Driven by strong results from its bread-and-butter natural gas pipelines and a 99% success rate in exploratory drilling, El Paso Corp. last week delivered 18 cents/share quarterly profit, two cents ahead of Wall Street expectations, and well ahead of the 50 cents/share loss a year earlier. Net income climbed to $126 million, versus a loss of $321 million in 3Q2005, and operating revenue rose 41% to $1.06 billion from $752 million.

Even with $16 million spent in the quarter to continue repairs to its Gulf of Mexico (GOM) natural gas pipelines damaged in last year’s storms, pipeline earnings before interest and taxes (EBIT) jumped 12% to $305 million. Natural gas and oil production also rose 7% from a year ago.

CEO Doug Foshee, who presided over a conference call with financial analysts, said that in the past few months, El Paso has “reached some important milestones — the completion of our exit from the domestic power business, the restructuring of our bank facilities at favorable terms, and the resolution of shareholder litigation. These accomplishments position the company well for the future.”

Total throughput on the pipelines rose 7.1% to 22.4 trillion Btu/d from 20.9 trillion Btu/d in 3Q2005. The segment’s gains followed the expiration of discounted rates to some El Paso Natural Gas (EPNG) customers; the implementation of new rates at EPNG; increased revenues from sales of additional firm capacity and various interruptible services and higher realized rates on several pipelines; and the contribution of pipeline expansion projects, including the Cheyenne Plains pipeline expansion, the Piceance Basin expansion on the Wyoming Interstate Co. system, and the Elba Island liquefied natural gas (LNG) terminal expansion. Offsetting these positives were $9 million of hurricane repair costs that will not be fully reimbursed by insurance.

In its exploration and production (E&P) segment, El Paso’s earnings rose 10% to about $186 million, excluding a hedging loss. Production volumes averaged 744 MMcfe/d, 7% higher than the 736 MMcfe/d reported in 3Q2005, and 3% higher sequentially than in 2Q2006. Unconsolidated affiliate volumes from its Four Star investment totaled 66 MMcfe/d, almost three times higher than the 23 MMcfe/d a year ago. Average natural gas sales volumes rose to 617 MMcf/d from 601 MMcf/d. Four Star’s average gas sales jumped to 48 MMcf/d, from the 17 MMcf/d a year earlier.

However, E&P capital expenditures rose to $314 million from $195 million a year ago. Like other U.S.-based producers, El Paso was hit by higher total per-unit cash costs, which increased to an average of $1.95/Mcfe, compared with $1.74/Mcfe for the same 2005 period. El Paso expects full-year 2006 per-unit cash costs to be $1.82-1.87/Mcfe.

“We don’t expect this trend to continue,” Foshee said of higher capital costs. “We are in the last big flood of hurricane repairs…which is not expected to last…This is likely to continue to be an issue” going into next year, but “we anticipate a big piece of capacity that caused most of the problems in the second half of 2005 and through 2006 to begin to mitigate” in the next six months.

Average daily equivalent production volumes in the quarter were negatively impacted by 7 MMcfe/d of continued shut-in volumes offshore. El Paso also experienced delays in achieving initial production on some wells in the GOM and South Louisiana and slower-than-planned ramp-up from two new rigs in East Texas. For the full year, shut-ins and longer-than-expected delays in bringing on GOM production are expected to reduce the company’s average annual production by 25 MMcfe/d.

“Recovery from last year’s storm season continued to be the theme this year,” Foshee said. “We’re still down about 5 million a day [in production volumes offshore], and we’re got a long lead time for being back on stream.” He said the GOM was El Paso’s “most challenging area this year, and is well below expectations.”

El Paso said its realized price for gas (before transportation costs) in 3Q2006 was $6.30/Mcf, versus $6.40/Mcf for the same period in 2005. Oil, condensate, and natural gas liquids (NGL) realized prices (before transportation costs) were $60.81/bbl, up 20% from $50.77/bbl a year earlier.

The marketing and trading segment reported loss of $108 million, compared to a loss of $398 million in 3Q2005. Results were primarily driven by a noncash, mark-to-market (MTM) loss on gas supply agreements with its Midland Cogeneration Venture (MCV) because of its sale. In 3Q2005, earnings were impacted by a $382 million MTM loss on production-related hedges, partially offset by a $45 million MTM gain on a tolling agreement.

El Paso’s power segment reported EBIT of $38 million for the quarter, compared with a loss of $46 million in 3Q2005. Results were primarily attributed to earnings from the company’s Brazilian investments, a $13 million gain on the sale of the company’s interest in the MCV power facility, and a $12 million gain on the sale of a portion of the company’s interests in IntercontinentalExchange.

At the end of the quarter, El Paso’s debt, net of cash, was $14.4 billion, a $1.7 billion reduction from Dec. 31, 2005. Gross debt stood at $15.2 billion on Sept. 30, a $3.1 billion reduction from the end of 2005. During the first nine months, El Paso closed $893 million of asset sales, and since the end of the third quarter, El Paso has closed another $90 million of asset sales, with $100 million more in various stages of completion.

El Paso expects 2006 average production will range between 790-800 MMcfe/d, about 25 MMcfe/d lower than the company estimated earlier this year. If recovery continues, Foshee said GOM production should be up another 25-40 MMcfe/d by the end of 1Q2007.

El Paso last week also restructured and expanded its hedging program to support its 2007 gas production.

“Our expanded hedge program provides support on approximately 210 Bcf of 2007 domestic natural gas production with an average floor price of $7.64/MMBtu,” said Foshee. “Importantly, 121 Bcf of the hedged volumes have an average capped price of $11.80/MMBtu, while the remainder of our 2007 production will retain unlimited upside. The risk management steps that we have taken, along with high expectations for our pipeline and E&P businesses, provide us with a great deal of confidence about our 2007 outlook.”

For 2007 El Paso has 55 Bcf of collars with an $8/MMBtu floor and $16.89 ceiling; 89 Bcf of floors at $7.50/MMBtu; and 66 Bcf of fixed-price swaps at $7.53/MMBtu.

None of the derivatives used to provide price risk management are subject to margin calls. The 89 Bcf of floors do not qualify for hedge accounting and are marked to market in El Paso Marketing and Trading’s economic hedge book. Prior to the expansion of the program, El Paso had 130 Bcf of collars for 2007 with an $8/MMBtu floor and $16.02/MMBtu ceiling. In addition, the company had fixed-price swaps on 5 Bcf of production with an average hedge price of $3.57/MMBtu.

Foshee had little to say about recent rumors that El Paso may sell its ANR Pipeline (see NGI, Nov. 6).

“We don’t comment on market rumors,” he said. “I will say, though, with regard to strategic alternatives generally, is that we spend a lot of time on issues as a management team and board. One of nice things now is that things are done that are from a position of strength, not a position of weakness. If and when the board and the company decides to make a strategic decision, we’ll announce it when we are ready to announce it.”

Following the earnings news, El Paso on Friday said subsidiary El Paso Exploration & Production Co. agreed to acquire Laredo Energy III LP for $255 million. Laredo owns 27,000 gross (23,000 net) acres in Zapata County, TX, close to El Paso’s existing operations in the Bob West field.

The assets have current net production of 19 MMcfe/d, and El Paso estimates proved reserves to be 84 Bcfe. Approximately 73% of the estimated proved reserves are undeveloped. The properties are 100% operated with an average working interest of 85%. The transaction is expected to close in January.

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