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With Turnaround Complete, El Paso Expects '06 to be 'Breakout Year'

El Paso Corp.'s two-year corporate turnaround is now complete, and 2006 "will cap our return as one of North America's premier natural gas companies," CEO Doug Foshee said Wednesday. The company, whose Gulf of Mexico pipelines and platforms were hard hit by Hurricanes Katrina and Rita, also expects to have nearly all of its operated production restored in the second quarter.

Speaking to an analyst conference in New York last week, Foshee and his management team spent most of Wednesday explaining their restructuring strategy, which began in December 2003. Foshee defined 2006 as El Paso's "breakout year," focusing almost exclusively on natural gas pipelines and exploration and production (E&P).

Lisa Stewart, who heads the company's E&P unit, pegged 2005 losses from the Gulf of Mexico storms at 12 Bcfe. Current offshore output stands at 130 MMcfe/d, and the gas pipelines are operating at about 85% of pre-hurricane volumes.

"The [production] impact was most evident if you look at the third and fourth quarters," she said. However, most of the company's operated production is expected to be restored by 2Q2006. The hurricanes scuttled construction of El Paso's West Cameron project into the winter season, where installation of a 14-mile pipeline to the coast was hit by high winds and seas. However, by early February, Stewart said about 23 MMcfe/d from two West Cameron wells should ramp up.

E&P repairs also are ongoing at El Paso's offshore Eugene Island 372 facility, where a third-party oil pipeline riser "was more damaged than originally thought," Stewart said. "It's not our riser, but we're working very closely with that riser, and we expect it to come on in the first quarter," which will restore about 20 MMcfe/d. Third-party restorations are taking more time, which affects about 10 MMcfe/d. "The timing is unknown on those restorations," but, "most of the production should be restored by early in the second quarter."

Foshee complimented the "incredible" work by his team over the past two years, and said El Paso had made "significant progress against the goals we laid out for ourselves in 2003, allowing us to now turn our focus toward growing our two core businesses, Pipelines and E&P. The growth opportunities in our pipeline business are unprecedented. Our E&P business moved out of crisis mode in 2005, and we expect it to show growth and improvement in virtually every area in 2006."

This year, El Paso plans to focus on four key objectives: Earning $1.00/share or better, growing both core businesses, generating significant free cash flow, and continuing to improve El Paso's credit metrics. The company set an earnings target in 2006 of $0.95-$1.05/share, with cash flow from operations of $2.5-$2.6 billion. It also is forecasting free cash flow of $400 million, with net debt reduced to $14 billion. The 2006 targets assume commodity prices of $8/MMBtu for gas and $60/bbl for oil.

Within its Pipeline Group, Foshee said, "rising natural gas demand and a shift in sources of supply will require our industry to make significant investments in North American infrastructure. Our pipelines have unmatched market presence and connectivity, making us uniquely situated to address those needs and capture new opportunities."

The Pipeline Group is expected to generate average annual earnings growth of 4-6% in 2006 and "beyond," through large-scale growth projects such as the expansions at the Elba Island liquefied natural gas (LNG) terminal and the related Cypress and Elba Express pipeline takeaway projects. In addition, the group has a significant backlog of various market-area and Rockies projects under development. This year's capital budget is $1 billion, of which $470 million is dedicated to growth projects. At least $450 million or more of growth capital annually is expected "for the foreseeable future."

Like its Pipeline Group, El Paso's E&P 2006 capital budget also is set at $1 billion, which will focus on exploration onshore, along the Texas Gulf Coast, offshore in the Gulf of Mexico and through international projects in Brazil. E&P operations are forecast to produce between 825-850 MMcfe/d in 2006, including its proportionate share of production in Four Star Oil & Gas Co.

El Paso reported year-end 2005 proved natural gas and oil reserves totaled 2.7 Tcfe, up 22% from 2004. The total included El Paso's share of proved reserves in Four Star Oil & Gas Co. During 2005, El Paso's exploration and production (E&P) capital expenditures totaled $1.867 billion, and reserve replacement costs were estimated to be $2.36/Mcfe. El Paso is targeting 5-10% reserve growth this year.

Based on an independent review of its reserves, El Paso in early 2004 reduced its estimated proved reserves by 41% (see NGI, Feb. 23, 2004). Following an independent review, El Paso reported some employees had used "unsupportable methods" over a four-year period, which allowed the overbooking of reserves (see NGI, May 10, 2004), and since then, it has revamped its reporting practices and sold off some of its reserves to concentrate on domestic production.

In a research note to clients, Wachovia Securities noted, "The updated reserves number (E&P), growth outlook, and multiple pipeline expansion proposals all bode well for continued share appreciation in 2006, in our opinion."

Harris Nesbitt analyst Patrick Rau also called El Paso's 2006 guidance a positive step. "We believe the increase in reserve gains as a percentage of production in 2005, along with higher 2006 production guidance, shows that El Paso's decision to focus on less risky drilling plays in 2005, particularly in the Texas Gulf Coast, is showing positive results." He noted there was not a lot of "incremental news" concerning the proposed Continental Connector, a pipeline beginning in the Rocky Mountains that would carry gas east, "but we continue to believe the odds of this project being built are less than even."

Although it does not yet have firm commitments, El Paso claims to have market support for the Continental Connector project already, garnering about 3 Bcf in preliminary interest (see NGI, Dec. 5, 2005). Kinder Morgan Energy Partners (KMEP) and Sempra Pipelines and Storage have a similar pipeline project on the table, Rockies Express, which so far has 1.3 Bcf/d in binding, conforming commitments (see NGI, Dec. 26, 2005).

"There are no firm commitments" for the Continental Connector project yet, Foshee told reporters following the meeting, but along with the nonbinding 3 Bcf, there has been additional "incremental interest." He said El Paso was beginning to convert the nonbinding interest to expressions of interest to ready for a binding open season, and then there will be "a real project move." He offered no further timetable.

Asked about the KMEP-Sempra proposal, Foshee said, "definitely, there is a competitive dynamic that exists," but the proposals are "not mutually exclusive." He said, "one of the keys and one of the strengths [of El Paso's proposal] is how fast it can be put in service and how scalable it is...with existing infrastructure and greenfield infrastructure." For producers "worried about basis out of the Rockies," El Paso would offer "a great deal of certainty of execution," which could "come on quickly and be of significant value."

Rau also noted the "legacy issues surrounding the company appear to be improving, but nonetheless remain. Management also stated it believes it can achieve investment grade status on its debt with another $1-$2 billion in debt reduction, but we continue to believe that is still several years away."

Foshee told reporters El Paso is targeting net debt of $14 billion by the end of 2006, which would put the company within an investment-grade target of $1-2 billion.

"Our long-term goal is to be investment grade, but the primary beneficiary is the pipeline business," Foshee said. The pipelines all hold credit ratings at least a notch above El Paso Corp., and as the debt falls, their ratings should move higher. "Our ability to get to investment grade will be driven by two things," he said. "how much debt reduction we achieve and how much we grow our footprint in our businesses." With growth expected in both the Pipeline Group and E&P, Foshee said the only thing holding El Paso back will be its ability to generate free cash flow and where commodity prices are.

El Paso sold most of its power book last year, and in 2006, the company expects to further reduce the size of its remaining legacy trading portfolio from a high of 37,000 transactions to fewer than 1,100 transactions. It also plans to continue to pursue the sale of its remaining domestic and certain international power plants, and it will continue to "actively pursue resolutions to contract disputes associated with its Brazilian power portfolio."

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