U.S. Energy Corp. - Time To Create Cash Flow And Shareholder Value

| About: U.S. Energy (USEG)

Summary

Overhead will be dramatically lower this year, but cash flow is uncertain until there is some operating history.

The Eagle Ford leases, though potentially valuable are not being drilled, calling into question their value. They may not be low cost to produce.

The company has no obvious growth avenue available to it, so an investment in the company is a bet on the new CEO's ability to build a company.

The $6 million long term debt needs much more permanent terms than the current arrangement of getting waivers from the lender.

The company has tax loss carry-forwards that may benefit an acquirer, but lacks an obvious source of cash to do its own acquisitions.

This company has gone through more trauma than most unleveraged companies. The fact that the company is still alive and has any hope for the future is solid testimony for not leveraging the balance sheet. Anything that could go wrong at U.S. Energy, Inc. (NASDAQ:USEG) has gone wrong. First molybdenum prices have hit the skids for a disturbing long amount of time, rendering the possibilities for the mine leases very unfavorable for the foreseeable future. Then the BUDA wells ran out of profitable places to drill, just when the company's production was beginning to hit record highs. The huge drop in oil prices all but insured a very quick drop in the Texas production so that most of the production now comes from some older Bakken wells that are long lived but also higher cost as the production declines. Any Eagle Ford test wells have been slow to get to the drilling stage in the current environment. Still some cash flow is better than none even if the long term debt is slowly strangling the company but compared to the prospects a year ago, things are definitely looking up and a speculative future is definitely on the horizon.

The new management of U.S. Energy Inc., has lowered overhead considerably. The company now has one full time employee. Since the company is not drilling or doing deals, that is probably plenty of personnel for what is needed. The accounting can be farmed out to a company specializing in such services and legal help can be hired as needed. This is a very different attitude from when the Larsen brothers ran the company and had considerably higher overhead.

This lower overhead is probably made possible by the focus on the oil and gas industry. The Larsens were mining people, but when they sold the mine there was some obvious doubt as to the proper future course so there were a number of projects tried in the name of diversification. The oil and gas was actually one of the last projects undertaken and it appeared at the time to be more of a cash flow vehicle for the molybdenum mine and other diversification projects that came along. But progressing the mine and watching the geothermal investment (among others) takes a lot of overhead (relatively speaking). Now with all that gone and a singular focus on the oil and gas prospects, far lower overhead is now possible. Plus the new president and CEO, David Veltri, has an extensive background in oil and gas, so exiting from the other projects was clearly indicated.

After the sale of the mine leases to Freeport-McMoRan (NYSE:FCX), the company was left with a working capital deficit of nearly $4 million, and the long term debt has been classified as current because the company needs to get periodic waivers to keep that long term debt from being called. While the bank is unlikely to call the loan and force the company into bankruptcy, refinancing options may well be limited in the current environment. This is leading to an unstable debt situation for the company. Plus the working capital deficit needs to decrease or better yet, disappear.

Much of the oil and gas income comes from North Dakota where the company has had operating partners for some years. Many of the partners such as Statoil (NYSE:STO) are rock solid. But even with diversification, and this company is well diversified, some of the smaller operators of U.S. Energy leases such as Emerald Oil (NYSEMKT:EOX) are in pretty sad shape. As the parade of bankruptcies climbs in the following months, the oil production may decrease a little more sharply and pinch the cash flow of the company slightly more than one might predict.

The company showed about $2.5 million in cash flow for the previous year (now that the mining leases are discontinued operations). But $1.1 million came from the accounts payable balance change, and another $1.4 million in cash flow was from over-payments. In short there really was no cash flow from operations. While the decrease in overhead should increase cash flow, commodity prices have dropped since the beginning of the year to shrink any cash flow created by the overhead expense drop.

This year, with only one full time employee, there will be some cash flow from operations. The first quarter report should reveal whether the cash flow will enable the company to find a long term loan deal for the $6 million classified as current on reasonable terms. Ideally, the company needs about $2 million in cash flow to achieve this. Even half that amount could be workable, however, the onus is on the company management to prove a steady and reasonable cash flow in the current environment. The track record from the past is not there for a much lower cost management.

The loss reported by the company of more than $90 million was giant for a company of this size. The loss was made up of one time impairment charges for the writedown of the oil and gas properties and valuation adjustments to the mining leases prior to their sale. Also discontinued operations of the water treatment plant on the mining leases were also a factor. Plus the company's long term debt did not increase as a result of these losses, though the current ratio deteriorated quite a bit. The total debt plus working capital deficit of about $10 million should be a solvable problem for a company of this size.

But the Bakken wells are older, and reworks and other items become more common as the wells age. Even long lived wells decrease in profitability as they age. There is been a fair amount of well design improvements and other operational changes throughout the industry that could well lead to some additional maintenance costs to improve cash flow in the long run and hurt cash flow in the short term. Many of the more significant wells were drilled further back using older technology, and there is a good chance that flow rates and operations can be improved. But with cash so tight at the company the company may not be able to afford to participate.

Further the company had some minimal hedging, but that hedging has not significantly overcome the effects of lower commodity pricing. Last year the hedges added more than $1.6 million to the sales. While that 15% increase in the overall selling price was welcome, far more income protection was needed than that amount. The good news from the Bakken is that the differential is expected to get better, however, the prices of oil and gas are still very low. If oil and gas prices go lower and stay lower, the company could permanently sink. So the first quarter report will be a key indicator as to the cash flow that current production will generate. It may also help (or hurt) to demonstrate the ability of the company to carry the $6 million dollar loan on a more permanent basis.

As HiddenValueInvestor points out, the company has some potentially valuable leases in the Eagle Ford and elsewhere. However, Contango Oil and Gas Company (NYSEMKT:MCF), the operator, is not drilling on these leases in the current environment. I have done articles on other operators such as Murphy Oil (NYSE:MUR) who are drilling on their leases in the current environment. So right now the value of the leases is at least questionable until development begins and profitable production is established.

In fact, the second biggest concern after the debt situation is the fact that the company is not drilling anywhere, and may not be able to afford to drill in the current operating environment. So currently the company has no obvious avenue for growth. That will continue to be a major investment concern for the time being until the growth issue is resolved. It will definitely hold back the price of the common stock.

As HiddenValueInvestor points out, the company does have some tax loss carry-forwards that could be valuable to a potential acquirer, but in the current environment, low cost producers will probably be acquired first. The company does not have an obvious source of cash at the current time to make its own acquisitions and grow by acquisition. Plus the most desirable properties will have considerable competition to bid for the properties. This company has an uphill battle to make a low cost acquisition at a cheap price.

So really an investment in the company at the present time is a bet that management, specifically the new CEO can build a new company with the assets that are available. Since the CEO built a company before, this could be a very viable investment thesis. Most likely the CEO would convert the company to some sort of operator model so that growth is not so dependent on other companies.

However, Emerald Oil was built during industry conditions that were much more favorable than the conditions that exist now. In the current low commodity price environment, Emerald is financially very weak and probably will not see the next industry cycle. Plus their acreage is not some of the more productive acreage. So readers are encouraged to determine which parts of the Emerald history and the current situation are the responsibility of David Veltri while he was an employee of Emerald. The CEO will have considerably more discretion and freedom running U.S. Energy, so his strengths and weaknesses need to be accurately determined in order to form a viable investment thesis in this company.

There is a very real danger that management could just stay put, collect checks and not do anything until conditions improve. While the company would definitely survive, shareholders would not profit from such a situation. Really the company is at the mercy of Contango for its most significant acreage unless it can make a profitable strategic acquisition. The future here is not well defined from an industry standpoint. But with the tax loss carry-forwards, and the experience of the CEO an investment in this speculative stock could work out. The company has come so far in the last year, but it has much further to go. Cash flow and earnings need to be a priority so it is time for the next miracle.

Disclaimer: I am not an investment advisor and this article is not meant to recommendation the purchase or sale of stock. Investors are advised to review all company documents, and press releases to see if the company fits their own investment qualifications.

Disclosure: I am/we are long USEG, MCF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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