Gastar Exploration Inc.
GASTAR EXPLORATION LTD (Form: 10-Q, Received: 08/14/2007 16:07:04)
Table of Contents

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, 2007 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 10, 2007 was 207,098,570.

 



Table of Contents

GASTAR EXPLORATION LTD.

QUARTERLY REPORT ON FORM 10-Q

FOR THE THREE MONTHS ENDED JUNE 30, 2007

TABLE OF CONTENTS

 

             Page

PART I – FINANCIAL INFORMATION

  

Item 1.

  Financial Statements   
   

Condensed Consolidated Balance Sheets as of June 30, 2007 and December 31, 2006

   1
   

Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2007 and 2006

   2
   

Condensed Consolidated Statement of Shareholders’ Equity for the Six Months Ended June 30, 2007

   3
   

Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2007 and 2006

   4
   

Notes to the Condensed Consolidated Financial Statements

   5

Item 2.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations    17

Item 3.

  Quantitative and Qualitative Disclosure about Market Risk    23

Item 4.

  Controls and Procedures    24

PART II – OTHER INFORMATION

  

Item 1.

  Legal Proceedings    24

Item 1A.

  Risk Factors    24

Item 2.

  Unregistered Sales of Equity Securities and Use of Proceeds    24

Item 3.

  Default Upon Senior Securities    24

Item 4.

  Submission of Matters to a Vote of Security Holders    25

Item 5.

  Other Information    25

Item 6.

  Exhibits    25
  SIGNATURES    26

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) “senior secured notes” refers to our $73.0 million principal amount of senior secured notes issued in 2005, (iv), “convertible senior debentures” refers to our $30.0 million principal amount of 9.75% convertible senior unsecured debentures, (v)”unsecured notes” refer to our $3.25 million principal amount of 10% subordinated unsecured notes payable, (vi) “warrants” refers to the warrants to purchase common shares issued to investors in connection with certain financing transactions or to our placement agents in connection with the offering of convertible senior debentures and certain other subordinated notes as partial compensation for their services, (vii) all dollar amounts appearing in this Form 10-Q are stated in United States dollars unless specifically noted in Canadian dollars (“CDN$”), and (viii) 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 United States 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.

 

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GASTAR EXPLORATION LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

 

       June 30,
2007
    December 31,
2006
 
     (Unaudited)        
     (in thousands)  

ASSETS

  

CURRENT ASSETS:

    

Cash and cash equivalents

   $ 92,696     $ 40,733  

Revenues receivable

     2,884       3,248  

Accounts receivable, net

     1,237       5,485  

Due from related parties

     2,086       4,394  

Prepaid expenses

     912       1,369  
                

Total current assets

     99,815       55,229  

PROPERTY, PLANT AND EQUIPMENT:

    

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

    

Unproved properties, not being amortized

     57,515       89,658  

Proved properties

     226,071       181,362  
                

Total natural gas and oil properties

     283,586       271,020  

Furniture and equipment

     615       600  
                

Total property, plant and equipment

     284,201       271,620  

Accumulated depreciation, depletion and amortization

     (149,092 )     (110,794 )
                

Total property, plant and equipment, net

     135,109       160,826  

OTHER ASSETS:

    

Deferred charges

     2,958       3,502  

Drilling advances

     6,249       9,137  

Other assets

     196       195  
                

Total other assets

     9,403       12,834  
                

TOTAL ASSETS

   $ 244,327     $ 228,889  
                

LIABILITIES AND SHAREHOLDERS’ EQUITY

    

CURRENT LIABILITIES:

    

Accounts payable

   $ 9,995     $ 15,471  

Accrued interest

     2,466       2,515  

Accrued drilling and operating costs

     3,897       5,680  

Other accrued liabilities

     8,366       6,584  

Due to related parties

     788       1,670  
                

Total current liabilities

     25,512       31,920  

LONG-TERM LIABILITIES:

    

Long-term debt

     95,426       93,803  

Asset retirement obligation

     5,464       4,218  

Liability to be settled by issuance of common shares

     —         606  
                

Total long-term liabilities

     100,890       98,627  

COMMITMENTS AND CONTINGENCIES (Note 10)

    

SHAREHOLDERS’ EQUITY:

    

Common stock, no par value, unlimited common shares authorized, 207,098,570 and 194,965,436 common shares issued and outstanding at June 30, 2007 and December 31, 2006, respectively

     249,973       225,986  

Additional paid-in capital

     12,585       10,418  

Accumulated other comprehensive loss

     (30 )     (34 )

Accumulated deficit

     (144,603 )     (138,028 )
                

Total shareholders’ equity

     117,925       98,342  
                

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

   $ 244,327     $ 228,889  
                

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

 

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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,

 
     2007     2006     2007     2006  
     (in thousands, except share and per share data)  

REVENUES

   $ 7,956     $ 6,684     $ 15,471     $ 13,307  

EXPENSES:

        

Production taxes

     220       366       514       766  

Lease operating expenses

     1,514       1,450       3,209       2,706  

Transportation and treating

     339       312       662       616  

Depreciation, depletion and amortization

     5,443       3,565       9,784       7,874  

Impairment of natural gas and oil properties

     28,514       —         28,514       37,301  

Accretion of asset retirement obligation

     72       57       138       114  

Mineral resource properties

     (136 )     33       (123 )     190  

General and administrative expenses

     3,519       3,107       6,704       5,626  

Litigation settlement expense

     —         1,200       4,972       1,200  
                                

Total expenses

     39,485       10,090       54,374       56,393  
                                

LOSS FROM OPERATIONS

     (31,529 )     (3,406 )     (38,903 )     (43,086 )

OTHER (EXPENSES) INCOME:

        

Interest expense

     (3,738 )     (3,816 )     (7,681 )     (7,575 )

Investment income and other

     772       492       1,135       1,020  

Gain on sale of unproved natural gas and oil properties

     38,872       —         38,872       —    

Foreign exchange gain

     3       3       2       4  
                                

INCOME (LOSS) BEFORE INCOME TAXES

     4,380       (6,727 )     (6,575 )     (49,637 )

Provision for income taxes

     —         —         —         —    
                                

NET INCOME (LOSS)

   $ 4,380     $ (6,727 )   $ (6,575 )   $ (49,637 )
                                

NET INCOME (LOSS) PER SHARE:

        

Basic and diluted

   $ 0.02     $ (0.04 )   $ (0.03 )   $ (0.30 )
                                

WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:

        

Basic and diluted

     201,918,634       166,513,762       198,488,244       165,663,086  
                                

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

 

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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, 2006

   194,965,436    $ 225,986    $ 10,418    $ (34 )   $ (138,028 )   $ 98,342     $ —    

Issuance of shares, senior secured debt

   375,939      606      —        —         —         606       —    

Issuance of shares – cash, net of offering costs of $134,000

   11,757,195      23,381      —        —         —         23,381       —    

Stock based compensation

   —        —        2,167      —         —         2,167       —    

Foreign currency translation

   —        —        —        4       —         4       4  

Net loss

   —        —        —        —         (6,575 )     (6,575 )     (6,575 )
                                                   

Balance at June 30, 2007

   207,098,570    $ 249,973    $ 12,585    $ (30 )   $ (144,603 )   $ 117,925     $ (6,571 )
                                                   

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

 

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GASTAR EXPLORATION LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

     For the Six Months
Ended June 30,
 
     2007     2006  
     (in thousands)  

CASH FLOWS FROM OPERATING ACTIVITIES:

    

Net loss

   $ (6,575 )   $ (49,637 )

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

    

Depreciation, depletion and amortization

     9,784       7,874  

Impairment of natural gas and oil properties

     28,514       37,301  

Amortization of deferred lease costs

     —         200  

Stock based compensation

     2,167       1,260  

Amortization of deferred financing costs and debt discount

     2,167       2,077  

Accretion of asset retirement obligation

     138       114  

Gain on sale of unproved natural gas and oil properties

     (38,872 )     —    

Changes in operating assets and liabilities:

    

Accounts receivable

     6,920       (449 )

Prepaid expenses

     457       456  

Accounts payable and accrued liabilities

     971       3,553  
                

Net cash provided by operating activities

     5,671       2,749  
                

CASH FLOWS FROM INVESTING ACTIVITIES:

    

Drilling advances

     2,888       (4,124 )

Development and purchases of natural gas and oil properties

     (46,813 )     (20,742 )

Proceeds from sale of unproved natural gas and oil properties, net of transaction costs

     66,849       —    

Purchase of furniture and equipment

     (15 )     (143 )

Other

     2       —    
                

Net cash provided by (used in) investing activities

     22,911       (25,009 )
                

CASH FLOWS FROM FINANCING ACTIVITIES:

    

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

     23,381       84  

Deferred financing charges and other

     —         (46 )
                

Net cash provided by financing activities

     23,381       38  
                

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS

     51,963       (22,222 )

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

     40,733       61,144  
                

CASH AND CASH EQUIVALENTS, END OF PERIOD

   $ 92,696     $ 38,922  
                

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

 

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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, 2006. 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, 2007 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 2007.

New Accounting Pronouncements

Accounting for Uncertainty in Income Taxes. Effective January 1, 2007, the Company adopted SFAS Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of SFAS Statement No. 109”   (“FIN 48”). This interpretation provides guidance for recognizing and measuring uncertain tax positions, as defined in SFAS No. 109, “Accounting for Income Taxes”. FIN 48 requires a company to evaluate whether the tax position taken by a company will more likely than not be sustained upon examination by the appropriate taxing authority. It also provides guidance on how a company should measure the amount of benefit that a company is to recognize in its financial statements. FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. There was no material cumulative effect of adopting FIN 48 on the Company’s financial statements.

Fair Value Measurements . In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157 , “Fair Value Measurements” (“SFAS No. 157”), which addresses how companies should measure fair value when companies are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting principles (“GAAP”). As a result of SFAS No. 157, there is now a common definition of fair value to be used throughout GAAP. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those years. Although the disclosure requirements may be expanded where certain assets or liabilities are fair valued such as those related to stock compensation expense and hedging activities, the Company does not expect the adoption of SFAS No. 157 to have a material impact on the Company’s financial statements.

 

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GASTAR EXPLORATION LTD. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

2. Drilling Advances

Drilling advances 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. Pursuant to the contract, the advance payment to a drilling contractor is being amortized over a three-year period commencing November 2006 as a reduction to proved property costs.

 

     Total  
     (in thousands)  

Balance as of December 31, 2006

   $ 9,137  

Advances

     147  

Applied to expenditures

     (3,035 )
        

Balance as of June 30, 2007

   $ 6,249  
        

3. 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 Texas, Wyoming, West Virginia and Montana and 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, 2007:

      

Cost:

      

Unproved properties, not being amortized

   $ 43,601     $ 13,914     $ 57,515  

Proved properties

     225,467       604       226,071  
                        

Total natural gas and oil properties

     269,068       14,518       283,586  

Furniture and equipment

     600       15       615  
                        

Total property, plant and equipment

     269,668       14,533       284,201  

Impairment of proved natural gas and oil properties

     (104,205 )     (604 )     (104,809 )

Accumulated depreciation, depletion and amortization

     (44,268 )     (15 )     (44,283 )
                        

Total property, plant and equipment, net

   $ 121,195     $ 13,914     $ 135,109  
                        

As of June 30, 2007, unproved properties not being amortized consisted of drilling in progress costs of $11.8 million and acreage acquisition costs of $45.7 million.

For the six months ended June 30, 2006 and 2007, the results of management’s ceiling test evaluation resulted in an impairment of United States proved properties of $37.3 million and $28.5 million, respectively. Management determined that no impairment was required on Australian properties at June 30, 2007 and 2006.

In May 2007, the Company sold a portion of its undeveloped natural gas and oil acreage in the Hilltop area of East Texas for approximately $68.2 million before transaction costs of approximately $1.4 million, resulting in a gain on sale of $38.9 million.

 

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GASTAR EXPLORATION LTD. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

4. Long-Term Debt

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

 

     As of
June 30,
2007
   As of
December 31,
2006
     (in thousands)

Senior secured notes

   $ 62,270    $ 60,671

Subordinated unsecured notes

     3,156      3,132

Convertible senior debentures

     30,000      30,000
             

Total net carrying value of long-term debt

     95,426      93,803

Debt discount costs to be accreted

     10,824      12,447
             

Total long-term debt at maturity

   $ 106,250    $ 106,250
             

Senior Secured Notes

On June 17, 2005, the Company issued $63.0 million in principal amount of senior secured notes. On September 19, 2005, the Company issued to the holders of these 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 our assets, bear interest at the sum of the three-month LIBOR rate plus 6% (11.36% at June 30, 2007), 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 our option at any time upon payment of the principal and accrued and unpaid interest plus a premium of 5% until the third anniversary of issuance, 4% from third anniversary to fourth anniversary and 3% from fourth anniversary until day before maturity. 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. The Company initially recorded a liability of $17.0 million related to common shares to be issued and a corresponding amount recorded as a debt discount to be accreted to interest expense using the effective interest method. The Company also incurred an estimated $3.0 million of direct financing costs for legal fees and fees paid to an agent as deferred charges and are amortizing these costs over the term of the senior secured notes. As of June 30, 2007, the Company had no obligation to issue additional common shares under the senior secured notes.

Under the senior secured notes, the PV(10) valuation 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. As of June 30, 2007, proved reserves PV(10) (“1P (PV10)”to net senior secured notes debt must be a minimum of 1.5:1, and it increases to 2.0:1 on the third anniversary date and for all test periods thereafter until maturity. Utilizing the reserve pricing criteria above, the proved plus probable reserves PV(10) (“2P PV10)” to net senior secured notes debt reserve ratio is a minimum of 3.0:1, and it increases to 3.5:1 on the third anniversary and for all test periods thereafter until maturity. 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. At June 30, 2007, the Company was in compliance with the debt covenant. 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.

 

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GASTAR EXPLORATION LTD. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Our bank deposit accounts are subject to account agreements in favor of our senior lenders that allow the senior lenders to take certain actions under specific circumstances to pay interest and/or principal outstanding related to the senior secured notes.

Convertible Senior Debentures

In November 2004, the Company issued $30.0 million aggregate principal amount of convertible senior unsecured 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 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, representing 130% of the final conversion price of $4.38.

Subordinated Unsecured Notes Payable

In July 2004, the Company completed a $3.25 million subordinated unsecured note financing. The unsecured notes mature between April 2009 and September 2009, bear interest at 10% per annum and became callable by the Company in July 2006 at 108% of the principal amount. The call premium reduces to 105% in July 2007 and to 101% in July 2008.

5. 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,
     2007    2006    2007    2006
     (in thousands)

Cash and accrued

   $ 2,647    $ 2,774    $ 5,514    $ 5,498

Amortization of deferred financing costs and debt discount

     1,091      1,042      2,167      2,077
                           

Total

   $ 3,738    $ 3,816    $ 7,681    $ 7,575
                           

6. Share Based Compensation

Share-Based Compensation Plans

2002 Stock Option 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. The vesting schedule has varied from two years to four years but generally has occurred over a four-year period at 25% per year beginning on the first anniversary date of the grant. Stock options issued pursuant to the Company’s 2002 Stock Option Plan have an exercise price determined by the Board of Directors, but that exercise price cannot be less than the market price on the date immediately prior to the date of grant as reported by any stock exchange on which the Company’s common shares are listed. If a stock option granted under the Company’s 2002 Stock Option Plan expires or terminates for any reason in accordance with the terms of the Company’s Stock Option Plan, the unpurchased common shares subject to that stock option become available for other stock option grants.

In April 2004, the Board of Directors amended the provisions of the Company’s 2002 Stock Option Plan to specifically incorporate a provision to provide for stock options to be exercised on a cashless basis, whereby the Company issues to the optionee the number of common shares equal to the stock option exercised, less the number of common shares which when multiplied by the market price at the date of exercise equals the aggregate exercise price for all of the common shares exercised.

 

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2006 Gastar Long-Term Stock Incentive Plan . On June 1, 2006, our 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, stock appreciation rights, bonus stock awards and any other type of award established by the Committee which is consistent with the Plan’s purposes to directors, officers and employees of the Company and its subsidiaries covering a maximum of 5.0 million common shares. The contractual life and vesting period for a grant will be determined by the Board of Directors at the time grant is awarded. As of June 30, 2007, no grants had been granted under the 2006 Gastar Long-Term Stock Incentive Plan.

Determining Fair Value under SFAS No. 123R

In applying the provisions of SFAS No. 123R, the Company used the following assumptions:

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 expensed using the “graded-vesting method”, which recognizes compensation costs over the requisite service period for each separately vesting tranche of an award as though the award were, in substance, multiple awards.

Expected Life . The expected life of awards granted represents the period of time that stock options are expected to be outstanding. The Company determined the expected life using the “simplified method” resulting in a 6.25-year expected life in accordance with Staff Accounting Bulletin No. 107 for all stock options issued with a four-year vesting period and a ten-year grant expiration. Using the simplified method, stock options that have been issued with two and three-year vesting periods and having a ten-year expiration have an expected life of 5.75 and 6.0 years, respectively. Prior to October 2005, the Company’s stock options had a five-year expiration and expected life.

Expected Volatility . Using the Black-Scholes-Merton valuation model, the Company estimates the volatility of its common shares at the beginning of the quarter in which the stock option is granted.

Risk-Free Interest Rate . The Company utilizes a risk-free interest rate equal to the rate of U.S. Treasury zero-coupon issues as of the date of grant with a term equivalent to the stock option’s expected life.

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 . In 2006, the Company began using a forfeiture rate of 5% in determining initial compensation expense, based on forfeitures of all unvested stock option as a percentage of all stock option grants calculated at the beginning of the year. The estimated forfeiture rate for 2007 also is 5.0%.

The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes-Merton valuation pricing model. During the six months ended June 30, 2007 and 2006, we granted 227,000 and 1,195,000 stock options, respectively. A summary of the assumptions for stock options granted during the six months ended June 30, 2007 and 2006 are as follows:

 

     For the Six Months
Ended June 30,
 
     2007     2006  

Expected life (in years)

   6.25     6.5  

Expected volatility

   44.4 %   42.0 %

Risk-free interest rate

   4.6% - 4.8 %   5.0 %

 

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Stock-Based Compensation

For the three months ended June 30, 2007 and 2006, the Company recorded stock-based compensation expense for stock options granted using the fair-value method of $931,000 and $772,000, respectively. For the six months ended June 30, 2007 and 2006, the Company recorded stock-based compensation expense for stock options granted using the fair-value method of $2.2 million and $1.3 million, respectively. All stock based compensation costs were expensed and not tax effected, as the Company currently records no income tax expense. All common shares issued upon exercise are reserved and non-assessable.

At June 30, 2007, the Company had unvested stock options to purchase 7,284,000 common shares with a weighted average grant date fair value of $1.17 per common share. As of June 30, 2007, the Company had approximately $3.0 million of total unrecognized compensation cost related to unvested stock options, which is expected to be amortized over the following periods:

 

     (in thousands)

Six months ending December 31, 2007

   $ 1,186

2008

     1,412

2009

     379

2010

     49

2011

     3
      

Total

   $ 3,029
      

Stock Option Activity

The following table summarizes the changes and option exercise prices for stock options under the Company’s Stock Option Plan for the six months ended June 30, 2007:

 

     Number of
Shares Under
Stock Options
   

Weighted

Average
Exercise
Price

Stock options outstanding as of December 31, 2006

   10,472,750     $ 2.86

Stock options granted

   227,000       2.14

Stock options exercised

   —         —  

Stock options cancelled/expired

   (502,000 )     2.65
            

Stock options outstanding as of June 30, 2007

   10,197,750     $ 3.06
            

Stock options exercisable:

    

June 30, 2007

   2,913,750     $ 3.41
            

As of June 30, 2007, the aggregate intrinsic value for outstanding stock options and the remaining weighted average contractual life of outstanding stock options was $2,000 and 5.6 years, respectively. As of June 30, 2007, there was no aggregate intrinsic value for exercisable stock options, and the remaining weighted average contractual life of exercisable stock options was 2.8 years. As of June 30, 2007, the total fair value of exercisable stock options was $3.2 million.

 

     For the Six Months
Ended June 30,
     2007    2006
     (in thousands)

Total fair value of stock options granted

   $ 245    $ 2,146

Weighted average fair value per share of stock options granted

   $ 1.08    $ 1.80

Total intrinsic value of stock options exercised (1)

   $ —      $ 1,221

(1) Intrinsic value of stock options is calculated using the difference between the common share price on the date of exercise and the exercise price times the number of stock options exercised. There were no stock options exercised during the six months ended June 30, 2007.

 

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The following table summarizes the range of exercise prices for stock options outstanding and exercisable as of June 30, 2007:

 

    

Number of Shares

Under Stock Options

  

Exercise

Prices (1)

Expiration Date

   Outstanding    Exercisable   

April 20, 2009

   725,000    543,750    $ 3.49

August 4, 2009

   3,803,750    1,898,750    $ 3.22

April 4, 2010

   21,000    10,500    $ 4.06

June 24, 2010

   345,000    86,250    $ 3.30

June 28, 2010

   50,000    12,500    $ 3.21

September 7, 2010

   150,000    37,500    $ 3.07

September 20, 2010

   40,000    10,000    $ 3.78

October 17, 2015

   75,000    18,750    $ 4.25

January 16, 2016

   270,000    67,500    $ 4.73

April 5, 2016

   863,000    215,750    $ 4.53

May 24, 2016

   50,000    12,500    $ 3.07

July 14, 2016

   3,580,000    —      $ 2.32

January 12, 2017

   25,000    —      $ 1.95

March 30, 2017

   200,000    —      $ 2.17
            
   10,197,750    2,913,750   
            

(1) Stock options granted with strike prices denominated in CDN$ have been converted to US$ at 0.94402, the exchange rate at June 30, 2007.

7. Income (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,

 
     2007    2006     2007     2006  
     (in thousands, except share and per share amounts)  

Basic and diluted income (loss) per share and shares outstanding:

         

Net income (loss)

   $ 4,380    $ (6,727 )   $ (6,575 )   $ (49,637 )

Weighted average common shares outstanding:

         

Basic and diluted

     201,918,634      166,513,762       198,488,244       165,663,086  

Income (loss) per share:

         

Basic and diluted

   $ 0.02    $ (0.04 )   $ (0.03 )   $ (0.30 )

Common shares excluded from the denominator as anti-dilutive:

         

Stock options

     10,197,750      16,131,150       10,197,750       16,131,150  

Warrants

     2,732,521      2,732,521       2,732,521       2,732,521  

Convertible debentures

     6,849,315      6,849,315       6,849,315       6,849,315  

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

     —        2,237,197       —         2,237,197  
                               

Total

     19,779,586      27,950,183       19,779,586       27,950,183  
                               

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

 

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8. Income Taxes

On January 1, 2007, the Company adopted FIN 48, “Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109”, regarding accounting for uncertainty in tax positions. The Company remains subject to examination of income tax filings in the United States and various state jurisdictions for the 2000-2005 tax years. The Company has also determined that it is subject to examination in various foreign jurisdictions for all prior periods due to the Company’s continued loss position in such jurisdictions. The Company has not filed its income tax returns for the tax year 2006; however, the Company expects that the tax positions taken in 2006 returns will be similar to positions taken in prior year returns. Within each of these jurisdictions, the material tax positions were examined under the more-likely-than-not guidance provided by FIN 48. If interest and penalties were to be assessed, the Company would charge interest to interest expense, and penalties to general and administrative expense.

As a result of the FIN 48 assessment, the Company concluded that it has not taken any uncertain tax positions on any of its open tax returns that would materially distort the Company’s financial statements. There was no material cumulative effect of adopting FIN 48 on the Company’s financial statements as of January 1, 2007.

9. Common Stock

On May 9, 2007, the Company completed the sale of a portion of the Company’s East Texas undeveloped natural gas and oil acreage to a third party for total consideration before transaction costs, of $88.2 million, including the purchase of 10 million newly issued Gastar common shares at a price of $2.00 per share, or $20 million.

On May 23, 2007 in conjunction with the May 9, 2007 sale of 10 million newly issued common shares, Chesapeake acquired an additional 1,757,195 of the Company’s common shares at $2.00 per share pursuant to its preemptive rights under a Common Stock Purchase Agreement dated November 4, 2005. The common share purchase resulted in Chesapeake owning 16.4% of the Company’s outstanding common shares.

10. Commitments and Contingencies

Litigation

The Company is party to various litigation matters arising out of the normal course of business. The ultimate outcome of the matters discussed below 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, results of operations or cash flow. The more significant litigation matters are summarized below.

Estate of Virgil Sparks and Oil Wells of Kentucky, Inc. vs. First Sourcenergy Group Inc. (now Gastar Exploration New South Wales, Inc. (“GENSW”)) and Geostar Corporation Arbitration . In August 2002, GENSW, 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. GENSW and Geostar have moved to dismiss the arbitration on the grounds of a claimed prior settlement and release agreement. GENSW and Geostar are vigorously defending the arbitration and firmly believe that their position is supportable and intend to continue to defend vigorously against the claim. Further, GENSW’s interest in ATP 560 was transferred from GENSW to a third party in 2001, the result of which means that, although GENSW is a named defendant, the third party and Geostar would bear primary liability from this arbitration action.

Navasota Resources L.P. (“Navasota”) vs. First Source Texas, Inc. (now Gastar Exploration Texas, Inc.), First Source Gas L.P. (now Gastar Exploration Texas LP) and Gastar Exploration Ltd. (Cause No. 0-05-

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

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 and 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 filed a Notice of Appeal to the Tenth Court of Appeals in Waco. All parties have filed their respective briefs, and the parties are waiting for the appellate court to set a date for oral argument. The Company intends to continue to vigorously defend itself against this claim.

Gastar Exploration Texas LP 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 that were part of 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 McFarlanes filed a Motion for Partial Summary Judgment, which was denied in December, 2006 by the trial court. In April, 2007, the McFarlanes filed a Motion for Partial Summary Judgment, which the trial court denied in early July 2007. A mediation of this lawsuit has been tentatively set for August 24, 2007. The Company will continue to vigorously pursue this claim.

Burning Rock Energy, LLC, et al (“Burning Rock”) vs. First Sourcenergy Wyoming, Inc. (now Gastar Exploration USA, Inc.), et al. Burning Rock contends in this 2006 lawsuit and other related lawsuits that the Company 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. At December 31, 2006, the Company’s present value, discounted at 10%, of the leases in dispute was approximately $742,000. In April 2007, the Company assigned its interest in the disputed leases for a full release from this litigation matter.

Larry McNiell v. Geostar Corporation, First Source Wyoming, Inc. and Gastar Exploration Ltd. (Case No. 2:06cv00911 TS); In the United States District Court for the District of Utah, Central Division. This lawsuit was filed by Larry McNiell, or the Plaintiff, seeking damages arising out of certain agreements entered into with First Source Wyoming, Inc. (“FSW”), a Geostar subsidiary, and Geostar. In the lawsuit, the Plaintiff asserts breaches of contract and conversion against Geostar and FSW for their alleged failures to make required payments, deliver required Company shares without restrictions and cover certain Plaintiff loans. The Plaintiff asserts a cause of action for declaratory judgment against the Company asking the Court to declare that the Company cannot place restrictions on the shares owed by Geostar to Plaintiff. The Company filed a Motion to Dismiss for lack of personal jurisdiction in Utah and for Plaintiff’s failure to state a claim upon which relief can be granted. On May 29, 2007, the federal court granted the Company’s Motion and dismissed McNeill’s claims against the Company for lack of personal jurisdiction.

Roland Spongberg v. Geostar Corporation, First Source Wyoming, Inc. and Gastar Exploration Ltd., and Does 1 through 100 (Case No. VC046736); In the Superior Court of California, Los Angeles County. This lawsuit was filed June 1, 2006 and arises out of Roland Spongberg’s, or the Plaintiff’s, investment in First Source Wyoming, Inc.’s, a Geostar subsidiary (“FSW”), Coalbed Methane Drilling Program. On December 28, 2001, Plaintiff entered a 2001 Coalbed Methane Subscription Agreement with FSW investing cash in exchange for a working interest in wells in the Powder River Basin in Wyoming. Plaintiff alleges that Geostar and the Company used FSW to offer investment securities to the general public in the form of oil, gas and coalbed methane working interests. Plaintiff alleges he entered into such agreement based on representations made at a meeting with certain Geostar and former Company officers. At the same time, Plaintiff entered into a Conversion Agreement with Geostar by which Plaintiff had the right to exchange his working interests for common shares of the Company held by Geostar. Plaintiff alleges he notified Geostar of his desire to convert his interest at a time when the Company stock was priced at $1.10 per share. Plaintiff alleges further that in September 2004, Geostar informed him that he did not properly exercise his conversion rights, and therefore did not have claim to any Company shares. Plaintiff alleges that between the date of his election and September 2004, the Company’s stock price

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

tripled. Plaintiff asserts claims against all defendants for fraud, negligent misrepresentation, breach of contract, breach of fiduciary duty, violations of Securities Exchange Act §10(b), and conspiracy to defraud, and seeks an accounting of the value of the Company’s stock, compensatory, special and punitive damages, interest and attorney’s fees. The Company has filed a Motion to Dismiss for lack of personal jurisdiction in California and for Plaintiff’s failure to state a claim upon which relief can be granted. The Court has entered an order permitting the Plaintiff a limited time period to conduct discovery on the jurisdictional issues, and the Motion has not been ruled on by the Court and remains pending. This claim is primarily related to Geostar actions and Company common shares claimed to be owed to the Plaintiff by Geostar. In June 2007, the parties completed limited discovery relating to the Company’s jurisdictional contacts with the state of California, and as a result of said discovery, Spongberg dismissed his claims against the Company with prejudice.

Spencer D. Plummer, III v. GeoStar Corporation, Classic Star LLC, Gastar Exploration, Ltd., Thom Robinson, Tony Ferguson, and John W. Parrott; In the United States District Court of Utah, Central Division (Case No. 2:07-CV-00409). This lawsuit was filed on May 24, 2007 initially in Utah state court by Spencer Plummer, or the Plaintiff, in which he asserts breaches of his Employment Agreement and subsequent Termination Agreement (the “Agreements”) with his employer, Classic Star. The Plaintiff claims that he has not received benefits promised under such Agreements, including 699,249 shares of Company stock. The Company is not a party to the Agreements on which Plaintiff’s claims are expressly based; however, the Company and Plaintiff are parties to a Stock Option Agreement on which Plaintiff claim to Company stock is partially based. The Defendants removed the case to federal court based on diversity jurisdiction. The Company filed an Answer and Motion to Dismiss for lack of personal jurisdiction in Utah and for Plaintiff’s failure to state a claim upon which relief can be granted. Plaintiff filed a Motion to Remand to state court, and the parties are waiting for the federal court to set said motions for hearing.

Commitments

During 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 advance payments totaling $2.0 million prior to drilling rig delivery in November 2006. The advance payments are being 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 three-year term of the agreement commencing November 2006.

In February 2006, the Company entered into a letter agreement with ETC Texas Pipeline, Ltd. that expands our existing transportation and treating agreement to meet the future gathering, treating and transportation of natural gas produced and owned or controlled by the Company in the Hilltop area of East Texas. Under the letter agreement, ETC would construct a gathering system sufficient to gather and treat up to 150 MMcfd, and the Company would deliver to ETC a minimum of approximately 135 Bcf over a 10-year period. Minimum annual sales over the 10-year period and fees for the gathering and treating of natural gas are currently being negotiated.

Arbitration and Litigation with Geostar Corporation and Affiliates

Arbitration against Geostar and Affiliates. On October 18, 2006, in connection with 10 wells to be drilled in Victoria, Australia on the jointly owned EL 4416 license operated by Geostar, the Company sent a letter to Geostar demanding the arbitration of certain disputed issues and interpretations under a Participation and Operating Agreement (“POA”) with Geostar and its subsidiaries. Among other items, the claims the Company presented for resolution in arbitration include claims relating to Geostar’s demands for cash calls under the POA while simultaneously asserting that certain provisions of the POA, including overhead reimbursement rates, need to be renegotiated on terms that the Company believes are not reasonable or within industry standards. The Company has also requested that Geostar’s Australian subsidiary provide a record title assignment of the Company’s beneficial interests in EL 4416, the exploration license in the Gippsland Basin property in Victoria, Australia. Geostar contends that the Company is not entitled to the record title assignment. The Company’s former Chairman of the Board is a major shareholder and President of Geostar. The arbitrators have not yet been appointed, though that process is currently underway. No hearing date for the arbitration has been scheduled. As discussed below, Geostar denies that the disputes raised in the arbitration proceeding are subject to arbitration and has recently filed a lawsuit in Michigan federal court, seeking, among other things, to enjoin the arbitration.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

(Unaudited)

 

Geostar Corporation and West Virginia Gas Corporation v. Gastar Exploration Ltd. and J. Russell Porter . On July 27, 2007, the Company was served with a lawsuit filed by Geostar and one of its affiliates, West Virginia Gas Corporation, in federal court in Saginaw, Michigan. The lawsuit relates to the arbitration referenced above and issues raised in that arbitration, as well as other issues. Geostar is asserting a broad range of claims against the Company and its current chief executive officer, J. Russell Porter. The Company disputes the allegations in the Michigan lawsuit and intends to challenge the jurisdiction of the Michigan court to hear the claims and the propriety of a Michigan forum for the resolution of the claims. Subject to its jurisdiction and forum challenges, the Company also intends to vigorously defend against the plaintiffs’ claims on the merits.

Specifically, Geostar claims in the Michigan lawsuit that the POA was cancelled effective January 1, 2005, and that the parties have operated under oral contracts since that date. Geostar alleges that the issues in the Company’s arbitration proceeding arose under the alleged oral contracts, not the POA, and that the Company’s claims asserted in the arbitration therefore are not subject to arbitration under the arbitration provision in the POA. Geostar seeks an order from the court enjoining the arbitration from going forward.

Geostar also claims that the Company has breached the alleged oral contracts by allegedly failing to pay joint interest billings, authorizations for expenditures, and cash calls relating to EL 4416 in Australia and West Virginia properties, in an unspecified amount exceeding $75,000. Geostar also claims that the Company has breached alleged agreements to reimburse Geostar for various payments and services allegedly performed by Geostar and its personnel and paid on behalf of the Company by Geostar. Geostar claims that the amounts of the payments and the value of the services exceed $10 million. Geostar alternatively alleges that if there was no contract covering those payments and services, it allegedly is entitled to reimbursement on equitable principles. Geostar also seeks a declaration that the Company does not own rights in EL 4416.

Geostar also asserts claims in the Michigan lawsuit relating to Texas properties that were the subject of Purchase and Sale Agreements entered into in 2005, under which the Company acquired the interests of Geostar-affiliated entities in properties in Texas. Specifically, Geostar claims that the Company breached the Purchase and Sale Agreements by failing to provide information in connection with “Look-Back Payments” under provisions of the Purchase and Sale Agreements, and by failing to make payments allegedly due to Geostar under the Look-Back provisions, arising out of alleged changes in reserves following the sale of the Texas properties in June 2005. Geostar is seeking an amount in excess of not less than 10 million shares or $10 million under the Look Back. Geostar also claims that the Company failed to timely comply with provisions of the Purchase and Sale Agreements relating to the drilling of 20 wells on the properties conveyed under the Purchase and Sale Agreements and by failing to drill and test at least two wells in the Travis Peak formation in Texas, allegedly entitling Geostar to unspecified damages and a farm-in interest allegedly giving Geostar the right to drill, complete, and operate wells in the Travis Peak formation on certain acreage. The Company asserts that it has not breached the Purchase and Sale Agreements and that it has satisfied its drilling and testing obligations with respect to the Travis Peak wells. Further, the Company assets that it has timely furnished all Look-Back information and that no 2006 Look-Back payments are owed to Geostar.

Geostar and West Virginia Gas Corporation, an affiliate of Geostar, also assert claims against the Company and its current chief executive officer, alleging that the Company and its current chief executive officer tortiously interfered with an alleged contract between Geostar and with certain West Virginia individuals and entities. According to the lawsuit, these individuals and entities allegedly promised to give their oil, gas, and coalbed methane opportunities in West Virginia and Pennsylvania to Geostar. Geostar and West Virginia Gas Corporation alleged that Gastar and its chief executive officer caused those individuals and entities to establish and use new business entities to allegedly conceal opportunities from West Virginia Gas Corporation and to funnel them to the Company, the Company’s chief executive officer and the West Virginia individuals and entities.

 

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Gastar Exploration, Ltd., Gastar Exploration Texas, Inc., f/k/a First Texas Development, Inc., Gastar Exploration Texas LLC, f/k/a Bossier Basin, LLC, and Gastar Exploration Texas LP, f/k/a First Source Gas, LP v. Geostar Corporation, First Source Texas, Inc., First Source Bossier, LLC, and First Texas Gas, LP. In July 2007, the Company filed a lawsuit against Geostar and affiliates seeking relief in connection with the failure by Geostar and its affiliates to execute formal assignments of certain leases that were omitted from the schedule of leases attached to the assignments executed by Geostar affiliates in June 2005 pursuant to Purchase and Sale Agreements covering Texas properties of Geostar and its affiliates. The lawsuit asks the court to decree that in the transaction evidenced by the Purchase and Sale Agreements, affiliates of the Company acquired title to all properties in Texas in which Geostar and its affiliates owned an interest and that Geostar and its affiliates are obligated to execute formal assignments with regard to all such leases. The lawsuit has been served on Geostar and its affiliates, and the case is in its early stages.

Gastar Exploration Ltd., Gastar Exploration USA, Inc. f/k/a First Sourcenergy Wyoming Inc., Gastar Exploration New South Wales, Inc., f/k/a First Sourcenergy Group, Inc., Gastar Exploration Victoria, Inc. f/k/a First Sourcenergy Victoria, Inc.,, Gastar Exploration Texas, Inc., f/k/a First Texas Development, Inc., Gastar Exploration Texas LLC, f/k/a Bossier Basin, LLC, and Gastar Exploration Texas LP, f/k/a First Source Gas, LP v. Geostar Corporation. In July 2007, the Company and affiliates filed a lawsuit in the District Court of Harris County, Texas against Geostar in connection with Geostar’s failure to deliver to the Company and its affiliates corporate records of the Company and its affiliates that have been retained by Geostar. Representatives of the Company and its affiliates have previously demanded return of the corporate records retained by Geostar, but Geostar has failed to return the records. The lawsuit asks the court to decree that the Company and its affiliates are entitled to possession of the corporate records and order their return to the Company and its affiliates. The lawsuit also seeks recovery of actual and punitive damages, costs, and attorney’s fees.

11. Supplemental Disclosure of Cash Flow Information

The following is a summary of supplemental cash paid and non-cash transactions disclosed in the notes to the consolidated financial statements:

 

    

For the Six Months

Ended June 30,

     2007    2006
     (in thousands)

Cash paid for interest

   $ 5,562    $ 5,512

Non-cash transactions:

     

Non-cash capital expenditures excluded from accounts payable and accrued drilling costs

   $ 7,379    $ 5,699

Asset retirement obligation included in oil and natural gas properties

   $ 1,109    $ 94

Common shares issued under senior secured notes

   $ 606    $ 4,249

 

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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 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, the impact of acquisitions, estimates of proved reserves, potential failure to achieve production from development projects, capital expenditures and other uncertainties, as well as those factors discussed in this Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2006, 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 unconventional natural gas exploration in the deep Bossier play in the Hilltop area in East Texas. 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

The majority of our activity focus has been in the deep Bossier play in the Hilltop area, located in East Texas approximately midway between Dallas and Houston in Leon and Robertson Counties, Texas. During the six months ended June 30, 2007, we continued our exploratory drilling program in this area, successfully drilling five gross (2.8 net) wells, resulting in successful completions of 15 out of 16 deep Bossier wells drilled to date. Drilling activities are continuing in the area. In May 2007, we sold a portion of our undeveloped natural gas and oil acreage in the Hilltop area of East Texas for approximately $68.2 million, net of transaction costs of approximately $1.4 million, resulting in a gain on sale of $38.9 million. As a result of the sale of undeveloped acreage, our post-sale acreage in East Texas is approximately 34,500 gross (16,350 net) acres. For the six months ended June 30, 2007, net production from the Hilltop area averaged 10.0 MMcfd.

During 2006, we participated in a 3-D seismic survey that covered all of our retained undeveloped acreage position in the Hilltop area. The 3-D processed seismic data has been processed and is currently being evaluated.

Coalbed Methane – Powder River Basin, Wyoming

We own an approximate 40% average working interest in 54,966 gross (21,854 net) acres in the Powder River Basin of Wyoming. During the six months ended June 30, 2007, we participated in the drilling of approximately 23 gross (10.5 net) wells. An active recompletion and drilling program is continuing. For the six months ended June 30, 2007, our net production from Powder River area averaged 4.4 MMcfd.

Coalbed Methane – PEL 238, Gunnedah Basin, New South Wales, Australia

We have a 35% interest in PEL 238, a CBM exploratory property covering approximately 2.0 million gross (700,000 net) acres, located in the Gunnedah Basin of New South Wales, approximately 250 miles northwest of Sydney, Australia, near the town of Narrabri.

 

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During 2006, we participated with our joint venture partners in the drilling of 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 early results from the pilot production phase of the program have been positive. If sustained commercial natural gas production rates are achieved, we and our joint venture partners will proceed with development of the CBM resources. Our current pilot program will evaluate the commercialization of the Gunnedah Basin CBM project, with a target to achieve initial certified natural gas reserves by the end of 2007.

In March 2007, we announced that we and our joint venture partner had executed a Memorandum of Understanding with Macquarie Generation, a NSW Government-owned electricity generator, for the potential future supply of natural gas for the expansion of its Bayswater power station. Macquarie Generation is Australia’s largest electricity producer and owns and operates two coal fired power stations in the Hunter Valley – Bayswater and Liddell. A potential long-term natural gas supply and purchase agreement could reach as much as 500 Bcf.

Coalbed Methane – PEL 433-434, Gunnedah Basin, New South Wales, Australia

In July 2007, we entered into a Farm-In Agreement with our PEL 238 joint venture partners under which we will earn a 35% working interest in the PEL 433 and adjoining PEL 434 properties, located in New South Wales. Under the terms of the Farm-In Agreement, we will pay the costs of a two core-hole program and the related costs of the evaluation of the coal reservoirs intersected by the core-holes.

PEL 433 is located south of PEL 238 where we and our joint venture partners are developing our Gunnedah Basin Gas Project (Coal Seam Gas Joint Venture) targeting independent certification of proved and probable (2P) gas reserves by year end 2007. The two core-hole drilling program commenced during July on PEL 433 to evaluate coal seam gas potential. The core-holes will evaluate the coal seam gas potential of the Hoskissons Coal Seam within the Late Permian Black Jack Coal Measures.

Coal evaluation core hole drilling completed during the 1970s and 1980s by the New South Wales Government has already identified the distribution and thickness of the coal measures within PEL 433. The Hoskissons Coal Seam is believed to be approximately 6 meters thick and widely distributed within the eastern part of PEL 433. There has been no previous coal seam gas exploration and evaluation work in the area, and there is no information on gas content, gas composition or coal permeability. The purpose of the PEL 433 core-hole program is to gather this additional information to evaluate the potential coal seam gas resource in the area.

The most prospective coal seam gas area within PEL 433 underlies the Central Ranges Natural Gas Pipeline that links Dubbo with Tamworth and joins with the larger Moomba-Sydney Gas Pipeline. This gas pipeline would enable gas sales within the region and potentially to Sydney and surrounding markets.

Coalbed Methane – EL 4416, Gippsland Basin, Victoria, Australia

We have a 75% interest in the CBM rights in EL 4416, an approximate 1.0 million gross (750,000 net) acre property covering a substantial part of the onshore portion of the Gippsland Basin of Victoria, Australia, located approximately 130 miles east of Melbourne. During 2006, we began initial long-term testing of the first of two wells completed on EL 4416. We have pre-funded $6.5 million for a 10-well drilling program, of which 2 gross (1.5 net) wells have been drilled during the six months ended June 30, 2007. The program includes the establishment of two “5-spot” pilots, one which incorporates two existing wells plus two wells designed to test for the presence and production potential of the coal at additional locations within the license area.

 

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Results of Operations

The following is a comparative discussion of the results of operations for the three and six months ended June 30, 2007 and 2006. 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, 2007 Compared to the Three Months Ended June 30, 2006.

Net income. We reported net income attributable to common shares for the three months ended June 30, 2007 of $4.4 million, compared to a net loss of $6.7 million for the three months ended June 30, 2006. Net income for the three months ended June 30, 2007 includes a gain of $38.9 million on the sale of a portion of our undeveloped natural gas an oil acreage in the Hilltop area of East Texas, which was partially offset by an impairment of natural gas and oil properties of $28.5 million. The net loss for the three months ended June 30, 2006 included 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 approximately $8.0 million for the three months ended June 30, 2007, up from $6.7 million for the comparable period in 2006. Of the 19% increase in revenues, 76% was attributable to increases in production resulting from the commencement of production of natural gas from new wells in East Texas in 2007, and 24% was attributable to increases in natural gas prices.

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,
     2007    2006

Production:

     

Natural gas (MMcf)

     1,357.7      1,182.8

Oil (MBbls)

     2.4      2.8

Total (MMcfe)

     1,372.2      1,199.3

MMcfe per day

     15.1      13.2

Average sales prices:

     

Natural gas (per Mcf)

   $ 5.75    $ 5.49

Oil (per Bbl)

   $ 63.06    $ 67.29

Production taxes. We reported production taxes of $220,000 for the three months ended June 30, 2007, down from $366,000 for the comparable period in 2006. The decrease in production taxes is primarily due to severance tax refunds on the Hilltop area wells.

Lease operating expense. We reported lease operating expenses of $1.5 million for the three months ended June 30, 2007 and 2006. Our lease operating expense per Mcfe decreased to $1.10 per Mcfe during the three months ended June 30, 2007 from $1.21 per Mcfe for the comparable period in 2006. The decrease in per Mcfe lease operating expense was primarily the result of a reduction in ad valorem taxes and the fixed costs associated with natural gas treatment plants in East Texas and higher production volumes.

Transportation and treating. We reported expenses for transportation and treating of $339,000 for the three months ended June 30, 2007, up from $312,000 for the comparable period in 2006. The increase was attributable to slightly higher production values and increased cost per Mcfe in Wyoming.

Depletion, depreciation and amortization. We reported depletion, depreciation and amortization (“DD&A”) of $5.4 million for the three months ended June 30, 2007, up from $3.6 million for the comparable period in 2006. The DD&A rate for the three months ended June 30, 2007 was $3.97 per Mcfe, compared to $2.97 per Mcfe for the three months ended June 30, 2006. The increase in DD&A rate is primarily due to additional Hilltop area capital expenditures.

 

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Impairment of natural gas and oil properties. We recorded a $28.5 million impairment of natural gas and oil properties for the three months ended June 30, 2007. The weighted average natural gas price utilized for the June 30, 2007 ceiling impairment evaluation was $5.75 per Mcf, held constant, as compared to $6.31 for the March 31, 2007 ceiling impairment evaluation, at which time there was no impairment. There was no impairment recorded during the three months ended June 30, 2006.

General and administrative expenses. We reported general and administrative expenses of $3.5 million for the three months ended June 30, 2007, up from $3.1 million for the comparable period in 2006. The increase in general and administrative expenses was primarily due to increased stock based compensation, increased personnel costs and initial Sarbanes-Oxley compliance costs. Non-cash stock-based compensation expense, which is included in general and administrative expenses, was $931,000 for the three months ended June 30, 2007, up from $772,000 for the comparable period in 2006.

Litigation settlement expense. We reported a $1.2 million litigation settlement expense accrual for the three months ended June 30, 2006, which represented the 2006 settlement cost incurred in conjunction with the Western Gas Resources, et. al. , litigation matter.

Interest expense. We reported interest expense of $3.7 million for the three months ended June 30, 2007, down from $3.8 million for the comparable period in 2006. For the three months ended June 30, 2007, our interest rate was 14.3% (10.1% excluding amortization and accretion charges) and 14.6% (10.6% excluding amortization and accretion charges), respectively.

Investment income and other. We reported $772,000 in investment income and other for the three months ended June 30, 2007, up from $492,000 for the comparable period in 2006. This increase was due to higher investable cash balances resulting from the sale of undeveloped acreage in the Hilltop area of East Texas in May 2007 and the related issuance of common shares.

Gain on sales of natural gas and oil properties . In May 2007, we sold a portion of our undeveloped natural gas and oil acreage in the Hilltop area of East Texas for approximately $68.2 million before transaction costs of approximately $1.4 million, resulting in a gain on sale of $38.9 million.

Six Months Ended June 30, 2007 Compared to the Six Months Ended June 30, 2006.

Net loss. We reported a net loss attributable to common shares for the six months ended June 30, 2007 of $6.6 million, compared to a net loss of $49.6 million for the six months ended June 30, 2006. Net income for the six months ended June 30, 2007 includes a gain of $38.9 million on the sale of a portion of our undeveloped acreage in the Hilltop area of East Texas, which was partially offset by an impairment of natural gas and oil properties of $28.5 million and a litigation settlement expense related to a proposed settlement with Geostar on certain matters The net loss for the three months ended June 30, 2006 included an impairment of natural gas and oil properties of $37.3 million and 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 $15.5 million for the six months ended June 30, 2007, up from $13.3 million for the comparable period in 2006. The 17% increase in revenues was attributable to a 21% increase in production resulting from the commencement of production of natural gas from new wells in East Texas in 2007. The increase in production was partially offset by a 4% decrease in natural gas prices.

 

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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,
     2007    2006

Production:

     

Natural gas (MMcf)

     2,610.8      2,176.2

Oil (MBbls)

     5.6      3.0

Total (MMcfe)

     2,644.3      2,194.2

MMcfe per day

     14.6      12.1

Average sales prices:

     

Natural gas (per Mcf)

   $ 5.80    $ 6.02

Oil (per Bbl)

   $ 58.49    $ 66.87

Production taxes. We reported production taxes of $514,000 for the six months ended June 30, 2007, down from $766,000 for the comparable period in 2006. The decrease in production taxes is primarily due to the severance tax refunds on wells in the Hilltop area.

Lease operating expense. We reported lease operating expenses of $3.2 million for the six months ended June 30, 2007, up from $2.7 million for the comparable period in 2006. This increase was attributable to higher production volumes and higher workover costs. Our lease operating expense per Mcfe decreased to $1.21 per Mcfe during the six months ended June 30, 2007 from $1.23 per Mcfe for the comparable period in 2006. The decrease in per Mcfe lease operating expense was primarily the result of lower ad valorem taxes and the fixed costs associated with natural gas treatment plants in East Texas being allocated over higher production volumes.

Transportation and treating. We reported expenses for transportation and treating of $662,000 for the six months ended June 30, 2007, up from $616,000 for the comparable period in 2006. The increase was attributable to higher costs per Mcf of natural gas produced in Wyoming.

Depletion, depreciation and amortization. We reported depletion, depreciation and amortization (“DD&A”) of $9.8 million for the six months ended June 30, 2007, up from $7.9 million for the comparable period in 2006. The DD&A rate for the six months ended June 30, 2007 was $3.70, compared to $3.59 per Mcfe for the six months ended June 30, 2006. The increase in DD&A rate is primarily due additional Hilltop area capital expenditures.

Impairment of natural gas and oil properties. We recorded a $28.5 million impairment of natural gas and oil properties for the six months ended June 30, 2007. The weighted average natural gas price utilized for the June 30, 2007 ceiling impairment evaluation was $5.75 per Mcf, held constant. For the six months ended June 30, 2006, we recorded an impairment of $37.3 million, utilizing a weighted average natural gas price of $5.79 per Mcf, held constant.

General and administrative expenses. We reported general and administrative expenses of $6.7 million for the six months ended June 30, 2007, up from $5.6 million for the comparable period in 2006. The increase in general and administrative expenses was primarily due to increased stock based compensation expense and increased personnel costs. Non-cash stock-based compensation expense, which is included in general and administrative expenses, was $2.2 million for the three months ended June 30, 2007, up from $1.3 million for the comparable period in 2006.

Litigation settlement expense. We reported a $5.0 million litigation settlement expense accrual for the six months ended June 30, 2007 related to a proposed settlement with Geostar on certain matters. (See Footnote 10, “Commitments and Contingencies – Geostar Corporation” for additional information on litigation settlement expense.) We reported a $1.2 million litigation settlement expense accrual for the six months ended June 30, 2006, which represented the 2006 settlement cost incurred in conjunction with the Western Gas Resources, et. al. , litigation matter.

 

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Interest expense. We reported interest expense of $7.7 million for the six months ended June 30, 2007, up from $7.6 million for the comparable period in 2006. For the six months ended June 30, 2007, our interest rate was 14.6% (10.5% excluding amortization and accretion charges) and 14.4% (10.4% excluding amortization and accretion charges), respectively.

Investment income and other. We reported $1.1 million in investment income and other for the six months ended June 30, 2007, up from $1.0 million for the comparable period in 2006. This increase was due to higher investable cash balances resulting from the sale of undeveloped acreage in the Hilltop area of East Texas in May 2007 and the related issuance of common shares.

Gain on sales of natural gas and oil properties. In May 2007, we sold a portion of our undeveloped natural gas and oil acreage in the Hilltop area of East Texas for approximately $68.2 million before of transaction costs of approximately $1.4 million, resulting in a gain on sale of $38.9 million.

Liquidity and Capital Resources

For the six months ended June 30, 2007, we reported positive cash flow from operations of $5.7 million. Capital expenditures on natural gas and oil properties totaled $46.8 million during the period. We received proceeds from the sale of unproved natural gas and oil properties of $66.8 million, after transaction costs, and net proceeds of $23.4 million from the issuance of common shares. At June 30, 2007, we had approximately $92.7 million in available cash and cash equivalents for future capital expenditures and general corporate purposes.

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 and Australia, additional funds will be needed for acreage 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, sale of assets, the issuance of subordinated debt 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 cannot be certain that future funds will be available to fully execute our current business plan. 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.

Our capital expenditures in the next 12 months under our current business plan are estimated to total approximately $82.0 million, of which $47.1 million is estimated to be spent on unconventional natural gas and oil exploration and development operations in East Texas, $4.1 million is estimated to be spent on CBM projects in the United States, $14.3 million on additional projects in the U.S. and $16.5 million is estimated to be spent on CBM projects in Australia. Based on our current budget, we have sufficient capital to fund our exploration and development activities in East Texas and Australia for at least the next twelve months.

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 2007. A senior secured notes covenant restricts us from hedging more than 50% of future production.

 

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Off-Balance Sheet Arrangements

As of June 30, 2007, 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 US GAAP 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 on Form 10-K for the year ended December 31, 2006.

 

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 three and six months ended June 30, 2007, a 10% change in the prices received for natural gas production would have had an approximate $796,000 and $1.5 million impact on our revenues, respectively. 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, 2007, we had approximately $106.3 million in principal amount of long-term debt of which $73.0 million of senior secured notes was subject to a floating interest rate of three-month LIBOR plus 6%. Our convertible senior debentures and subordinated unsecured notes payable are fixed rate debt, 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 $391,000 impact on annual interest expense.

Currency Translation Risk

Our revenues and expenses and the majority of our capital expenditures are primarily in U.S. dollars, thus limiting our exposure to currency translation risk. For the six months ended June 30, 2007, our Australian activities consisted of capital expenditures totaling approximately $5.8 million. We have no plans in the foreseeable future to implement hedges or financial instruments to manage international currency changes.

 

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Item 4. Controls and Procedures

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

As required by SEC Rule 13a-15(b), we have evaluated, under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Our disclosure controls and procedures are designed to provide reasonable assurance that the information required to be disclosed by the Company in reports that it files under the Exchange Act is accumulated and communicated to the Company’s management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure and is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC. Our principal executive officer and principal financial officer have concluded that our current disclosure controls and procedures were effective as of June 30, 2007 at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

There was no change in our internal control over financial reporting during the quarter ended June 30, 2007 that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II – OTHER INFORMATION

 

Item 1. Legal Proceedings

A discussion of current legal proceedings is set forth in Note 10 of the Notes to Condensed Consolidated Financial Statements, 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, 2006, 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, operating results and cash flows.

 

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

On May 9, 2007, the Company completed the sale of a portion of the Company’s East Texas undeveloped natural gas and oil acreage to a third party for total consideration, transaction costs, of $88.2 million, including the purchase of 10 million newly issued Gastar common shares at a price of $2.00 per share, or $20 million. The issuance of the common shares was exempt from registration pursuant to Rule 506 of Regulation D of the Securities Act of 1933.

On May 23, 2007 in conjunction with the May 9, 2007 sale of 10 million newly issued common shares, Chesapeake acquired an additional 1,757,195 of the Company’s common shares at $2.00 per share pursuant to its preemptive rights under a Common Stock Purchase Agreement dated November 4, 2005. The issuance of the common shares was exempt from registration pursuant to Rule 506 of Regulation D of the Securities Act of 1933.

 

Item 3. Default Upon Senior Securities

None.

 

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

On June 1, 2007, we held our annual meeting of shareholders. At the annual meeting, there were 131,368,312 common shares entitled to vote attending by person or by proxy. As a result, the total common shares represented at the meeting were 67.25% of the total 195,341,375 of common shares outstanding as of the record date and entitled to vote. The following matters were voted upon and passed:

 

  1. To fix the board of directors of the Company at five (5) members: VOTES FOR 130,930,495, WITHHELD 437,817.

 

  2. To elect a board of directors of the Company for the ensuing year:

 

     For    Withheld

Abby Badwi

   130,983,209    385,104

Thomas Crow

   130,970,810    397,504

Richard Kapuscinski

   130,278,546    1,089,769

J. Russell Porter

   129,779,445    1,588,871

John M. Selser, Sr.

   130,978,113    390,204

 

  3. To approve the reappointment 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 131,181,352, VOTES WITHHELD 186,966.

 

  4. To approve amendments to Bylaws. VOTES FOR 71,293,944, VOTES WITHHELD 623,164.

 

  5. To approve amendments to Articles. VOTES FOR 49,803,734, WITHHELD 22,112,375.

 

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.

 

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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, 2007     By:  

/s/ J. RUSSELL PORTER

      J. Russell Porter
      Chairman, President and Chief Executive Officer
      (principal executive officer)
Date: August 14, 2007     By:  

/s/ MICHAEL A. GERLICH

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

 

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EXHIBIT INDEX

 

Exhibit

Number

 

Description

 
 3.1   Amended and Restated Articles of Incorporation of Gastar Exploration Ltd. (incorporated herein by reference to Appendix B to the Company’s Proxy Statement for the Annual and Special Meeting of Shareholders dated April 30, 2007 to be held June 1, 2007.
3(ii)   Bylaws of Gastar Exploration Ltd. approved at March 31, 2000 and amended August 21, 2006 (incorporated herein by reference to Exhibit 3(ii) of the Company’s Current Report on Form 8-K dated December 19, 2006. File No. 001-37214).
 4.1   Indenture dated November 12, 2004 between Gastar Exploration Ltd. and CIBC Mellon Trust Company as trustee (incorporated by reference to Exhibit 4.1 of the Company’s Registration Statement on Form S-1, filed on August 12, 2005. Registration No. 333-127498).
 4.2   Form of 9.75% Convertible Senior Unsecured Subordinated Debenture of Gastar Exploration Ltd. (incorporated by reference to Exhibit 4.2 of the Company’s Registration Statement on Form S-1, filed on August 12, 2005. Registration No. 333-127498).
 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 Debenture of Gastar Exploration Ltd. (incorporated by reference to Exhibit 4.3 of the Company’s Registration Statement on Form S-1, filed on August 12, 2005. Registration No. 333-127498).
 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. (incorporated by reference to Exhibit 4.4 of the Company’s Registration Statement on Form S-1, filed on August 12, 2005. Registration No. 333-127498).
 4.5   Form of Subscription Agreement for U.S. purchasers of 9.75% Convertible Senior Unsecured Subordinated Debenture of Gastar Exploration Ltd (incorporated by reference to Exhibit 4.5 of the Company’s Registration Statement on Form S-1, filed on August 12, 2005. Registration No. 333-127498).
 4.6   Form of Subscription Agreement for foreign purchasers of 9.75% Convertible Senior Unsecured Subordinated Debenture of Gastar Exploration Ltd. (incorporated by reference to Exhibit 4.6 of the Company’s Registration Statement on Form S-1, filed on August 12, 2005. Registration No. 333-127498).
 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 (incorporated by reference to Exhibit 4.7 of the Company’s Registration Statement on Form S-1, filed on August 12, 2005. Registration No. 333-127498).
 4.8   Form of Senior Secured Note dated as of June 17, 2005 (incorporated by reference to Exhibit 4.8 of the Company’s Registration Statement on Form S-1, filed on August 12, 2005. Registration No. 333-127498).
 4.9   Registration Rights Agreement dated as of June 17, 2005, by and among Gastar Exploration Ltd. and the purchasers named therein (incorporated by reference to Exhibit 4.9 of the Company’s Registration Statement on Form S-1, filed on August 12, 2005. Registration No. 333-127498).
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 (incorporated by reference to Exhibit 4.10 of the Company’s Registration Statement on Form S-1, filed on August 12, 2005. Registration No. 333-127498).
4.11   Form of Subscription Agreement for foreign purchasers of common shares of Gastar Exploration Ltd. in a private placement dated June 30, 2005 (incorporated by reference to Exhibit 4.11 of the Company’s Registration Statement on Form S-1, filed on August 12, 2005. Registration No. 333-127498).
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 (incorporated by reference to Exhibit 4.12 of the Company’s Registration Statement on Form S-1, filed on August 12, 2005. Registration No. 333-127498).
4.13   Placement agent warrant to purchase 1,989,475 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 (incorporated by reference to Exhibit 4.13 of the Company’s Registration Statement on Form S-1, filed on August 12, 2005. Registration No. 333-127498).

 

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  4.14   Form of 10% subordinated note issued June 2004 (incorporated by reference to Exhibit 4.14 of the Company’s Amendment No. 4 to Registration Statement on Form S-1/A, filed on December 22, 2005. Registration No. 333-127498).
  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 (incorporated by reference to Exhibit 4.15 of the Company’s Registration Statement on Form S-1, filed on August 12, 2005. Registration No. 333-127498).
  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 (incorporated by reference to Exhibit 4.16 of the Company’s Registration Statement on Form S-1, filed on August 12, 2005. Registration No. 333-127498).
  4.17   Agreement between Gastar Exploration Ltd. and Geo Star Corporation dated August 11, 2005 (incorporated by reference to Exhibit 4.17 of the Company’s Amendment No. 1 to Registration Statement on Form S-1/A, filed on October 30, 2005. Registration No. 333-127498).
  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 (incorporated by reference to Exhibit 4.18 of the Company’s Amendment No. 1 to Registration Statement on Form S-1/A, filed on October 30, 2005. Registration No. 333-127498).
  4.19   Common Share Purchase Agreement between Gastar Exploration Ltd. and Chesapeake Energy Corporation dated November 4, 2005 (incorporated by reference to Exhibit 4.19 of the Company’s Amendment No. 2 to Registration Statement on Form S-1/A, filed on November 22, 2005. Registration No. 333-127498).
  4.20   Registration Rights Agreement between Gastar Exploration Ltd. and Chesapeake Energy Corporation dated November 4, 2005 (incorporated by reference to Exhibit 4.20 of the Company’s Amendment No. 2 to Registration Statement on Form S-1/A, filed on November 22, 2005. Registration No. 333-127498).
  4.21   Facsimile of common share certificate of Gastar Exploration Ltd. (incorporated by reference to Exhibit 4.21 of the Company’s Amendment No. 3 to Registration Statement on Form S-1/A, dated December 15, 2005. Registration No. 333-127498).
  4.22   Form of Subscription Agreement for private offering of 25 million common shares (incorporated by reference to the Company’s Current Report on Form 8-K dated November 15, 2006.)
10.1*   The Gastar Exploration Ltd. 2002 Stock Option Plan, dated July 5, 2002 as periodically amended (incorporated by reference to Exhibit 4.1 of the Company’s Current Report on Form 8-K dated November 15, 2006. File No. 001-32714).
10.2*   Employment Agreement dated March 23, 2005 by and among First Sourcenergy Wyoming, Inc., Gastar Exploration Ltd. and J. Russell Porter (incorporated by reference to Exhibit 10.2 of the Company’s Registration Statement on Form S-1, filed on August 12, 2005. Registration No. 333-127498).
10.3*   Employment Agreement dated April 26, 2005 by and among First Sourcenergy Wyoming, Inc., Gastar Exploration Ltd. and Michael A Gerlich (incorporated by reference to Exhibit 10.3 of the Company’s Registration Statement on Form S-1, filed on August 12, 2005. Registration No. 333-127498).
10.4   Purchase and Sale Agreement between Geostar Corporation and Gastar Exploration Ltd. covering Wyoming and Montana producing properties dated June 16, 2005 (incorporated by reference to Exhibit 10.4 of the Company’s Amendment No. 1 to Registration Statement on Form S-1/A, filed on October 30, 2005. Registration No. 333-127498).
10.5   Purchase and Sale Agreement between Geostar Corporation and Gastar Exploration Ltd. covering Wyoming and Montana non-producing properties dated June 16, 2005 (incorporated by reference to Exhibit 10.5 of the Company’s Amendment No. 1 to Registration Statement on Form S-1/A, filed on October 30, 2005. Registration No. 333-127498).
10.6   Purchase and Sale Agreement between Geostar Corporation and Gastar Exploration Ltd. covering Texas producing properties dated June 16, 2005 (incorporated by reference to Exhibit 10.6 of the Company’s Amendment No. 1 to Registration Statement on Form S-1/A, filed on October 30, 2005. Registration No. 333-127498).
10.7   Purchase and Sale Agreement between Geostar Corporation and Gastar Exploration Ltd. covering Texas non-producing properties dated June 16, 2005 (incorporated by reference to Exhibit 10.7 of the Company’s Amendment No. 1 to Registration Statement on Form S-1/A, filed on October 30, 2005. Registration No. 333-127498).

 

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Table of Contents
10.8   Participation and Operating Agreement between Geostar Corporation and Gastar Exploration Ltd. dated June 15, 2001 (incorporated by reference to Exhibit 4.19 of the Company’s Amendment No. 2 to Registration Statement on Form S-1/A, filed on November 22, 2005. Registration No. 333-127498).
10.9   Promissory Note for $15 million between Geostar Corporation and Gastar Exploration Ltd. dated August 11, 2001 (incorporated by reference to Exhibit 10.9 of the Company’s Amendment No. 1 to Registration Statement on Form S-1/A, filed on October 30, 2005. Registration No. 333-127498).
10.10*   Form of Gastar officer stock option grant (incorporated herein by reference to Exhibit 10.10 of the Company’s annual Report on form 10-K for the fiscal year ended December 31, 2005. File No. 001- 32714).
10.11*   Gastar Exploration Ltd. 2006 Long-Term Stock Incentive Plan (incorporated herein by reference to Exhibit 10.11 of the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2006. File No. 001-32714).
10.12   Form of Indemnity Agreement for Directors and Certain Executive Officers (incorporated herein by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K dated December 19, 2006. File No. 001-32714).
10.13*   Form of Gastar Exploration Ltd. Employee Change of Control Severance Plan effective as of March 23, 2007 (incorporated by reference to Exhibit 10.13 of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006. File No. 001-32714).
10.14   Common Share Purchase Agreement between Gastar Exploration Ltd. and Navasota Resources, L.P. dated as of May 9, 2007, in connection with the issuance and sale of 10,000,000 common shares (incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K dated May 15, 2007. File No. 001-32714).
10.15   Registration Rights Agreement by and between Gastar Exploration Ltd. and Navasota Resources, L.P. dated as of May 9, 2007 (incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K dated May 15, 2007. File No. 001-32714).
10.16   Ratification and Assumption of LOI between and among Gastar Exploration Ltd., Gastar Exploration Texas LP and Navasota Resources, L.P. dated May 9, 2007, with Letter of Intent dated April 27, 2007 between and among Gastar Exploration Ltd., Gastar Exploration Texas LP, Chesapeake Energy Corporation and Chesapeake Exploration Limited Partnership, attached thereto as Exhibit A (incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K dated May 15, 2007. File No. 001-32714).
14.1   Gastar Exploration Ltd. Code of Ethics, adopted effective December 15, 2005 (incorporated herein by reference to Exhibit 14.1 of the Company’s Amendment No 4 to Registration Statement on Form S-1/A, dated December 22, 2005, Registration No. 333-27498).
21.1   Subsidiaries of Gastar Exploration Ltd. (incorporated herein by reference to Exhibit 10.11 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2006. File No. 001-32714).
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 chief executive officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ††
32.2   Certification of chief financial officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ††

* Management contract or compensatory plan or arrangement.
Filed herewith.
†† Furnished herewith.

 

29


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, 2007

 

/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, 2007

 

/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 Quarterly Report on Form 10-Q for the three and six months ended June 30, 2007 (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, 2007

 

/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 Quarterly Report on Form 10-Q for the three and six months ended June 30, 2007 (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, 2007

 

/s/ MICHAEL A. GERLICH

Michael A. Gerlich

Chief Financial Officer