Big Sky Industrial Inc.: Form 10-Q for the period ended Sep 30, 2023

Introduction

This information should be read in conjunction with the interim unaudited financial statements and the notes thereto included in this Quarterly Report on Form 10-Q, and the audited financial statements and notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained in our Annual Report on Form 10-K for the year ended December 31, 2022, filed with the Securities and Exchange Commission on April 13, 2023 (the “Annual Report”).

Certain abbreviations and oil and gas industry terms used throughout this Report are described and defined in greater detail under “Glossary of Oil and Natural Gas Terms” on page 4 of our Annual Report.

Certain capitalized terms used below and otherwise defined below, have the meanings given to such terms in the footnotes to our unaudited condensed consolidated financial statements included above under “Part I - Financial Information” – “Item 1. Financial Statements”.

In this Quarterly Report on Form 10-Q, we may rely on and refer to information regarding the industries in which we operate in general from market research reports, analyst reports and other publicly available information. Although we believe that this information is reliable, we cannot guarantee the accuracy and completeness of this information, we have not independently verified any of it, and we have not commissioned any such information.

See also “Cautionary Statement About “Forward-Looking Statements” above.

Unless the context requires otherwise, references to the “Company,” “we,” “us,” “our,” “U.S. Energy”, and “U.S. Energy Corp.” refer specifically to U.S. Energy Corp. and its consolidated subsidiaries.

In addition, unless the context otherwise requires and for the purposes of this report only:

• “Bbl” refers to one stock tank barrel, or 42 U.S. gallons liquid volume, used in this report in reference to crude oil or other liquid hydrocarbons;
• “BOE” refers to barrels of oil equivalent, determined using the ratio of one Bbl of crude oil, condensate or natural gas liquids, to six Mcf of natural gas;
• “Bopd” refers to barrels of oil per day;
• “Mcf” refers to a thousand cubic feet of natural gas;
• “Mcfe” means 1,000 cubic feet equivalent, determined using the ratio of six Mcf of natural gas to one Bbl of crude oil, condensate or natural gas liquids;
• “NGL” refers to natural gas liquids;
• “Exchange Act” refers to the Securities Exchange Act of 1934, as amended;
• “SEC” or the “Commission” refers to the United States Securities and Exchange Commission;
• “Securities Act” refers to the Securities Act of 1933, as amended; and
• “WTI” means West Texas Intermediate.

21

Where You Can Find Other Information

We file annual, quarterly, and current reports, proxy statements and other information with the SEC. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC like us at https://www.sec.gov (our filings can be found at https://www.sec.gov/cgi-bin/browse-edgar?action=getcompany&CIK=0000101594) and on the “Investors – SEC Filings” page of our website at https://usnrg.com. Copies of documents filed by us with the SEC are also available from us without charge, upon oral or written request to our Secretary, who can be contacted at the address and telephone number set forth on the cover page of this Report.

Summary of The Information Contained in Management’s Discussion and Analysis of Financial Condition and Results of Operations

Our Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is provided in addition to the accompanying unaudited condensed consolidated financial statements and notes to assist readers in understanding our results of operations, financial condition, and cash flows. MD&A is organized as follows:

• General Overview. A general overview of the Company and our operations.
• Recent Developments. Discussion of recent developments affecting the Company and our operations.
• Plan of Operations and Strategy. Discussion of our strategy moving forward and how we plan to seek to increase stockholder value.
• Critical Accounting Policies and Estimates. Accounting estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results and forecasts.
• Results of Operations. An analysis of our financial results comparing the three and nine months ended September 30, 2023 and 2022.
• Liquidity and Capital Resources. A discussion of our financial condition, including descriptions of balance sheet information and cash flows.

General Overview

U.S. Energy Corp. was incorporated in the State of Wyoming on January 26, 1966, and reincorporated to Delaware effective on August 3, 2022. We are an independent energy company focused on the acquisition and development of oil and natural gas producing properties in the continental United States. Our principal properties and operations are in the Rockies region (Montana, Wyoming and North Dakota), the Mid-Continent region (Oklahoma, Kansas, and North and East Texas), and the West Texas, South Texas, and Gulf Coast region.

We have historically explored for and produced oil and natural gas through a non-operator business model, however, during 2020 we acquired operated properties in North Dakota, New Mexico, Wyoming, and the Texas Gulf Coast, and on January 5, 2022, we closed the acquisitions of certain oil and gas properties from three separate sellers, representing a diversified portfolio of primarily operated, producing, oil-weighted assets located across the Rockies, West Texas, South Texas, and Mid-Continent regions.

Our business strategy is to enhance the value of our acquired operated assets through evaluation of selected properties with the goal of increasing production and reserves. We plan to deploy our capital in a conservative and strategic manner and pursue value-enhancing transactions. We also continuously evaluate strategic alternative opportunities that we believe will enhance stockholder value.

Global commodity and financial markets continue to be subject to heightened levels of uncertainty and volatility as a result of inflation, disruptions resulting from recent bank failures, and the ongoing conflict between Russia and Ukraine and associated economic and trade sanctions on Russia, and the ongoing conflict in the Middle East. These circumstances have driven commodity price volatility and have contributed to increased service provider costs as well as other costs and a rise in interest rates and could have further industry-specific impacts that may require us to adjust our business plan.

Material Developments

Acquisitions

On January 5, 2022, we closed the acquisitions of assets from three separate Purchase and Sale Agreements entered into by the Company on October 4, 2021, with (i) Lubbock Energy Partners LLC, (ii) Banner Oil & Gas, LLC, Woodford Petroleum, LLC and Llano Energy LLC (collectively, “Banner”), and (iii) Synergy Offshore LLC for approximately $66.4 million. The acquisition had an effective date of January 1, 2022. The purchase price included payment of $1.25 million in cash and issuance of 19,905,736 shares of our common stock, valued at $64.7 million. In addition, we assumed Banner’s debt of approximately $3.3 million and derivative positions, which were in a loss position of $3.1 million. The assets acquired include certain oil and gas properties representing a diversified portfolio of primarily operated, producing, oil-weighted assets located across the Rockies, West Texas, South Texas, and Mid-Continent. The acquisition also included certain wells, contracts, technical data, records, personal property and hydrocarbons associated with the acquired assets.

On May 3, 2022, the Company acquired certain operated oil and gas producing properties in Liberty County, Texas, adjacent to its existing assets in the area, for $1.0 million in an all-cash transaction. The effective date of the transaction was April 1, 2022. The assets include approximately 1,022 acres, which are 100% held by production, a gas pipeline and associated infrastructure. In addition, the Company assumed suspense accounts of $0.2 million and asset retirement obligations of $0.5 million. The Company accounted for the acquisition as an asset acquisition.

On June 29, 2022, the Company entered into a Purchase and Sale Agreement (the “PSA”) with ETXENERGY, LLC (the “Seller”). Pursuant to the PSA, we agreed to acquire all of the Seller’s rights to, and interest in, certain operated producing properties totaling approximately 16,600 net acres, located in Henderson and Anderson Counties, Texas, adjacent to the Company’s existing assets in the area. Substantially all of the acreage is developed and/or held by production. The acquisition also included certain wells, pipelines, contracts, technical data, records, personal property and hydrocarbons associated with the Properties, including two pipeline gathering systems and related infrastructure (collectively with the oil and gas properties to be acquired, the “ETXEnergy Assets”). The PSA closed on July 27, 2022, at which time we acquired the ETXEnergy Assets in consideration for the purchase price of $11.875 million in cash, less purchase price adjustments. The effective date of the acquisition was June 1, 2022.

On July 26, 2022, in anticipation of the closing of the PSA, we entered into a letter agreement with FirstBank whereby we increased our borrowing base under the Credit Agreement from $15 million to $20 million, and paid the administrative agent an upfront fee of $32,500 in connection with such increase (the “Borrowing Base Increase”).

Dividends

On February 23, 2023 and May 30, 2023, the Company paid a quarterly cash dividends of $0.0225 per share of common stock outstanding to stockholders of record at the close of business on February 10, 2023 and May 19, 2023, respectively. Total dividends paid during the nine months ended September 30, 2023 were $1.2 million. The Board of Directors suspended the Company’s dividend payment policy on August 9, 2023, with the associated capital resources going towards the Company’s share repurchase program and repayments of our credit facility’s outstanding balance.

Stock Repurchase Program

On April 26, 2023, the Board of Directors of the Company authorized and approved a share repurchase program for up to $5.0 million of the currently outstanding shares of the Company’s common stock. Subject to any future extensions, the repurchase program is scheduled to expire on the earlier of June 30, 2024, when a maximum of $5.0 million of the Company’s common stock has been repurchased, or when the program is discontinued by the Company.

Under the stock repurchase program, shares may be repurchased from time to time in the open market or through negotiated transactions at prevailing market prices, or by other means in accordance with federal securities laws. Repurchases will be made at management’s discretion at prices management considers to be attractive and in the best interests of both the Company and its stockholders, subject to the availability of stock, general market conditions, the trading price of the stock, alternative uses for capital, and the Company’s financial performance. The repurchase program will be funded using the Company’s working capital.

During the nine months ended September 30, 2023, the Company paid $241 thousand for the repurchase of 163,300 shares at a weighted average price of $1.48 per share. There were no share repurchases during the three months ended September 30, 2023.

Full-Cost Method Ceiling Test

The reserves used in the ceiling test incorporate assumptions regarding pricing and discount rates over which management has no influence in the determination of present value. In the calculation of the ceiling test as of September 30, 2023, the Company used $78.53 per barrel for oil and $3.43 per one million British Thermal Units (MMbtu) for natural gas (as further adjusted for property, specific gravity, quality, local markets and distance from markets) to compute the future cash flows of the Company’s producing properties. The discount factor used was 10%.

The Company recorded a $6.5 million ceiling test write-down of its oil and gas properties during the three and nine months ended September 30, 2023, primarily due to a reduction in the value of proved oil and natural gas reserves as a result of a decrease in crude oil and natural gas prices. In addition, asset retirement obligation cost and life revisions and transfers of unevaluated properties into the full cost pool increased the net book value of our oil and gas properties subject to the ceiling test.

Depending on actual commodity prices, estimated price differentials, lease operating costs, revisions to reserve estimates, and the amount and timing of capital expenditures, additional write-downs of $3 million to $4 million could be incurred in the fourth quarter of 2023.

Plan of Operations and Strategy

Continuing through the end of 2023 and beyond, we intend to seek additional opportunities in the oil and natural gas sector, including but not limited to further acquisition of assets, participation with current and new industry partners in their exploration and development projects, acquisition of existing companies, and the purchase of oil and natural gas producing assets. In addition, we plan to grow production by performing workovers on operated idle wells acquired in 2022 to return them to production.

Key elements of our business strategy include:

• Deploy our Capital in a Conservative and Strategic Manner and Review Opportunities to Bolster our Liquidity. In the current industry environment, maintaining liquidity is critical. Therefore, we plan to be highly selective in the projects we evaluate and plan to review opportunities to bolster our liquidity and financial position through various means.
• Evaluate and Pursue Value-Enhancing Transactions. We continuously evaluate strategic alternative opportunities that we believe will enhance shareholder value.

Critical Accounting Policies and Estimates

The preparation of our unaudited condensed consolidated financial statements in conformity with generally accepted accounting principles in the United States (“GAAP”) requires us to make assumptions and estimates that affect the reported amounts of assets, liabilities, revenues and expenses, as well as the disclosure of contingent assets and liabilities at the date of our financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from these estimates under different assumptions or conditions. A summary of our significant accounting policies is detailed in Part II, Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations of our 2022 Annual Report on Form 10-K filed with the SEC on April 13, 2023.

Recently Adopted Accounting Standards

On January 1, 2023, the Company adopted Accounting Standards Update (“ASU”) 2016-13 to Topic 326, Financial Instruments-Credit Losses. See Note 1 in the accompanying notes to unaudited condensed consolidated financial statements included in Part 1, Item 1 for additional discussion of the impact of the adoption of this ASU on our financial statements and disclosures.

Results of Operations

Comparison of our Statements of Operations for the Three Months Ended September 30, 2023 and 2022

For the three months ended September 30, 2023, we recorded a net loss of $8.8 million, which was primarily due to oil and natural gas property impairment expense of $6.5 million from reduced commodity prices used in the full cost pool ceiling test as well as increased asset retirement costs from cost and life revisions and transfers of unevaluated properties into the full cost pool. Lower commodity prices and production also resulted in reduced revenue for the period. For the three months ended September 30, 2022, we recorded net income of $4.1 million. In the following sections we discuss our revenue, operating expenses and other income (expense) for the three months ended September 30, 2023, compared to the three months ended September 30, 2022.

Revenue. Presented below is a comparison of our oil and gas sales, production quantities and average sales prices for the three months ended September 30, 2023 and 2022:

(in thousands except average prices and production quantities)

The decrease in our oil and gas revenue of $3.1 million for the three months ended September 30, 2023, as compared to the three months ended September 30, 2022, was primarily due to a decrease in commodity pricing of 21% on a per BOE basis, as well as a decrease of 6% in production quantities on a per BOE basis. For the three months ended September 30, 2023, we produced 152,013 BOE, or an average of 1,652 BOE per day, as compared to 161,206 BOE or an average of 1,752 BOE per day during the comparable period in 2022. The decrease in our production quantities relates to shut-ins due to lightning strikes and fires in the Mid-Content region. The Company is evaluating the damage and if cost effective, some production may be brought back online, though we do not expect a full recovery to historical pre-fire levels. During the three months ended September 30, 2023, our production was 66% oil and 34% natural gas and liquids compared to 59% oil and 41% natural gas and liquids produced during the three months ended September 30, 2022.

Oil and Gas Production Costs. Presented below is a comparison of our oil and gas production costs for the three months ended September 30, 2023 and 2022:

(in thousands)

For the three months ended September 30, 2023, lease operating expenses were $4.0 million or $26.31 per BOE, a decrease of $1.2 million when compared to the $5.2 million or $32.28 per BOE for the three months ended September 30, 2022. The decrease in lease operating expense was due to a reduction in well workover activity in 2023 when compared to 2022. The decrease on a per BOE basis is the result of increased efficiency from the integration of assets acquired in 2022.

For the three months ended September 30, 2023, gathering, transportation, and treating costs were $167 thousand, an increase of $48 thousand, or 40%, compared to the comparable period of 2022. This increase was attributable to non-operated activities.

For the three months ended September 30, 2023, production taxes were $596 thousand, a decrease of $221 thousand, or 27%, compared to the comparable period of 2022. This decrease was attributable to the decrease in revenue of 26% discussed above as production taxes remained flat at 7% of revenue.

Depreciation, Depletion and Amortization. Our depreciation, depletion and amortization (“DD&A”) was $2.9 million and $2.5 million for the three months ended September 30, 2023 and 2022, respectively. Our depletion rate was $16.39 per BOE and $13.84 per BOE for the three months ended September 30, 2023 and 2022, respectively. Our DD&A rate can fluctuate because of acquisitions, changes in drilling and completion costs, impairments, revisions in asset retirement obligation cost estimates or timing, divestitures, changes in the mix of our production, the underlying proved reserve volumes and estimated future development costs.

Impairment of oil and natural gas properties. Impairment of $6.5 million was driven by reduced commodity prices used in the full cost pool ceiling test as well as increased asset retirement costs from cost and life revisions and transfers of unevaluated properties into the full cost pool.

General and Administrative Expenses. Presented below is a comparison of our general and administrative expenses for the three months ended September 30, 2023 and 2022:

(in thousands)

General and administrative expenses increased by $116 thousand during the three-month period ended September 30, 2023, as compared to the prior year period. The increase was primarily attributable to the severance package awarded to our former Chief Operating Officer, offset by a decrease in professional fees, insurance, and other.

Other Income (Expense). Presented below is a comparison of our other income (expense) for the three months ended September 30, 2023 and 2022:

(in thousands)

25

Commodity derivative gain (loss), net, is the result of changes in derivative fair values associated with fluctuations in forward price curves for the commodities underlying our outstanding derivative contracts and the monthly cash settlements of our derivative positions during the period. For the three months ended September 30, 2023, we recognized losses on commodity derivative contracts of $0.5 million, primarily as the result of an increase in the mark-to-market liability of our outstanding commodity derivative contracts. See Note 7 Commodity Derivatives in the notes to the unaudited condensed consolidated financial statements.

Interest expense primarily represents the interest on our credit facility with FirstBank Southwest. The increase in interest expense is primarily driven by the increase in the interest rate. As of September 30, 2023, we had borrowed $12.0 million on the credit facility as compared to $12.5 million borrowed as of September 30, 2022. The average interest rate increased to 9.1% per annum for the three months ended September 30, 2023, as compared to 6.3% per annum for the three months ended September 30, 2022. See Note 6 Debt in the notes to the unaudited condensed consolidated financial statements.

Other income (expense), net is primarily impacted from changes in the fair value of our investment in Anfield Energy. We recognized a gain of $70 thousand on this investment for the three months ended September 30, 2023, but recognized a loss of $44 thousand for the comparable period of 2022. Held for sale losses recognized on our real estate assets also impact other income (expense). We had no losses recognized on our real estate assets held for sale for the three months ended September 30, 2023, but recognized a loss of $75 thousand for the comparable period of 2022.

Comparison of our Statements of Operations for the Nine Months Ended September 30, 2023 and 2022

For the nine months ended September 30, 2023, we recorded a net loss of $12.6 million, which was primarily due to oil and natural gas property impairment expense of $6.5 million from reduced commodity prices used in the full cost pool ceiling test as well as increased asset retirement costs from cost and life revisions and transfers of unevaluated properties into the full cost pool. Lower commodity prices also resulted in reduced revenue for the period. For the nine months ended September 30, 2022, we recorded net income of $0.9 million.

Revenue. Presented below is a comparison of our oil and gas sales, production quantities and average sales prices for the nine months ended September 30, 2023 and 2022:

(in thousands except average prices and production quantities)

The decrease in our oil and gas revenue of $9.2 million for the nine months ended September 30, 2023 as compared to the nine months ended September 30, 2022, was due primarily to a decrease in commodity prices. Our realized price on a BOE basis decreased 33% from the prior year period. Partially offsetting the decrease in revenues from declines in commodity prices was an increase in the volumes we produced during the period. For the nine months ended September 30, 2023, we produced 485,633 BOE, or an average of 1,779 BOE per day, as compared to 444,147 BOE or 1,627 BOE per day, during the comparable period in 2022. Our oil production was up 4% and our natural gas and liquids production was up 20% compared to the prior year period. The increase in the volumes of natural gas and liquids produced is primarily due to the acquisition of our East Texas assets in July 2022 with relatively more natural gas production. See Note 2 – Acquisitions. The production mix shifted to become slightly less oil weighted in 2023 when compared to 2022. Our BOE production mix was 63% oil and 37% natural gas and liquids during the nine months ended September 30, 2023 compared to 66% oil and 34% natural gas and liquids in the comparable period of 2022.

Oil and Gas Production Costs. Presented below is a comparison of our oil and gas production costs for the nine months ended September 30, 2023 and 2022:

(in thousands)

26

For the nine months ended September 30, 2023, lease operating expenses were $12.1 million or $25.01 per BOE, a decrease of $0.2 million when compared to the $12.3 million or $27.80 per BOE for the nine months ended September 30, 2022. Lease operating expense per BOE decreased as a result of increased efficiency from the integration of assets acquired in 2022.

For the nine months ended September 30, 2023, gathering, transportation, and treating costs were $419 thousand, an increase of $63 thousand, or 18%, compared to the comparable period of 2022. This increase was primarily driven by the increase in natural gas production for the period.

For the nine months ended September 30, 2023, production taxes were $1.7 million, a decrease of $0.6 million, or 28%, compared to the comparable period of 2022. This decrease was primarily attributable to the decrease in revenue of 27% discussed above as production taxes remained flat at 7% of revenue.

Depreciation, Depletion and Amortization. Our DD&A rate for the nine months ended September 30, 2023, was $14.74 per BOE, compared to $13.94 per BOE for the nine months ended September 30, 2022. Our DD&A rate can fluctuate because of acquisitions, changes in drilling and completion costs, impairments, revisions in asset retirement obligation cost estimates or timing, divestitures, changes in the mix of our production, the underlying proved reserve volumes and estimated future development costs to develop reserves.

Impairment of oil and natural gas properties. Impairment of $6.5 million was driven by reduced commodity prices used in the full cost pool ceiling test as well as increased asset retirement costs from cost and life revisions and transfers of unevaluated properties into the full cost pool.

General and Administrative Expenses. Presented below is a comparison of our general and administrative expenses for the nine months ended September 30, 2023 and 2022:

(in thousands)

General and administrative expenses increased by $0.7 million during the nine-month period ended September 30, 2023, as compared to the prior year period. The increase was primarily attributable to an increase in compensation and benefits of $0.9 million due to the employees added in the last half of 2022 and the first half of 2023. Professional fees, insurance and other expenses increased $0.4 million, primarily due to increased consulting, accounting, legal and insurance expenses related to the acquisition of properties in January 2022. Stock-based compensation decreased $0.6 million due to the amortization of stock-based compensation awards granted to employees and directors in January 2022, which were in connection with new directors and officers appointed in connection with the January 2022 acquisition.

Other Income (Expense). Presented below is a comparison of our other income (expense) for the nine months ended September 30, 2023 and 2022:

(in thousands)

Commodity derivative gain (loss), net is the result of changes in derivative fair values associated with fluctuations in forward price curves for the commodities underlying our outstanding derivative contracts and the monthly cash settlements of our derivative positions during the period. For the nine months ended September 30, 2023, we recognized gains on commodity derivative contracts of $0.7 million. See Note 7 Commodity Derivatives in the notes to the condensed consolidated financial statements.

Interest expense primarily represents the interest related to our credit facility with FirstBank Southwest. The increase in interest expense is primarily driven by the increase in the interest rate. We had $12.0 million borrowed on the credit facility on September 30, 2023 and September 30, 2022. During the nine months ended September 30, 2023, the interest rate on the Credit Facility increased to an average of 8.8% per annum compared to the average rate during the nine months ended September 30, 2022 of 5.1% per annum. See Note 6-Debt in the notes to the condensed consolidated financial statements.

Other income (expense), net is primarily impacted from changes in the fair value of our investment in Anfield Energy. We recognized a gain of $54 thousand on this investment for the nine months ended September 30, 2023, but recognized a loss of $85 thousand for the comparable period of 2022. Held for sale losses recognized on our real estate assets also impact other income (expense). We had no losses recognized on our real estate assets held for sale for the nine months ended September 30, 2023, but recognized a loss of $75 thousand for the comparable period of 2022.

Liquidity and Capital Resources

Based on the current commodity price environment, we believe we have sufficient liquidity and capital resources to execute our business plan while continuing to meet our current financial obligations. We continue to manage our commitments in order to maintain flexibility with regard to our activity level and capital expenditures.

We do not anticipate operating any drill rigs within the next 12 months or performing any developmental or exploratory drilling except on a limited basis in some of our non-operated properties. We will incur approximately $0.2 million on lease commitments and approximately $1.0 million on interest expense assuming no material changes to interest rates over the next 12 months. Our capital budget is typically comprised of return to production workovers, repairs and maintenance, plugging and abandonment costs, and similar activities to support our asset base. We view some of these investments as discretionary for which we can control both the timing and amount of these expenditures. Other activities, such as some repairs and maintenance and plugging activities, may be required from time to time by regulatory bodies. While we do not yet have an approved budget for 2024, we anticipate any such expenditures would be sourced primarily by operating cash flows. In the event that our operating cash flows are not sufficient to fund these expenditures, we have access to our credit facility and equity markets if such a need arises.

Sources of Cash

For the nine months ended September 30, 2023, we funded our capital expenditures with cash on hand and cash flows from operating activities. During the fourth quarter of 2023 and first quarter of 2024, if cash flows are not sufficient to fund our capital expenditures and operations, we may also use borrowings under our credit facility or raise funds through new equity offerings or from other sources of financing and re-evaluate our capital spend program as economic conditions warrant. Additionally, we may enter into carrying cost and sharing arrangements with third parties for certain development programs. All of our sources of liquidity can be affected by the changes in economic conditions, rising interest rate, changes in debt and equity markets, force majeure events, fluctuations in commodity prices, operating costs, tax law changes, and volumes produced, all of which would affect us and our industry.

We have no control over the market prices for oil and gas, although we may be able to influence the amount of our realized revenues from oil and gas through the use of commodity derivative contracts as part of our commodity price risk management program. Commodity derivative contracts may limit the prices we receive from our oil and gas sales if oil and gas prices rise substantially over the price established by the commodity derivative contract. See Note 7- Commodity Derivatives in Part I, Item 1 of this report for additional information about our oil and gas commodity derivative contracts currently in place and the timing of the settlement of those contracts.

Credit Agreement

On January 5, 2022, we entered into a four-year credit agreement with FirstBank Southwest as administrative agent, which provides for a revolving line of credit with a borrowing base of $20 million, and a maximum credit amount of $100 million (the “Credit Agreement”). Under the Credit Agreement, revolving loans may be borrowed, repaid and re-borrowed until January 5, 2026, when all outstanding amounts must be repaid. The Credit Agreement contains customary indemnification requirements, representations and warranties and customary affirmative and negative covenants applicable to the Company and its subsidiaries. In addition, the Credit Agreement contains financial covenants, tested quarterly, that limit our ratio of total debt to EBITDAX (as defined in the Credit Agreement) to 3:1 and require our ratio of consolidated current assets to consolidated current liabilities (as each is described in the Credit Agreement) to remain at 1:1 or higher. We were in compliance with all financial covenants as of September 30, 2023. Please refer to Note 6 - Debt in Part I, Item 1 of this report for additional discussion.

The borrowing base is redetermined semi-annually, commencing on or about April 1 and October 1 of each year during the four-year term of the Credit agreement. At the April 2023 redetermination we reaffirmed the borrowing base. The next borrowing base redetermination is expected to be completed later in the fourth quarter of 2023. Our borrowing base can be adjusted as a result of changes in commodity prices, acquisitions or divestitures of proved properties, or financing activities, all as provided for in the Credit Agreement.

Cash flows provided by our operating activities, proceeds received from divestitures of properties, capital markets activities, and our capital expenditures, including acquisitions, all impact the amount we borrow under our revolving Credit Agreement. The amount outstanding on the Credit Agreement as of September 30, 2023, was $12.0 million.

Uses of Cash

We use cash for the acquisition and development of oil and gas properties and for the payment of operating and general and administrative costs, settlements of commodity derivative contracts, debt obligations including interest, share repurchases, and dividends. Expenditures for the acquisition and development of oil and gas properties are the primary use of our capital resources. During the nine months ended September 30, 2023, we spent approximately $3.4 million on capital expenditures.

The amount and allocation of our future capital expenditures will depend upon a number of factors, including our cash flows from operating, investing, and financing activities, our ability to execute our development program, and the number and size of acquisitions that we complete. In addition, the impact of oil and gas, prices on investment opportunities, the availability of capital, tax law changes, and the timing and results of our development activities may lead to changes in funding requirements for future development. We periodically review our capital expenditure budget to assess if changes are necessary based on current and projected cash flows, acquisition and divestiture activities, and other factors. Our 2023 capital program is expected to be less than $4.5 million. We will continue to monitor the economic environment through the remainder of the year and adjust our activity level as warranted.

Cash Flows

The following table summarizes our cash flows for the nine months ended September 30, 2023 and 2022:

(in thousands)

29

Operating Activities. Cash provided by operating activities for the nine months ended September 30, 2023 was $3.0 million as compared to cash provided by operating activities of $8.5 million for the comparable period in 2022. The decrease in cash provided by operating activities is mainly attributable to a reduction in cash receipts for revenues as a result of a decrease in the prices we received for our oil and natural gas production and an increase in cash based general and administrative expenses such as compensation and benefits and professional fees, insurance and other expenses. These reductions in operating cash flows were partially offset by decreases in cash paid to settle commodity derivative contracts.

Investing Activities. Cash used in investing activities for the nine months ended September 30, 2023, was $3.4 million as compared to $17.1 million for the comparable period in 2022. The primary use of cash in our investing activities for the nine months ended September 30, 2023, was the capital expenditures related to returning idle wells to production and improvements to our gathering system in East Texas. In 2022, For the nine months ended September 30, 2022 the primary use of cash in our investing activities was for the acquisition of the East Texas assets from ETXENERGY, LLC of $10.9 million and capital expenditures related to returning idle wells to production on assets acquired during the period of $5.2 million

Financing Activities. Cash used in financing activities for the nine months ended September 30, 2023,was $2.1 million as compared to cash inflows from financing activities of $7.3 million for the comparable period in 2022. The cash used in financing activities during the nine months ended September 30, 2023, was primarily attributable to cash dividends paid of $0.2 million and principal payments on our insurance premium finance note payable of $0.5 million. Cash inflows from financing activities during the nine months ended September 30, 2022, primarily related to borrowings under our credit facility of $15.2 million, offset by repayments of on our credit facility of $6.1 million, cash dividends paid of $0.0 million, and payments of principal on our insurance premium finance note of $0.4 million.

Pursuant to Item 305(e) of Regulation S-K (§ 229.305(e)), the Company is not required to provide the information required by this Item as it is a “smaller reporting company,” as defined by Rule 229.10(f)(1).

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

We are required to maintain disclosure controls and procedures (as defined by Rules 13a-15(e) and 15d-15(e) under the Exchange Act) that are designed to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms and (ii) accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

As of September 30, 2023, our management, including our Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. Based on the results of the evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls were not effective as of September 30, 2023 to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms and is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures. Such determination was made in part on material weaknesses in our internal control over financial reporting as of December 31, 2022, as discussed below.

A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis. As previously reported in our Annual Report on Form 10-K for the year ended December 31, 2022, filed with the SEC on April 13, 2023, in connection with our assessment of the effectiveness of our internal control over financial reporting at the end of our last fiscal year, management identified the following material weaknesses in our internal control over financial reporting as of December 31, 2022 and is in the process of remediating such material weaknesses as of September 30, 2023:

• Third party information technology general controls (“ITGCs”) related to our accounting system were not designed appropriately and reliance could not be placed on the processing integrity of the accounting system.
• Certain control activities with a review component were not implemented and operating effectively for a sufficient portion of the period and did not include sufficient evidence of review procedures performed or formal approval by the reviewer.
• Certain business process controls were not implemented for a sufficient portion of the period and did not include sufficient evidence of operation.

Limitations on Effectiveness of Controls and Procedures

In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.

Changes in Internal Control over Financial Reporting

Except as disclosed below there were no changes in our internal control over financial reporting during the three months ended September 30, 2023, that have materially affected or are reasonably likely to materially affect, our internal control over financial reporting.

During the quarter ended September 30, 2023, we have made efforts to improve the documentation and evidence of review for control activities. We continue to consider transitioning to a new accounting system. The accounting system we select will have ITGCs that are designed effectively by the software provider and independently tested.

There have been no material changes from the risk factors previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2022, as filed with the SEC on April 13, 2023, under the heading “Item 1A. Risk Factors”, except as discussed below, and investors should review the risks provided in the Annual Report, prior to making an investment in the Company. The business, financial condition and operating results of the Company can be affected by a number of factors, whether currently known or unknown, including but not limited to those described in the Annual Report, under “Item 1A. Risk Factors”, and below, any one or more of which could, directly or indirectly, cause the Company’s actual financial condition and operating results to vary materially from past, or from anticipated future, financial condition and operating results. Any of these factors, in whole or in part, could materially and adversely affect the Company’s business, financial condition, operating results and stock price.

Our stock repurchases are discretionary and even if effected, they may not achieve the desired objectives.

On April 26, 2023, the Board of Directors of the Company authorized and approved a share repurchase program for up to $5.0 million of the currently outstanding shares of the Company’s common stock. Subject to any future extensions, the repurchase program is scheduled to expire on June 30, 2024. Under the stock repurchase program, shares may be repurchased from time to time in the open market or through negotiated transactions at prevailing market rates, or by other means in accordance with federal securities laws. Repurchases will be made at management’s discretion at prices management considers to be attractive and in the best interests of both the Company and its stockholders, subject to the availability of stock, general market conditions, the trading price of the stock, alternative uses for capital, and the Company’s financial performance. During the three months ended June 30, 2023, the Company paid $241 thousand for the repurchase of 163,300 shares at a weighted average price of $1.48 per share in open market transactions. The program does not obligate the Company to acquire a minimum amount of shares.

There can be no assurance that any repurchases pursuant to our stock repurchase program will enhance stockholder value because the market price of our common stock may decline below the levels at which we repurchase such shares. The amounts and timing of the repurchases may also be influenced by general market conditions, regulatory developments (including recent legislative actions which, subject to certain conditions, may impose an excise tax of 1% on our stock repurchases) and the prevailing price and trading volumes of our common stock. If our financial condition deteriorates or we decide to use our cash for other purposes, we may suspend repurchase activity at any time.

Our Board of Directors has determined to suspend our quarterly cash dividend.

On April 13, 2022, August 5, 2022, November 7, 2022, February 9, 2023 and May 18, 2023, the Company’s Board of Directors approved the declaration and payment of quarterly cash dividends of $0.0225 per share of common stock. Our Board of Directors, at its sole discretion, determines the amount of the quarterly dividends to be distributed to our shareholders, if any, based on consideration of a number of factors including, but not limited to, our results of operations, cash flow and capital requirements, economic conditions, tax considerations, borrowing capacity and other factors, including future acquisitions and divestitures. Consequently, our dividend levels may fluctuate. On August 9, 2023, the Board of Directors determined it appropriate to suspend dividend payments, with the associated future capital resources being allocated towards the Company’s share repurchase program and repayments of the outstanding balance on our credit facility. The Board of Directors may or may not reinstate future dividend payments in the future, the amount and frequency of which will be determined at the sole discretion of the Board. To the extent that the dividend is not reinstated in the future, only appreciation of the price of our common stock, which may not occur, will provide a return to our stockholders.

We may enter into strategic transactions in the future which may result in a material change in our operations and/or a change of control.

In the future, we or our majority stockholders, may enter into transactions with, or undertake transactions with, parties seeking to merge and/or acquire us and/or our operations. While neither we, nor our majority stockholders have entered into any such agreements or understandings to date, in the event that we or our majority stockholders do enter into such a transaction or transactions in the future, it could result in a change in our business focus, the acquisition of significant amounts of our outstanding common stock, or a change in our majority stockholders. We and our majority stockholders have not entered into any agreements relating to any strategic transaction involving the Company as of the date of this filing and may never enter into such agreement(s) in the future. Any future strategic transaction involving the Company or its operations may have a material effect on our operations, cash flows, results of operations, prospects, plan of operations, the listing of our common stock on the Nasdaq Capital Market, our officers, directors and majority stockholders, and the value of our securities.

We have written down, and may in the future be forced to further write-down, material portions of our assets due to low oil and natural gas prices.

The full cost method of accounting is used for oil and gas acquisition, exploration, development and production activities. Under the full cost method, all costs associated with the acquisition, exploration, and development of oil and natural gas properties are capitalized and accumulated in a country-wide cost center. This includes any internal costs that are directly related to development and exploration activities, but does not include any costs related to production, general corporate overhead, or similar activities. Proceeds received from disposals are credited against accumulated cost, except when the sale represents a significant disposal of reserves, in which case a gain or loss is recognized. The sum of net capitalized costs and estimated future development and dismantlement costs for each cost center is depleted on the equivalent unit-of-production method, based on proved oil and natural gas reserves. Excluded from amounts subject to depreciation, depletion, and amortization are costs associated with unevaluated properties.

Under the full cost method, net capitalized costs are limited to the lower of (a) unamortized cost reduced by the related net deferred tax liability and asset retirement obligations, and (b) the cost center ceiling. The cost center ceiling is defined as the sum of (i) estimated future net revenue, discounted at 10% per annum, from proved reserves, based on unescalated costs, adjusted for contract provisions, any financial derivatives qualifying as accounting hedges and asset retirement obligations, and unescalated oil and natural gas prices during the period, (ii) the cost of properties not being amortized, and (iii) the lower of cost or market value of unproved properties included in the cost being amortized, less income tax effects related to tax assets directly attributable to the natural gas and crude oil properties. If the net book value reduced by the related net deferred income tax liability and asset retirement obligations exceeds the cost center ceiling limitation, a non-cash impairment charge is required in the period in which the impairment occurs.

We perform a quarterly ceiling test for our only oil and natural gas cost center, which is the United States. During 2022 we did not record a ceiling test write-down. The ceiling test incorporates assumptions regarding pricing and discount rates over which we have no influence in the determination of present value. In arriving at the ceiling test for the year ended December 31, 2022, we used an average price applicable to our properties of $93.67 per barrel for oil and $6.36 per Mcfe for natural gas, based on average prices per barrel of oil and per Mcfe of natural gas at the first day of each month of the 12-month period prior to the end of the reporting period, to compute the future cash flows of each of the producing properties at that date.

In the calculation of the ceiling test as of September 30, 2023, the Company used $78.53 per barrel for oil and $3.43 per one million British Thermal Units (MMbtu) for natural gas (as further adjusted for property, specific gravity, quality, local markets and distance from markets) to compute the future cash flows of the Company’s producing properties. The discount factor used was 10%.

The Company recorded a $6.5 million ceiling test write-down of its oil and gas properties during the three and nine months ended September 30, 2023, primarily due to a reduction in the value of proved oil and natural gas reserves as a result of a decrease in crude oil and natural gas prices. In addition, asset retirement obligation cost and life revisions and transfers of unevaluated properties into the full cost pool increased the net book value of our oil and gas properties subject to the ceiling test.

Depending on actual commodity prices, estimated price differentials, lease operating costs, revisions to reserve estimates, and the amount and timing of capital expenditures, additional write-downs of $3 million to $4 million could be incurred in the fourth quarter of 2023.

Material future write-downs or impairments of our oil and gas properties may have a material adverse effect on our assets and/or our financial condition, either of which may cause the value of our securities to decline in value.

The conflicts in Ukraine and Israel and related price volatility and geopolitical instability could negatively impact our business.

In late February 2022, Russia launched significant military action against Ukraine. The sanctions announced by the United States and other countries against Russia and Belarus following Russia’s invasion of Ukraine to date include restrictions on selling or importing goods, services, or technology in or from affected regions and travel bans and asset freezes impacting connected individuals and political, military, business, and financial organizations in Russia and Belarus. The United States and other countries could impose wider sanctions and take other actions should the conflict further escalate. Separately, in October 2023, Israel and certain Iranian-backed Palestinian forces began an armed conflict in Israel, the Gaza Strip, and surrounding areas, which threaten to extend into other Middle Eastern countries. These conflicts have caused, and could intensify, volatility in natural gas, oil and NGL prices. The extent and duration of the military actions, sanctions, and resulting market disruptions could be significant and could potentially have a substantial negative impact on the global economy and/or our business for an unknown period of time. We believe that the increase in crude oil prices during the first half of 2022 was partially due to the impact of the conflict between Russia and Ukraine on the global commodity and financial markets, and in response to economic and trade sanctions that certain countries have imposed on Russia. Any such volatility and disruptions may also magnify the impact of other risks described herein, and in our Annual Report on Form 10-K for the year ended December 31, 2022.

The Company’s operations have in the past been, and could in the future be, disrupted by natural or human causes beyond its control.

The Company’s operations are subject to disruption from natural or human causes beyond its control, including risks from hurricanes, severe storms, floods, lightning strikes, heat waves, other forms of severe weather, wildfires, ambient temperature increases, sea level rise, war, accidents, civil unrest, political events, fires, earthquakes, system failures, cyber threats, terrorist acts and epidemic or pandemic diseases such as the COVID-19 pandemic, some of which may be impacted by climate change and any of which could result in suspension of operations or harm to people or the natural environment. For example, during the three months ended September 30, 2023, decreases in our production quantities compared to the three months ended September 30, 2022, related to temporary and indefinite shut-ins due to lightning strikes and fires in the Mid-Content region. Any of the above events could have a future material adverse effect on the Company’s results of operations or financial condition.