Offshore northwestern Australia, Papua New Guinea (PNG) is a country that has vast natural resources-hydrocarbons and many others-most of which have yet to be tapped. While the government recognizes the importance of prudent economic diversification, the energy sector is viewed as an important driver for growing the economy and boosting standards of living. This burgeoning opportunity is presently in the hands of The Woodlands, Texas- and Cairns, Australia-based InterOil Corp. The American Stock Exchange-listed company is building a fully integrated-upstream, midstream and downstream-energy business in the country. InterOil currently operates PNG's only commercial refinery and owns a network of retail and wholesale distribution outlets. Upstream, it is pursuing exploration on 8.8 million acres. Home to some 5.5 million people, PNG consumed roughly 15,000 barrels of oil per day in 2001, representing 74% of energy demand. The balance was supplied by natural gas and hydroelectric power. In a visit in May with InterOil management, several senior government officials discussed macroeconomic developments in the country, particularly within the energy sector, and InterOil's role in furthering economic growth. It was clear that tremendous commercial opportunities exist in PNG. There is a plan for a "Petroleum Park" at Napa Napa, the Port Moresby site where InterOil's refinery is located. Joseph Gabut, secretary of the PNG petroleum and energy department, highlighted the importance of gas-pipeline development in the country to monetize stranded gas in the western highlands, as well as the opportunity for additional infrastructure investment that would be created by a gas pipeline into the proposed "Petroleum Park." Joshua Kalinoe, government chief secretary, stressed the government's interest in continuing to create fiscal policy conducive to further investment in the country. The government recognizes the significance in timely policy reform, which should ultimately result in higher employment and a rising gross domestic product (GDP in 2004 was approximately $12 billion) and tax base to fund social programs. The refinery, of course, would provide the core for such an ambitious project. But there would be much more to come. First of all, as announced in February, two large Japanese companies-Mitsubishi Gas Chemical Co. and Itochu Corp.-are conducting a feasibility study to build a large petrochemical plant at Napa Napa. "In addition, other world LNG leaders and petrochemical owners are working with InterOil for planned expansion facilities next to the refinery, to leverage the benefits of share logistics and infrastructure to fast-track projects," according to InterOil founder and chairman Phil Mulacek. One of the proposed plants would produce dimethyl ether from methanol, with the output marketed in Japan and/or elsewhere in Asia. InterOil is working to fast-track exploration so that discoveries will commercialize gas on its acreage, allowing InterOil to sell gas as raw input for the petrochemical plants. There is also the possibility of a liquefied natural gas (LNG) liquefaction plant, and InterOil may also play a key role in this. Whatever the ultimate shape of the "Petroleum Energy Park," it carries a high level of importance for the PNG economy, and consequently, for InterOil, as GDP is estimated to increase by 300% through these investments. A large investment in PNG, by well-established industrial companies, is likely to boost foreign investor confidence in the fundamentals of the PNG economy and the attractiveness of the market. Coming a few months after Standard & Poor's Ratings Services boosted its credit outlook for PNG, this represents further evidence that PNG continues to industrialize and develop generally. "Trinidad has experienced vast GDP growth and now feeds about 70% of the LNG to the U.S. Now, PNG and InterOil aim to become the 'Trinidad' to China, Japan and southeast Asia," says Mulacek. Energy demand in all developing countries is largely a function of industrialization, and the construction of large industrial facilities can be expected to materially increase domestic demand for refined petroleum products, which are produced at the InterOil refinery. Because of robust domestic margins, InterOil would benefit if domestic demand for products such as diesel and gasoline were to grow because of such investments. InterOil has a strategic arrangement with the PNG government to supply all the refined products for the domestic market during a 30-year period. "Our refinery just completed start-up operation, with the third quarter being the first real quarter of operations. This puts the company in the start of positive income," Mulacek says. Upstream In late April, InterOil spudded Black Bass #1, the first well in its eight-well 2005-06 exploration program. Tests confirmed the presence of reservoir-quality sandstones with liquid-rich natural gas in a more regional play than had previously been thought. As a result, Black Bass #1 appears to have opened a larger exploration opportunity along the coast of the Gulf of Papua. With partial results available from drillstem tests and wireline logs, the company plans to acquire new seismic data surrounding the first well. Drillstem testing proved inconclusive, despite encouraging gas flows that had been observed during drilling. However, the Wedge Limestone appears to have significant reservoir potential, with log-derived porosity of 15% to 18% to a peak of 32%, and a gross thickness of 587 feet. Pending further seismic and geological work to evaluate the size of the discovery, Black Bass #1 was temporarily plugged, and the rig was mobilized to the Triceratops prospect, which is also a gas opportunity. The Triceratops-1 exploration well, which is InterOil's first exploration test in petroleum prospecting license (PPL) 237, targets gas and is some 2.2 miles north of the Bwata-1 discovery (estimated 300 billion cubic feet of total reserves) made by BP in 1959 that flowed at 29 million cubic feet of gas per day. The prospect was developed using airborne gravity analysis and a seismic survey in May. The target is the Puri fractured limestone reservoir, and the projected depth is 7,050 feet. The well is expected to take about 50 days to drill and log, so results could come in mid-November. InterOil's third well will be Elk, an oil prospect in PPL 238, scheduled to spud using a recently acquired heliportable rig from Houston-based Loadmaster Rig Systems that is capable of drilling to 13,123 feet. While investors will closely watch each well, only the completion of a portfolio of drilling projects will yield a successful appraisal of the hydrocarbon potential of the area. New seismic data and improving geologic interpretation continue to reduce risk in the exploration program. The key hydrocarbon system for InterOil is a new sandstone and turbidite reservoir discovered by InterOil through surface coring. The sandstones are the pale sandstone and Subu sandstones. "It is this new sand system that could prove to be a world class system for InterOil and PNG," Mulacek says. "A major seismic program is currently being executed by InterOil on these sandstone structures with over 400 people in field operations, working to have prospects ready for drilling in early 2006." Development of the sand systems required the new heli-rig, which arrived October 6. The rig provides InterOil its first opportunity to explore the new sandstone reservoir systems. Refining A major milestone in InterOil's corporate history was achieved when the refinery received its certificate of practical completion at the end of January. This enabled InterOil to begin booking refinery sales as revenues for the first time since the facility became operational in the summer of 2004. In second-quarter 2005, midstream revenues totaled $114.7 million, up 14% on a sequential basis. Most product is contracted to Shell. Throughput in the second quarter averaged 20,500 barrels per day, down from 23,500 in the first quarter, while start-up issues were being sorted out. The throughput rates will increase and should approach capacity as export-target margins are achieved in conjunction with the overall refinery optimization schedule. The first real quarter of operations is the third quarter of 2005 for the refinery, with a target to build volume and earnings thereafter. In September, the refinery was turning a profit for the first time since the facility started commissioning operations in late 2004. Wayne Andrews and Pavel Molchanov are Houston-based equity analysts for Raymond James & Associates Inc.