U.S. Energy Got A Second Chance When Freeport-McMoRan Purchased The Molybdenum Mine

| About: U.S. Energy (USEG)
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A subsidiary of Freeport-McMoRan will take over the operation of the water treatment plant and the leases for the molybdenum mine.

Freeport-McMoRan received preferred stock that can be converted into common stock up to a maximum of roughly 16% of the company's outstanding common shares.

Between the disposal of the molybdenum mine, and the reduction in personnel, the company figures that it has saved about $7 million in annual operating costs.

The company has a six million long term loan that it is unlikely to regain compliance for, so it is instead looking for another source of financing.

Despite some hedging, the company may not have adequate cash flow for the rest of the year. Current management definitely has its work cut out for it.

The following announcement may well have saved U.S. Energy (NASDAQ:USEG) from extinction:

"On February 11, 2016, U.S. Energy Corp., a Wyoming corporation (the "Company"), entered into an Acquisition Agreement (the "Acquisition Agreement") with Mt. Emmons Mining Company, a subsidiary of Freeport-McMoRan Inc. ("MEM"), whereby MEM acquired the Company's Mt. Emmons mine site located in Gunnison County, Colorado, including the Keystone Mine, a related water treatment plant (the "WTP") and other related properties (collectively, the "Purchased Assets"). Under the Acquisition Agreement, MEM will replace the Company as the permittee and owner of the WTP and will discharge the obligation of the Company to operate the WTP from and after the closing in accordance with the applicable permits issued by the Colorado Department of Public Health and Environment."

Freeport-McMoRan (NYSE:FCX) had acquired Phelps Dodge a few years back. However, Phelps Dodge was a previous partner of U.S. Energy in developing the mine at Mt. Emmons. Phelps Dodge was therefore found to be liable for the operation of the water treatment plant. Since Freeport-McMoRan, the parent company, is far more able to discharge the obligations of the leases than U.S. Energy in the current environment, the larger company has taken over the operation of the water treatment plant.

The transfer of the leases to Freeport-McMoRan came with a price of 50,000 shares of series A convertible preferred stock with a liquidating preference of $40 per share (less a whole $500). The stock is originally convertible into 80 shares of U.S. Energy, but that can change under various circumstances. However, the preferred stock as a whole group cannot convert into more than roughly 16% of the company under any circumstances. Also the dividend will not be paid in cash, but will be added to the liquidating preference amount at the rate of 12.25% compounded quarterly in arrears. Since U. S. Energy probably does not have the ability to pay any kind of dividends at all right now and in the foreseeable future, this is a very good deal for the common shareholders who faced the very real possibility of being wiped out in bankruptcy eminently.

The preferred has all kinds of covenants about buying back common stock, paying dividends on the common stock, and potential dilution. Probably none of that is a worry right now because of the current financial situation of the company. However, the company can force conversion of the common stock if and when U.S. Energy stock trades for more than five dollars a share for the specified time. That is also a goal that feels like it is a mile away from the present circumstances. But investors would be well advised to read up on the preferred stock covenants so that if and when things get better for this company they are prepared.

Every bit as important was the following clarification about cost savings:

"With the divestiture of the Mount Emmons Mining operations, U.S. Energy Corp. will have eliminated its mining related operating costs of approximately $3 million per year, a portion of which relates to operation of the water treatment plant. Coupled with the overhead reduction of $4 million at year end 2015, approximately $7 million savings can be realized on an annualized basis."

For a company that was grossing $350K a month from the oil business in the third quarter (and that was down from roughly one million a month a year earlier), this company really needed a strong hedging program and it did not have it. As of the third quarter as noted in the previous article, the company had cash flow from operations of about $1.2 million, and oil prices have declined substantially since then. So this company was in an impossible situation with the mine water treatment costs of nearly three million.

But with the obligation to fund three million per year of water treatment costs and other mining property expenses taken over by Freeport-McMoRan, U.S. Energy shareholders have reason to celebrate. Based upon the current value of the company's stock, Freeport-McMoRan had reason to take the whole company to fund future obligations and yet did not. So common shareholders definitely dodged a bullet here. Even though there is now a new potentially large shareholder of the company, common shareholders still own a significant amount of the shares and still have a potential future that just a few months back seemed non-existent.

The company will take a $2 million charge for the issuance of the preferred stock and will write off the capitalized costs of the mine (another $22 million charge). But these roughly $24 million charges are non-cash and therefore won't make the company's financial situation any worse than it already is. The focus needs to be on the debt and the cash flow available to pay that debt back.

The company has about $6 million in long term debt that has been classified as current because the company is not in compliance with the covenants and is getting waivers to remain in good standing with the bank. But current lower oil prices may not provide the company with the cash flow for the company to pay this debt. As part of the recent announcements, David Veltri, President and CEO, has stated that this loan needs to be replaced.

The company may have trouble paying interest and principal from the cash flow because the company has 350 barrels per day of oil hedged for the first half of the year and 300 barrels per day of oil for the second half of the year. That is less than half of the last reported production. The gain (on the balance sheet) on those hedges was about a million as of September 30, 2016. While those hedges probably have increased in value, they also included some hedges from the end of 2015 that are now gone.

At the nine month period, the company showed sales of $8.6 million in sales (mostly oil), and about $1.2 million in cash flow. It also showed $3.9 million in cash as well as $1.2 million in accrued compensation (probably the retirement obligations that have not yet been paid). That cash flow represents about 14% of the selling price, yet oil prices have been cut roughly in half since the third quarter was reported. While the hedging of a little more than half the production helps (as well as the mine sale and the retirements), this company could be losing large amounts on the rest of the production and therefore faces the possibility of very minimal if any cash flow. A best case scenario, with lower production costs and reworks would probably be about $200,000 per month from the wells. General and administrative costs need to be deducted from that and the balance sheet needs some repairs. If the company keeps costs to a minimal amount, it just might get through the downturn and pay down some of that loan.

With the long term debt classified as current, the current ratio was roughly two-to-ten, which is extremely weak. Without the long term debt in the current ratio, the ratio is two-to-three, which is still pretty weak but probably workable. The company has reduced its personnel to four people as of the third quarter but even that may be too many in the current operating environment.

The company does not operate any of its properties, and much of its production comes from older wells in the Bakken. Those wells are very likely to be shut-in in a low price environment such as this because they tend to be high cost and not worth the cost of reworking. Even if they are reworked, that cost of reworking will come out of the cash flow to the company. So even though that six million dollars in long term liabilities looks like a relatively modest amount of debt, there is a good chance that the company has no way in the current environment of paying off that debt or it may have to pay it down very slowly. So whomever the company finds to replace that debt will likely charge a far higher interest rate and manage to create an even larger repayment challenge. If oil prices rally some, then the company might be able to regain compliance. Right now, in the current low oil price environment, regaining loan compliance with the bank (Wells Fargo) does not look like a going proposition.

The company is not participating in any significant drilling activity at the present time. Therefore its cash flow is also at risk from the lack of drilling activity as wells that it relies on for production grow older. Plus it is hard to cut costs when no new more efficient wells are being drilled. The Texas wells that were very profitable had very high decline rates, and so are now a far smaller part of the latest production figures. Those wells did pay back quickly, but that source of revenue is now gone.

The company management has stated in the past that they are looking to acquire properties to right the ship. The company does have a fair amount of tax loss carry forwards to shelter some income, and the right kind of transaction could help this company as well as the selling party, but that kind of transaction is a specialty, and may not appeal to owners of desirable properties. In short, this company still has its work cut out for it and its survival is far from assured. Nevertheless the track record of company management overcoming hurdles so far is very impressive and bodes well for the speculative chances of this company in the future. Frankly, this company already could have been dead several times over, but it is still in there chasing what chances it has. That is a sign of a winner, and this company may yet make it through a very tough operating environment.

An investor would be well advised to watch this play out from the sidelines until there is more clarity about how the company will succeed. The stock does from time to time offer some very good trading opportunities on the periodic announcements as the stock jumped considerably on the announcement on the sale of the mine. Hopefully investors took the opportunity to sell after that announcement and can wait until another volatile trading opportunity presents itself.

The leases owned by the company probably have some value, but with many operators not drilling, it is hard at the current time to determine what value those leases have, if any. There are many distressed properties on the market and not many buyers. The Texas leases may be lower cost than the Bakken, but the operator, Contango (NYSEMKT:MCF) is not drilling new wells, though it may be completing an Eagle Ford well. Without the mining properties, the market should recognize the value of the cash flow from the oil wells. However, that cash flow will decline until new wells are drilled. In the current pricing environment, that may be a while. The market will probably wait to see the income stream from the producing wells, and if that income stream can be maintained or increased. Therefore this stock remains a play on the recovery of oil prices or the continued decrease in well costs (plus the continued progress in oil recovery, and IP's etc...), maybe both. Don't expect much long term price progress until the operators restart the lease development through more drilling.

The company had also been notified by the Nasdaq that it was not in compliance with the minimum price of $1 per share. However, the company has also been granted a waiver until July 5, 2016, to comply with that requirement. But as discussed above, that compliance is the least of the company's worries. The company has plenty of time to regain compliance.

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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