IMHO, another waste of money. Airheads simply don't show engine wear like Japanese or English bikes do. You won't find anything wrong, other than the cam chain, slack-side cam chain tensioner blade, cam chain tensioner blade spring, and possibly the previously noted oil by-pass valve. The average Airhead engine is good for 250K miles.

Airheads need the PRT Seals about every 10 years. Those 4 rubber parts are your most glaring deficiency right now.

Allow me to tell you how this will end up: You'll have $10,000 in a motorcycle worth $2000. It might look better for a week or 2, but it won't run any better or cruise any faster. 

However, if you take that same $8000 and put it in a Vanguard account, it will be worth about $120,000 when you get ready for it. You simply have to decide if you want a sparking motorcycle now, or travel the world later. 

I am very close to finishing the wiring harness and once it is complete and tested I will be stripping the bike and sending the frame to powder coat. While the frame is getting done, I will dive in to the engine more and report back. 

Richard is making better sense.  IF I could turn the clock back,  I would have as he says cleaned things up, checked torque on the head bolts (most likely not a problem but easy to do first) rode and checked again.  Good money says the issue was just a leaking push rod seal.

I agree with him that vapor blasting is not needed.  I have never used his choice of chemical, there are a few out there that do the job.  If you want to see what kind of finish you can get with just chemical cleaning go to Brook Ream's website and take a look at the restorations he has done.

The problem you're fighting is wind. When you ride the bike, the passing air does not flow from front-to-rear in perfect straight lines. (Forget about all those movies you've seen of airplanes and F1 cars in wind tunnels, because that is not your situation.) No sir, the air under the cylinder is turbulent. That is to say it's going in every conceivable direction as soon as it hits the push rod tubes. So it's entirely within reason that oil from the PRT Seals is pushed upward onto the bottom of the cylinder base, where due to the surface irregularities, it may tend to linger and "cake up" over time.  

It's unfortunate that the connecting rod seems to have slapped the engine case. But that surface is not the sealing gasket surface. From the photos you supplied I see no issues with removing the old gasket, and installing new BMW brand gaskets, O-rings and PRT seals. And then riding the bike.

As far as the vapor blasting... for my money you'll get a lot further with a stringent detergent, like Purple Power, or a very strong (slightly acidic) mag wheel cleaner. You can spray the assembled engine, let it sit for 5 min, and then pressure rinse and get the exact same look/ effect for hundreds of dollars less and hundreds of labor hours saved.

What the YouTube 'experts' don't tell you is that 2 weeks after you spend all this extra money and time (when you could have been riding), your engine will look exactly the same as my suggestions. What you'll learn is that YouTube and internet 'experts' are really only expert at spending other people's money.

"If it ain't broke, then don't fix it" applies here.

Hope this helps.

Yeah, you could put it all back together and not have a problem.  Or, it could leak.  I am sure it would not take long for any seepage to make itself known.  

At least, you can do the work keeping the cost down.   

Buying a replacement engine opens up the issue of is it infected with previous owner's disease?  We can't see into engines to tell if there are bad or worn bearings.   One of the riders here bought an engine to build a project and despite being told it had low miles turned out to have bad bearings.

Good luck, sorry I can't help more. St

When I got the bike, the area below the left cylinder was completely caked with oil/ grime all the way up to and including the cylinder base. I would have assumed this was just from the push rod seals, but after removing the cylinder, I noticed the marring and divots at the cylinder mating surface. Would anyone with more airhead experience than I expect that this could be a source of the oil seepage?

my goal is for this to be a high level custom build. I would hate to skip something now, only to have to address it after the bike is complete. 

I do agree - as long as the mating cylinder to block mating surfaces are in good shape, the engine should go together ok. 

I wonder if the damage on the block was made by bumping the starter (like Richard suggested) with a tool (long bit) inserted in the lower connecting rod bolt.

If you do not tear the engine down further, you might consider new connecting rod bearing shells and new bolts. 

As for the Motogadget unit, my friend built a custom scrambler for a customer and used one.   Good luck, St.

Although the evidence inside the engine is puzzling, I don't think it warrants any special steps... and especially not any further disassembly. Your bike is nearing 50 years old, and this is what's inside a lot of 50 year old motorcycles. 

If forced to venture a guess... it looks like someone had the cylinder(s) off, and another person stupidly pressed the electric start button. Some friends are just "helpful" like that. 

You stated that the bike ran good for your short ride. So what is it that you expect to cure or fix by opening up the engine any further ? Oil leaks around the push rod tube seals is standard equipment on older Airheads. In my humble opinion, the engine should be reassembled and ridden. The only thing you will accomplish by a full tare down is spending a BIG pile of money simply to get a better view. 

So I suggest re-assembly, with possibly more care than usual as to the prep and condition of the gasket surfaces. If you just "had to" spend an extra $2000, then I'd use it to buy a second complete short block and install that.

Instead, spend your time and money doing something really constrictive, like replacing the cam chain/ guides/ guide spring, installing EI and checking the condition of the oil by-pass valve. 

All the best.