Falcon Oil & Gas has unproven flow rates but over 40Tcf potential in gas hungry central Europe. We are initiating coverage of Falcon with an Outperform rating and $3.50 target price.

Large unconventional natural gas play in Hungary

• Drilling results to date have proven the presence of gas, but the economics of producing it have not yet been established. An independent report estimates 43.9Tcf of technically recoverable gas resources and 97.8MMBbl of contingent oil resources at Falcon’s Hungarian discovery in the Makó Trough.

• ExxonMobil recently signed an agreement whereby it must spend US$300m to earn a 67% interest in an area covering 75% of Falcon’s production licence. Falcon will receive US$150m and US$150m will be spent on operations.

• The key to commercializing the play is to fracture stimulate multiple tight sands to induce economic flow rates from the wells. In its first phase of operations ExxonMobil (operator) will test existing and/or new wells which should validate the potential of the primary zone.

• We expect the first test results to be public within the next six to nine months.

Valuation – still a speculative investment at this point

• Economic flow rates have to be achieved before an accurate valuation for the Makó Trough can be determined. However, we have assumed the wells meet our minimum economic threshold and have modelled a scenario whereby a 1,445-well (30-year) development plan is implemented. Using our model and a long-term gas price of US$11.66/Mcf, the NAV for the development program is C$3.52 per fully diluted share (net to Falcon).

• The major risk is that the play is not economic. Realistically, if the wells prove to meet economic thresholds, we expect ExxonMobil to drill three to five times as many wells as we have modeled to recover the gas-in-place.

Piceance Basin optionality – results expected within six months

• Falcon intends to acquire a 25% working interest in five wells located within the Buckskin Mesa project located in the Piceance Basin, Colorado, and to undertake a completion and testing program on the wells. If testing is successful, Falcon will have an option to acquire a 50% working interest in the Buckskin Mesa project. Success in the project could result in another revenue stream for the company.

Catalysts

• Two key catalysts are expected within the next six to nine months. Well test results from the Buckskin Mesa (within six months) and well test results from Hungary (within six to nine months).