USEG - U.S. Energy Corp. Has To Improve Costs Before Becoming An Opportunity

2023-03-06 01:44:09 ET

Summary

• U.S. Energy is an unconventional oil and gas producer in Texas, North Dakota, and the Mid Continent.
• The company quickly increased production in 2022 thanks to three private companies' contribution of already productive assets in exchange for a majority stake in USEG.
• However, USEG's costs are too high, considering the production mix between oil and natural gas. Using an equivalent barrel calculation of profitability leads to error.
• These costs imply historically high market prices are needed for the company to break even and higher for the company to provide an adequate return.
• Further, USEG has not drilled new wells yet, a mandatory and costly operation for an unconventional producer. I do not agree with some of the company's capital allocation policies either.

U.S. Energy Corp ( USEG ) is an oil explorer and producer with unconventional assets in Texas, North Dakota, and the Mid Continent.

The company was revamped in 2022 after three private companies contributed their already productive O&G assets to USEG in exchange for an 82% stake in the company. Eighteen months ago, a stagnant exploration company, today USEG is drilling approximately 1.7 thousand BOE daily and has multiplied its proven developed reserves by 14x.

Unfortunately, the company's extraction costs per BOE are too high, given its oil and natural gas production mix. This makes it difficult for the company to profit even with relatively elevated commodity prices. The recent collapse of natural gas prices puts more pressure on the company.

Also, USEG engaged in much more expensive acquisitions in 2022 after oil prices spiked, indicating pro-cyclical capital allocation practices. I disagree with other capital allocation policies, like paying dividends and taking debt simultaneously.

Further, the company has not yet shown that it can drill efficiently, a requirement for an unconventional producer, given the fast decay of unconventional wells.

In this context, I believe USEG is not an opportunity.

Note: Unless otherwise stated, all information has been obtained from USEG's filings with the SEC .

Business description

A new company : USEG's operations before 2022 have little to do with the company that it is today. Before 2022, USEG, a former E&P company, had been divesting exploration rights and maintained only net participation in properties operated by other companies.

But then the company was revamped after three private companies contributed their already productive assets in exchange for an 82% stake in USEG. The company hired a COO in 2022 and started producing.

Production, which had been running at less than 400 BOE per day, through participations, up to FY21 , was already running at 1.7 thousand BOE per day, directly produced, by 2Q22 .

Unconventional assets : USEG claims on its FY21 report that substantially all of its assets are unconventional. Unconventional O&G has a particular rhythm of CAPEX and cash flows. While conventional production requires significant CAPEX before ever producing any output but then can produce consistently for years, unconventional wells are much cheaper but decay fast.

Unconventional wells decay at a rate of above 10% per month. The EIA calls this dynamic hyperbolic decline. In effect, before a year, the well is producing 30% of what it was producing before, before two years, less than 10%, and so on.

Strategy

Continued acquisitions : The company's management has commented on its 3Q22 earnings call that it plans to continue growing through the acquisition of more properties. In June 2022, the company acquired properties in Texas for $11 million, representing recoverable reserves of $22 million.

Continuing with acquisitions in 2022 and 2023 seems very pro-cyclical. The properties are probably much more expensive today than in 2020 or 2021 when oil and gas prices were lower.

Estimations of recoverable reserves (the PDP PV-10 calculation indicated by the SEC) are based on current prices. June 2022 saw a peak in oil prices, so the recoverable reserves of the Texas properties are affected by that contingency.

Ideally, I would prefer the company to accumulate cash when commodity prices are high and acquire only when commodity prices are low.

Capital allocation : A company expanding production must invest in new wells. The cheapest drilling costs have been around $7 million , but this also depends on property type and company experience. USEG will have to invest in new wells soon if it does not want production to fall fast.

However, the company has returned capital in the form of dividends. At $0.0225 quarterly or $0.1 per share annualized, dividends would represent $2.5 million in cash returned. This is unusual for O&G companies at this stage of development.

On the other hand, USEG has taken debt at a variable rate of prime + 0.75% to 1.75%. The company's credit facility allows it to draw up to $20 million, from which it has already drawn $11 million. Taking debt is normal for O&G companies at this stage, but it is contradictory to pay dividends simultaneously.

Valuation

Breakeven analysis : O&G companies with few properties can be analyzed through breakeven costs. As of 3Q22, USEG's lease and tax costs represented $38 per barrel, plus another $16 per barrel in depreciation, depletion, and amortization ( O&G depletion is calculated based on ultimate recovery ). This implies a breakeven BOE (oil and gas mixed) cost of $54.

Oil versus gas, energy, and price : The calculations above are made for barrel equivalents at a rate of 6 thousand cubic feet (6Mcfe) of natural gas per barrel of oil. Although this is an energy equivalence, it does not imply price equivalence. For example, with gas prices at $8/Mcfe (record prices from June 2022), a gas BOE sells for $48, which is considered a low price for oil, selling around $110 through that same month.

Therefore, revenue calculations cannot be based on oil prices multiplied by BOE but separately for natural gas and oil. USEG's mix has been approximately 40% natural gas and 60% oil, and the company has not guided what future ratios might be, so we will use these.

Fixed costs : USEG currently requires $3 million for SG&A expenses and $1 million yearly for interest charges (assuming no new debt and no further rate hikes). This adds up to $4 million in fixed expenses that must be covered with revenues above variable costs of $54/BOE.

Scenarios : Assuming a mix of 40% natural gas, 60% oil, and no production growth (which is consistent with depreciation equating to CAPEX), we can provide price scenarios. Oil prices in the first row (per barrel), gas prices in the first column (per thousand cubic feet), and yearly revenue - variable in the cells, assuming 1.7 thousand BOE per day (4 million cubic feet of gas and 1 thousand barrels of oil).

Breakeven prices are too high : The problem with the table above is that to obtain the $4 million necessary to cover its fixed costs (debt and SG&A), USEG needs a price of at least $80 per barrel of oil and $4 per thousand cubic feet of natural gas.

As the chart below shows, not only are these prices not the current ones (oil has been above and below $80 for months, and natural gas prices are close to $2.5), but in historical terms, they are also high.

Growth does not improve the equation too much : Of course, the $4 million in fixed costs imply operational leverage. As USEG produces more oil and gas, its breakeven prices for the company are lowered because fixed costs are diluted on a wider volume base.

However, the improvements are not spectacular. If USEG increased production by 50% and assuming fixed SG&A and no new debt (very hard assumptions), its breakeven would move to $3.5/Mcfe for natural gas, with oil fixed, or conversely $77 per oil barrel, with gas fixed.

Profitability and growth : If we add more requirements for profitability and self-financed CAPEX, breakeven prices are even higher. The calculations above do not even consider net income for common shareholders.

For example, to cover $5.5 million in net income to justify a current market cap of $55 million, the company would need to generate $4 million for SG&A and interest, plus $7 million in pre-tax income. The table above shows that surplus over variable costs of $11 million can only be achieved with oil prices above $80 and gas prices above $5.

Conclusions

USEG's recent profitability is based on price spikes, particularly in the natural gas market. Those spikes have already receded.

The company's operating costs per barrel equivalent are too high, considering the mix between natural gas and oil that the company produces. These costs imply that hydrocarbon prices must be historically high for the company to break even and higher to produce an adequate return.

Therefore, I do not believe USEG is an opportunity at these prices. I will reconsider if the company can significantly improve its operational costs.

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