Gastar Exploration Inc.
GASTAR EXPLORATION LTD (Form: 10-Q, Received: 08/14/2006 14:27:33)

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-Q

 


 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2006

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM              TO              .

Commission file number 001-32714

 


GASTAR EXPLORATION LTD.

(Exact name of registrant as specified in its charter)

 


 

Alberta, Canada   38-3324634

(State or other jurisdiction of

incorporation or organization)

 

(IRS Employer

Identification No.)

 

1331 Lamar Street, Suite 1080  
Houston, Texas 77010   77010
(Address of principal executive offices)   (ZIP Code)

(713) 739-1800

(Registrant’s telephone number, including area code)

 


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes   x     No   ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer   ¨     Accelerated filer   ¨     Non-accelerated filer   x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes   ¨     No   x

Total number of common shares, no par value per share, outstanding as of August 14, 2006 was 167,909,420.

 



GASTAR EXPLORATION LTD.

QUARTERLY REPORT ON FORM 10-Q

FOR THE THREE MONTHS ENDED JUNE 30, 2006

TABLE OF CONTENTS

 

         Page
  PART I – FINANCIAL INFORMATION   

Item 1.

  Financial Statements   
 

Condensed Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005

   1
 

Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2006 and 2005

   2
 

Condensed Consolidated Statement of Shareholders’ Equity for the Six Months Ended June 30, 2006

   3
 

Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2006 and 2005

   4
 

Notes to the Condensed Consolidated Financial Statements

   5

Item 2.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations    18

Item 3.

  Quantitative and Qualitative Disclosure about Market Risk    24

Item 4.

  Controls and Procedures    24
  PART II – OTHER INFORMATION   

Item 1.

  Legal Proceedings    25

Item 1A.

  Risk Factors    25

Item 2.

  Unregistered Sales of Equity Securities and Use of Proceeds    25

Item 3.

  Default Upon Senior Securities    25

Item 4.

  Submission of Matters to a Vote of Security Holders    26

Item 5.

  Other Information    26

Item 6.

  Exhibits    26
  SIGNATURES    27

Unless otherwise indicated or required by the context, (i) “we”, “us”, and “our” refer to Gastar Exploration Ltd. and its subsidiaries and predecessors, (ii) “GeoStar Acquisition” refers to our June 2005 acquisition from GeoStar Corporation (“GeoStar”) of additional reserves and working interests in the Powder River Basin and in East Texas, (iii) “convertible debentures” refers to our $30.0 million principal amount of 9.75% convertible senior unsecured debentures, (iv) “warrants” refers to the warrants to purchase common shares issued to investors in connection with certain financing transactions or to our placement agents in connection with the offering of convertible debentures and certain other subordinated notes as partial compensation for their services, (v) “senior secured notes” refers to our $73.0 million principal amount of senior secured notes issued in 2005, (vi) all dollar amounts appearing in this Form 10-Q are stated in U.S. dollars unless specifically noted in Canadian dollars (“CDN$”), and (vii) all financial data included in this Form 10-Q has been prepared in accordance with accounting principles generally accepted in the United States of America.

General information about us can be found on our website at www.gastar.com . The information on our website is neither incorporated into, nor part of, this report. Our Annual Reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, as well as any amendments and exhibits to those reports, will be available free of charge through our website as soon as reasonably practicable after we file or furnish them to the U.S. Securities and Exchange Commission (“SEC”). Information is also available at www.sec.gov for United States filings and on SEDAR at www.sedar.com for Canadian filings.

 

i


GASTAR EXPLORATION LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

 

     June 30,
2006
    December 31,
2005
 
     (in thousands)  
     (unaudited)        
ASSETS     

CURRENT ASSETS:

    

Cash and cash equivalents

   $ 38,922     $ 61,144  

Revenues receivable

     3,148       4,416  

Accounts receivable, net

     1,819       40  

Due from related parties

     2,255       2,317  

Prepaid expenses

     1,095       1,551  
                

Total current assets

     47,239       69,468  

DEFERRED CHARGES

     4,192       4,922  

CASH CALL RECEIVABLE

     4,515       391  

PROPERTY AND EQUIPMENT:

    

Natural gas and oil properties, full cost method of accounting:

    

Unproved properties, not being amortized

     83,895       73,580  

Proved properties

     145,813       129,592  
                

Total natural gas and oil properties

     229,708       203,172  

Furniture and equipment

     503       360  
                

Total property and equipment

     230,211       203,532  

Accumulated depreciation, depletion and amortization

     (83,359 )     (38,185 )
                

Total property and equipment, net

     146,852       165,347  
                

TOTAL ASSETS

   $ 202,798     $ 240,128  
                
LIABILITIES AND SHAREHOLDERS’ EQUITY     

CURRENT LIABILITIES:

    

Accounts payable

   $ 11,809     $ 3,935  

Accrued interest

     2,403       2,418  

Accrued drilling and operating costs

     5,647       3,008  

Other accrued liabilities

     3,335       2,465  

Due to related parties

     —         2,116  
                

Total current liabilities

     23,194       13,942  

LONG-TERM LIABILITIES:

    

Long-term debt

     92,164       90,631  

Asset retirement obligation

     3,766       3,558  

Liability to be settled by issuance of common shares

     4,855       11,221  
                

Total long-term liabilities

     100,785       105,410  

COMMITMENTS AND CONTINGENCIES (Note 12)

    

SHAREHOLDERS’ EQUITY:

    

Common stock, no par value, unlimited shares authorized, 167,909,420 and 164,674,266 shares issued and outstanding at June 30, 2006 and December 31, 2005, respectively

     173,906       167,456  

Additional paid-in capital

     7,769       6,509  

Accumulated other comprehensive loss

     (30 )     —    

Accumulated deficit

     (102,826 )     (53,189 )
                

Total shareholders’ equity

     78,819       120,776  
                

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

   $ 202,798     $ 240,128  
                

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

1


GASTAR EXPLORATION LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

    

For the Three Months

Ended June 30,

   

For the Six Months

Ended June 30,

 
     2006     2005     2006     2005  
     (in thousands, except share and per share data)  

REVENUES

   $ 6,684     $ 4,943     $ 13,307     $ 9,674  

EXPENSES:

        

Lease operating, transportation and selling expenses

     2,128       477       4,088       1,792  

Depreciation, depletion and amortization

     3,565       2,275       7,874       4,965  

Impairment of natural gas and oil properties

     —         4,288       37,301       8,698  

Accretion of asset retirement obligation

     57       24       114       43  

Mineral resource properties

     33       5       190       34  

General and administrative expenses

     3,107       1,772       5,626       3,537  
                                

Total expenses

     8,890       8,841       55,193       19,069  
                                

LOSS FROM OPERATIONS

     (2,206 )     (3,898 )     (41,886 )     (9,395 )

OTHER (EXPENSES) INCOME:

        

Interest expense

     (3,816 )     (4,955 )     (7,575 )     (7,108 )

Investment income and other

     492       22       1,020       62  

Litigation settlement expense

     (1,200 )     —         (1,200 )     —    

Foreign exchange gain

     3       168       4       142  
                                

LOSS BEFORE INCOME TAXES

     (6,727 )     (8,663 )     (49,637 )     (16,299 )

Provision for income taxes

     —         —         —         —    
                                

NET LOSS

   $ (6,727 )   $ (8,663 )   $ (49,637 )   $ (16,299 )
                                

NET LOSS PER SHARE:

        

Basic and diluted

   $ (0.04 )   $ (0.07 )   $ (0.30 )   $ (0.14 )
                                

WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:

        

Basic and diluted

     166,513,762       117,286,718       165,663,086       115,547,122  
                                

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

2


GASTAR EXPLORATION LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(Unaudited)

 

     Common Stock   

Additional
Paid-in
Capital

   Accumulated
Other
Comprehensive
Loss
    Accumulated
Deficit
   

Total
Shareholders’

Equity

    Comprehensive
Loss
 
     Shares    Amount            
     (in thousands, except share data)  

Balance at December 31, 2005

   164,674,266    $ 167,456    $ 6,509    $ —       $ (53,189 )   $ 120,776     $ —    

Exercise of stock options – cashless

   905,636      —        —        —         —         —         —    

Share warrants exercised – cash

   21,948      84      —        —         —         84       —    

Issuance of shares, senior secured debt

   1,759,442      4,249      —        —         —         4,249       —    

Issuance of shares, GeoStar Acquisition final settlement

   548,128      2,117      —        —         —         2,117       —    

Stock based compensation

   —        —        1,260      —         —         1,260       —    

Foreign currency translation

   —        —        —        (30 )     —         (30 )     (30 )

Net loss

   —        —        —        —         (49,637 )     (49,637 )     (49,637 )
                                                   

Balance at June 30, 2006

   167,909,420    $ 173,906    $ 7,769    $ (30 )   $ (102,826 )   $ 78,819     $ (49,667 )
                                                   

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

3


GASTAR EXPLORATION LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

     For the Six Months
Ended June 30,
 
     2006     2005  
     (in thousands)  

CASH FLOWS FROM OPERATING ACTIVITIES:

    

Net loss

   $ (49,637 )   $ (16,299 )

Adjustments to reconcile net loss to net cash provided by (used in) operating activities:

    

Depreciation, depletion and amortization

     7,874       4,965  

Impairment of natural gas and oil properties

     37,301       8,698  

Amortization of deferred lease costs

     200       136  

Stock based compensation

     1,260       1,540  

Amortization of deferred financing costs and debt discount

     2,077       2,818  

Accretion of asset retirement obligation

     114       43  

Other

     —         (2 )

Changes in operating assets and liabilities:

    

Accounts receivable

     (449 )     (2,255 )

Prepaid expenses

     456       177  

Accounts payable and accrued liabilities

     9,252       11,019  
                

Net cash provided by operating activities

     8,448       10,840  
                

CASH FLOWS FROM INVESTING ACTIVITIES:

    

Cash call receivable

     (4,124 )     3,496  

Development and purchases of natural gas and oil properties

     (26,441 )     (36,771 )

Purchase of natural gas and oil properties from related parties

     —         (30,900 )

Proceeds from sale of natural gas and oil properties

     —         2  

Purchase of furniture, equipment and other

     (143 )     (93 )
                

Net cash used in investing activities

     (30,708 )     (64,266 )
                

CASH FLOWS FROM FINANCING ACTIVITIES:

    

Repayment of senior notes

     —         (26,483 )

Proceeds from issuance of senior secured notes

     —         63,000  

Proceeds from issuance of common shares, net of share issue costs

     84       17,097  

Deferred financing charges and other

     (46 )     (2,717 )
                

Net cash provided by financing activities

     38       50,897  
                

NET DECREASE IN CASH AND CASH EQUIVALENTS

     (22,222 )     (2,529 )

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

     61,144       15,842  
                

CASH AND CASH EQUIVALENTS, END OF PERIOD

   $ 38,922     $ 13,313  
                

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:

    

Cash paid for income taxes

   $ —       $ —    
                

Cash paid for interest

   $ 5,512     $ 4,137  
                

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

4


GASTAR EXPLORATION LTD. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Summary of Significant Accounting Policies

The accounting policies followed by Gastar Exploration Ltd, (the “Company”) are set forth in the notes to the Company’s audited consolidated financial statements in its Annual Report on Form 10-K for the year ended December 31, 2005. Such policies have been continued without change except for the adoption of Financial Accounting Standards Board (“FASB”) SFAS 123R, “Shared Based Payments” (“SFAS 123R”). Additionally, refer to the notes to those financial statements for additional details of the Company’s financial condition, results of operations and cash flows. All material items included in those notes have not changed except as a result of normal transactions in the interim, or as disclosed within this report. The accompanying interim condensed consolidated financial statements have not been audited by independent accountants, but in the opinion of management, reflect all normal and recurring adjustments considered necessary for a fair presentation of the financial position and results of operations. The results of operations for the three and six months ended June 30, 2006 are not necessarily indicative of results to be expected for the full year.

The condensed consolidated financial statements of the Company are presented in United States (“U.S.”) dollars unless otherwise noted and have been prepared by management in accordance with accounting principles generally accepted in the United States of America (“US GAAP”). The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates with regard to these financial statements include the estimate of proved natural gas and oil reserve quantities and the related present value of estimated future net cash flows.

The condensed consolidated financial statements include the accounts of the Company and the consolidated accounts of all its subsidiaries. The entities included in these consolidated accounts are all wholly owned. All significant intercompany accounts and transactions have been eliminated in consolidation.

Certain information provided for the prior periods has been reclassified to conform to the presentation adopted in 2006.

2. Deferred Charges

Deferred financing charges include costs of debt financings undertaken by the Company including commissions, legal fees and other direct costs of the financing. Using the interest method, the deferred financing charges are amortized over the term of the related debt. Deferred leasing charges represent future demobilization and transportation costs of leased natural gas treatment plants in East Texas. The deferred leasing charges are amortized into lease operating expense over the term of the agreements.

The following table sets forth information regarding deferred charges for the period indicated:

 

     Deferred
Financing
Charges
    Deferred
Leasing
Charges
    Total  
     (in thousands)  

Balance as of December 31, 2005

   $ 4,577     $ 345     $ 4,922  

Additions

     14       —         14  

Amortization

     (544 )     (200 )     (744 )
                        

Balance as of June 30, 2006

   $ 4,047     $ 145     $ 4,192  
                        

 

5


GASTAR EXPLORATION LTD. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

3. Cash Call Receivable

Cash call receivable represents the Company’s proportionate share of planned authorized expenditures payable to the operator upon execution of the final drilling authorization of expenditures and an advance payment to a drilling contractor to secure a drilling rig. The advance payment to a drilling contractor will be applied against future rig drilling costs over the next three years.

 

     Total  
     (in thousands)  

Balance as of December 31, 2005

   $ 391  

Cash call applied to expenditures

     (1,116 )

Amounts advanced

     5,240  
        

Balance as of June 30, 2006

   $ 4,515  
        

4. Property and Equipment

The amount capitalized as natural gas and oil properties was incurred for the purchase and development of various properties in the states of California, Montana, Texas, West Virginia and Wyoming in the United States and in New South Wales and Victoria in Australia. The following schedule represents natural gas and oil property costs by country:

 

     United States     Australia     Total  
     (in thousands)  

From inception to June 30, 2006:

      

Cost:

      

Unproved properties, not being amortized

   $ 80,791     $ 3,104     $ 83,895  

Proved properties

     143,247       2,566       145,813  
                        

Total natural gas and oil properties

     224,038       5,670       229,708  

Furniture, equipment and other

     487       16       503  
                        

Total property and equipment

     224,525       5,686       230,211  

Impairment of proved natural gas and oil properties

     (56,714 )     (605 )     (57,319 )

Accumulated depreciation, depletion and amortization

     (26,028 )     (12 )     (26,040 )
                        

Total property and equipment at June 30, 2006, net

   $ 141,783     $ 5,069     $ 146,852  
                        

As of June 30, 2006, unproved properties not being amortized consisted of drilling in progress costs and acreage acquisition costs of $8.0 million and $75.9 million, respectively.

For the six months ended June 30, 2006 and 2005, the results of management’s ceiling test evaluation resulted in an impairment of United States proved properties of $37.3 million and $8.7 million, respectively. No impairment of natural gas and oil properties was reported for the three months ended June 30, 2006. An impairment of $4.3 million was recorded in the three months ended June 30, 2005. Management determined that an impairment was not required on the Australian properties at June 30, 2006 and 2005.

 

6


GASTAR EXPLORATION LTD. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

5. Long-Term Debt

The following summarizes the Company’s long-term debt as of the dates indicated:

 

     As of
June 30,
2006
   As of
December 31,
2005
     (in thousands)

Senior secured notes

   $ 59,055    $ 57,546

Subordinated unsecured notes payable

     3,109      3,085

Convertible senior debentures

     30,000      30,000
             

Total net carrying value of long-term debt

     92,164      90,631

Debt discount costs to be accreted

     14,086      15,619
             

Total long-term debt at maturity

   $ 106,250    $ 106,250
             

For the three months ended June 30, 2006 and 2005, the Company recorded debt discount amortization of $770,000 and $1.7 million, respectively. For the six months ended June 30, 2006 and 2005, the Company recorded debt discount amortization of $1.5 million and $1.9 million, respectively.

Senior Secured Notes

On June 17, 2005, the Company issued $63.0 million in principal amount of senior secured notes (“Senior Secured Notes”). On September 19, 2005, the Company issued to the holders of the Senior Secured Notes an additional $10.0 million of Senior Secured Notes on substantially the same terms as the original June 2005 private placement. The Senior Secured Notes are secured by substantially all of the Company’s assets, bear interest at the sum of the three-month LIBOR rate plus 6% (11.48% at June 30, 2006), payable quarterly and mature five years and one day from the date of issuance. The Senior Secured Notes are redeemable in whole or in part prior to maturity at the Company’s option at any time after the first anniversary date of issuance upon payment of the principal and accrued and unpaid interest plus a premium ranging from 5% to 3% of redeemed principal; provided that, a redemption at the Company’s option is not permitted following the public announcement of certain pending, proposed or intended change of control transactions.

In connection with the Senior Secured Notes issuances, the Company agreed to issue to the note holders, for no additional consideration, common shares in increments valued at CDN$4.5 million with respect to the $63.0 million of Senior Secured Notes and additional common shares in increments valued at CDN$714,286 with respect to the $10.0 million of Senior Secured Notes at closing and on each of the six, twelve and eighteen-month anniversaries of the closing date, valued on a five day weighted average trading price immediately prior to the date of issuance. On March 20, 2006, the six-month anniversary of the September 19, 2005 $10.0 million Senior Secured Notes issuance, the Company issued to the note holders an additional 152,299 common shares at CDN$4.69 per share. On June 19, 2006, the twelve-month anniversary of the June 17, 2005 $63.0 million Senior Secured Notes issuance, the Company issued to the note holders an additional 1,607,143 common shares at CDN$2.80 per share. The issuance of common shares was recorded based on their fair issuance values recorded to common shares issued and a corresponding reduction in the liability to be settled by the issuance of common shares.

The Company has the right on a quarterly basis to require the note holders to purchase up to an aggregate of $10.0 million principal amount of additional Senior Secured Notes through June 16, 2007. If additional Senior Secured Notes are issued, the note holders will be entitled to receive, for no additional consideration, additional common shares on similar terms as those issued with the original Senior Secured Notes in a pro rata amount based on the additional principal amount of the Senior Secured Notes.

 

7


GASTAR EXPLORATION LTD. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Convertible Senior Debentures

In November 2004, the Company issued $30.0 million aggregate principal amount of convertible senior unsecured debentures (“Convertible Senior Debentures”). The Convertible Senior Debentures have a term of five years, bear interest at 9.75% per annum, payable quarterly and mature on November 20, 2009. The Convertible Senior Debentures are convertible by the holders into common shares at a conversion price of $4.38 per share. The Convertible Senior Debentures are not redeemable by the Company on or before November 12, 2006, except in the event of the satisfaction of certain conditions after a “change of control”, as defined in the Trust Indenture. After November 12, 2006, the Convertible Senior Debentures may be redeemed at any time by the Company at a redemption price equal to par plus accrued and unpaid interest; provided that, the volume weighted average trading price of the common shares of the Company, for at least 20 trading days in any consecutive 30-day period, equals or exceeds $5.69.

Subordinated Unsecured Notes Payable

In July 2004, the Company completed a $3.25 million subordinated unsecured note financing (“Unsecured Notes”). The Unsecured Notes mature between April 2009 and September 2009, bear interest at 10% per annum and are callable by the Company after two years at 108% of the principal amount. The call premium reduces to 105% after three years and 101% after four years.

6. Liability to be Settled by the Issuance of Company Shares

The liability to be settled by the issuance of Company common shares is comprised of future issuance obligations in connection with the Senior Secured Notes and the GeoStar Acquisition. On March 20, 2006, the six-month anniversary of the September 19, 2005 $10.0 million Senior Secured Notes issuance, the Company issued to the note holders an additional 152,299 common shares valued at $606,000 (CDN$714,286). On March 31, 2006, the Company issued 548,128 common shares to GeoStar valued at $2.1 million as part of the final purchase price adjustment in connection with the GeoStar Acquisition. On June 19, 2006, the twelve-month anniversary of the June 17, 2005 $63.0 million Senior Secured Notes issuance, the Company issued to the note holders an additional 1,607,143 common shares valued at $3.6 million (CDN$4.5 million). At June 30, 2006, the liability to be settled is comprised of the remaining twelve-month and eighteen-month Senior Secured Notes anniversary issuances.

7. Interest Expense

The following table summarizes the Company’s interest expense components for the periods indicated:

 

     For the Three Months
Ended June 30,
   For the Six Months
Ended June 30,
     2006    2005    2006    2005
     (in thousands)

Cash and accrued

   $ 2,774    $ 2,584    $ 5,498    $ 4,290

Amortization of deferred financing costs and debt discount

     1,042      2,371      2,077      2,818
                           

Total

   $ 3,816    $ 4,955    $ 7,575    $ 7,108
                           

8. Share Based Compensation

Share-based compensation plan

The Company’s 2002 Stock Option Plan was approved and ratified by the Company’s shareholders in July 2002. It authorizes the Company’s Board of Directors to issue stock options to directors, officers, employees and consultants of the Company and its subsidiaries to purchase a maximum of 25.0 million common shares. Stock option grant expirations vary between five and ten years. Vesting generally occurs over a four-year period at 25% per year. Once exercisable, the employee may purchase common shares of the Company at the market price on the date the option was granted. New common shares are issued in regards to stock option exercises.

 

8


GASTAR EXPLORATION LTD. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

On June 1, 2006, at annual meeting of shareholders, the shareholders approved the 2006 Gastar Long Term Stock Incentive Plan. The 2006 Gastar Long Term Stock Incentive Plan authorizes the Company’s Board of Directors to issue stock options to directors, officers and employees of the Company and its subsidiaries to purchase a maximum of 5.0 million common shares. The contractual life and vesting period for options granted will be determined by the Board of Directors at the time stock options are granted. As of June 30, 2006, no stock options had been granted under the 2006 Gastar Long Term Stock Incentive Plan.

Effective January 1, 2003, the Company adopted the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation”, using the modified prospective application method. In December of 2004, the FASB issued SFAS 123R which addressed the accounting for transactions in which an entity exchanges its equity instruments for goods and services. It also addressed transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. This statement supersedes APB Opinion No. 25 and requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost is recognized over the period during which an employee is required to provide service in exchange for the award – the requisite service period (usually the vesting period). Because the Company had previously adopted SFAS 123 and recorded the fair value of stock options granted after January 1, 2003, SFAS 123R had minimal impact upon adoption effective January 1, 2006.

Determining Fair Value Under SFAS No. 123R

Valuation and Amortization Method . The Company estimates the fair value of share-based awards granted using the Black-Scholes-Merton valuation model. The fair value of all awards is amortized on a straight-line basis over the requisite service periods, which are generally the vesting periods.

Expected Life . The expected life of awards granted represents the period of time that stock options are expected to be outstanding. The Company determines the expected life using the “simplified method” in accordance with Staff Accounting Bulletin No. 107 for all stock options issued with ten-year grant expiration. An expected life of five years was utilized for all stock options with five-year grant expiration.

Expected Volatility . Using the Black-Scholes-Merton valuation model, the Company estimates the volatility of its common shares at the date of grant based on its historical volatility.

Risk-Free Interest Rate . The Company assumes a risk-free interest rate of 5.0% in the Black-Scholes-Merton option valuation model, which approximates the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term equal to the expected life of the award.

Expected Dividend Yield . The Company has not paid any cash dividends on its common shares and does not anticipate paying any cash dividends in the foreseeable future. Consequently, a dividend yield of zero is utilized in the Black-Scholes-Merton valuation model.

Expected Forfeitures . To date the Company has had limited forfeitures and thus has not included expected forfeitures in determining compensation expense.

 

9


GASTAR EXPLORATION LTD. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

The fair value of each option grant is estimated on the date of grant using the Black-Scholes-Merton valuation pricing model. During the first six months of 2006 and 2005, we granted 1,195,000 and 426,000 stock options, respectively. A summary of the weighted average assumptions and results for stock options granted during the six months ended June 30, 2006 and 2005 are as follows:

 

     For the Six Months
Ended June 30,
 
     2006     2005  

Expected life (in years)

     6.5       5.0  

Expected volatility

     42.0 %     42.0 %

Risk-free interest rate

     5.0 %     5.0 %

Expected dividend yield

     0.0 %     0.0 %

Expected forfeiture rate

     0.0 %     0.0 %

Weighted average grant date fair value of stock options granted

   $ 1.80     $ 1.06  

Share Based Compensation

For the three months ended June 30, 2006 and 2005, the Company recorded $772,000 and $748,000, respectively, in stock-based compensation expense for stock options granted using the fair-value method. For the six months ended June 30, 2006 and 2005, the Company recorded $1.3 million and $1.5 million, respectively, in stock-based compensation expense for stock options granted using the fair-value method and $7,500 for director fees waived during the during the first six months of 2006. All stock based compensation costs were expensed and not tax effected as the Company currently records no tax expense.

At June 30, 2006, the Company had unvested stock options to purchase 5,439,500 shares with a weighted average grant date fair value of $1.14. As of June 30, 2006, the Company had approximately $2.3 million of total unrecognized compensation cost related to unvested stock options, which is expected to be amortized over the following periods:

 

     (in thousands)

2006

   $ 875

2007

     981

2008

     364

2009

     100

2010

     13

The table below reflects the pro-forma impact of stock-based compensation on the Company’s net loss and loss per share had the Company applied SFAS No. 123R to stock options granted prior to January 1, 2003 that vested in 2005 and subsequent periods:

 

     For the Three Months
Ended June 30,
   

For the Six Months

Ended June 30,

 
     2006     2005     2006     2005  
     (in thousands, except per share amounts)  

Net loss, as reported

   $ (6,727 )   $ (8,663 )   $ (49,637 )   $ (16,299 )

Cost of compensation expense using fair value (not tax effected)

     (2 )     (274 )     (7 )     (559 )
                                

Net loss, pro forma

   $ (6,729 )   $ (8,937 )   $ (49,644 )   $ (16,858 )

Net loss per share, as reported

   $ (0.04 )   $ (0.07 )   $ (0.30 )   $ (0.14 )

Net loss per share, pro forma

   $ (0.04 )   $ (0.08 )   $ (0.30 )   $ (0.15 )

 

10


GASTAR EXPLORATION LTD. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Stock Option Activity

The following table summarizes the changes and option exercise prices for stock options under the Company’s Stock Option Plan for six months ended June 30, 2006:

 

    

Number of

Shares Under

Option

   

Weighted Average

Exercise Price (1)

   Weighted
Average
Grant Date
Fair Value
per Share
       CDN$    US$   

Stock options outstanding as of December 31, 2005

   17,500,600     3.02    2.04    $ 1.24

Stock options granted

   1,195,000     4.78    4.10    $ 1.80

Stock options exercised (2)

   (2,054,450 )   2.76    1.80    $ 1.43

Stock options cancelled

   (510,000 )   2.80    1.84    $ 1.44
              

Stock options outstanding as of June 30, 2006

   16,131,150     3.17    2.31    $ 1.25
              

Stock options exercisable as of June 30, 2006

   10,691,650     2.87    1.93    $ 1.30
              

(1) Stock option grants are denominated in CDN$. U.S. dollar equivalent was calculated at the exchange rate that existed on the date of grant.
(2) Includes 1,148,814 stock options forfeited due to cashless exercise.

As June 30, 2006, the aggregate intrinsic value of outstanding stock options was $5.4 million, and the remaining weighted average contractual life was 1.9 years. As of June 30, 2006, the aggregate intrinsic value of outstanding exercisable stock options was $5.4 million, and the remaining weighted average contractual life was 0.5 years.

 

     For the Six Months
Ended June 30,
     2006    2005
     (in thousands)

Total fair value of stock options granted

   $ 2,146    $ 449

Total intrinsic value of stock options exercised

   $ 1,221    $ 18,845

The following table summarizes the range of exercise prices for stock options outstanding and exercisable as of June 30, 2006:

 

Exercise Prices

  

Number of Shares

Under Stock Options

    
   Outstanding    Exercisable    Expiration Date

CDN$2.76 ($1.80)

   8,426,400    8,426,400    July 13, 2006

CDN$2.81 ($1.80)

   700,000    700,000    April 26, 2007

CDN$3.70 ($2.75)

   725,000    362,500    April 20, 2009

CDN$3.41 ($2.71)

   4,403,750    1,096,250    August 4, 2009

CDN$4.80 ($3.89)

   10,000    2,500    March 1, 2010

CDN$4.30 ($3.54)

   21,000    5,250    April 4, 2010

CDN$3.50 ($2.84)

   345,000    86,250    June 24, 2010

CDN$3.40 ($2.76)

   50,000    12,500    June 28, 2010

CDN$3.25 ($2.74)

   150,000    —      September 7, 2010

CDN$4.00 ($3.42)

   40,000    —      September 20, 2010

CDN$4.50 ($3.80)

   75,000    —      October 18, 2015

CDN$4.80 ($4.10)

   865,000    —      April 5, 2016

CDN$3.25 ($2.91)

   50,000    —      May 24, 2016

CDN $5.01($4.32)

   270,000    —      January 16, 2016
            
   16,131,500    10,691,650   
            

 

11


GASTAR EXPLORATION LTD. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

9. Loss per Share

In accordance with the provisions of SFAS No. 128, “Earnings per Share”, basic earnings per share is computed on the basis of the weighted average number of common shares outstanding during the periods. Diluted earnings per share is computed based upon the weighted average number of common shares plus the assumed issuance of common shares for all potentially dilutive securities. Diluted amounts are not included in the computation of diluted loss per share, as such would be anti-dilutive.

 

    

For the Three Months

Ended June 30,

   

For the Six Months

Ended June 30,

 
     2006     2005     2006     2005  
     (in thousands, except share and per share amounts)  

Basic and diluted loss per share and shares outstanding:

        

Net loss

   $ (6,727 )   $ (8,663 )   $ (49,637 )   $ (16,299 )

Weighted average common shares outstanding

     166,513,762       117,286,718       165,663,086       115,547,122  

Basic and diluted loss per share

   $ (0.04 )   $ (0.07 )   $ (0.30 )   $ (0.14 )

Common shares excluded from the denominator as anti-dilutive:

        

Stock options

     16,131,150       17,329,600       16,131,150       17,329,600  

Warrants

     2,732,521       4,997,288       2,732,521       4,997,288  

Convertible debentures

     8,964,710       8,964,710       8,964,710       8,964,710  

Liability to be settled by issuance of common shares (1)

     2,237,197       3,760,446       2,237,197       3,760,446  
                                

Total

     30,065,578       35,052,044       30,065,578       35,052,044  
                                

(1) Assumes conversion of liability to be settled by issuance of common shares for the Senior Secured Notes at a June 30, 2006 and 2005 closing price of CDN$2.65 and CDN$3.59, respectively, per common share.

10. Common Stock

On February 3, 2006, the Company issued 21,948 common shares valued at $84,000 upon exercise of warrants at CDN$4.65 per share issued in connection with the sale of the Convertible Senior Debentures.

On March 20, 2006, the Company issued 152,299 common shares valued at $606,000 (CDN$714,286) based upon a five-day weighted average trading price of CDN$4.69 per share upon the six-month anniversary of the private placement of $10.0 million Senior Secured Notes.

On March 31, 2006, in connection with Gastar’s June 2005 purchase of the GeoStar Acquisition properties, the Company issued to GeoStar as part of the final purchase price adjustment 548,128 common shares valued at CDN$4.50 per share, or $2.1 million.

During the six months ended June 30, 2006, pursuant to the Company’s Stock Option Plan, the Company issued 905,636 commons shares in connection with the cashless exercise of stock options.

On June 19, 2006, the Company issued 1,607,143 common shares valued at $3.6 million (CDN$4.5 million) based upon the a five-day weighted average trading price of CDN$2.80 per share upon the one year anniversary of the private placement of $63.0 million Senior Secured Notes.

11. Warrants

In February 2006, the Company issued 21,948 common shares upon exercise of warrants related to the Convertible Senior Debentures. In May 2006 the remaining 237,792 of Convertible Subordinated Debenture warrants expired, resulting in total warrants outstanding at June 30, 2006 of 2,732,521.

 

12


GASTAR EXPLORATION LTD. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

12. Commitments and Contingencies

Litigation

The Company is party to various litigation matters arising out of the normal course of business. The ultimate outcome of each of these matters cannot presently be determined, nor can the liability that could potentially result from an adverse outcome be reasonably estimated at this time. The Company does not expect that the outcome of these proceedings will have a material adverse effect on its financial position or results of operations. The more significant litigation matters are summarized below.

Estate of Virgil Sparks and Oil Wells of Kentucky, Inc. vs. First Sourcenergy Group Inc. and Geostar Corporation Arbitration . In August 2002, FSG, a wholly owned Company subsidiary, was a named party to this arbitration proceeding. The dispute involves historical dealings with the development of an Authority to Prospect (“ATP”) Area in Queensland, Australia, as well as an ancillary agreement. The formal arbitration is in discovery stages. FSG and GeoStar have moved to dismiss the arbitration on the grounds of a claimed prior settlement and release agreement. FSG and GeoStar are vigorously defending the arbitration, and firmly believe that its position is sound and intends to continue to defend vigorously against the claim. Further, FSG’s interest in ATP 560 were transferred from FSG to a third party in 2001, the result of which means that, although FSG is a named defendant, the third party and GeoStar would bear primary liability from this arbitration action.

Western Gas Resources, Lance Oil and Gas Company, Inc. and Williams Production RMT Company vs. First Sourcenergy Wyoming, Inc. and First Sourcenergy Group, Inc. On May 3, 2005, FSW and FSG, both wholly owned Company subsidiaries, were party to a complaint concerning a June 2002 Lease Exchange and Purchase Agreement between certain of the parties. The issue involves a certain natural gas gathering agreement and its applicability to some of the properties exchanged under the June 2002 Agreement. A formal response to the complaint was filed in June 2005. Discovery on this matter is currently underway and trial is scheduled to commence in September 2006. After evaluation of potential exposure and legal preparation and trial costs, the Company elected to settle this matter by cash payment of $1.2 million. Settlement documents and payment are anticipated to be completed by the end of August 2006.

Navasota Resources L.P. vs. First Source Texas, Inc., First Source Gas L.P. and Gastar Exploration Ltd. (Cause No. 0-05-451) District Court of Leon County, Texas 12 th Judicial District. This lawsuit contends that the Company breached Navasota’s preferential right to purchase 33.33% of the Company’s interest in certain natural gas and oil leases located in Leon and Robertson Counties sold to Chesapeake Energy Corporation pursuant to a transaction closed November 4, 2005. The preferential right claimed is under an operating agreement dated July 7, 2000. The Company contends, among other things, that Navasota neither properly nor timely exercised any preferential right election it may have had with respect to the inter-dependent Chesapeake transaction. In July 2006, the District Court of Leon County, Texas issued a summary judgment in favor of the Company and Chesapeake. Navasota has filed an appeal of the summary judgment ruling. The Company intends to continue to vigorously defend against this claim.

Gastar Exploration Texas L P vs. John E. McFarlane, et al (Cause No. 0-06-161) 87 th Judicial District Court of Leon County, Texas. This suit is one to quiet title to minerals under an oil and gas lease dated December 4, 2003 covering approximately 2,598 gross acres (“Lease”). John E. McFarlane, and certain other family members, contend that minerals subject to the Estate of Fay Watson McFarlane are not subject to the Lease. The Company claims that said minerals are in fact subject to the Lease. The existence of unleased mineral interests in this Lease could adversely impact future development of the Lease. The Company will continue to vigorously pursue this claim.

 

13


GASTAR EXPLORATION LTD. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Burning Rock Energy, LLC, et al vs. First Sourcenergy Wyoming, Inc. (now Gastar Exploration USA, Inc.), et al. Burning Rock contends in this 2006 lawsuit that Gastar and the operator of certain Wyoming properties were obligated under a January 1, 2004 Exchange Agreement to make lease maintenance payments on certain leases to be assigned to Burning Rock under the Exchange Agreement. The case is in the discovery phase and the Company intends to vigorously defend against the claim.

Commitments

In March 2006, the Company entered into an agreement with a drilling contractor to provide contracted drilling services in the Hilltop Area of East Texas for a three year period at agreed upon day rates. The Company made an initial payment of $1.0 million upon execution of the agreement and is required to make a second advance payment of $1.0 million upon rig delivery, which is anticipated prior to year end 2006. The advance payments will be amortized over the three-year term of the agreement. The Company is required to pay the drilling contractor a minimum of $6.3 million per year in drilling day rate fees, net of the amortization of the advance payments, during the term of the agreement.

Future Share Issuances

Pursuant to the GeoStar Acquisition, GeoStar may receive additional common shares based on look-backs at June 30, 2006 and June 30, 2007 on the East Texas assets, based on a required number of drilled wells, and net reserve additions valued at $1.50 per Mcf less attributable development expenditures to GeoStar’s acquired interest. The look-back calculations are to be based on a third party engineering report and calculated within 60 days of receipt of the engineering report. Common shares to be issued, if any, are to be based on the five day weighted average trading price on the day preceding the actual payment of shares, discounted by ten percent.

13. Supplemental Disclosure of Cash Flow Information

Non-cash transactions have been disclosed in Notes 2, 5, 6, 8 and 10.

14. Differences between Canadian and U.S. Generally Accepted Accounting Principles

The Condensed Consolidated Financial Statements have been prepared in accordance with US GAAP. United States principles differ from Canadian principles as follows:

Reconciliation of Net Loss under US GAAP to Canadian GAAP

 

     For the Three Months
Ended June 30,
    For the Six Months
Ended June 30,
 
     2006     2005     2006     2005  
     (in thousands, except per share amounts)  

Net loss in accordance with U.S. principles

   $ (6,727 )   $ (8,663 )   $ (49,637 )   $ (16,299 )

Impact of Canadian principles:

        

Depreciation, depletion and amortization (1)(4)

     (1,495 )     (531 )     (1,924 )     (940 )

Natural gas and oil impairment (4)

     —         4,287       37,301       8,698  

Mineral resource properties (3)

     33       6       190       34  

Accretion expense on convertible notes (2)

     (14 )     (14 )     (28 )     (28 )

Amortization expense - deferred charges (5)(6)

     (770 )     (1,616 )     (1,533 )     (1,776 )

Interest - debt discount (5)(6)

     770       1,616       1,533       1,776  
                                

Net adjustments

     (1,476 )     3,748       35,539       7,764  
                                

Net loss in accordance with Canadian principles

   $ (8,203 )   $ (4,915 )   $ (14,098 )   $ (8,535 )
                                

Loss per common share in accordance with Canadian principles: Basic and diluted

   $ (0.05 )   $ (0.04 )   $ (0.09 )   $ (0.07 )
                                

 

14


GASTAR EXPLORATION LTD. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Condensed Consolidated Statements of Operations – Canadian GAAP

 

    

For the Three Months

Ended June 30,

   

For the Six Months

Ended June 30,

 
     2006     2005     2006     2005  
     (in thousands, except per share and share amounts)  

REVENUES

   $ 6,684     $ 4,943     $ 13,307     $ 9,674  

EXPENSES:

        

Lease operating, transportation and selling expenses

     2,128       477       4,088       1,792  

Depreciation, depletion and amortization (4)

     5,060       2,806       9,798       5,905  

Accretion on asset retirement obligation

     57       24       114       43  

General and administrative expenses

     3,107       1,772       5,626       3,537  
                                

LOSS FROM OPERATIONS

     (3,668 )     (136 )     (6,319 )     (1,603 )

Interest expense (5)(6)

     (3,830 )     (4,969 )     (7,603 )     (7,136 )

Investment income

     492       22       1,020       62  

Litigation settlement expense

     (1,200 )     —         (1,200 )     —    

Foreign exchange gain

     3       168       4       142  
                                

LOSS BEFORE INCOME TAX

     (8,203 )     (4,915 )     (14,098 )     (8,535 )

Provision for income taxes (7)

     —         —         —         —    
                                

NET LOSS

   $ (8,203 )   $ (4,915 )   $ (14,098 )   $ (8,535 )
                                

NET LOSS PER SHARE:

        

Basic and diluted

   $ (0.05 )   $ (0.04 )   $ (0.09 )   $ (0.07 )
                                

WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:

        

Basic and diluted

     166,513,762       117,286,718       165,663,086       115,547,122  
                                

 

15


GASTAR EXPLORATION LTD. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Condensed Consolidated Balance Sheets (US GAAP and Canadian GAAP)

 

     As of June 30, 2006    As of December 31. 2005
     U.S.
GAAP
   Canadian
GAAP
   U.S.
GAAP
   Canadian
GAAP
     (in thousands)
ASSETS            

Current assets

   $ 47,239    $ 47,239    $ 69,468    $ 69,468

Deferred charges (5)(6)

     4,192      18,278      4,922      20,541

Cash call receivable

     4,515      4,515      391      391

Property and equipment, net (1) (3) (4)

     146,852      196,230      165,347      179,158
                           

Total assets

   $ 202,798    $ 266,262    $ 240,128    $ 269,558
                           
LIABILITIES AND SHAREHOLDERS’ EQUITY            

Current liabilities

   $ 23,194    $ 23,194    $ 13,942    $ 13,942

Senior secured notes (6)

     59,055      73,000      57,546      73,000

Subordinated, unsecured notes payable (5)

     3,109      3,250      3,085      3,250

Convertible senior debentures (2)

     30,000      29,810      30,000      29,782

Asset retirement obligation

     3,766      3,766      3,558      3,558

Liability to be settled by issuance of common shares

     4,855      4,855      11,221      11,221

Shareholders’ equity (2)

     78,819      128,387      120,776      134,805
                           

Total liabilities and shareholders’ equity

   $ 202,798    $ 266,262    $ 240,128    $ 269,558
                           

Reconciliation of Shareholders’ Equity under US GAAP to Canadian GAAP:

 

     As of June 30,
2006
   As of December 31,
2005
     (in thousands)

Shareholders’ equity, in accordance with U.S. principles

   $ 78,819    $ 120,776

Convertible notes, beneficial conversion feature (2)

     190      218

Mineral resource properties (3)

     331      141

Natural gas and oil properties (1)(4)

     49,047      13,670
             

Shareholders’ equity, in accordance with Canadian principles

   $ 128,387    $ 134,805
             

(1) In accordance with U.S. principles, the Company recognizes revenue and expenses on the statement of operations without regard to levels of commercial production and calculated and reported depletion on the income statement. For Canadian principles, since the Company had not reached commercial levels of production, it was considered to be in the pre-production stage. While in the pre-production stage, the Company netted their natural gas and oil revenue and lease operating expenses against natural gas and oil properties on the balance sheet and did not record depletion on their natural gas and oil properties. The Company was in the pre-production stage until June 30, 2002.
(2) In accordance with U.S. principles, the amount of Convertible Senior Debentures is recognized as debt and is offset by the value attributable to the beneficial conversion feature. The value of the warrants attached to debt as well as the value of the conversion feature of the convertible debt is recognized as paid-in capital in Shareholders’ Equity. The amortization of the beneficial conversion feature is amortized over the term of the related convertible notes. For Canadian principles, these convertible notes are considered to be compound financial instruments and the liability component and the equity component must be presented separately as determined at initial recognition.
(3) In accordance with U.S. principles, expenditures on mineral resource properties are expensed. For Canadian principles, the Company capitalizes expenditures on mineral resource properties.
(4) In accordance with U.S. principles, a ceiling test is applied to ensure the unamortized capitalized costs in each cost center do not exceed the sum of the present value, discounted at 10 percent, of the estimated unescalated future net operating revenue from proved reserves plus unimpaired unproved property costs less future development costs, related production costs, abandonment and reclamation costs and applicable taxes, as

 

16


GASTAR EXPLORATION LTD. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

determined by independent engineers. For Canadian principles, the Company adopted the new Canadian guideline AcG-16 in 2003, in which a similar ceiling test calculation is performed with the exception that cash flows from proved reserves are undiscounted and utilize forecast pricing, based on sales prices achievable under existing contracts and posted average reference prices in effect between the end of the year and the finalization of the year end audit and current costs to determine whether impairment exists. Any impairment amount is measured using the fair value of proved and probable reserves. Unproved properties are tested separately for impairment.

In computing its consolidated net loss for US GAAP purposes, the Company recorded a write down of properties in 2000, 2001, 2002, 2003, 2004, 2005 and 2006 as a result of the application of the US GAAP ceiling test. For Canadian principles, the Company recorded a write down in 2002 and 2003 only. Therefore, the depletion base of unamortized capitalized costs is less for US GAAP purposes.

Effective January 1, 2004, the Canadian Accounting Standard’s Board amended the Full Cost Accounting Guideline. Under Canadian GAAP, depletion charges are calculated by reference to proved reserves estimated using estimated future prices and costs. Under US GAAP, depletion charges are calculated by reference to proved reserves estimated using constant prices.

 

(5) For U.S. principles, the value of the warrants is allocated based on relative fair values and is netted against the debt and is amortized as interest expense. For Canadian principles, the fair value of the warrants are recorded as a deferred charge and amortized over the life of the note.
(6) In accordance with U.S. principles, debt discount is netted against the debt and not deferred as a financing cost. The debt discount is amortized as interest expense using the interest method. For Canadian principles, the fair value of the debt discount is recorded as a deferred charge and amortized over the life of the note.
(7) There are no tax effects as the Company currently is not taxable and a valuation allowance has been recorded for the balance of the deferred tax assets.

 

17


Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with accompanying condensed consolidated financial statements and related notes included elsewhere in this Form 10-Q. It contains forward looking statements that reflect our future plans, estimates, beliefs and expected performance. The forward looking statements are dependent upon events, risks and uncertainties that may be outside our control. Our actual results could differ materially from those discussed in these forward looking statements. Factors that could cause or contribute to such differences include, but are not limited to, market prices for natural gas and oil, economic and competitive conditions, regulatory changes, estimates of proved reserves, potential failure to achieve production from development projects, capital expenditures and other uncertainties, as well as those factors discussed below in this Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2005, particularly in “Risk Factors” and “Cautionary Notes Regarding Forward Looking Statements”, all of which are difficult to predict. In light of these risks, uncertainties and assumptions, the forward looking events discussed may not occur.

Overview

We are an independent energy company engaged in the exploration, development and production of natural gas and oil in the United States and Australia. Our principal business activities include the identification, acquisition, and subsequent exploration and development of natural gas and oil properties. Our emphasis is on prospective deep structures identified through seismic and other analytical techniques as well as unconventional natural gas reserves, such as coal bed methane, or CBM. We currently are pursuing conventional natural gas exploration in the Deep Bossier play in the Hilltop area in East Texas and the Appalachian Basin in West Virginia. Our primary CBM properties are in the United States in the Powder River Basin and in the Gunnedah and Gippsland Basins of Australia.

Recent Activities

Hilltop Area, East Texas

During the six months ended June 30, 2006, we continued our exploratory drilling program in the Hilltop area of East Texas. In January 2006, we placed the Donelson #1 (100% working interest) and #2 (100% working interest) wells on production. The Donelson #1 is producing from the lower Bossier formation, while the Donelson #2 was initially completed in the Knowles formation. In May 2006, the Donelson #2 was dually completed in the Pettet formation, significantly increasing the well’s oil and natural gas and oil production. In January 2006 drilling commenced on the Wildman Trust #1 (67% working interest) and the well was ultimately completed in the middle and upper Bossier formations in May 2006.

Also in May 2006, we added an additional rig in East Texas and commenced drilling the Wildman Trust #2 (56% before casing point, 67% after casing point working interest) and the John Parker #1 (42% before casing point, 50% after casing point) wells. The Wildman Trust #2 well, located in the Hilltop area, is targeted to test the upper, middle and lower Bossier formations with a projected total depth of approximately 19,200 feet. Total well depth is anticipated to be reached in September 2006. The John Parker #1 well is located on the northwestern portion of our leasehold position and is in a structural position projected to be similar to recent successful wells drilled in close proximity by other operators. This well is targeted to test the middle Bossier formation with a projected total depth of approximately 17,500 feet. Total depth is anticipated to be reached in late August 2006.

Our operational plans for the deep Bossier play for the remainder of 2006 include the drilling of at least two additional deep Bossier wells following the John Parker #1 and the Wildman Trust #2 wells and the possible addition of a third rig in the fourth quarter of 2006. We also are participating in a large scale 3-D seismic survey that will cover the majority of our acreage position in the Hilltop area. The 3-D seismic data should be available for processing during the first quarter of 2007.

Sabine Island, Orange County, Texas

In May 2006, we commenced drilling on the Odom #1well (33% before casing point, 25% after casing point working interest) located in Orange County, Texas. This 3-D seismic based non-operated exploratory well is targeting the Yegua formation. The well is anticipated to reach the targeted depth during the third quarter of 2006.

 

18


PEL 238, Gunnedah Basin, New South Wales, Australia.

We have a 35% interest in PEL 238, a CBM property covering approximately 2.0 million gross acres (700,000 net acres), located in the Gunnedah Basin of New South Wales approximately 250 miles northwest of Sydney, Australia. During the six months ended June 30, 2006, the operator drilled eight new vertical coal seam natural gas wells on approximately 40 acre spacing in close proximity to an existing well within the Bohena Project Area. The new wells will be perforated in the Bohena coal seam and then hydraulically fracture stimulated before being placed into test production during the fourth quarter. The closely spaced “nine-spot” production pilot is designed to accelerate dewatering of the thick Bohena coal seam and to achieve commercial natural gas production rates in a shorter period than would be possible for an isolated well or for wells drilled on wider spacing. A pressure monitoring well was drilled approximately 2.2 kilometers (1.4 miles) north of the existing wells in 2006 to assist in determining the extent of in-seam permeability communication in the Bohena coal seam.

EL 4416, Gippsland Basin, Victoria, Australia

We have a 75% interest in the CBM rights in EL 4416, an approximate 1.0 million gross acre property (750,000 net acres), covering a substantial portion of the onshore Gippsland Basin. The property is located east of Melbourne in the State of Victoria, Australia. During the second quarter of 2006 we began initial long-term testing of the first of two wells completed on EL 4416. Early water production has been significant, indicating permeability in the targeted coal seam. Current plans are to increase the downhole pump capacity to accelerate the dewatering process. Drilling of additional wells is anticipated to commence by early 2007 to evaluate the viability of commercial CBM production from this property.

Results of Operations

The following is a comparative discussion of the results of operations for the three and six months ended June 30, 2006 and 2005. It should be read in conjunction with the condensed consolidated financial statements and the related notes and other information included elsewhere in this Form 10-Q.

Three Months Ended June 30, 2006 Compared to the Three Months Ended June 30, 2005.

Net loss. We reported a net loss attributable to common shares for the three months ended June 30, 2006 of $6.7 million, compared to a net loss of $8.7 million for the three months ended June 30, 2005. The net loss for 2006 includes a litigation settlement expense of $1.2 million. The net loss for 2005 includes an impairment of natural gas and oil properties of $4.3 million.

Revenues. Substantially all of our revenues are derived from the production of natural gas in the United States. We reported revenues of $6.7 million for the three months ended June 30, 2006, up from $4.9 million for the comparable period in 2005. The 35% increase in revenues was primarily attributable to a 58% increase in production resulting from the June 2005 GeoStar Acquisition, commencement of production of natural gas from several new wells in East Texas in 2005 and 2006 and an increase, effective June 1, 2006, in our Wyoming properties net revenue interest as a result of a joint venture payout. The increase in production was partially offset by a 15% decline in natural gas prices.

 

19


Natural Gas and Oil Production and Average Sales Prices. Natural gas represents substantially all of our production. The table below sets forth production and sales information for the periods indicated:

 

     For the Three Months
Ended June 30,
     2006    2005

Production:

     

Natural gas (MMcf)

     1,182.8      757.4

Oil (MBbls)

     2.8      0.5

Total (MMcfe)

     1,199.3      760.4

MMcfe per day

     13.2      8.4

Average sales prices:

     

Natural gas (per Mcf)

   $ 5.49    $ 6.50

Oil (per Bbl)

   $ 67.29    $ 49.03

Lease operating, transportation and selling. We reported expenses for lease operating, transportation and selling of $2.1 million for the three months ended June 30, 2006, up from $477,000 for the comparable period in 2005. This increase was attributable to higher production volumes and the inclusion of a severance tax refund benefit in 2005 of $350,000. Our lease operating expense per Mcfe increased to $1.77 per Mcfe during the three months ended June 30, 2006 from $1.09 per Mcfe for the comparable period in 2005, excluding the 2005 severance tax refund benefit. The increase in per Mcfe cost primarily was the result of additional fixed costs associated with natural gas treatment plants in East Texas and an increase in the number of producing wells.

Depletion, depreciation and amortization. We reported depletion, depreciation and amortization (“DD&A”) of $3.6 million for the three months ended June 30, 2006, up from $2.3 million for the comparable period in 2005. The DD&A increase primarily due to higher production volumes. The DD&A rate for the three months ended June 30, 2006 was $2.97 per Mcfe, compared $2.99 per Mcfe for the three months ended June 30, 2005.

Impairment of natural gas and oil properties. The weighted average natural gas price utilized for the June 30, 2006 ceiling impairment evaluation was $6.60 per Mcf, held constant, and resulted in a ceiling cushion of natural gas and oil properties of $26.7 million. For the three months ended June 30, 2005, we reported a $4.3 million impairment of natural gas and oil properties, primarily as a result of lower natural gas prices. The impairment of natural gas and oil properties for the three months ended June 30, 2005 was based on a weighted average natural gas price of $5.32 per Mcf, held constant.

Interest and debt related items. We reported interest expense of $3.8 million for the three months ended June 30, 2006, down from $5.0 million for the comparable period in 2005. In June 2005, as a condition to the issuance of the senior secured notes, the 15% senior notes were called and repaid in full resulting in 2005 interest expense including a call premium of $662,000 and expensing of unamortized deferred costs of $630,000.

General and administrative expenses. We reported general and administrative expenses of $3.1 million for the three months ended June 30, 2006, up from $1.8 million for the comparable period in 2005. The increase in general and administrative expenses was primarily due to a higher level of permanent and contract staff and professional service charges. Included in current quarter general and administrative expenses is approximately $345,000 of professional fees related to the proposed Gippsland Basin Victoria, Australia brown coal acquisition that was ultimately canceled.

Investment income and other. We reported $492,000 in investment income and other for the three months ended June 30, 2006, up from $22,000 for the comparable period in 2005. This increase was due to investment income earned on the cash balances from the proceeds received as a result of the issuance of common shares in November 2005.

Litigation settlement expense. Represents 2006 settlement cost to be incurred in conjunction with the Western Gas Resources, et al litigation matter.

 

20


Six Months Ended June 30, 2006 Compared to the Six Months Ended June 30, 2005.

Net loss. We reported a net loss attributable to common shares for the six months ended June 30, 2006 of $49.6 million, compared to a net loss of $16.3 million for the six months ended June 30, 2005. The net losses for 2006 and 2005 include impairment of natural gas and oil properties of $37.3 million and $8.7 million, respectively. The net loss for 2006 also includes a litigation settlement expense of $1.2 million.

Revenues. Substantially all of our revenues are derived from the production of natural gas in the United States. We reported revenues of $13.3 million for the six months ended June 30, 2006, up from $9.7 million for the comparable period in 2005. The increase in revenues was primarily attributable to a 36% increase in production resulting from the June 2005 GeoStar Acquisition, the commencement of production of natural gas from new wells in East Texas in 2005 and 2006 and an increase in Wyoming production from new CBM wells drilled in the Powder River Basin and effective June 1, 2006 an increase in the company’s Wyoming net revenue interest as a result of a joint venture payout. Of the increase in revenues, 96% was attributed to higher production rates and 4% resulted from natural gas and oil price increases.

Natural Gas and Oil Production and Average Sales Prices. Natural gas represents substantially all of our production. The table below sets forth production and sales information for the periods indicated:

 

     For the Six Months
Ended June 30,
     2006    2005

Production:

     

Natural gas (MMcf)

     2,176.2      1,606.4

Oil (MBbls)

     3.0      1.2

Total (MMcfe)

     2,194.2      1,613.6

MMcfe per day

     12.1      8.9

Average sales prices:

     

Natural gas (per Mcf)

   $ 6.02    $ 5.99

Oil (per Bbl)

   $ 66.87    $ 47.09

Lease operating, transportation and selling. We reported expenses for lease operating, transportation and selling of $4.1 million for the six months ended June 30, 2006, up from $1.8 million for the comparable period in 2005. This increase was attributable to higher production volumes and the inclusion of a severance tax refund benefit in 2005 of $350,000. Our lease operating expense per Mcfe increased to $1.86 per Mcfe during the first six months of 2006, up from $1.33 per Mcfe for the comparable period in 2005, excluding the severance tax refund benefit. The increase in per Mcfe cost primarily was the result of additional fixed costs associated with natural gas treatment plants in East Texas and an increase in the number of producing wells.

Depletion, depreciation and amortization. We reported depletion, depreciation and amortization (“DD&A”) of $7.9 million for the six months ended June 30, 2006, up from $5.0 million for the comparable period in 2004. DD&A increased primarily due to higher production rates and a higher DD&A rate per unit. Of the increase in DD&A expense, 61% was attributed to higher production rates and 39% was due to an increase in DD&A rate per unit. The DD&A rate for the six months ended June 30, 2006 was $3.59 per Mcfe, compared $3.08 per Mcfe for the six months ended June 30, 2005.

Impairment of natural gas and oil properties. We reported a non-cash ceiling test impairment of natural gas and oil properties for the six months ended June 30, 2006 of $37.3 million, up from the $8.7 million reported for the comparable period in 2005. The impairment was the result of a decline in natural gas prices from year end 2005, together with limited first quarter drilling results in East Texas and the related lag in reserve recognition. At March 31, 2006, the weighted average natural gas price utilized for ceiling impairment was $5.79 per Mcf, held constant, a 22% decline from year end 2005 comparable price of $7.39 per Mcf. The weighted average natural gas price utilized for the June 30, 2006 ceiling impairment evaluation was $6.60 per Mcf, held constant, and resulted in a ceiling cushion of natural gas and oil properties of $26.7 million. The impairment of natural gas and oil properties for the six months ended June 30, 2005 of $8.7 million was based on a weighted average natural gas price of $5.32 per Mcf, held constant.

 

21


Interest and debt related items. We reported interest expense of $7.6 million for the six months ended June 30, 2006, up from $7.1 million for the comparable period in 2005. This increase was due to an increase in debt outstanding as a result of the issuance of $73.0 million of senior secured notes in June and December 2005, which was partially offset by the repayment of $25.0 million senior notes in June 2005. In June 2005, as a condition to the issuance of the senior secured notes, the 15% senior notes were called and repaid in full resulting in 2005 interest expense including a call premium of $662,000 and expensing of unamortized deferred costs of $667,000.

General and administrative expenses. We reported general and administrative expenses of $5.6 million for the six months ended June 30, 2006, up from $3.5 million for the comparable period in 2005. The increase in general and administrative expenses was primarily due to a higher level of permanent and contract staff and professional service charges. Included in the six months ended June 30, 2006 general and administrative expenses is approximately $345,000 of professional fees related to the proposed Gippsland Basin Victoria, Australia brown coal acquisition that was ultimately canceled.

Investment income and other. We reported $1.0 million in investment income and other for the six months ended June 30, 2006, up from $62,000 for the comparable period in 2005. This increase was due to investment income earned on the cash balances from the proceeds received as a result of the issuance of common shares in November 2005.

Litigation settlement expense. Represents 2006 settlement cost to be incurred in conjunction with the Western Gas Resources, et al litigation matter.

Liquidity and Capital Resources

For the six months ended June 30, 2006, we reported positive cash flow from operations of $8.4 million. Capital expenditures on natural gas and oil properties totaled $26.4 million during the period. At June 30, 2006, approximately $38.9 million remained in available cash and cash equivalents for future capital expenditures as well as other corporate purposes.

Pursuant to the terms of our senior secured notes, we have the right, exercisable quarterly to June 16, 2007, to require the original purchasers of the senior secured notes to purchase additional notes in an amount limited to an aggregate of $10.0 million in principal, provided that we comply with proved plus probable reserve present value discounted at 10%, or PV(10), to net senior secured debt coverage ratio of 2.0:1 and other general covenants and conditions. The PV(10) value is to be based on a third party independent reserve report utilizing constant pricing based on the lower of current natural gas and oil prices, adjusted for area basis differentials, or $6.00 per Mcf of natural gas and $40.00 per barrel of oil. Utilizing the same reserve pricing criteria above, the proved plus probable reserves PV(10) (“2P PV(10)”) to net senior secured notes debt reserve maintenance ratio covenant must be a minimum of 1.5:1 from date of issuance of the notes up to the day immediately preceding the first anniversary date. On the first anniversary date of the senior secured notes, the 2P PV(10) reserve ratio maintenance covenant increased to a minimum of 2.5:1 and will increase on the second anniversary to 3.0:1 and on the third anniversary and for all test periods thereafter until maturity to 3.5:1. Utilizing the same reserve pricing criteria above, the proved reserves PV(10) (“1P PV(10)”) to net senior secured notes debt reserve maintenance ratio covenant must be a minimum of 1.0:1 from date of issuance of the notes up to the day immediately preceding the second anniversary date. On the second anniversary date of the senior secured notes, the 1P PV(10) reserve ratio maintenance covenant increases to a minimum of 1.5:1 and on the third anniversary and for all test periods thereafter until maturity to 2.0:1. We must maintain compliance with the reserve ratio covenants at all future quarterly and annual covenant determination dates or be subject to mandatory principal redemptions under certain conditions. The senior secured notes prohibit us from issuing any debt senior or pari passu to the senior secured notes and may limit our ability to borrow subordinated funds and payment of dividends.

We continually evaluate our capital needs and compare them to our capital resources. To execute our operational plans, particularly our drilling plans in East Texas, additional funds will be needed for acreage

 

22


acquisition, seismic and other geologic analysis, drilling, undertaking completion activities and for general corporate purposes. We may have to significantly reduce our drilling and development program if our internally generated cash flow from operations and cash flow from financing activities are not sufficient to pay debt service, corporate overhead and expenditures associated with our projected drilling and development activities. We expect to fund these expenditures from internally generated cash flow, cash on hand, the issuance of additional senior secured notes or the issuance of additional equity. We may also attempt to balance future capital expenditures through joint venture development of certain properties with industry partners. We are in the early stages of exploration and development of our East Texas properties. Amounts and timing of future cash flows is dependent on confirmation of production from recently completed wells, together with the success of currently drilling and future wells to be drilled. We cannot be certain that future funds will be available to fully execute our current business plan.

Our capital expenditures in the next 12 months under our current business plan are estimated to total approximately $79.0 million, of which $68.3 million is estimated to be spent on conventional natural gas and oil exploration and development operations, $4.5 million is estimated to be spent on CBM projects in the United States and $6.2 million is estimated to be spent on CBM projects in Australia. Given the forecast for natural gas and oil prices, cash on hand and projected production volume increases, we believe that approximately $30 million of additional financing will be necessary to execute our business and operational plans over the next 12 months. The additional financing funds will most likely include the issuance of additional equity and additional senior secured notes.

We are highly dependent upon natural gas pricing. A material decrease in current and projected natural gas prices could impact our ability to fund future activities, impair our ability to raise additional capital on acceptable terms and result in a financial covenant default under the senior secured notes, resulting in mandatory principal reduction under certain conditions.

We currently have no natural gas price financial instruments or hedges in place. Our natural gas marketing contracts use “spot” market prices. We may enter into long-term fixed-price natural gas contracts, swap or hedge positions, other gas financial instruments or financial derivatives later in 2006. A senior secured notes covenant restricts us from hedging more than 50% of future production.

As of June 30, 2006, we were in compliance with all debt covenants.

Off-Balance Sheet Arrangements

As of June 30, 2006, we had no off-balance sheet arrangements. We have no plans to enter into any off-balance sheet arrangements in the foreseeable future.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses, contingent assets and liabilities and the related disclosures in the accompanying condensed consolidated financial statements. Changes in these estimates and assumptions could materially affect our financial position, results of operations or cash flows. Management considers an accounting estimate to be critical if:

 

    It requires assumptions to be made that were uncertain at the time the estimate was made; and

 

    Changes in the estimate or different estimates that could have been selected could have a material impact on our consolidated results of operations or financial condition.

Significant accounting policies that we employ and information about the nature of our most critical accounting estimates, our assumptions or approach used and the effects of hypothetical changes in the material assumptions used to develop each estimate are presented in our Annual Report of Form 10-K for the year ended December 31, 2005.

 

23


Item 3. Quantitative and Qualitative Disclosure about Market Risk

Commodity Risk

Our major commodity price risk exposure is to the prices received for our natural gas production. Realized commodity prices received for our production are the spot prices applicable to natural gas in the region produced. Prices received for natural gas are volatile and unpredictable and are beyond our control. For the six months ended June 30, 2006, a 10% change in the prices received for natural gas production would have had an approximate $1.3 million impact on our revenues. To date, we have not entered into hedge transactions to mitigate our commodity pricing risk.

Interest Rate Risk

The carrying value of our debt approximates fair value. At June 30, 2006, we had approximately $106.3 million in principal amount of long-term debt of which $73.0 million of the senior secured notes was subject to a floating interest rate of LIBOR plus 6%. Our convertible senior debentures and subordinated unsecured notes payable are fixed debt rate, but the interest rates are not materially different than current prevailing market rates and, as such, their carrying value approximates fair value. A 10% fluctuation in interest rates would have an approximate $838,000 impact on annual interest expense.

Currency Translation Risk

Because our revenues and expenses are primarily in U.S. dollars, we have little exposure to currency translation risk, and, therefore, we have no plans in the foreseeable future to implement hedges or financial instruments to manage international currency changes.

Item 4. Controls and Procedures

Management’s Conclusion on the Effectiveness of Disclosure Controls and Procedures

Our Chief Executive Officer and the Chief Financial Officer performed an evaluation of our disclosure controls and procedures. As defined in Exchange Act Rule 13a-15(e) and 15d-15(e), disclosure controls and procedures are designed to ensure that information required to be disclosed by us in reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2006 at a reasonable assurance level. While our disclosure controls and procedures provide reasonable assurance that the appropriate information will be available on timely basis, this assurance is subject to limitations inherent in any control system, no matter how well it may be designed or administered.

Changes in Internal Control over Financial Reporting

There was no change in our internal control over financial reporting during the quarter ended June 30, 2006, that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

24


PART II – OTHER INFORMATION

Item 1. Legal Proceedings

All current legal proceedings are set forth in Note 12 of the Notes to Condensed Consolidated Financial Statements for the six months ended June 30, 2006, included herein.

Item 1A. Risk Factors

In addition to other information set forth in this report, you should carefully consider the factors discussed in Part I, Item 7, under the heading “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2005, which could materially affect our business, financial condition and future results. The risks described in our Annual Report on Form 10-K are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

On February 3, 2006, the Company issued 21,948 common shares valued at $84,000 upon exercise of warrants at CDN$4.65 per share issued in connection with the sale of the Convertible Senior Debentures.

On March 20, 2006, the six-month anniversary of the September 19, 2005 $10.0 million Senior Secured Notes issuance, the Company issued to the note holders an additional 152,299 common shares valued at $606,000 (CDN$714,286).

On March 31, 2006, in connection with Gastar’s purchase of the GeoStar Acquisition Properties in June 2005, the Company issued to GeoStar as part of the final purchase price adjustment 548,128 common shares valued at CDN$4.50 per share, or $2.1 million. The issuance of the shares and unsecured subordinated notes to GeoStar was exempt from registration pursuant to Section 4(2) under the Securities Act.

During the six months ended June 30, 2006, pursuant to the Company’s Stock Option Plan, the Company issued 905,636 commons shares in connection with the cashless exercise of stock options.

On June 19, 2006, the twelve-month anniversary of the June 17, 2005 $63.0 million Senior Secured Notes issuance, the Company issued to the note holders an additional 1,607,143 common shares valued at $3.6 million (CDN$4.5 million).

Item 3. Default Upon Senior Securities

None

 

25


Item 4. Submission of Matters to a Vote of Security Holders

On June 1, 2006, we held our annual meeting of shareholders. At the annual meeting, there were 166,302,278 common share entitled to vote attending by person or by proxy. The following matters were voted upon and passed:

 

  1. To fix the board of directors of the Company at five (5) members: VOTES FOR 111,619,246, VOTES AGAINST 488,550, WITHHELD 193,647.

 

  2. To elect a board of directors of the Company for the ensuing year: Each nominee for director received at least 88,413,616 votes for, which is greater than 67% of the total votes entitled to be cast by common shareholders of record, as follows:

 

     For    Withheld

Abby Badwi

   88,595,201    17,000

Thomas Crow

   88,608,851    3,350

Richard Kapuscinski

   88,607,151    5,050

J. Russell Porter

   88,549,091    63,110

Thomas Robinson

   88,413,616    198,585

 

  Matthew J.P. Heysel did not stand for reelection.

 

  3. To approve the appointment of BDO Seidman, LLP, as the independent registered public accounting firm of the Company for the ensuing year and to authorize the board of directors to fix the auditors’ remuneration: VOTES FOR 112,062,060, VOTES WITHHELD 239,383.

 

  4. To approve and adopt a 2006 Long-Term Stock Incentive Plan. VOTES FOR 60,174,824, VOTES AGAINST 7,336,334, WITHHELD 292,260.

Item 5. Other Information

None

Item 6. Exhibits

The following is a list of exhibits filed as part of this Form 10-Q. Where so indicated by a footnote, exhibits, which were previously filed, are incorporated herein by reference.

 

Exhibit

Number

 

Description

31.1   Certification of chief executive officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2   Certification of chief financial officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1   Certification of the chief executive officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ††
32.2   Certification of the chief financial officer pursuant Section 906 of the Sarbanes-Oxley Act of 2002. ††

Filed herewith.
†† Furnished herewith.

 

26


SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

  GASTAR EXPLORATION LTD.
Date: August 14, 2006   By:  

/s/ J. RUSSELL PORTER

    J. Russell Porter
    Chairman, President and Chief Executive Officer
    (principal executive officer)
Date: August 14, 2006   By:  

/s/ MICHAEL A. GERLICH

    Michael A. Gerlich
    Vice President and Chief Financial Officer
    (principal financial and accounting officer)

 

27


EXHIBIT INDEX

 

Exhibit

Number

 

Description

3.1   Amended and Restated Articles of Incorporation of Gastar Exploration Ltd. (1)
3.2   Bylaws of Gastar Exploration Ltd. (1)
4.1   Indenture dated November 12, 2004 between Gastar Exploration Ltd. and CIBC Mellon Trust Company as trustee. (1)
4.2   Form of 9.75% Convertible Senior Unsecured Subordinated Debenture of Gastar Exploration Ltd. (1)
4.3   Form of placement agent warrant to purchase common shares of Gastar Exploration Ltd. in connection with issuances of 9.75% Convertible Senior Unsecured Subordinated Debenture of Gastar Exploration Ltd. (1)
4.4   Agency Agreement dated as of November 12, 2004 between Gastar Exploration Ltd. and Westwind Partners Inc. in connection with issuances of 9.75% Convertible Senior Unsecured Subordinated Debenture of Gastar Exploration Ltd. (1)
4.5   Form of Subscription Agreement for U.S. purchasers of 9.75% Convertible Senior Unsecured Subordinated Debenture of Gastar Exploration Ltd. (1)
4.6   Form of Subscription Agreement for U.S. purchasers of 9.75% Convertible Senior Unsecured Subordinated Debenture of Gastar Exploration Ltd. (1)
4.7   Securities Purchase Agreement dated as of June 17, 2005, by and among Gastar Exploration Ltd. and the purchasers named therein for the purchase of $63.0 million in principal amount of Senior Secured Notes. (1)
4.8   Form of Senior Secured Note dated as of June 17, 2005. (1)
4.9   Registration Rights Agreement dated as of June 17, 2005, by and among Gastar Exploration Ltd. and the purchasers named therein. (1)
4.10   Form of Subscription Agreement for U.S. purchasers of common shares of Gastar Exploration Ltd. in a private placement dated June 30, 2005. (1)
4.11   Form of Subscription Agreement for U.S. purchasers of common shares of Gastar Exploration Ltd. in a private placement dated June 30, 2005. (1)
4.12   Placement agent warrant to purchase 510,525 common shares of Gastar Exploration Ltd. in connection with the sale of $15.0 million in principal amount of 15% subordinated notes in October 2004. (1)
4.13   Placement agent warrant to purchase 1,989,475 common shares of Gastar Exploration Ltd. in connection with the sale of $10.0 million in principal amount of 15% subordinated notes in October 2004. (1)
4.14   Form of 10% subordinated note issued June 2004. (1)
4.15   Form of warrant to purchase common shares of Gastar Exploration Ltd. issued in connection with the sale of 10% subordinated notes in June 2004. (1)
4.16   Form of warrant to purchase common shares of Gastar Exploration Ltd. issued in connection with a private placement of working interests in 2002. (1)
4.17   Agreement between Gastar Exploration Ltd. and GeoStar Corporation dated August 11, 2005. (1)
4.18   First Amendment dated September 6, 2005 to Securities Purchase Agreement dated as of June 17, 2005, by and among Gastar Exploration Ltd. and the purchasers named therein for the purchase of $63.0 million in principal amount of Senior Secured Notes. (1)
4.19   Common Share Purchase Agreement between Gastar Exploration Ltd. and Chesapeake Energy Corporation dated November 4, 2005. (1)
4.20   Registration Rights Agreement between Gastar Exploration Ltd. and Chesapeake Energy Corporation dated November 4, 2005. (1)
4.21   Facsimile of common share certificate of the Company. (1)
10.1*   The Gastar Exploration Ltd. 2002 Stock Option Plan, dated February 14, 2004, as amended. (1)
10.2*   Employment Agreement dated March 23, 2005 by and among First Sourcenergy Wyoming, Inc., Gastar Exploration Ltd. and J. Russell Porter. (1)
10.3*   Employment Agreement dated April 26, 2005 by and among First Sourcenergy Wyoming, Inc., Gastar Exploration Ltd. and Michael A. Gerlich. (1)

 

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10.4   Purchase and Sales Agreement between GeoStar Corporation and Gastar Exploration Ltd. covering Wyoming and Montana producing properties dated June 16, 2005. (1)
10.5   Purchase and Sales Agreement between GeoStar Corporation and Gastar Exploration Ltd. covering Wyoming and Montana non-producing properties dated June 16, 2005. (1)
10.6   Purchase and Sales Agreement between GeoStar Corporation and Gastar Exploration Ltd. covering Texas producing properties dated June 16, 2005. (1)
10.7   Purchase and Sales Agreement between GeoStar Corporation and Gastar Exploration Ltd. covering Texas non-producing properties dated June 16, 2005. (1)
10.8   Participation and Operating Agreement between GeoStar Corporation and Gastar Exploration Ltd. dated June 15, 2001. (1)
10.9   Promissory Note for $15.0 million between GeoStar Corporation and Gastar Exploration Ltd. dated August 11, 2001. (1)
10.10*   Form of Gastar officer stock option grant. (2)
10.11†   Gastar Exploration Ltd. 2006 Long-Term Stock Incentive Plan.
14.1   Gastar Exploration Ltd. Code of Ethics, adopted effective December 15, 2005. (1)
21.1   Subsidiaries of Gastar Exploration Ltd. (2)
31.1   Certification of chief executive officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2   Certification of chief financial officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1   Certification of the chief executive officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ††
32.2   Certification of the chief financial officer pursuant Section 906 of the Sarbanes-Oxley Act of 2002. ††

* Management contract or compensatory plan or arrangement.
Filed herewith.
†† Furnished herewith.
(1) Filed as an exhibit to the Company’s Registration Statement on Form S-1 (Registration No. 333-127498), as filed with the Securities and Exchange Commission on January 4, 2006.
(2) Filed as an exhibit to the Company’s Annual Report on Form 10-K, as filed with the Securities and Exchange Commission on March 31, 2006.

 

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Exhibit 10.11

GASTAR EXPLORATION LTD.

2006 LONG-TERM STOCK INCENTIVE PLAN

1. PURPOSES . The purposes of the Plan are (i) to attract and retain for the Company and its Affiliates the best available personnel, (ii) to provide additional incentive to Employees and Directors and to increase their interest in the Company’s welfare, and (iii) to promote the success of the business of the Company and its Affiliates.

2. DEFINITIONS . As used herein, unless the context requires otherwise, the following terms shall have the meanings indicated below:

(a) “ Affiliate ” means (i) any corporation, partnership or other entity which owns, directly or indirectly, a majority of the voting equity securities of the Company, (ii) any corporation, partnership or other entity of which a majority of the voting equity securities or equity interest is owned, directly or indirectly, by the Company, and (iii) with respect to an Option that is intended to be an Incentive Stock Option, (A) any “parent corporation” of the Company, as defined in Section 424(e) of the Code or (B) any “subsidiary corporation” of the Company as defined in Section 424(f) of the Code, any other entity that is taxed as a corporation under Section 7701(a)(3) of the Code and is a member of the “affiliated group” as defined in Section 1504(a) of the Code of which the Company is the common parent, and any other entity as may be permitted from time to time by the Code or by the Internal Revenue Service to be an employer of Employees to whom Incentive Stock Options may be granted; provided, however, that in each case the Affiliate must be consolidated in the Company’s financial statements.

(b) “ Award ” means any right granted under the Plan, whether granted singly or in combination, to a Grantee pursuant to the terms, conditions and limitations that the Committee may establish.

(c) “ Award Agreement ” means a written agreement with a Grantee with respect to any Award, including any amendments thereto.

(d) “ Board ” means the Board of Directors of the Company.

(e) “ Bonus Stock Agreement ” means a written agreement with a Grantee with respect to a Bonus Stock Award, including any amendments thereto.

(f) “ Bonus Stock Award ” means an Award granted under Section 8 of the Plan.

(g) “ Change in Control ” of the Company means the occurrence of any of the following events: (i) any “person” (as such term is used in Sections 13(d) and 14(d) of the Exchange Act) is or becomes the “beneficial owner” (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of securities of the Company representing 50 percent or more of the combined voting power of the Company’s then outstanding securities; (ii) as a result of, or in connection with, any tender offer or exchange offer, merger, or other business combination (a “ Transaction ”), the persons who were directors of the Company immediately before the Transaction shall cease to constitute a majority of the Board of Directors of the


Company or any successor to the Company; (iii) the Company is merged or consolidated with another corporation and as a result of the merger or consolidation less than 75 percent of the outstanding voting securities of the surviving or resulting corporation shall then be owned in the aggregate by the former shareholders of the Company; (iv) a tender offer or exchange offer is made and consummated for the ownership of securities of the Company representing 50 percent or more of the combined voting power of the Company’s then outstanding voting securities; or (v) the Company transfers all or substantially all of its assets to another corporation which is not controlled by the Company; provided, however, no Change in Control shall be deemed to occur under this Section 2(g) in connection with any transaction involving a direct or indirect wholly-owned subsidiary of the Company.

(h) “ Code ” means the Internal Revenue Code of 1986, as amended, and any successor statute. Reference in the Plan to any section of the Code shall be deemed to include any amendments or successor provisions to such section and any Treasury regulations promulgated under such section.

(i) “ Committee ” means the committee (or committees), as constituted from time to time, of the Board that is appointed by the Board to administer the Plan, or if no such committee is appointed (or no such committee shall be in existence at any relevant time), the term “Committee” for purposes of the Plan shall mean the Board; provided, however, that while the Common Stock is publicly traded, the Committee shall be a committee of the Board consisting solely of two or more Outside Directors, in accordance with Section 162(m) of the Code, and/or solely of two or more Non-Employee Directors, in accordance with Rule 16b-3, as necessary and deemed desirable by the Board from time to time in each case to satisfy such requirements with respect to Awards granted under the Plan. Within the scope of such authority, the Board or the Committee may (i) delegate to a committee of one or more members of the Board who are not Outside Directors the authority to grant Awards to eligible persons who are either (A) not then Covered Employees and are not expected to be Covered Employees at the time of recognition of income resulting from such Awards or (B) not persons with respect to whom the Company wishes to comply with Section 162(m) of the Code, and/or (ii) delegate to a committee of one or more members of the Board who are not Non-Employee Directors the authority to grant Awards to eligible persons who are not then subject to Section 16 of the Exchange Act. The Board may assume any or all of the powers and responsibilities prescribed for the Committee, and to the extent it does so, the term “Committee” as used herein shall also be applicable to the Board.

(j) “ Common Stock ” means the Common Stock, without par value per share, of the Company or the common stock that the Company may in the future be authorized to issue (as long as the common stock varies from that currently authorized, if at all, only in amount of par value) in replacement or substitution thereof.

(k) “ Company ” means Gastar Exploration Ltd., a corporation governed by the laws of the Province of Alberta.

(l) “ Continuous Service ” means that the provision of services to the Company or an Affiliate in any capacity of Employee or Director is not interrupted or terminated. Except as otherwise provided in the Award Agreement, service shall not be considered interrupted or

 

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terminated for this purpose in the case of (i) any approved leave of absence, (ii) transfers among the Company, any Affiliate, or any successor, in any capacity of Employee or Director, or (iii) any change in status as long as the individual remains in the service of the Company or an Affiliate in any capacity of Employee or Director. An approved leave of absence shall include sick leave, military leave, or any other authorized personal leave. For purposes of each Incentive Stock Option, if such leave exceeds ninety (90) days, and re-employment upon expiration of such leave is not guaranteed by statute or contract, then the Incentive Stock Option shall be treated as a Non-Qualified Stock Option on the day that is three (3) months and one (1) day following the expiration of such ninety (90)-day period.

(m) “ Covered Employee ” means the chief executive officer and the four other most highly compensated officers of the Company for whom total compensation is required to be reported to shareholders under Regulation S-K, as determined for purposes of Section 162(m) of the Code.

(n) “ Director ” means a member of the Board.

(o) “ Disability ” means the “disability” of a person (i) as defined in a then effective written employment agreement between a person and the Company or (ii) if such person is not covered by a written employment agreement with the Company, as defined in a then effective long-term disability plan maintained by the Company that covers such person, or (iii) if neither a written employment agreement nor a plan exists at any relevant time, “Disability” means the permanent and total disability of a person within the meaning of Section 22(e)(3) of the Code. For purposes of determining the time during which an Incentive Stock Option may be exercised under the terms of an Option Agreement, “Disability” means the permanent and total disability of a person within the meaning of Section 22(e)(3) of the Code. Section 22(e)(3) of the Code provides that an individual is totally and permanently disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than twelve (12) months.

(p) “ Employee ” means any person, including an Officer or Director, who is employed, within the meaning of Section 3401 of the Code, by the Company or an Affiliate. The provision of compensation by the Company or an Affiliate to a Director solely with respect to such individual rendering services in the capacity of a Director, however, shall not be sufficient to constitute “employment” by the Company or that Affiliate.

(q) “ Exchange Act ” means the Securities Exchange Act of 1934, as amended, and any successor statute. Reference in the Plan to any section of the Exchange Act shall be deemed to include any amendments or successor provisions to such section and any rules and regulations relating to such section.

 

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(r) “ Fair Market Value ” means, as of any date, the United States dollar value of the Common Stock determined as follows:

(i) If the Common Stock is listed on any established United States stock exchange or traded on the NASDAQ National Market or the NASDAQ Capital Market (formerly known as the NASDAQ SmallCap Market), the Fair Market Value of a share of Common Stock shall be the closing sales price for such a share of Common Stock (or the closing bid, if no sales were reported) as quoted on such exchange or market (or if the Common Stock is listed or traded on more than one such exchange or market, the exchange or market with the greatest volume of trading in the Common Stock) on the day of determination (or if no such price or bid is reported on that day, on the last market trading day prior to the day of determination), as reported by the applicable exchange or market or such other source as the Committee deems reliable.

(ii) In the absence of any such established United States market for the Common Stock, the Fair Market Value shall be determined in good faith by the Committee.

(s) “ Grantee ” means an Employee or Director to whom an Award has been granted under the Plan.

(t) “ Incentive Stock Option ” means an Option granted to an Employee under the Plan that meets the requirements of Section 422 of the Code.

(u) “ Non-Employee Director ” means a Director of the Company who either (i) is not an Employee or Officer, does not receive compensation (directly or indirectly) from the Company or an Affiliate in any capacity other than as a Director (except for an amount as to which disclosure would not be required under Item 404(a) of Regulation S-K), does not possess an interest in any other transaction as to which disclosure would be required under Item 404(a) of Regulation S-K and is not engaged in a business relationship as to which disclosure would be required under Item 404(b) of Regulation S-K, or (ii) is otherwise considered a “non-employee director” for purposes of Rule 16b-3.

(v) “ Non-Qualified Stock Option ” means an Option granted under the Plan that is not intended to be an Incentive Stock Option.

(w) “ Officer ” means a person who is an “officer” of the Company or any Affiliate within the meaning of Section 16 of the Exchange Act (whether or not the Company is subject to the requirements of the Exchange Act).

(x) “ Option ” means an Award in the form of a stock option granted pursuant to Section 7 of the Plan to purchase a specified number of shares of Common Stock, whether granted as an Incentive Stock Option or as a Non-Qualified Stock Option.

(y) “ Option Agreement ” means the written agreement evidencing the grant of an Option executed by the Company and the Optionee, including any amendments thereto.

(z) “ Optionee ” means an individual to whom an Option has been granted under the Plan.

 

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(aa) “ Outside Director ” means a Director of the Company who either (i) is not a current employee of the Company or an “affiliated corporation” (within the meaning of the Treasury regulations promulgated under Section 162(m) of the Code), is not a former employee of the Company or an “affiliated corporation” receiving compensation for prior services (other than benefits under a tax qualified pension plan), has not been an officer of the Company or an “affiliated corporation” at any time and is not currently receiving (within the meaning of the Treasury regulations promulgated under Section 162(m) of the Code) direct or indirect remuneration from the Company or an “affiliated corporation” for services in any capacity other than as a Director, or (ii) is otherwise considered an “outside director” for purposes of Section 162(m) of the Code.

(bb) “ Performance Criteria ” means (1) earnings; (2) earnings per share; (3) EBITDA (earnings before interest, taxes, depreciation and amortization); (4) EBIT (earnings before interest and taxes); (5) economic profit; (6) cash flow; (7) revenue; (8) revenue growth; (9) sales growth; (10) net profit before tax; (11) gross profit; (12) operating income or profit; (13) return on equity; (14) return on assets; (15) return on capital; (16) changes in working capital; (17) shareholder return; (18) cost reduction; (19) customer satisfaction or growth; or (20) employee satisfaction; and any other performance objective approved by the shareholders of the Company in accordance with Section 162(m) of the Code.

(cc) “ Plan ” means this Gastar Exploration Ltd. 2006 Long-Term Stock Incentive Plan, as set forth herein and as it may be amended from time to time.

(dd) “ Qualifying Shares ” means shares of Common Stock which either (i) have been owned by the Grantee for more than six (6) months and have been “paid for” within the meaning of Rule 144 promulgated under the Securities Act, or (ii) were obtained by the Grantee in the public market.

(ee) “ Regulation S-K ” means Regulation S-K promulgated under the Securities Act, as it may be amended from time to time, and any successor to Regulation S-K. Reference in the Plan to any item of Regulation S-K shall be deemed to include any amendments or successor provisions to such item.

(ff) “ Rule 16b-3 ” means Rule 16b-3 promulgated under the Exchange Act, as it may be amended from time to time, and any successor to Rule 16b-3.

(gg) “ Section ” means a section of the Plan unless otherwise stated or the context otherwise requires.

(hh) “ Securities Act ” means the Securities Act of 1933, as amended, and any successor statute. Reference in the Plan to any section of the Securities Act shall be deemed to include any amendments or successor provisions to such section and any rules and regulations relating to such section.

(ii) “ Stock Appreciation Right ” means an Award granted under Section 9 of the Plan.

 

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(jj) “ Stock Appreciation Rights Agreement ” means a written agreement with a Grantee with respect to an Award of Stock Appreciation Rights, including any amendments thereto.

(kk) “ Ten Percent Shareholder ” means a person who owns (or is deemed to own pursuant to Section 424(d) of the Code) at the time an Option is granted stock possessing more than ten percent (10%) of the total combined voting power of all classes of stock of the Company or of any of its Affiliates.

3. TYPES OF INCENTIVE AWARDS AVAILABLE UNDER THE PLAN . Awards granted under this Plan may be (a) Incentive Stock Options, (b) Non-Qualified Stock Options, (c) Bonus Stock Awards, (d) Stock Appreciation Rights, and (e) any other type of Award established by the Committee which is consistent with the Plan’s purposes, as designated at the time of grant.

4. SHARES SUBJECT TO PLAN . Subject to adjustment pursuant to Section 11(a) hereof, the total amount of Common Stock with respect to which Awards may be granted under the Plan shall not exceed Five Million (5,000,000) shares. At all times during the term of the Plan, the Company shall reserve and keep available such number of shares of Common Stock as will be required to satisfy the requirements of outstanding Awards under the Plan. Any shares of Common Stock covered by an Award (or a portion of an Award) that is forfeited or canceled or that expires shall be deemed not to have been issued for purposes of determining the maximum aggregate number of shares of Common Stock which may be issued under the Plan and shall again be available for Awards under the Plan. Nothing in this Section 4 shall impair the right of the Company to reduce the number of outstanding shares of Common Stock pursuant to repurchases, redemptions, or otherwise; provided, however, that no reduction in the number of outstanding shares of Common Stock shall (a) impair the validity of any outstanding Award, whether or not that Award is fully vested or exercisable, or (b) impair the status of any shares of Common Stock previously issued pursuant to an Award as duly authorized, validly issued, fully paid, and nonassessable. The shares to be delivered under the Plan shall be made available from (a) authorized but unissued shares of Common Stock, (b) Common Stock held in the treasury of the Company, or (c) previously issued shares of Common Stock reacquired by the Company, including shares purchased on the open market, in each situation as the Committee may determine from time to time in its sole discretion.

5. ELIGIBILITY . Awards other than Incentive Stock Options may be granted to Employees, Officers and Directors. Incentive Stock Options may be granted only to Employees (including Officers and Directors who are also Employees), as limited by clause (iii) of Section 2(a). The Committee in its sole discretion shall select the recipients of Awards. A Grantee may be granted more than one Award under the Plan, and Awards may be granted at any time or times during the term of the Plan. The grant of an Award to an Employee, Officer or Director shall not be deemed either to entitle that individual to, or to disqualify that individual from, participation in any other grant of Awards under the Plan.

6. LIMITATION ON INDIVIDUAL AWARDS . Any and all shares available for Awards under the Plan may be awarded by way of Options, Bonus Stock Awards or Stock

 

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Appreciation Rights (regardless of the form of payment) to any one person. Subject to the provisions of Section 11(a), the maximum number of shares of Common Stock that may be subject to Options, Bonus Stock Awards and Stock Appreciation Rights granted to any one Covered Employee under the Plan shall not exceed One Million Two Hundred Fifty Thousand (1,250,000) shares. The limitations set forth in the preceding sentence shall be applied in a manner which will permit compensation generated under the Plan, where appropriate, to constitute “performance-based” compensation for purposes of Section 162(m) of the Code, including counting against such maximum number of shares, to the extent required under Section 162(m) of the Code and applicable interpretive authority thereunder, any shares of Common Stock subject to Options or other Awards that are canceled or repriced.

7. OPTIONS .

(a) Grant of Options . An Option is a right to purchase shares of Common Stock during the option period for a specified exercise price. The Committee shall determine (i) whether each Option shall be granted as an Incentive Stock Option or as a Non-Qualified Stock Option, and (ii) the provisions, terms and conditions of each Option including, but not limited to, the vesting schedule, the number of shares of Common Stock subject to the Option, the exercise price of the Option (which may never be less than Fair Market Value of the Common Stock on the date of the grant of the Award), the period during which the Option may be exercised, forfeiture provisions, methods of payment, and all other terms and conditions of the Option.

(b) Limitations on Incentive Stock Options . The aggregate Fair Market Value (determined as of the date of grant of an Option) of Common Stock which any Employee is first eligible to purchase during any calendar year by exercise of Incentive Stock Options granted under the Plan and by exercise of incentive stock options (within the meaning of Section 422 of the Code) granted under any other incentive stock option plan of the Company or an Affiliate shall not exceed $100,000. If the Fair Market Value of stock with respect to which all incentive stock options described in the preceding sentence held by any one Optionee are exercisable for the first time by such Optionee during any calendar year exceeds $100,000, the Options (that are intended to be Incentive Stock Options on the date of grant thereof) for the first $100,000 worth of shares of Common Stock to become exercisable in such year shall be deemed to constitute incentive stock options within the meaning of Section 422 of the Code and the Options (that are intended to be Incentive Stock Options on the date of grant thereof) for the shares of Common Stock in the amount in excess of $100,000 that become exercisable in that calendar year shall be treated as Non-Qualified Stock Options. If the Code or the Treasury regulations promulgated thereunder are amended after the effective date of the Plan to provide for a different limit than the one described in this Section 7(b), such different limit shall be incorporated herein and shall apply to any Options granted after the effective date of such amendment.

(c) Acquisitions and Other Transactions . Notwithstanding the provisions of Section 10(g), in the case of an Option issued or assumed pursuant to Section 10(g), the exercise price and number of shares for the Option shall be determined in accordance with the principles of Section 424(a) of the Code and the Treasury regulations promulgated thereunder. The Committee may, from time to time, assume outstanding options granted by another entity, whether in connection with an acquisition of such other entity or otherwise, by either (i) granting

 

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an Option under the Plan in replacement of or in substitution for the option assumed by the Company, or (ii) treating the assumed option as if it had been granted under the Plan if the terms of such assumed option could be applied to an Option granted under the Plan. Such assumption shall be permissible if the holder of the assumed option would have been eligible to be granted an Option hereunder if the other entity had applied the rules of the Plan to such grant. The Committee also may grant Options under the Plan in settlement of or substitution for, outstanding options or obligations to grant future options in connection with the Company or an Affiliate acquiring another entity, an interest in another entity or an additional interest in an Affiliate whether by merger, stock purchase, asset purchase or other form of transaction.

(d) Payment or Exercise . Payment for the shares of Common Stock to be purchased upon exercise of an Option may be made in cash (by check) or, if elected by the Optionee and in one or more of the following methods stated in the Option Agreement (at the date of grant with respect to any Option granted as an Incentive Stock Option) and where permitted by law: (i) if a public market for the Common Stock exists, through a “same day sale” arrangement between the Optionee and a broker-dealer that is a member of the National Association of Securities Dealers, Inc. (an “ NASD Dealer ”) whereby the Optionee irrevocably elects to exercise the Option and to sell a portion of the shares of Common Stock so purchased to pay for the exercise price and whereby the NASD Dealer irrevocably commits upon receipt of such shares of Common Stock to forward the exercise price directly to the Company; (ii) if a public market for the Common Stock exists, through a “margin” commitment from the Optionee and an NASD Dealer whereby the Optionee irrevocably elects to exercise the Option and to pledge the shares of Common Stock so purchased to the NASD Dealer in a margin account as security for a loan from the NASD Dealer in the amount of the exercise price, and whereby the NASD Dealer irrevocably commits upon receipt of such shares of Common Stock to forward the exercise price directly to the Company; or (iii) by surrender for cancellation of Qualifying Shares at the Fair Market Value per share at the time of exercise (provided that such surrender does not result in an accounting charge for the Company). No shares of Common Stock may be issued until full payment of the purchase price therefor has been made.

8. BONUS STOCK AWARDS .

(a) Bonus Stock Awards . A Bonus Stock Award is a grant of shares of Common Stock for such consideration, if any, and subject to such restrictions on transfer, rights of first refusal, repurchase provisions, forfeiture provisions and other terms and conditions as are established by the Committee.

(b) Forfeiture Restrictions . Shares of Common Stock that are the subject of a Bonus Stock Award may be subject to restrictions on disposition by the Grantee and to an obligation of the Grantee to forfeit and surrender the shares to the Company under certain circumstances (the “ Forfeiture Restrictions ”). The Forfeiture Restrictions shall be determined by the Committee in its sole discretion, and the Committee may provide that the Forfeiture Restrictions shall lapse on the passage of time, the attainment of one or more performance targets established by the Committee, or the occurrence of such other event or events determined to be appropriate by the Committee; provided, however, that (i) for a Bonus Stock Award subject to Forfeiture Restrictions based on the passage of time, the Forfeiture Restrictions shall lapse ratably over a

 

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minimum period of three (3) years, and (ii) for a Bonus Stock Award subject to Forfeiture Restrictions based on Performance Criteria or any other event, the Forfeiture Restrictions shall not lapse prior to one year after grant of the Bonus Stock Award. The Forfeiture Restrictions, if any, applicable to a particular Bonus Stock Award (which may differ from any other such Bonus Stock Award) shall be stated in the Bonus Stock Agreement.

(c) Rights as Shareholder . Shares of Common Stock awarded pursuant to a Bonus Stock Award shall be represented by a stock certificate registered in the name of the Grantee of such Bonus Stock Award. The Grantee shall have the right to receive dividends with respect to the shares of Common Stock subject to a Bonus Stock Award, to vote the shares of Common Stock subject thereto and to enjoy all other shareholder rights with respect to the shares of Common Stock subject thereto, except that, unless provided otherwise in this Plan, or in the Bonus Stock Agreement, (i) the Grantee shall not be entitled to delivery of the shares of Common Stock except as the Forfeiture Restrictions expire, (ii) the Company or an escrow agent shall retain custody of the shares of Common Stock until the Forfeiture Restrictions expire, (iii) the Grantee may not sell, transfer, pledge, exchange, hypothecate or otherwise dispose of the shares of Common Stock until the Forfeiture Restrictions expire.

(d) Stock Certificate Delivery . One or more stock certificates representing shares of Common Stock, free of Forfeiture Restrictions, shall be delivered to the Grantee promptly after, and only after, the Forfeiture Restrictions have expired. The Grantee, by his acceptance of the Bonus Stock Award, irrevocably grants to the Company a power of attorney to transfer any shares so forfeited to the Company, agrees to execute any documents requested by the Company in connection with such forfeiture and transfer, and agrees that such provisions regarding transfers of forfeited shares shall be specifically performable by the Company in a court of equity or law.

(e) Payment for Bonus Stock . The Committee shall determine the amount and form of any payment for shares of Common Stock received pursuant to a Bonus Stock Award. In the absence of such a determination, the Grantee shall not be required to make any payment for shares of Common Stock received pursuant to a Bonus Stock Award, except to the extent otherwise required by law.

(f) Forfeiture of Bonus Stock . Unless otherwise provided in a Bonus Stock Agreement, on termination of the Grantee’s Continuous Service prior to lapse of the Forfeiture Restrictions, the shares of Common Stock which are still subject to the Forfeiture Restrictions under Bonus Stock Award shall be forfeited by the Grantee. Upon any forfeiture, all rights of the Grantee with respect to the forfeited shares of the Common Stock subject to the Bonus Stock Award shall cease and terminate, without any further obligation on the part of the Company except to repay any purchase price per share paid by the Grantee for the shares forfeited.

(g) Waiver of Forfeiture Restrictions; Committee’s Discretion . With respect to a Bonus Stock Award that has been granted to a Covered Employee where such Award has been designed to meet the exception for performance-based compensation under Section 162(m) of the Code, the Committee may not waive the Forfeiture Restrictions applicable to such Bonus Stock Award.

 

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9. STOCK APPRECIATION RIGHTS .

(a) Stock Appreciation Rights . A Stock Appreciation Right is a right to receive, upon exercise of the right, shares of Common Stock or their cash equivalent in an amount equal to the increase in Fair Market Value, if any, of the Common Stock between the grant and exercise dates.

(b) Tandem Rights . Stock Appreciation Rights may be granted in connection with the grant of an Option, in which case exercise of Stock Appreciation Rights will result in the surrender of the right to purchase the shares under the Option as to which the Stock Appreciation Rights were exercised. Alternatively, Stock Appreciation Rights may be granted independently of Options in which case each Award of Stock Appreciation Rights shall be evidenced by a Stock Appreciation Rights Agreement. With respect to Stock Appreciation Rights that are subject to Section 16 of the Exchange Act, the Committee shall retain sole discretion (i) to determine the form in which payment of the Stock Appreciation Right will be made ( i.e. , cash, securities or any combination thereof), or (ii) to approve an election by a Grantee to receive cash in full or partial settlement of Stock Appreciation Rights.

(c) Limitations on Exercise of Stock Appreciation Rights . A Stock Appreciation Right shall be exercisable in whole or in such installments and at such times as determined by the Committee.

10. GENERAL PROVISIONS REGARDING AWARDS .

(a) Form of Award Agreement . Each Award granted under the Plan shall be evidenced by a written Award Agreement in such form (which need not be the same for each Grantee) as the Committee from time to time approves, but which is not inconsistent with the Plan, including any provisions that may be necessary to assure that any Option that is intended to be an Incentive Stock Option will comply with Section 422 of the Code.

(b) Awards Criteria . In determining the amount and value of Awards to be granted, the Committee may take into account the responsibility level, performance, potential, other Awards and such other considerations with respect to a Grantee as it deems appropriate. The terms of an Award Agreement may provide that the amount payable as an Award may be adjusted for dividends or dividend equivalent.

(c) Date of Grant . The date of grant of an Award will be the date specified by the Committee as the effective date of the grant of an Award or, if the Committee does not so specify, will be the date on which the Committee makes the determination to grant such Award. The Award Agreement evidencing the Award will be delivered to the Grantee with a copy of the Plan and other relevant Award documents within a reasonable time after the date of grant.

(d) Stock Price . The exercise price or other measurement of stock value relative to any Award shall be the price determined by the Committee (which shall be not less than either the Fair Market Value or the par value of the shares of Common Stock on the date of grant of the Award). The exercise price of any Incentive Stock Option shall not be less than 100% of the

 

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Fair Market Value of the shares of Common Stock for the date of grant of the Option; provided, however, the exercise price of any Incentive Stock Option granted to a Ten Percent Shareholder shall not be less than 110% of the Fair Market Value of the shares of Common Stock for the date of grant of the Option.

(e) Period of Award . Awards shall be exercisable or payable within the time or times or upon the event or events determined by the Committee and set forth in the Award Agreement. Unless otherwise provided in an Award Agreement, Awards other than Bonus Stock Awards shall terminate on (and no longer be exercisable or payable after) the earlier of: (i) ten (10) years from the date of grant of the Award; (ii) for an Incentive Stock Option granted to a Ten Percent Shareholder, five (5) years from the date of grant of the Option; (iii) three (3) months after the Grantee is no longer serving in any capacity as an Employee or Director of the Company for a reason other than the death or Disability of the Grantee; (iv) one (1) year after death of the Grantee; or (v) one (1) year after Disability of the Grantee.

(f) Transferability of Awards . Awards granted under the Plan, and any interest therein, shall not be transferable or assignable by the Grantee, and may not be made subject to execution, attachment or similar process, otherwise than by will or by the laws of descent and distribution, and shall be exercisable or payable during the lifetime of the Grantee only by the Grantee; provided, that the Grantee may designate persons who or which may exercise or receive his Awards following his death. Notwithstanding the preceding sentence, Awards other than Incentive Stock Options may be transferred to such family members, family member trusts, family limited partnerships and other family member entities as the Committee, in its sole discretion, may approve prior to any such transfer. No such transfer will be approved by the Committee if the Common Stock issuable under such transferred Award would not be eligible to be registered on Form S-8 promulgated under the Securities Act.

(g) Acquisitions and Other Transactions . The Committee may, from time to time, approve the assumption of outstanding awards granted by another entity, whether in connection with an acquisition of such other entity or otherwise, by either (i) granting an Award under the Plan in replacement of or in substitution for the awards assumed by the Company, or (ii) treating the assumed award as if it had been granted under the Plan if the terms of such assumed award could be applied to an Award granted under the Plan. Such assumption shall be permissible if the holder of the assumed award would have been eligible to be granted an Award hereunder if the other entity had applied the rules of this Plan to such grant.

(h) Payment . Payment of an Award (i) may be made in cash, Common Stock or a combination thereof, as determined by the Committee in its sole discretion, (ii) shall be made in a lump sum or in installments as prescribed by the Committee in its sole discretion, and (iii) to the extent applicable, shall be based on the Fair Market Value of the Common Stock for the payment or exercise date. The Committee may permit or require the deferral of payment, subject to such rules and procedures as it may establish, which may include provisions for the payment or crediting of interest, dividend equivalents or other forms of investment return.

(i) Notice . If an Award involves an exercise, it may be exercised only by delivery to the Company of a written exercise agreement approved by the Committee (which need not be the

 

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same for each Grantee), stating the number of shares of Common Stock being purchased, the method of payment, and such other matters as may be deemed appropriate by the Company in connection with the issuance of shares upon exercise of the Award, together with payment in full of any exercise price for any shares of Common Stock being purchased. Such exercise agreement may be part of a Grantee’s Award Agreement.

(j) Withholding Taxes . The Committee may establish such rules and procedures as it considers desirable in order to satisfy any obligation of the Company to withhold the statutory prescribed minimum amount of federal or state income taxes or other taxes with respect to the grant, exercise or payment of any Award under the Plan, including procedures for a Grantee to have shares of Common Stock withheld from the total number of shares of Common Stock to be issued or purchased upon grant or exercise of an Award. Prior to issuance of any shares of Common Stock, the Grantee shall pay or make adequate provision acceptable to the Committee for the satisfaction of the statutory minimum prescribed amount of any federal or state income or other tax withholding obligations of the Company, if applicable. Upon grant, exercise or payment of an Award, the Company shall withhold or collect from the Grantee an amount sufficient to satisfy such tax withholding obligations.

(k) Exercise of Award Following Termination of Continuous Service.

(i) An Award may not be exercised after the expiration date of such Award set forth in the Award Agreement and may be exercised following the termination of a Grantee’s Continuous Service only to the extent provided in the Award Agreement.

(ii) Where the Award Agreement permits a Grantee to exercise an Award following the termination of the Grantee’s Continuous Service for a specified period, the Award shall terminate to the extent not exercised on the last day of the specified period or the last day of the original term of the Award, whichever occurs first.

(iii) Any Option designated as an Incentive Stock Option, to the extent not exercised within the time permitted by law for the exercise of Incentive Stock Options following the termination of an Optionee’s Continuous Service, shall convert automatically to a Non-Qualified Stock Option and thereafter shall be exercisable as such to the extent exercisable by its terms for the period specified in the Option Agreement.

(iv) The Committee shall have discretion to determine whether the Continuous Service of a Grantee has terminated and the effective date on which such Continuous Service terminates and whether the Grantee’s Continuous Service terminated as a result of the Disability of the Grantee.

(l) Limitations on Exercise .

(i) The Committee may specify a reasonable minimum number of shares of Common Stock or a percentage of the shares subject to an Award that may be purchased on any exercise of an Award; provided, that such minimum number will not prevent a

 

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Grantee from exercising the full number of shares of Common Stock as to which the Award is then exercisable.

(ii) The obligation of the Company to issue any shares of Common Stock pursuant to the exercise of any Award or otherwise make payments hereunder shall be subject to the condition that such exercise and the issuance and delivery of such shares and other actions pursuant thereto comply with the Securities Act, all applicable state securities and other laws and the requirements of any stock exchange or national market system upon which the shares of Common Stock may then be listed or quoted, as in effect on the date of exercise. The Company shall be under no obligation to register the shares of Common Stock with the Securities and Exchange Commission or to effect compliance with the registration, qualification or listing requirements of any state securities laws or stock exchange or national market system, and the Company shall have no liability for any inability or failure to do so.

(iii) As a condition to the exercise of an Award, the Company may require the person exercising such Award to represent and warrant at the time of any such exercise that the shares of Common Stock are being purchased only for investment and without any present intention to sell or distribute such shares of Common Stock if, in the opinion of counsel for the Company, such a representation is required by any securities or other applicable laws.

(m) Privileges of Stock Ownership . Except as provided in the Plan with respect to Bonus Stock Awards, no Grantee will have any of the rights of a shareholder with respect to any shares of Common Stock subject to an Award until such Award is properly exercised and the purchased or awarded shares are issued and delivered to the Grantee, as evidenced by an appropriate entry on the books of the Company or of a duly authorized transfer agent of the Company. No adjustment shall be made for dividends or distributions or other rights for which the record date is prior to such date of issuance and delivery, except as provided in the Plan.

(n) Breach; Additional Terms . A breach of the terms and conditions of this Plan or established by the Committee pursuant to the Award Agreement shall cause a forfeiture of the Award. At the time of such Award, the Committee may, in its sole discretion, prescribe additional terms, conditions or restrictions relating to the Award, including provisions pertaining to the termination of the Grantee’s employment (by retirement, Disability, death or otherwise) prior to expiration of the Forfeiture Restrictions or other vesting provisions. Such additional terms, conditions or restrictions shall also be set forth in an Award Agreement made in connection with the Award.

(o) Performance-Based Compensation . The Committee may designate any Award as “qualified performance-based compensation” for purposes of Section 162(m) of the Code. Any Awards designated as “qualified performance-based compensation” shall be conditioned on the achievement of any one or more Performance Criteria, and the measurement may be stated in absolute terms or relative to individual performances, comparable companies, peer or industry groups or other standard indexes, and in terms of Company-wide objectives or in terms of absolute or comparative objectives that relate to the performance of divisions, affiliates,

 

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departments or functions within the Company or an Affiliate. Notwithstanding any other provision of the Plan, the Committee may grant an Award that is not contingent on performance goals or is contingent on performance goals other than the Performance Criteria, so long as the Committee has determined that such Award is not intended to satisfy the requirements for “qualified performance-based compensation” within the meaning of Section 162(m) of the Code.

11. ADJUSTMENT UPON CHANGES IN CAPITALIZATION AND CORPORATE EVENTS .

(a) Capital Adjustments . The number of shares of Common Stock (i) covered by each outstanding Award granted under the Plan, the exercise, target or purchase price of each such outstanding Award, and any other terms of the Award that the Committee determines require adjustment and (ii) available for issuance under Sections 4 and 6 shall be adjusted to reflect, as deemed appropriate by the Committee, any increase or decrease in the number of shares of Common Stock resulting from a stock dividend, stock split, reverse stock split, combination, reclassification or similar change in the capital structure of the Company without receipt of consideration, subject to any required action by the Board or the shareholders of the Company and compliance with applicable securities laws; provided, however, that a fractional share will not be issued upon exercise of any Award, and either (i) any fraction of a share of Common Stock that would have resulted will be cashed out at Fair Market Value or (ii) the number of shares of Common Stock issuable under the Award will be rounded up to the nearest whole number, as determined by the Committee; and provided further that the exercise, target or purchase price may not be decreased to below either the Fair Market Value or the par value, if any, for the shares of Common Stock as adjusted pursuant to this Section 11(a). Except as the Committee determines, no issuance by the Company of shares of capital stock of any class, or securities convertible into shares of capital stock of any class, shall affect, and no adjustment by reason hereof shall be made with respect to, the number or price of shares of Common Stock subject to an Award.

(b) Dissolution or Liquidation . The Committee shall notify the Grantee at least twenty (20) days prior to any proposed dissolution or liquidation of the Company. Unless specifically provided otherwise in an individual Award or Award Agreement or in a then-effective written employment agreement between the Grantee and the Company or an Affiliate, to the extent that an Award has not been previously exercised, if applicable, such Award shall terminate immediately prior to consummation of such dissolution or liquidation.

(c) Change in Control . Unless specifically provided otherwise with respect to Change in Control events in an individual Award or Award Agreement or in a then-effective written employment agreement between the Grantee and the Company or an Affiliate, if, during the effectiveness of the Plan, a Change in Control occurs, the surviving entity or purchaser described in Section 2(g), the “Purchaser”, shall either assume the obligations of the Company under the outstanding Awards or convert the outstanding Awards into awards of at least equal value as to capital stock of the Purchaser. In the event such Purchaser refuses to assume or substitute Awards pursuant to a Change in Control, each Award which is at the time outstanding under the Plan shall (i) except as provided otherwise in an individual Award or Award Agreement, automatically become, subject to all other terms of the Award or Award Agreement,

 

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fully vested and exercisable or payable, as appropriate, and be released from any repurchase or forfeiture provisions, immediately prior to the specified effective date of such Change in Control, for all of the shares of Common Stock at the time represented by such Award, (ii) the Forfeiture Restrictions applicable to all outstanding Bonus Stock Awards shall lapse and shares of Common Stock subject to such Bonus Stock Awards shall be released from escrow, if applicable, and delivered to the Grantees of the Awards free of any Forfeiture Restriction, (iii) all other Awards shall become fully vested and payment thereof shall be accelerated using, if applicable, the then-current Fair Market Value to measure any payment that is based on the value of the Common Stock or using such higher amount as the Committee may determine to be more reflective of the actual value of such stock, and (iv) notwithstanding any contrary terms in the Award or Award Agreement, expire on a date at least twenty (20) days after the Committee gives written notice to Grantees specifying the terms and conditions of such termination.

To the extent that a Grantee exercises an Award before or on the effective date of the Change in Control, the Company shall issue all Common Stock purchased by exercise of that Award (subject to the Grantee’s satisfaction of the requirements of Section 10(j)), and those shares of Common Stock shall be treated as issued and outstanding for purposes of the Change in Control. Upon a Change in Control, when the outstanding Awards are not assumed by the Purchaser, the Plan shall terminate and any unexercised Awards outstanding under the Plan at that date shall terminate.

12. SHAREHOLDER APPROVAL . The Company shall obtain the approval of the Plan by the Company’s shareholders to the extent required to satisfy Sections 162(m) or 422 of the Code or to satisfy or comply with any applicable laws or the rules of any stock exchange or national market system on which the Common Stock may be listed or quoted.

13. ADMINISTRATION . The Plan shall be administered by the Committee. The Committee shall interpret the Plan and any Awards granted pursuant to the Plan and shall prescribe such rules and regulations in connection with the operation of the Plan as it determines to be advisable for the administration of the Plan. The Committee may rescind and amend its rules and regulations from time to time. The interpretation by the Committee of any of the provisions of the Plan or any Award granted under the Plan shall be final and binding upon the Company and all persons having an interest in any Award or any shares of Common Stock purchased or other payments received pursuant to an Award. Notwithstanding the authority hereby delegated to the Committee to grant Awards to Employees and Directors under the Plan, the Board shall have full authority, subject to the express provisions of the Plan, to grant Awards to Employees and Directors under the Plan, to interpret the Plan, to provide, modify and rescind rules and regulations relating to it, to determine the terms and provision of Awards granted to Employees and Directors under the Plan and to make all other determinations and perform such actions as the Board deems necessary or advisable to administer the Plan. No member of the Committee or the Board shall be liable for any action taken or determination made in good faith with respect to the Plan or any Award granted hereunder.

14. EFFECT OF PLAN . Neither the adoption of the Plan nor any action of the Board or the Committee shall be deemed to give any Employee or Director any right to be

 

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granted an Award or any other rights except as may be evidenced by the Award Agreement, or any amendment thereto, duly authorized by the Committee and executed on behalf of the Company, and then only to the extent and on the terms and conditions expressly set forth therein. The existence of the Plan and the Awards granted hereunder shall not affect in any way the right of the Board, the Committee or the shareholders of the Company to make or authorize any adjustment, recapitalization, reorganization or other change in the Company’s capital structure or its business, any merger or consolidation or other transaction involving the Company, any issue of bonds, debentures, or shares of preferred stock ranking prior to or affecting the Common Stock or the rights thereof, the dissolution or liquidation of the Company or any sale or transfer of all or any part of the Company’s assets or business, or any other corporate act or proceeding by or for the Company. Nothing contained in the Plan or in any Award Agreement or in other related documents shall confer upon any Employee or Director any right with respect to such person’s Continuous Service or interfere or affect in any way with the right of the Company or an Affiliate to terminate such person’s Continuous Service at any time, with or without cause.

15. NO EFFECT ON RETIREMENT AND OTHER BENEFIT PLANS . Except as specifically provided in a retirement or other benefit plan of the Company or an Affiliate, Awards shall not be deemed compensation for purposes of computing benefits or contributions under any retirement plan of the Company or an Affiliate, and shall not affect any benefits under any other benefit plan of any kind or any benefit plan subsequently instituted under which the availability or amount of benefits is related to level of compensation. The Plan is not a “Retirement Plan” or “Welfare Plan” under the Employee Retirement Income Security Act of 1974, as amended.

16. AMENDMENT OR TERMINATION OF PLAN . The Board in its discretion may, at any time or from time to time after the date of adoption of the Plan, terminate or amend the Plan in any respect, including amendment of any form of Award Agreement, exercise agreement, or instrument to be executed pursuant to the Plan; provided, however, to the extent necessary to comply with the Code, including Sections 162(m) and 422 of the Code, other applicable laws, or the applicable requirements of any stock exchange or national market system, the Company shall obtain shareholder approval of any Plan amendment in such manner and to such a degree as required. No Award may be granted after termination of the Plan. Any amendment or termination of the Plan shall not affect Awards previously granted, and such Awards shall otherwise remain in full force and effect as if the Plan had not been amended or terminated, unless mutually agreed otherwise in a writing (including an Award Agreement) signed by the Grantee and the Company.

17. EFFECTIVE DATE AND TERM OF PLAN . The Plan shall become effective March 29, 2006, which is the date of adoption of the Plan by the Board. The Plan shall continue in effect for a term of ten (10) years from March 29, 2006 and terminate on March 29, 2016, unless sooner terminated by action of the Board.

18. SEVERABILITY AND REFORMATION . The Company intends all provisions of the Plan to be enforced to the fullest extent permitted by law. Accordingly, should a court of competent jurisdiction determine that the scope of any provision of the Plan is too broad to be enforced as written, the court should reform the provision to such narrower scope as

 

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it determines to be enforceable. If, however, any provision of the Plan is held to be wholly illegal, invalid, or unenforceable under present or future law, such provision shall be fully severable and severed, and the Plan shall be construed and enforced as if such illegal, invalid, or unenforceable provision were never a part hereof, and the remaining provisions of the Plan shall remain in full force and effect and shall not be affected by the illegal, invalid, or unenforceable provision or by its severance.

19. GOVERNING LAW . The Plan and all issues or matters relating to the Plan shall be governed by, determined and enforced under, and construed and interpreted in accordance with the laws of the State of Texas.

20. INTERPRETIVE MATTERS . Whenever required by the context, pronouns and any variation thereof shall be deemed to refer to the masculine, feminine, or neuter, and the singular shall include the plural, and visa versa. The term “include” or “including” does not denote or imply any limitation. The captions and headings used in the Plan are inserted for convenience and shall not be deemed a part of the Plan for construction or interpretation.

21. SECTION 409A COMPLIANCE. Notwithstanding any other provision of the Plan to the contrary, it is not the intention of the Company that this Plan or any Award granted under the Plan result in unfavorable tax consequences to any Grantee under Section 409A of the Code. The Company intends that the Plan and any Award granted under the Plan shall at all times be exempt from or otherwise comply with the provisions of Code Section 409A. The provisions, terms and conditions of the Plan and any Award granted under the Plan may be amended at anytime, if necessary, in order to be exempt from or otherwise comply with the provisions of Code Section 409A; provided, however, that neither the Company nor a Grantee shall be required to assume an increased economic burden in connection with any such amendment.

 

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Exhibit 31.1

CERTIFICATION OF CHIEF EXECUTIVE OFFICER

PURSUANT TO 15 U.S.C. SECTION 7241, AS ADOPTED

PURSUANT TO SECTION 302 OF THE

SARBANES-OXLEY ACT OF 2002

I, J. Russell Porter, certify that:

1. I have reviewed this Quarterly Report on Form 10-Q of Gastar Exploration, Ltd. (the “Registrant”);

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this report;

4. The Registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the Registrant and we have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Evaluated the effectiveness of the Registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(c) Disclosed in this report any change in the Registrant’s internal control over financial reporting that occurred during the Registrant’s most recent fiscal quarter (the Registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the Registrant’s internal control over financial reporting; and

5. The Registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Registrant’s auditors and the audit committee of the Registrant’s board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant’s internal control over financial reporting.

Date: August 14, 2006

 

/s/ J. RUSSELL PORTER

J. Russell Porter
Chief Executive Officer

Exhibit 31.2

CERTIFICATION OF CHIEF FINANCIAL OFFICER

PURSUANT TO 15 U.S.C. SECTION 7241, AS ADOPTED

PURSUANT TO SECTION 302 OF THE

SARBANES-OXLEY ACT OF 2002

I, Michael A. Gerlich, certify that:

1. I have reviewed this Quarterly Report on Form 10-Q of Gastar Exploration, Ltd. (the “Registrant”);

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this report;

4. The Registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the Registrant and we have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Evaluated the effectiveness of the Registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(c) Disclosed in this report any change in the Registrant’s internal control over financial reporting that occurred during the Registrant’s most recent fiscal quarter (the Registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the Registrant’s internal control over financial reporting; and

5. The Registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Registrant’s auditors and the audit committee of the Registrant’s board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant’s internal control over financial reporting.

Date: August 14, 2006

 

/s/ MICHAEL A. GERLICH

Michael A. Gerlich
Chief Financial Officer

Exhibit 32.1

Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

I, J. Russell Porter, Chief Executive Officer of Gastar Exploration, Ltd. (the “Company”), hereby certify that the accompanying Annual Report on Form 10-Q for the six months ended June 30, 2006 (the “Report”), filed by the Company with the Securities and Exchange Commission on the date hereof pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 fully complies with the requirements of that section.

I further certify that the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: August 14, 2006

 

/s/ J. RUSSELL PORTER

J. Russell Porter
Chief Executive Officer

Exhibit 32.2

Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

I, Michael A. Gerlich, Chief Financial Officer of Gastar Exploration, Ltd. (the “Company”), hereby certify that the accompanying Annual Report on Form 10-Q for the six months ended June 30, 2006 (the “Report”), filed by the Company with the Securities and Exchange Commission on the date hereof pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 fully complies with the requirements of that section.

I further certify that the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: August 14, 2006

 

/s/ MICHAEL A. GERLICH

Michael A. Gerlich
Chief Financial Officer