Series B Preferred Stock is convertible, at the option of the holder at anytime, into shares of the Company's common stock as determined by dividing the lower of $.09 or the price per share paid by the holder of the Series B Preferred Stock by a conversion price determined on the date the related certificate is surrendered. The conversion price is subject to periodic adjustment and is initially established at $.00773. Series B Preferred Stock is automatically convertible into shares of the Company's common stock upon (i) the date specified by vote or written consent or agreement of holders of at least three quarters of the shares of Series B Preferred Stock outstanding, or (ii) upon the closing of the sale of Company's common stock in a firm commitment, Underwritten public offering registered under the Securities Act in which the Company receives gross proceeds of no less than $20 Million. Series B Preferred Stock has a liquidation preference of the greater of $.09 per share or the amount that such share would be entitled to upon liquidation or distribution. The Series B Preferred Stock has voting rights, except as to the election of directors, equal to the number of shares of common stock into which the Series B Preferred Stock is convertible. The Series B Preferred Stockholders have the right to elect one director of the Company.

 

Note 5 – Goodwill

     At September 30, 2007, goodwill consists of the following:

		September 30, 2007
Goodwill		$	683,877
Less accumulated amortization
Less Impairment		$
Total		$	683,877

                                                                              

Goodwill was analyzed on December 31, 2006 for impairment as it has an indeterminant life.  Based on the Company's analysis performed, an impairment loss of $61,820 was required to be recorded during the years ended December 31, 2006.

The impairment was determined in part by the company closing its Oklahoma Facility acquired with the DRV Energy Acquisition.  The facility performed installation and service of gasoline conversion systems.

F-8

---

Note 6 – Intangible Assets

 

Amortization expense charged to operations was $0 and $68,948 for the period ended September 30, 2007 and 2006, respectively.

Based  on the  Company's  analysis  for  impairment  as of  December  31,  2006, impairment losses of $781,411which was the remaining unamortized balance required to be recorded.  The impairment was determined by the analysis of our current operating results, trends and undiscounted future cash flows.

Due to analysis of the companies gross profit for the certified gasoline systems the company revised it business model in 2006.  The new model reflected the closing of the Installation and service facility in Oklahoma a selling and installing the gasoline conversions systems through our dealer network across the United States.  After a further analysis of the operating results in 2006 the company determined it did not achieve the sales from the certified systems it expected through our dealer network.

In 2007 the company has changed its plan for the sales of these certified systems.  Due to the operating results from 2006 and the unknown result of our plan for 2007 management has been unable to forecast projected profits, therefore we have recorded the impairment on the assets as of December 31, 2006.  The Company will continue to analyze and review sales and will try to improve on revenues and profits generated from these certifications.

Note 7 - Debt in Default

The Company did not meet the payment terms on the note payable to Peachtree National Bank through September 30, 2007. The Company did remit $5,000 of the PeachTree debt during May 2007.  The note is secured by the common stock owned by Robby Davis and Ricky Davis, both employees of the Company during the quarter ended September 30, 2007. The provisions of the note allow for the note to become immediately and fully payable upon default of payments. While the bank had not initiated any remedy actions for the default as of September 30, 2007, the full balance of the note has been reclassified as a current liability. The remaining principal balance as of September 30, 2007 was approximately $46,000.

 

         The Company is delinquent in payment of payroll taxes. The Company finalized payments in May 2006 on a payment schedule for the federal payroll tax delinquencies prior to 2004.  Current estimated delinquency along with accrued penalties and interest are as follows, as of September 30, 2007.

		September 30, 2007
Payroll and sales taxes		$	371,453
Accrued penalties and interest			32,753
		$	404,206

                                                                                                                                   

Note 8 – Litigation

 

On November 14, 2003, Ambac International Corporation filed a lawsuit seeking $109,915 together with interest at the rate of 15% per annum. The suits stems from a contract for delivery of certain parts for use in the manufacturing of our systems from 2002. We maintain the parts were delivered substantially past the date of anticipated delivery and that the parts when received were defective. During the first quarter, 2007, the Arbitrator awarded AMBAC a total of $ 259,440 including interest and court costs.  Ambac and U.S. Energy Initiatives entered into a repayment agreement as of September 2007 for total payments of $350,361.  The agreement allows the company to make monthly payments with interest to satisfy the debt.  As of September 30, 2007, the Company had not remitted any payments towards the arrangement. As of September 30th 2007 no penalties or actions have been taken.

 

F-9

---

On February 21, 2007, Boonville Natural Gas Corporation filed an action seeking $112,071.  The suit alleges the Company breached it Contract to sell and install three Diesel/CNG  conversion systems for use on Boonville’s specially purchased vehicles.  The suit seeks reimbursement for damages of the cost for 3 specialized vehicles, cost of tanks and employee labor and travel expenses.  The Warrick Superior Court No. 2 in the State of Indiana ordered in favor of Booneville gas for the principal amount of $73,642, attorney fees and expenses of $6,974 and pre-judgment interest and post-judgment interest at the highest rate allowed by law.  On August 7, 2007 a foreign judgment was filed in Hillsborough County Clerk of the Circuit Court 13^th Judicial Circuit.

On April 18, 2007 Discount Enterprises Inc. filed an action against U.S. Energy Initiatives (along with one other defendant) alleging that the defendants did not comply with the terms of the Contract in regards to the timeliness of installation and the vehicles that were converted had mechanical problems.  A deposition date is set for November 2007. As of September 30th 2007 the outcome of the suit can not be determined.

Mariann Bailey and David Bailey has filed a suit against U.S. Energy Initiatives and Automated Engineering on August 28, 2007 with the Circuit Court of the Thirteenth Judicial Circuit in Hillsborough County in the principal amount of $120,398 together with court costs, attorneys fees and any expenses incurred in the proceedings.  The Baileys claim that they as guarantors made payment on an alleged debt owed by AEC to Platinum Bank and that the debt was part of the stock purchase agreement entered into with U.S. Energy Initiatives.  The Company filed a motion to dismiss in October 2007.  The company takes the position that the debt paid by the Baileys was not included as a creditor on the Schedule included in the purchase agreement.

Bud Industries an Automated Engineering vendor field a claim with the Circuit Court of the Thirteenth Judicial Circuit in Hillsborough County in the amount of $30,418 for goods sold and delivered.  A Judgment was issued and the company has repaid approximately $15,049 of the outstanding debt.

Renewable Energy Resources, Inc. the predecessor or Internal Hydro International filed a suit with the Circuit Court of the Thirteenth Judicial Circuit in Hillsborough County for damages in the amount of $200,000 for a breach of contract.  The suit was filed on the 6^th day of August 2007.  As of September 30, 2007 the outcome of the suit can not be determined.

From time to time the Company is subject to litigation relating to claims arising out of its operations in the ordinary course of business.  Such claims, if successful, could exceed applicable insurance coverage.  Other than what is currently disclosed herein the company is not currently a party to any material legal proceedings.

Note 9 - Stock Options and Warrants

The Company's Stock Option Plan ("SOP") was adopted in 2001 to provide for the grant to employees up to 2,000,000 incentive stock options within the meaning of Section 422 of the Internal Revenue Code. The SOP, which is administered by the Company's Board of Directors, is intended to provide incentives to directors, officers, and other key employees and enhance the Company's ability to attract and retain qualified employees. Stock options are granted for the purchase of common stock at a price not less than the 100% of fair market value of the Company's common stock on the date of the grant (110% for holders of more than 10% of the total combined voting power of all classes of capital stock then outstanding). As of September 30, 2007 and 2006, no options had been granted under the plan.

F-10

---

 

Note 10 - Derivative Financial Instruments

The captions derivative financial instruments consist of (a) the embedded conversion feature bifurcated from the Convertible Debentures, (b) the Warrants issued in connection with the Convertible Debts, (c) interest rate index, and (d) put options. These derivative financial instruments are indexed to an aggregate of 11,334,663 shares at September 30, 2006 and are carried at fair value.

At September 30, 2007 the following derivative liabilities related to common stock options and warrants and embedded derivative instruments were outstanding: (At September 30, 2007, the closing price for the Company's securities was $0.04.

Issue Date	Expiration Date	Instrument		Exercise Price Per Share				Value at Issue Date				Value at 9/30/07
3/05/05	3/05/10	1,600,000 warrants issued to  Alpha Capital		$	0.19			$	928,000			$	17,920
11/4/05	11/4/10	314,815 warrants issued to Dutchess Private Equity		$	0.27			$	85,000			$	3,683
Fair value of freestanding derivative instrument liabilities for options and warrants												$	21,603

 

 

Issue Date	Expiration Date	Instrument		Exercise Price Per Share				Value at Issue Date				Value at 9/30/07
12/20/05	12/21/06	Dutchess $1,362,500 term note		$	0.27			$	302,778			$	294
3/23/06	3/23/07	Dutchess $1,412,500 term note		$	0.27			$	470,833			$	394
7/13/06	10/13/07	Dutchess $845,000 term note		$	0.27			$	338,169			$	0.00
Fair value of freestanding derivative instrument liabilities for term notes												$	688
Total fair value of freestanding derivative instrument liabilities													22,291

 

 

The financial derivatives are accounted for as a liability according to the guidance of EITF 00-19 and FAS 133 and the fair values have been determined using the Black Scholes valuation model with the assumptions listed in the table below

As this transaction occurred in the middle of a reporting period, the Company has designated the acquisition date for accounting purposes to be the end of the month of June.  Therefore, operational results for this acquired entity will commence in the month of July 2006.

 

Note 13 - Segment Information

        Commencing with the Company’s acquisition of Automated Engineering Corporation in the second quarter of 2006 the Company operates in two business segments. The Natural gas vehicle conversion system segment operates development of natural gas conversion systems for light and heavy duty vehicles. The Electronic Manufacturing segment is electronic design, production and ability to proto-type and produce electronic control devices.

 

SEGMENT INFORMATION FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2007 IS AS FOLLOWS:

		Hybrid Fuels				Manufacturing				Total
Revenue			23,018				780,868				803,886
Cost of sales			30,404				687,006				717,410
Gross Profit			(7,386	)			93,862				86,476
Operating Expenses
Consulting and professional			483,196				15,937				499,133
Research & development			22,750				15,763				38,513
Compensation			1,047,633				226,956				1,274,589
Depreciation and amotization			62,576				18,428				81,004
Impairment loss							1,310				1,310
Rent			87,956				83,534				171,490
Insurance			137,536				45,314				182,850
Moving expense			2,900				7,200				10,100
Other operating expenses			180,997				45,933				226,930
			2,025,544				460,375				2,485,919
Loss from operations			(2,032,930	)			(366,513	)			(2,399,443	)
Other income (expense)
Derivative (loss)			274,239								274,239
Interest expense			2,069,140				14,544				2,083,684
Miscellaneous			(3	)							(3	)
			2,343,376				14,544				2,357,920
Loss from continuing operations				)				)				)
Net loss for reportable segments			(4,376,306	)			(381,057	)			(4,757,363	)
Total Assets			1,029,844				1,010,968				2,040,812
Reconciliation of Segment Amounts Reported to Condensed
Consolidated Amounts
Revenue
Total revenues for reportable segments							803,886
Total consolidated revenue							803,886
Net loss
Net loss for reportable segments							4,757,363
Net loss consolidated							4,757,363

F-13

---

  Note 14 –Recent Accounting Pronouncements

In February 2006, FASB issued SFAS 155.  This accounting standard permits fair value re-measurement for any hybrid financial instrument containing an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133; establishes a requirement to evaluate interests in securitized financial assets to identify them as freestanding derivatives or as hybrid financial instruments containing an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in form of subordination are not embedded derivatives; and amends SFAS No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument pertaining to a beneficial interest other than another derivative financial instrument.  SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year beginning after September 15, 2006.  SFAS No. 155 has not had a material effect on our results of operations and financial position.

In March 2006, the FASB issued SFAS No. 156, which addresses the accounting for servicing assets and liabilities.  SFAS No. 156 is effective at the beginning of an entity’s first fiscal year beginning after September 15, 2006.  SFAS No. 156 has not had a material effect on our results of operations or financial position.

In July 2006, the FASB issued Interpretation No. 48, “ Accounting for Uncertainty in Income Taxes”  (FIN48), effective for fiscal years beginning after December 15, 2006.  FIN 48 requires a two-step approach to determine how to recognize tax benefits in the financial statements where recognition and measurement of a tax benefit must be evaluated separately.  A tax benefit will be recognized only if it meets a “more-likely-than-not” recognition threshold.  For tax positions that meet this threshold, the tax benefit recognized is based on the largest amount of tax benefit that is greater than 50 percent likely of being realized upon ultimate settlement with the taxing authority.  The adoption of Fin 48 did not have a material impact on the consolidated financial statements.

In September 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (“SFAS”) No 157, “fair Value Measurements.” SFAS No. 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes  the information used to develop those assumptions.  Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy.  SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years, with early adoption permitted.  The Company does not expect the adoption of SFAS No. 157 to materially impact its financial statements.

In February 2007, FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.”  This Statement permits entities to choose to measure many financial instruments and certain other items at fair value.  This Statement is effective for fiscal years beginning after November 15, 2007.  The adoption of SFAS No. 159 is not expected to materially impact the financial statements..

 

Note 15 – Subsequent Events

During October of 2007 a licensed Hybrid Fuel Systems Distributor, Witco Systems Inc., cancelled their distribution agreement.  They cited a lack of sales opportunities in their sales area (Asia, South East Asia and the Middle East) the long gestation required between the introduction of the technology and the actual acceptance of the product was deemed to long for them to continue to participate.  They cited excessive costs and continuing losses as their reason for termination.

On October 26, 2007 USEI sold the fixed assets, research and development inventory, and all research and development tools and software to Engine Control Technology, LLC.  This sale was consummated upon the approval of General Motors of our dual fuel technology.  GM had indicated that we were about to commence the production phase of this new product introduction.  The Board decided that since no additional R&D was required, USEI should divest itself of all R&D personnel and developmental equipment.  Therefore at the end of October 2007 USEI sold all R&D Inventory, and R&D Equipment to Engine Control Technology, LLC for the sum of $200,000.

F-14

---

Item 2 - Management's Discussion and Analysis or Plan of Operations

This Report contains forward-looking statements, within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, which reflect our expectation or belief concerning future events that involve risks and uncertainties. Our actions and performance could differ materially from what is contemplated by the forward-looking statements contained in this Report. Factors that might cause differences from the forward-looking statements include those referred to or identified under "Risk Factors" in our Annual Report on Form 10-KSB for the year ended December 31, 2006 and other factors that may be identified elsewhere in this Report. Reference should be made to such factors and all forward-looking statements are qualified in their entirety by the above cautionary statements. The following discussion and analysis provides information which management believes is relevant to an assessment and understanding of the results of our operations and financial condition. The discussion should be read in conjunction with the financial statements and notes thereto.

The following discussion should be read in conjunction with our condensed consolidated financial statements and notes to those statements. In addition to historical information, the following discussion and other parts of this report contain forward-looking information that involves risks and uncertainties.

OVERVIEW

As of October 2007 US Energy is operating in 3 segments due to its recent acquisition of Seaspray Aerosol, Inc.

·

The alternative fuels market segment through the design and sale of our patent dual-fuel, diesel-natural gas conversion systems. In June of this year General Motors announced that our dual fuel kit had successfully completed the 100,000 km and that further development was not needed.  The next step is to commence kit sales and conversion of GM vehicles in Thailand.  Having the GM certification in hand, it was decided to cancel all further R&D expenses and to shut down the Atlanta Facility and sell all R&D equipment and excess Inventory.  The Atlanta facility did not support the manufacture of kits and AEC was already producing all of the electrical components and has successfully outsourced all of the mechanical components.  This decision dramatically reduced the expenses of USEI.

·	The electronic manufacturing segment through the operations of our subsidiary Automated Engineering Corporation (AEC). AEC is an ISO 9001 certified, nineteen year-old company providing electronic design, prototype and production of electronic systems and components. We conduct our electronics design and manufacturing at our facility in Tampa, Florida. We also house our executive offices in our Tampa, Florida facility.
·	The specialty aerosol filling segment, through the operations of our recently acquired subsidiary, Advanced Aerosol Technologies, Inc.  (AATI).  AATI is a ten year old company currently undergoing ISO 9001 certification, that formulates and sells its own proprietary products as well as providing private labeling services to a variety of companies.   We offer our Aerosol filling capabilities primarily to clients requiring smaller production quantities that would not be economicable feasable for large aerosol concerns.  The company is fully staffed with management, sales, and quality personnel.  The USEI CEO overseas this company and assists in contract acquisition.

We have sought to insert our dual-fuel technology into the marketplace through original equipment manufacturers (OEMs) parallel with expanding our direct-to-consumer activities.

We offer our electronic design and manufacturing services primarily to clients that require smaller production runs that would not be economically feasible for larger production facilities.

1

---

·

Calculating the comparisons between our reporting periods

·

Providing meaningful insight into our product and manufacturing costs as well as expenses incurred in delivering our technology have been difficult because we have previously sold our systems at the rate of one or two a month under federal and/or state grants. We have not had the ability for our product to take advantage of quantity discounts in our raw materials and component parts. Further, our labor costs in our present environment would appear unusually high given our revenues. However, in order for us to position our company to maximize opportunities, we have found it necessary to engage professionals and mechanics in sufficient number to complete the build-out of our facility in Atlanta as well as developing new systems.

In the case of our electronic manufacturing, we acquired AEC during June 2006 and have sought to make improvements in manufacturing efficiencies, procurement and to expand our design and prototyping services. As a result, the following annual and quarter comparisons may not be indicative of future operating results.

Discussion of Operations for 2006:

We executed our Memorandum of Understanding with General Motors Thailand (GMTh) in support of their C190 Colorado Pick-Up Program for model years 2007 through 2009. During the third and fourth quarter 2006 into the first quarter 2007, we continued durability testing and engineering analysis with GMTh. We completed a number of new installations for GMTh during the fourth quarter 2006 and early 2007. GMTh notified the Company during March 2007 they had completed their durability testing to their satisfaction and they are now prepared to proceed by offering our dual-fuel system as an option through their dealerships beginning in Thailand.   We completed the acquisition of Automated Engineering Corporation (“AEC”). We acquired AEC to manufacture in-house the electronic control unit component. The core of our system is incorporated into our electronic control unit. Our ability to manufacture the device in-house has resulted in a lower cost of goods and allowed us to ensure our system is manufactured under the highest quality standards. With the current equipment, machinery and facilities we now have, the Company can manufacture approximately 2,000 systems per month. We believe this provides us ample capacity to react to the potential sales we are pursuing .

We executed an agreement with PS Gas Company (“PSGas”) in Thailand for the conversion of diesel powered buses over a five year period. During the first quarter 2007, we successfully field-tested a system in a bus provided by PSGas in Thailand. The converted bus was taken on a 100 kilometer road test. We are now working with PSGas to schedule the intial roll-out of our dual-fuel systems through their fleet.   We expanded our exclusive fulfillment license with WITCO Intl for a host of countries including China, India, Malaysia, Korea and several other Asian countries. WITCO has now opened a field office in China and during the first quarter 2007, we shipped the ten production units to WeiChai Peterson Motors in China . We realized an increase in revenues from $652,400 at the year ended December 31, 2005 to $1,375,418 at the year-end 2006. Our loss to operations during the same periods were $(8,261,371) for the year ended 2005 and $(11,029,040) for the year ended 2006.

Our business model is patterned around our core dual fuel diesel to natural gas conversion technology and contract electronic manufacturing. Our model was primarily developed as a result of our operating experiences, available assets and our opinion of the market place in general. We highlight certain challenges we faced during 2005 and the fundamental adjustments we've made in developing our resultant business.

Determined that pursuing the sale of our dual fuel system exclusively to government municipalities and direct to consumers was sufficiently inconsistent as to retard our ability to achieve profitable operations. The appeal of our product is tied directly to the price differential between diesel and natural gas. When municipalities allocate funds to convert a vehicle or fleet of vehicles, the objective is to clean up emissions and not necessarily to justify a return on investment. When market factors beyond our control cause the price of diesel or gasoline to temporarily rise in price elevating the differential over natural gas, we would experience a temporary increase in demand for our conversion systems. However, we are unable to predict with certainty when government funds would become available or when the price of fuels would take an extraordinary shift in price. As a result, while we continue to pursue both government and consumer sales, we are predominantly focused on delivering our technology through an original equipment manufacturer. In our opinion, the OEM tends to purchase an annual minimum quantity of products similar to our conversion system and then resells the system in tandem with their vehicle sales.

Determined that engineering and code writing for systems in a mobile setting would not allow us to achieve a level of precision and repeatability essential to maximizing our technology. Historically, we would conduct systems engineering in a mobile setting. While this technique is effective, it is time consuming, expensive and susceptible to error. As a result, we entered a ten year lease at our new 12,000 square foot facility in December 2004 and throughout 2005 into 2006, we incurred costs of approximately $750,000 in construction costs and equipment purchases. Since November, 2005, we been developing systems in a tightly controlled lab setting.

Shortly after our acquisition of AEC during June 2006, we noted a number of operating discrepancies that could have prevented us from operating at full capacity. We adjusted the methods we use in production and in ordering component parts. We also anticipated an upsurge in electronics manufacturing during the fourth quarter which is consistent with that business segment. However, given that we were the new owners of AEC and had not yet matured our own internal selling procedures, we were not able to capitalize on this annual upsurge. We have now improved our selling techniques and we’ve established a number of new client relationships which we believe will allow us to take advantage of annual sale cycles.

 

2

---