by the two firms, FDI and Citron, were that IOC provided pressure readings and other data for several of the earlier ELK test wells, but not for the Antelope 1 well. This data could have been used to help determine the decline profile of the well output. Apparently one of the ELK wells was in a formation that would promote a very high initial flow rate, but a very early decline. The data that could have been used on Antelope to compare it to Elk in this respect was not provided. Why?

The geologists that FDI engaged to develop their position on the company reached the conclusion that Antelope 1 likely suffered from the same geologic formations and thus the same rapid decline as ELK and would not be commercially viable. They felt a large number of wells would be needed to be drilled before the data was sufficient for large oil companies to bankroll an LNG facility. The cost of drilling these wells to define the resource could be prohibitive.

FDI also made a strong argument that IOC was in violation of Rule 10b5 when they said they already had sufficient data to support their claims about the resource and its commercial viability to support an investment by others in an LNG facility, when in fact they did not.

MS chose not to discuss these claims, but rather discussed the criminal background of FDI principals. One of the principals of FDI was Eddie Antar’s CFO and relative.

I am not sure who MS sent to Papua New Guinea (PNG), but if it was just one analyst as implied all they did was get their ticket punched for going on a DD trip. It would have taken a team, including a couple forensic accountants to actually accomplish anything.

Who actually went to PNG?

Was it the junior analyst whose name is on the reports and has he had any training or experience in detecting a fraud. I am not saying there was fraud. I don’t know, but I don’t think MS does either. I am not persuaded by their legalistic argument in their Sep 18th research report.

The MS argument about the 70 firms in the data room and the two geology firms that support IOC kinda leaves both arguments with equal weight in my mind, but I do have a hunch there is some fraud here.

Even if there is no fraud I don’t see this is such a great investment at $62. MS calculates the whole shootin match is worth $65 based on project completion and flowing wells at company projected rates. After reviewing their analysis I mostly agree with the way they arrived at their numbers, given their assumptions. Not sure what their LNG price is going forward as they were somewhat cryptic about it?

No doubt if IOC gets a firm contract to build an LNG plant without contingencies the stock will hit $90+ at this point. Given all the uncertainty in getting that contract though, that’s hardly a compelling risk reward trade off.

There is still a substantial chance this project won’t get funded even if everything is as IOC says it is. For one thing what corporation is going to bet $6 billion on a project that relies on one man, Phil Mulicek, IOCs CEO, for product supply? For another even more important reason, who is going to commit to build LNG facilities in the current price environment for NG? The favorable cost of production projected by MS is likely dependent on the favorable well flow projections of the company for Antelope 1 & 2.

With shale gas technology in operation now all over North America and with technology transfer taking place now for much of the rest of the world the outlook for LNG is not as rosy as it may have been. It is not hard to imagine NG selling all over the world for under $5, especially as some of it will be drilled in consuming nations like Europe.

This will of course lead to a complete shutdown in new projects and postponements in others until demand once again requires additional supply. Qatar stopped all new LNG projects about two years ago. Eventually LNG plants will be built again, but given the scale of these plants with a cost in the billions of dollars, there will likely always be either a shortage or oversupply of plants for long periods of time as is common in all industries with expensive long lead time capital projects.

This is why it is so important for them to drill again deeper in Antelope in search of oil. Even with their projected 16,000 BOEs/d of condensates, they need oil to make this project work. Oil does not involve the infrastructure commitment and huge capital outlay that LNG needs. They could likely move the oil through their own refinery.

In my mind the announcement of further drilling for oil is tantamount to an admission the project won’t go forward without finding oil. I also wonder what drilling for oil does to the ability to take further readings from the test well to verify the resource for NG? On Friday I also learned from people with expertise in this area, it is unlikely the oil they may find will be commercially viable.

I think there is an excellent chance the LNG plant will not go forward now or in a relevant time frame, even if the geology for NG turns out to be ok. Even if by some miracle it gets built there is a great likelihood this company will fall far short of the earnings necessary to sustain the $60 share price, given the market for LNG.

The most likely path of pay off for this company is not LNG at this point and it appears the odds are against the company finding commercially viable oil.

With all the uncertainties surrounding IOC going forward I don’t see a reason to own it today at this price. Yes it could go to $100, but it could also go below $30.

Barry Zee

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