USEG - U.S. Energy Corp.: Unrecognized Potential

Summary

• USEG is a relatively small oil & gas producer that acquired production assets in early January 2022.
• The timing would have been impeccable, but they constrained their upside by entering into hedges that limited income.
• In fact, derivative losses caused them to lose money when oil prices surged.
• But the future does not appear to be as gloomy as the past.
• They may be able to greatly increase income if they are more adaptive in their hedging strategy.

U.S. Energy Corp. ( USEG ) ("the Company") is a relatively small oil & gas producer founded in 1966. Its General Overview and Strategy as a consolidator of smaller entities is described below.

Performance

Its long-term share price performance has been disastrous. Since the early 1990s, USEG has lost 98.39% of its value. That compares to a total return of 1,645.44 % in the SP500TR.

Over the past year, USEG has returned -12.16%. That compares to a -10.16 % loss in the SP500TR.

Given the surge in oil & gas prices over the past year, USEG's total revenues on a barrel of oil equivalent basis, which includes natural gas, have risen by 61% in the first six months of 2022. Additionally, its production levels expanded by 406% in the first half of 2022 due to acquisitions in January 2022.

However, the company still lost money in the first half of 2022 because it had hedged its sales prices prior to the surge in February 2022 related to Russia's invasion of Ukraine and sanctions imposed on Russian oil and gas exports. Specifically, total revenues rose to $22.3 million, but hedging losses ("Commodity derivative losses") totaled $9.1 million, resulting in a $3.3 million net income loss.

Oil and Natural Gas Hedges

Assuming USEG production levels in the first half of 2022 continue, it appears that about 82% of its second half 2022 production and about 60% of its 2023 production has been hedged. Prior to its January 2022 acquisitions, it had hedged its much lower oil production at fixed prices of just $49.99/bbl and natural gas at $2.96/MMBtu.

The chart below illustrates the magnitude of the opportunity cost of the fixed price hedge in 2022.

And the hedges have decoupled the relationships between USEG and spot WTI prices. Over the past year, the correlation between USEG and spot WTI has only been about 35 %.

The Company stated that on January 12, 2022, it had entered into "commodity derivative collar contracts for a total of 210,500 Bbls of crude oil from February 1, 2022 to December 31, 2022 with a floor of $65.00 and a ceiling of $89.40."

Looking forward, the opportunity cost of hedging will drop sharply, based on the current NYMX futures price curve. While the fixed price hedges remain far below futures prices, they are limited in volume to only about 3% of USEG's expected production in 2023. And the hedge ceiling is not too much below NYMEX futures prices through 2Q23 and is even above NYMEX for 3Q23 and 4Q23. The production volume subject to the hedge is about 56 % in 2023.

Seeking Alpha's Warning

On Seeking Alpha's Summary page, readers will be alerted to the warning below.

On April 5th, they provided the following explanation:

• U.S. Energy Corp. ( USEG ) has characteristics which have been historically associated with poor future stock performance. USEG has inferior profitability and decelerating momentum when compared to other Energy stocks, to the point that it gets a Sell rating from our Quant rating system. Stocks rated Sell or worse by our Quant rating system have massively underperformed the S&P 500, as this article will describe.
• The company has EBITDA Margin ((TTM)) of -10.47% while the Energy sector median is 24.94%.

They currently grade USEG's profitability outlook a "D."

NYMEX Futures Prices and Future Hedging

The long-term outlook for USEG share prices is highly dependent on the market's outlook for future crude oil prices. As of September 2nd, 2022, the NYMEX WTI futures price curve was "backwardated," a market condition in which the nearby prices exceed the deferred prices, as shown below.

Futures prices have fallen by about 13% since the end of the second quarter of 2022, and so USEG's hedges would show marked-to-market gains. Moreover, its unhedged production volumes would realize higher net sales revenues than under heavy hedges as in 2Q22.

Conclusions

The fundamentals of the oil market shifted radically in 2022 with Russia's invasion of Ukraine and NATO's sanctions. Because Russia is one of the top oil suppliers in the world, and Europe is shifting its future dependence on oil and gas away from Russia, there are longer-term consequences that benefit Western oil producers.

Looking forward, the futures price curve is much stronger than looking backward. And so USEG's future earnings prospects are more favorable than past income statements.

As is clear from the 2022 experience, USEG's hedging strategy may substantially impact future net income. However, this year's derivative losses will hopefully not impact prudent future risk management, but it is a lesson that such activities must be closely monitored and adjusted if there is a radical change in underlying market conditions.

USEG's earnings should improve over time with relatively higher prices and with the higher production volumes acquired in early 2022. And for those reasons I view it as a "Hold."

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