Description

Gastar Exploration is a small E&P take-out candidate trading at a 51-82% discount to NAV, suggesting upside to the stock of 100-460%.  I believe GST is a very attractive target for E&P asset aggregators like HK and MHR and that management would be amenable to a sale.  There is also plenty of cashflow and upside to make it attractive to private equity at some point.  If the company isn’t sold, 2013 earning will support a much higher valuation.  The company is conservatively financed and decently hedged in the current environment.

Sugar1 wrote this stock up last fall and I suggest you read that write-up for the back story.  This write-up will focus on: the current financial position, some reasons for the current undervaluation, and a much deeper dive into the valuation of the assets.  There are a number of potential catalysts for the stock in the next month or two, including disclosure of their new mid-continent play, well results which will shed some light on the value of the “super rich” Marcellus asset, and the potential for competitors to have success in the Eagle Ford near Gastar’s East Texas acreage.

Fiscal Position: 

Gastar has $50 million drawn on their revolver, which has a capacity of $100 million.  They expect to get a small bump in capacity at their September redetermination and a substantial increase next April.  Due to their rapidly increasing production in the Marcellus, I would expect a bump to $115 million this fall and possibly as much as $200 million in capacity next April.  They will exit this year with about $90 million drawn, so this is cause for some concern.  They have hedges in place for 2013 (and 2012) that I do not include in my valuation.  I would estimate that they could monetize their 2013 hedges at the end of the year for $7.5 million in cash (at current prices).  They have no other debt, but they will exit the year with $100 million of 8.62% perpetual preferred shares (non-convertible). 

In the current environment, management suggested they might drill 25 gross wells in the “super rich” Marcellus per year going forward rather than the 30 that are planned.  At this level of activity they would still not have any HBP issues.  It will cost them $90 million to drill 25 wells next year and they will have 2013 cashflow of around $70 million, so the funding gap is not large.  Their capex is discretionary (although at significantly lower activity levels they could run into HBP issues) so I don’t expect them to get into trouble, but the market would clearly like some clarity on this issue.

Reasons for undervaluation:

                Midstream issues have caused a number of delays and shut-ins over the last year, which have disappointed the market.  There is uncertainty of how – if at all – they plan to raise additional money to fund their 2013 capex.  They have not given a type curve or other information to allow the sell side to model their “super rich” Marcellus asset.  Natural gas in general has obviously been a disaster, and in the absence of a firm understanding of what their asset is worth and how they are funding themselves, this isn’t a good time to be a small cap named “Gastar”.  I think the assets are actually quite good and the financial position is also relatively solid in this environment. 

Valuation:

It may be helpful to read the valuation section along with Gastar’s corporate presenation, to get a better idea of where their acreage is: 

http://files.shareholder.com/downloads/GST/1886054393x0x559111/48bba92e-ad5f-4e94-8118-329cf5b63083/IPAA%20April%202012%20vFinal%20[Compatibility%20Mode].pdf

                Gastar has three areas of operations: The Marcellus (SW PA and WV), East Texas, and the Mid-Continent.  Within these three groups are five distinct assets:

1)      Bossier tight gas - This is Gastar’s legacy East Texas position.  They are no longer drilling here because it is uneconomic in this environment, but they have 21,800 net acres and legacy production of 9.5 MMcf/day (as of the end of this year).

2)      “Super Rich” Marcellus - Gastar has 8,325 net acres in NW West Virginia.  This is where they are currently drilling and producing very high BTU “wet” gas from the Marcellus formation. 

3)      Other Marcellus - Gastar has 5,900 net acres in Pennsylvania and 56,100 net acres in West Virginia. 

4)      Mid-Continent oil - Gastar is spending $20 million this year (mostly spent) to build a 12,500 net acre position and drill 3 wells.  They have not disclosed what this play is other than to say it is not the Mississippi Lime.

5)      EagleBine - Gastar’s legacy East Texas position is right in the middle of both the Woodbine sands and the Northeast extent of the Eagleford shale oil window.  There is significant upside here if the Eagleford is economic in this area.

VALUATION:

                Gastar has 50% of their production in the Bossier currently, which is all legacy dry gas production.  The will exit the year with 9-10 MMcf/day of production in this area.  I value this production to be worth $51 million based on current strip prices.  I expect gas prices to be moderately higher than the strip, which gives a PV10 value in my model of $80 million.  This works out to $5,100-$8,000 per mcf/day of production, which is reasonable for low decline gas production.

                The “Super Rich” Marcellus is Gastar’s most valuable asset.  They are drilling 24 gross wells this year with an average working interest of 45%.  This should rise to 30 gross wells at 50% WI for the next three years (unless they pull back to conserve cash).  Up until this point their working interest has been smaller but they have traded land with other companies so that they and their partner, Atinum, should have a 100% working interest going forward (50/50).  They have had takeaway issues in the first half of this year which should be largely solved by the addition of new compression and dehydration equipment.  Williams paid $2.5 billion in March to buy out their midstream service provider and is planning to spend $1.5 billion to expand and enhance the system, so I expect things to run much more smoothly in the future. 

                Rather than try to value this area on a per acre basis, I have modeled the actual wells and come up with a PV10 value for this area.  All of this drilling will take place over the next three years and on a geological scale, this is a pretty small area that should be relatively homogenous.  So while the majority of this “reserve” value is currently unbooked, it will quickly be moved in the PUD and then PDP category. 

                There is limited production information from Gastar’s wells in this area, due in large part to the midstream issues which have plagued them.  These issues should now be resolved and I expect management will give a lot more data when they report Q2.  From what information they have released, two of their wells look like Range Resources “super rich” Marcellus type curve and four look like Range’s “wet gas” type curve.  Management stated that condensate production at these four wells on the Corley pad may have been temporarily low due to frac fluid flowback. 

                Gastar’s acreage is in the area Range has identified as the “wet gas” window and “super rich” wet gas window.  I think it makes sense to use a blended version of Range’s type curves for these two plays in order to model Gastar’s drilling program.  Gastar’s own expectation for 2/3 gas and 1/3 liquids (of which 2/3 are NGLs and 1/3 is condensate) fits this model.

                I will note that Range is drilling shorter laterals and has an all-in well cost in this area of $4.5-5 million, as compared to Gastar’s all-in cost of $7.2 million (this should come down 5% with lower service costs).  Even at the higher well cost these wells and currently depressed NGL prices these wells are very economic. 

I derive a combined Mcfe value from these ratios and strip pricing and then subtract $1.00 per Mcfe in order to account for gathering and compression costs.  This final row in the below table is the effective wellhead price GST will receive on an Mcf equivalent basis:

                Using Range’s “wet gas” and “super rich” type curves (which are similar on an Mcfe basis), I come up with the following type curve for Gastar’s wells (GST shared a model type curve with me, which was similar but it was more optimistic than my model so I did not change anything):

                I actually model the wells through year ten and then assign them a terminal value in year 11 that is equal to 3X the cashflow in year 10.  The production from the above well, which is a 2012 vintage, has a present value of $13.4 million (the vintage of the wells matters because for 2013 onward the effective Mcfe price would be a lot higher in year one).  I assume 20% royalties, so the actual PV is $10.7 million, from which I subtract the $7.2 million well cost to get a net PV10 value for this well of $3.3 million dollars. At the current strip, 2013 wells will have a PV10 of $4.75 million when they are drilled, which must be discounted back to today at 10%.  I model the well program for 2013-2015 (at which point their acreage will be exhausted) to a present value of $429 million:

                Gastar will have an average working interest in these wells of 50% so the PV10 net to them is $214 million.  They have spent $90 million drilling wells in this area this year, as well as received cashflow from some of the wells.  In order to account for all of this (as well as get past the noise of the midstream problems) I look forward to the end of the year and value the 37 MMcfe of production they will have in this area at a PV10 of $102 million (I ran off production faster than the curve would suggest to yield this value), putting a total value on this play of $316 million.

                I am more optimistic for oil and gas pricing than the market is currently, so I put together a price deck that I think is more likely (but in no way aggressive):

                Using these prices, the 2013-2015 drilling program has a PV10 of $288 million net to Gastar and the current production at year end will be worth $138.  As a check I divide this total value of $426 million by 8,325 to get a per acre value in this area of $51,171.  This sounds like a huge number, but MRO just paid the same price for Eagleford acreage with similar economics.  Like the acreage in that transaction, Gastar’s acreage will have significant production by the end of this year, and they will have spent over $100 million drilling.

                Gastar’s other Marcellus acreage is extremely difficult to value, as most of the value is optionality to higher future gas prices.  This is a much smaller component of the overall value, however, so I value it based on acreage.  Of their 5,900 net acres in Pennsylvania, they have 2,450 acres in Butler County (wet gas) and 3,450 in Fayette & Somerset counties.  Last year I would have valued this acreage at $10k and $5k per acre respectively, which would be in line with transaction values.  In this environment I use half that number.

                Gastar also has 56,100 net acres in Eastern West Virginia, which is within the extent of the Marcellus shale, but is dry gas outside of the core NW dry gas area.  Gastar paid $30 million for this acreage and it is likely still worth that price.  I will assume it is worth zero today but there is significant upside to this acreage in a higher gas price environment.  Tier II Marcellus acreage has traded at $2,500 an acre in the past, so I will assume it is worth half of that in my upside case, or $70 million.

                The midcontinent oil play sounds like it has very good economics, which you can read about in Gastar’s press release.  I have nothing intelligent to add because they haven’t disclosed where it is.  I will assume it is worth the $20 million they are spending on it this year, but there is likely upside to this if the economics of the play are as good as Gastar expects.

                Gastar’s “Eaglebine” potential is similarly hard to value because it is hypothetical at this point, although there is an increasing amount of data to suggest a non-zero value currently.  The Woodbine sands have much better economics (this is a sand that has collected the oil that seeped up out of the Eagleford shale over time) and nearby acreage has recently changed hands at $20k an acre.  The CEO of Gastar said on the last call:

                “on our acreage, we have more of the true shale in place, however, we do have one of those Woodbine sands, it’s called the Sub-Clarksville . . . we got some log and core information . . .which looks pretty encouraging”

                EOG has a producing Eagleford well just south of their acreage which is rumored to be producing 1,000-1,400 boe per day.  Encana has leases surrounding their acreage and has tested the Eagleford with two wells in close proximity to Gastar’s acreage.  These wells (released today) had 30 day IP rates of 234 BOE/day, but this was a restricted rate while they await pumping.  Encana says they are encouraged and are looking to double the lateral length and add pumping.  Another industry well in the area had initial production of 700 Boe/day.  I would guess that they could sell their rights to this interval today for $1,000 an acre, and that it will be worth $20,000 an acre if Encana or anyone else is able to replicate the rumored success of EOG 6 miles south of Gastar’s acreage.  I will use half of that, or $10,000 an acre for my upside case:

                I come up with a total asset value of $430-856 million.  From this I subtract assumed year-end debt of $90 million and $100 million worth of preferred shares:

                There are 65.7 million shares out and I assume a fully diluted share count of 68 million to account for options and restricted shares that have been or will be granted:

Catalyst