U.S. Energy Offers Compelling Upside For Investors

| About: U.S. Energy (USEG)

Investors are usually looking for one of three things: (1) growth at a reasonable price, (2) deep value, or (3) strong momentum. For those looking for momentum, the company below is not your stock. It is a thinly traded and highly overlooked microcap oil and gas stock with a current market cap of only $65.6 million. But for those looking to find a deeply undervalued stock that offers significantly under appreciated growth opportunities, look no further than U.S. Energy (NASDAQ:USEG). Microcap stocks are much more volatile than large-mid cap stocks that have broad coverage on Wall Street. Additionally, microcap stocks do not have the same level of access to financing as large-mid cap stocks and are therefore inherently riskier.

U.S. Energy conducts business as a non-operator in the Bakken, Eagle Ford, and along the Gulf Coast in Louisiana and Texas. Their partners in the Bakken include Brigham Exploration (NYSE:STO) and Zavanna LLC. Their partner in the Eagle Ford is Crimson Exploration (NASDAQ:CXPO). Their main partner along the Gulf Coast is Petroquest (NYSE:PQ), along with Houston Energy LLC and Southern Resources LLC. The company also has corporate assets, a molybdenite mine, and real estate valued at $40 million net of a $10 million mortgage. The company plans to monetize most of these assets. This means the stock market is valuing the oil and gas business of U.S. Energy at $25 million. The objective of this article is to highlight the oil and gas business opportunities for U.S. Energy. The company has a $100 million line of credit with a borrowing base of $30 million. In the May update U.S. Energy had $5 million drawn on the line of credit. The company had $82,856 of net oil and gas assets under the full cost accounting method. This understates U.S. Energy's assets because the company recently completed three transactions that resulted in a gain of $23.7 million. Under full cost accounting the gain was applied to lower the net oil and gas asset value from $106 million to $83 million resulting in lower ongoing depreciation, depletion, and amortization charges.

For starters, in the first quarter of 2012 U.S. Energy had oil and gas sales of $8.3 million. This consisted of 92,552 barrels of oil, 89,772 mcf of natural gas, and 4,492 of natural gas liquids. Over 93% of the oil sales are from the Bakken in the Williston Basin in North Dakota. In the first quarter there was a big dropoff in oil prices in February of Bakken spot crude prices compared to West Texas Intermediate crude spot prices of over $30 per barrel. For the first quarter U.S. Energy's realized oil prices in the Bakken were over $20 less than WTI. In the last 10 days the differential between Bakken spot prices and WTI spot prices has averaged $1. This means U.S. Energy is getting much better pricing for its realized oil sales in the Bakken compared to the first quarter. Additionally, production in the first quarter was held back by a delay in the completion of wells and shutting in of wells for workovers and as nearby infill wells were fracked. Late in the quarter in Mid-March U.S. Energy had three important wells come online that should add to second quarter production:

  • The Lloyd 34-3 #2H (infill) well was completed with 38 fracture stimulation stages and had an early 24-hour flow back rate of 4,300 BOE/D. The company has an approximate 14% WI and an 11% NRI in this well. This is the highest initial production rate reported in a Company participated well in the Williston Basin program to date.
  • The Wang 10-3 #1H well was fracture stimulated with 35 stages and had an early 24-hour flow back rate of 2,208 BOE/D on a 36/64" restricted choke during drillout of the plugs. The company has an approximate 18% WI and 14% NRI in this well.
  • The Crescent Farms 7-6 #1H well was fracture stimulated with 35 stages and had an early 24-hour flow back rate of 2,437 BOE/D on a 36/64" restricted choke during drillout of the plugs. The company has an approximate 27% WI and 21% NRI in this well. The Crescent Farms well represents the highest reported IP rate for a Zavanna drilling program well to date.
  • So far in the second quarter U.S. Energy had two wells completed and has two wells currently being fracked:
  • The CDK 15-22 #1H well has been drilled to depth and has been fracture stimulated with 35 stages. The operator is scheduled to drill out the plugs in the well, the final step in order to turn the well over to production, in late May 2012. The company has an approximate 32% WI and 25% NRI in this well.
  • The Larsen 29-32 #1H well, is currently being fracture stimulated with a planned 35 stages. The company has an approximate 28% WI and 21% NRI. U.S. Energy has four lower working interest wells drilled and awaiting completion between now and July.
  • The Skorpil 11-2 #1H has also been fracture stimulated with 35 stages and had an early 24-hour flow back rate of 1,533 BOE/D on a 36/64" restricted choke during drillout of the plugs. The initial production rate consisted of approximately 1,416 barrels of oil and 702 MCF of natural gas. The company has an approximate 23% WI and 18% NRI in this well. planned 35 stages.
  • The Bayou Bend well, located in southeastern Texas, was drilled by Mueller Exploration during the third quarter of 2011. The well was drilled to a depth of 11,265 feet and three prospective pay zones were encountered. The well targeted a liquids rich gas formation. The well began sales in April 2012, and had initial flow back rates of approximately 200 BOE/D, which consisted of approximately 80 Barrels of oil and 700 MCF of natural gas. The company has an approximate 13.5% WI and a 9.9% NRI in this well. The primary target remains behind pipe. This is a vertical well and the company has several additional drilling positions in this play.
  • The most exciting upside potential for the company is not in the Bakken, but in the Eagle Ford. The KM Ranch #2H well in Zavala County, our second well in the Leona-River acreage block, has been drilled to a total measured depth of 12,875 feet, including a 6,100 foot lateral, and is awaiting completion. The operator continues to monitor specific completion activity, methods and performance in the surrounding area in order to develop a more effective completion for optimum recovery in this high potential, but low reservoir energy, environment. The operator not yet scheduled the completion of the KM Ranch #2, as we both believe that it is more important to first develop that best practices set of procedures for completions in the region that will maximize our return on investment. We are also monitoring recent activity of other operators in other formations in the Dimmit County area that could increase the upside potential for our position there dramatically. The company has an approximate 30% WI and 22.5% NRI in this well. Chesapeake Energy (NYSE:CHK) has drilled 8 wells in Dimmit county with initial production rates over 1,000 Boepd. Additionally, Dan Hughes LLC has drilled several successful Buda wells near Crimson and U.S. Energy's leases. Crimson stated they hoped to drill a Buda well before 2013.

On May 9, 2012, the company signed a Letter Agreement to sell an undivided 87.5% of its acreage in Daniels County, Montana to a third party for $3.68 million. The agreement is conditioned upon execution of a mutually acceptable Purchase and Sale Agreement and will be effective on June 1, 2012. Under the terms of the agreement, the company will retain a 12.5% working interest in the acreage and reserved overriding royalty interests ("ORRI") in excess of 81%. The purchaser will also commit to drill a vertical test well to depths sufficient to core the Bakken and Three Forks formations on or before December 31, 2015. The company will deliver an 80% NRI to the purchaser and a 1% ORRI to a land broker. The company will also pay the land broker a 10% commission for the cash consideration paid by the purchaser. U.S. Energy had a $1.2 million cost in this property and the gain will be applied to the full cost accounting pool to lower the net asset value. This sale will contribute to U.S. Energy's strong liquidity position. The company has over $15 million of its 2012 capital expenditure budget available for an acquisition of additional leasehold opportunities and proven reserves.

For a company with little debt and positive cashflow U.S. Energy is trading at levels well below comparable oil and gas companies, especially Bakken and Eagle Ford focused companies. Like all oil and gas companies U.S. Energy is exposed to declines in commodity prices. The company already suffered through a sharp drop in oil prices in the Bakken in February. Natural gas prices have collapsed because of the recent storage glut. The outlook for oil prices is uncertain due to the slowing global economy and tension in the Middle East. Investors looking for this type of opportunity should do their own due diligence.

Disclosure: I am long USEG.