Gastar Exploration (GST) is a small oil and gas company trading a large discount to its net asset value and at a fraction of the valuation of its peers. It is drilling wells in one of the most prolific areas in the country and is due to announce results from these wells in late July/early August. When it announces the results of the wells, I believe the stock will either be substantially re-rated, or the company will be taken private, due to the tremendous demand in the public and private markets for producing oil and gas assets of the type Gastar owns.

Business Description:

Gastar has two oil and gas fields, one in East Texas and the other in Pennsylvania and West Virginia. It is currently producing approximately 25 MMcfe/d, almost entirely from its field in East Texas, and almost entirely dry gas. The field in East Texas is comprised of 15,000 net acres, most of which is prospective both for deep, highly economic dry gas, as well as potentially prospective for shallower Eagle Ford and Glen Rose oil.

The field in PA and WV is comprised of just over 80,000 net acres of leases prospective for the Marcellus shale. Approximately 15,000 net acres are in the liquids rich core of the play in West Virginia, in Marshall and Wetzel Counties. Gastar drilled one of the best vertical wells in the play in 2009 in Wetzel County, and it is in the process of drilling and completing 2 wells in that area.

History in brief:

Gastar is a natural gas oriented E&P company, founded in 2000. It was over-levered and under-hedged going into the 2008 crash, and was forced to sell a prime asset (a massive development-stage CBM field in Australia) and use the proceeds to pay down its debt. Gastar built its Marcellus position on the cheap in 2008, following Chesapeake and buying in areas Chesapeake was most interested in. In 2010, Gastar JV'd its Marcellus asset, settled various lawsuits, raised equity, issued preferred (non-convertible) stock to finance development, had disappointing East Texas well results and is now ramping up the development of its Marcellus asset.

Valuation:

Gastar's peers are trading for over $5,000/acre in the Marcellus in general, and some are trading in excess of $10,000/acre. Gastar's acreage is at least as prospective in aggregate as most of these peers' acreage. This $5,000/acre metric would imply a value of over $400 million to Gastar, or $6.40/share. If Gastar showed good results, it could trade closer to $10,000/acre, yielding an $800 million value or $12.80 per share. Asset transactions have come in in the Marcellus recently in excess of $10,000/acre, supporting a $12.80+ valuation for Gastar based solely on their Marcellus acreage. Gastar's East Texas acreage has fewer recent transaction comps and no directly comparable peers, but would likely sell for over $150 million, or another $2.40/share.

Gastar's current production is likely worth $7,000 per mcf. At 25 MMcfe/d, implying a value of ~$175 million, or $2.80 per share. Gastar expects to ramp production to over 40 MMcfe/d by year end, implying a value of ~$4.50 per share. By the end of 2012, assuming success in the Marcellus, Gastar should be producing over 60 MMcfe/d, implying a value of $6.72. This assumes no liquids production and no value for acreage.

The right valuation is likely a blend of acreage and production value. My estimate is that if Gastar were bought out, it could achieve a $7/share value, in line with Tudor Pickering's estimate of Gastar's 3P value, which excludes half of Gastar's Marcellus position. And if the Marcellus wells are as good I think they will be, the stock could begin to incorporate the full potential value of the assets, which could be up to $15 per share.

Risks and (mitigation):

Funding/dilution (mitigated through preferred offering),

Well results (recent well results in East Texas have been disappointing, but drilling in emerging liquids rich core of Marcellus, and small operators there have gotten great results)

Key-man risk (not that CEO leaves, but that he does something the market perceives as stupid or value-destroying; this is a real risk given the company's history; however, so far, decisions the market has hated, like getting into the Marcellus or selling the Australian asset, have worked out well for the company)

Commodity price risk (natural gas prices are already depressed, not particularly dependent on oil prices, has a meaningful near-term hedge position, thesis likely to play out near-term)

Catalysts:

Well results, asset sale, company sale.

Now is a good time to buy Gastar. Rumor has it Gastar's two recent wells in the Marcellus were stunning successes. Supposedly the frac's were executed flawlessly and, while field level professionals have been unwilling to comment so far regarding specifics of well production, the rumor is they are extremely pleased with what they've seen so far. Management has not to my knowledge commented on the well results.

Obviously one does not want to invest on rumor, but in this case it's believable, and there is solid asset value underlying the stock. Gastar has drilled 2 wells in the very best part of the South Western Marcellus. The rumor is believable because other adjacent operators have drilled some of the best wells in the Marcellus, and because Gastar has an experienced operations professional running its Marcellus operations, who has drilled dozens of high-performing wells in the Marcellus for other operators. And Gastar is using BJs for its well services and frac services; BJs is considered among the best service providers in the area.

If Gastar's wells are successful, I believe the stock will be re-rated, and the market will award it closer to its 3P value, and will start to consider increasing that 3P value to include a greater portion of Gastar's Marcellus acreage. As a nearly pure play Marcellus company, Gastar has the potential to trade at a premium to its peers, or to be taken out by larger competitors desiring Gastar's enviable acreage position. And if neither of these happen, Gastar is a private equity buyout candidate. The CEO has on several occasions mentioned his willingness to sell the company at an appropriate price if the market does not award it sufficient value, especially in light of success in the Marcellus.

Finally, earlier this month, over 4,000 December $5 calls were purchased in a block, likely by the investor who visited the well site, spoke with the service providers and observed their reactions (and started the rumor). To be clear, I did not buy this block of calls and did not start the rumor of good well results.

I think investing on a rumor is a bad idea. However, investing in a tremendously undervalued company, with a large margin of safety, in-demand assets, virtually no debt, low-cost commodity producer, etc, with the benefit of a rumor from the field of high performing wells is actually a good idea. And in full disclosure, I currently own Gastar stock and reserve the right to buy or sell Gastar stock, preferred stock or options at any time without further notice.