In reaction to El Paso Corp.’s weak exploration and production (E&P) performance in the third quarter, Moody’s Investors Service on Tuesday reduced its rating outlook to negative from stable, while analysts with Credit Suisse First Boston (CSFB) suggested a partial sale or spin-off for the E&P unit.

On Monday, El Paso’s exploration and production segment, housed within subsidiary El Paso Production Holding Co. (EPPH), reported a 42% drop in earnings, and equivalent production dropped 32%, which El Paso blamed on the sale of nearly 1.6 Tcfe of proved reserves since a year ago, normal declines in base production and mechanical failures on some of its wells (see Daily GPI, Nov. 11).

John Diaz, managing director of Moody’s Corporate Finance unit said the production decline was in line with Moody’s EPPH operational concerns, which it reviewed in May. EPPH owns 45% of El Paso’s production and 54% of its oil and gas reserves.

“We noted then that EPPH’s 74% production concentration in very short-lived reserves, the nature of its development and exploration base, and its capital available for reinvestment in that base could be insufficient to sustain reserves, production and capital costs suitable for the ratings,” Diaz said. The negative outlook won’t change, he said, until “sustainable production, proven developed (PD) reserves and total unit-full cycle costs can be reliably gauged.”

Moody’s also expressed concern that EPPH’s “leading edge reserve replacement costs substantially exceed its total three-year average replacement costs, especially for the 60% of production coming at the time from Gulf of Mexico (GOM) reserves having a very short 2.2 year PD reserve life and 14% of production coming from South Texas/Gulf Coast reserves with a short 4.6 year PD reserve life.”

Because of the company’s “concentrations of very short-lived production, we expect production trends to be vulnerable as EPPH attempts to transition from high reliance on initially flush but short-lived production plays to longer-lived coalbed methane production.” In the fourth quarter, Moody’s analysts said that EPPH needs to stabilize its production, demonstrate “acceptable” year-end reserve replacement costs and gear up for growth in 2004.

Up to now, EPPH has focused on the GOM and South Texas, where PD reserves have not been replenished with reserves of comparable quality,” and “the concentration of production in short-lived reserves tends to cause sequential quarter production trends to be more vulnerable to completion delays and inevitable periods of less productive drilling.” Also, its “high proportion” of short-lived reserves “reduces its ability to curtail capital spending at times of weaker prices without a materially negative impact on production.”

Meanwhile, CSFB analysts, which also analyzed the company’s E&P business and its “prospects with a view toward future potential transactions,” said Tuesday that El Paso’s “need for ongoing debt reduction provides more impetus for a partial sale or spin-off scenario for the E&P unit.”

Analyst Curt Launer said, “with almost 25% or about 76 Bcf of ’04 production hedged at $2.65/Mcf and higher finding costs, we have reduced our outlook for E&P and continue to view the unit as a cash flow user in ’04. This scenario clearly limits El Paso’s ability to pay down debt and impedes El Paso’s balance sheet recovery plan.”

El Paso is undervalued, said Launer, “in part due to the value of its exploration and production unit. We value the unit at $2.9 billion ($4.30/share), net of $3 billion in debt.”

El Paso did not comment on the reports.

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