Gastar Exploration (NYSEMKT:GST), an independent energy company, has been among the many beneficiaries of the oil & gas boom in the United States. With a strong position in Marcellus Shale and initiation of operations in the Hunton Limestone horizontal oil play, Gastar Exploration has hit the right chord.
Backed by strong exploration and production development, Gastar Exploration has surged by 105% in the last one year even after the recent correction. Over the last one year, the stock has surged from $3.07 to current levels of $6.31.
However, after peaking out at $8.99 on June 23, 2014, the stock has corrected by 30% over the next two months and I believe that this correction was primarily some profit booking.
Several oil & gas plays have seen some correction in the stock even as operational progress remains excellent. Callon Petroleum (NYSE:CPE), a company I recently initiation, is another example of a company witnessing some sharp correction in the recent past.
I believe that a 30% correction for Gastar Exploration is an excellent opportunity to consider exposure to this junior oil & gas play and I will back my point with fundamental reasons in the initiation.
Company And Assets Overview
Gastar Exploration is an independent junior energy company engaged in the exploration, development and production of oil, natural gas, condensate and natural gas liquids in the United States.
The company's principal business activities include the identification, acquisition, and subsequent exploration and development of oil and natural gas properties with an emphasis on unconventional reserves, such as shale resource plays.
Gastar Exploration is currently pursuing development within the primarily oil-bearing reservoirs of the Hunton Limestone horizontal oil play in Oklahoma and the development of liquids-rich natural gas in the Marcellus Shale play and dry gas in the Utica Shale play in West Virginia.
As of March 2014, the company had 60,100 net acres in the Marcellus Shale, 11,400 net acres in the Utica Dry Gas and 128,500 net acres in the Hunton Limestone Oil Play. Further, as of December 2013, the company had 54.6mmboe of proved and probable reserves.
The company's acreage in Marcellus and Utica lies near leading players in the basin such as Chevron (NYSE:CVX), Statoil (NYSE:STO), Exxon (NYSE:XOM) and Chesapeake Energy (NYSE:CHK). In Hunton, the company has an early mover advantage with large acreage and 130mmboe of net potential resources.
For the year ended December 2013, Gastar Exploration has an average daily production of 8,870mmboe and the company clocked revenue of $92.5 million for the same period.
Phenomenal Reserves Growth...
Gastar Exploration's reserves growth has been nothing short of phenomenal and is one of the major reasons for the stock surging higher in the last one year. With huge acreage still to be developed, I believe that reserves growth will continue to be one of the major stock upside catalyst.
To put things into perspective, Gastar Exploration's proved reserves have increased from 8.1mmboe in 2009 to 54.6mmboe in 2013. This represents a CAGR of 61% over the last four years and is certainly exceptional.
Growth in proved reserves was more robust in FY13 and is one of the critical factors for a 105% stock upside over the last one year. In FY13, the company's proved reserves increased by 81% to 54.6mmboe from 30.2mmboe in FY12. Further to this, excluding acquisitions and divestment, the company replaced approximately 532% of 2013 production through the drill bit.
What is interesting and positive to note here is that strong reserves growth has continued for Gastar Exploration in the first half of 2014 and this is likely to support stock upside. On July 21, 2014, Gastar Exploration reported its mid-year proved reserves. As of June 2014, proved reserves had surged to 78.0mmboe as compared to 54.6mmboe in December 2013. This represents a 43% increase in proved reserves in six months. With high focus on the company's Hunton prospect, proved reserves are likely to increase significantly even in the second half of 2014.
The first point to back the company's current undervaluation also comes from the growth in proved reserves and the net present value of proved reserves. According to the company's new release -
Using SEC pricing, the pre-tax present value discounted at 10% (PV-10) of proved reserves increased to $826.3 million at June 30, 2014, an increase of 39% versus $592.5 million at year-end 2013. Marcellus reserves in the Appalachian Basin represented 71% of proved reserve volumes and 51% of the PV-10 value, while Hunton Limestone reserves in Oklahoma represented 29% of proved reserve volumes and 49% of the PV-10 value.
As of 1Q14, Gastar Exploration had a debt of $313.5 million and a cash position of $26.9 million. Considering the company's NPV of proved reserves and adjusting for debt and cash, the company's valuation come to $540 million and this represents a 38% discount to the company's current market capitalization of 390 million.
Gastar Exploration is therefore trading at a discount to proved reserves value and once the stock starts to move higher after the current correction phase, the valuation gap is likely to be covered. I believe that this might be the right time to buy the stock as Gastar Exploration reports its second quarter results on August 8, 2014 and the correction trend is likely to reserve on strong results.
Also, the company's proved reserves growth has been robust at 43% for 1H14, even if proved reserves grow by another 20%-30%, the potential upside for Gastar Exploration increased based on the NPV of proved reserves.
...Associated With Strong Production Growth...
I believe that the probability of the company to close the valuation gap based on the market capitalization and NPV of proved reserves largely depends on the monetization of reserves. The monetization of reserves can be ascertained from the company's production growth. For Gastar Exploration, production growth has been equally robust and has been another major stock catalyst in the last one year. I believe that strong production growth is likely to continue as the company embarks on a high impact exploration and development program.
To put the production growth in terms of numbers, Gastar Exploration's production has increased from 4,240boepd in FY09 to 8,870boepd in FY13. This represents a robust production growth CAGR of 20.3% over the last four years.
Very similar to the reserves growth trend, production growth has been far more robust in the recent past and that explains the strong stock upside in the last one year. For FY13, production averaged 8,870boepd, representing a 46% increase in production as compared to FY12 production of 6,050boepd. Production growth for 1Q14 has been equally robust with the company reporting an average production of 9,700boepd, representing a 43% increase in production as compared to 1Q13 production of 6,800boepd.
For the second quarter of 2014, the company has provided a guidance of 8,400-8,800boepd and I believe that this guidance will be easily met when the company releases its second quarter results on Friday.
For FY14, the company's guidance is equally robust at 9,700boepd to 11,000boepd. Considering the mid-range of the guidance, Gastar Exploration should close FY14 with a production of 10,350boepd. This would represent a 17% production growth as compared to FY13. I believe that any revision of production target for FY14 (on second quarter results) will provide an additional catalyst for stock upside. I am expecting strong production growth considering the company's high impact exploration program.
Before I move to the exploration program, I would also like to mention here that Gastar Exploration's liquids production has increased significantly over the years and is likely to increase further with big focus on Hunton. In terms of numbers, liquids, as a percentage of total production, have increased from 23% in FY11 to 45% in FY13.
...Further Backed By High Impact Exploration
Coming to the high impact exploration and drilling program for FY14, I believe this will be a major stock upside catalyst for FY14 as well as FY15. For FY14, Gastar Exploration has a total capital budget of $192 million and this involves drilling of 23.1 net wells with 73% of the company's capital expenditure allocated to drilling.
In terms of location, 17.1 net wells are expected to be drilled in Hunton, 5.0 net wells in Marcellus and 1.0 net well in Utica. This is important to mention as 96% of the 2014 drilling and infrastructure budget involves liquids-rich plays. In other words, the company's liquids composition of sales is likely to increase significantly in FY14 and FY15.
Another important point to mention here is that the company's Hunton prospect with 128,500 net acres is largely unexplored. The company estimates 130mmboe of net resources in its acreage and had identified 542 drilling locations. In addition, the stacked play includes 212 net Woodford location and 300 net MS line locations.
The conclusion is that Gastar Exploration has a big drilling inventory and I believe that the company's high impact exploration and drilling program will continue in FY15. This implies that the company's proved reserves growth will remain robust and so will the company's production growth.
Further, production will increasingly tilt towards liquids as the company's program focuses on prospects that are liquids rich. The company's activity is currently concentrated ultra liquids-rich portion of Marcellus besides the Hunton play. The company has 106 net locations in the liquids rich window of Marcellus.
Strong 1Q14 Growth And Solid Fundamentals
It is important to look at the fundamentals for a company that has a high capital expenditure program lined-up for the next few years. From a fundamental perspective, Gastar Exploration looks good and the company has strong financial flexibility to invest heavily in prospective assets.
Coming to the company's strong performance in 1Q14; Revenue increased by 154% to $38.8 million as compared to $15.3 million in 1Q13. The strong performance was driven by an increase in production by 43% to 9,700boepd in 1Q14 as compared to 6,800boepd in 1Q13. A higher contribution of oil and natural gas liquids to sale also positively impacted growth. With more focus on liquid plays in the next few quarters, the company's growth will be driven by increasing liquids production.
As of 1Q14, Gastar Exploration had a strong balance sheet with relatively high loan-to-reserves cushion. Considering the company's long-term debt of $313.5 million and the present value of proved reserves at $826 million, the company's loan-to-value for 1Q14 was 38%, giving sufficient financial flexibility.
Further, Gastar Exploration had a cash position of $26.9 million and an undrawn credit facility of $120 million as of 1Q14. These resources are more than sufficient to cover for the company's FY14 capital expenditure. In addition, the company is likely to generate operating cash flows in excess of $100 million for FY14 and this will also boost the company's overall financial flexibility.
Revenue And EBITDA Outlook For FY14 and FY15
While the NPV already suggests undervaluation for Gastar Exploration, a forecast for FY14 and FY15 will help strengthen the upside thesis.
For FY14, Gastar Exploration has already provided a guidance of 9,700boepd to 11,000boepd production. A mid-range of 10,350boepd is entirely likely with the company re-affirming its guidance. I will not be surprised if the company revised its guidance on the upside when the second quarter results are released tomorrow. The high impact exploration program supports the probability of guidance revision.
For now, I have assumed an average annual production of 10,350boepd with 43% liquids (mid-range of 42%-44% liquids guidance). As per the proportion of oil, natural gas liquids and natural gas in 1Q14, the likely average daily production for FY14 will be 2,560boepd of oil, 1,891boepd of natural gas liquids and 35,400mcf of gas.
In terms of price, the oil and natural gas liquids realized priced averaged $79.6 for 1Q14 and I believe that $80 is a good base case scenario for FY14 as oil & natural gas liquids prices remain largely around the same levels. I do believe that oil & natural gas liquids prices will remain firm for FY14 and FY15. Natural gas price per mcf for 1Q14 was $4.34 and I believe that prices will be in the range of $4.3-$4.5 for FY14 and $4.4 per mcf is a good base case assumption.
These assumptions translate into annual revenue of $187 million, representing revenue growth of 102% as compared to FY13 revenue of $92.5 million. Therefore, the company's strong revenue growth in 1Q14 is likely to sustain for the remainder of 2014.
In terms of EBITDA, Gastar Exploration had an EBITDA margin of 67% for 1Q14 and I believe that EBITDA margin will sustain at these levels with oil & natural gas price assumption remaining largely the same as 1Q14. An EBITDA margin of 67% would imply a FY14 EBITDA of $125 million. Further, with an EBITDA cash conversion ratio of 89% for 1Q14, the company's operating cash flow is likely to be $110 million for FY14.
For FY15, Gastar Exploration is yet to provide guidance related to production. However, I do believe that production growth in FY15 can potentially be 20%-30% considering $192 million of capital expenditure and 23 net wells to be drilled in FY14. Further, with vast prospective areas, FY15 will also have an equally high impact exploration program and I believe that my assumption on production growth is likely to be achieved easily. Even considering 25% production growth for FY5, Gastar Exploration is likely to have a production of 13,000boepd in FY15. Further, with 96% of the exploration and drilling focus in FY14 on liquids play, I will not be surprised if the liquids and gas sales mix for FY15 is 50% each.
Considering these assumptions and further considering that oil and natural gas prices remain at the same level as FY14, the likely revenue for FY15 works out to $254 million and this represents a likely revenue growth of 36% as compared to FY14. I believe that these are conservative estimates as oil & natural gas prices have been considered at same levels as compared to FY14. However, this serves as a good base case scenario.
Coming to the EBITDA margin, I do believe that EBITDA margins will expand on higher production even if oil & natural gas prices remain the same as FY14. Further, Hunton is a relatively low operating cost location and with big focus on Hunton in FY14, the company's EBITDA margin is likely to expand. I have assumed a 300 basis points EBITDA margin expansion in FY15 to 70% and this translates into a FY15 EBITDA of $178 million.
Gastar Exploration is therefore set for strong revenue, EBITDA and cash flow growth in FY14 as well as FY15 and the current correction of 30% is a great entry point in this high growth stock. Further, the company is likely to generate an operating cash flow of over $250 million in the next two years and this should take care of the company's high impact exploration program.
Forward Valuations Support Thesis Conclusion
Gastar is trading at a discount of 38% to its NPV (adjusted for debt). This was the first undervaluation factor discussed in the initiation. Forward EV/EBITDA valuations also support the thesis of stock upside.
Gastar Exploration is currently trading at a market capitalization of $390 million and has a current debt position of $313 million. The forward EV assumption is that the company also used the undrawn $120 million credit facility by the end of 2015 and the company's net debt position as of FY15 is likely to be $500 million.
I must mention here that over the next two years, a potential $268 million of OCF will also lend support to the company's high impact capital expenditure program besides the incremental debt. Considering an EV of $756 million and a FY15 EBITDA of $178 million, Gastar Exploration is trading at a FY15 EV/EBITDA of 4.2.
This is inexpensive as compared to the EV/EBITDA of peers. Rex Energy (NASDAQ:REXX) is trading at a FY15 EV/EBITDA of 4.5, Clayton Williams (NASDAQ:CWEI) is trading at a FY15 EV/EBITDA of 5.3 and Range Resources (NYSE:RRC) is trading at a FY15 EV/EBITDA of 9.7. These add up to an average peer EV/EBITDA of 6.5.
Gastar Exploration, with a FY15 EV/EBITDA of 4.2, is currently trading at a 53% discount to peer EV/EBITDA valuations. Therefore, both the NPV and EV/EBITDA valuation suggests potential upside for Gastar Exploration and the upside can range between 38% and 53%. The upside target can be revised higher if the company's likely production growth for FY15 is higher than 25%.
Gastar Exploration is an attractive stock to consider after a correction of 30%. Considering both the valuation methods, it is clear that the correction is overdone and the company has significant upside potential over the next 12-18 months.
With the company's results releasing on Friday, the trigger for the next round of upside can potentially be 2Q14 outperformance, FY14 guidance revision or some indication on likely production growth in FY15. I do believe that the company's growth will remain robust given the current capital expenditure program.
Considering the factors and valuation discussed in the article, my conclusion is that Gastar Exploration is a strong buy and hold. The next round of the rally for Gastar Exploration can be equally exciting as the first.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.