El Paso Corp.’s accounting for results from restructured power contracts was in the headlines again Tuesday in the Wall Street Journal and The New York Times, and investors avoided EP shares like the plague in reaction to the news. El Paso’s stock plummeted 23% to $10.40, only a day after UBS Warburg raised its stock rating on the company to “Strong Buy.” Meanwhile, Standard and Poor’s (S&P) said it found nothing new in the newspaper reports and reaffirmed El Paso’s “BBB+/Stable/A2” credit ratings, despite the sharp downturn in its stock and in investor sentiment.

The newspaper articles rehashed old news about concerns related to the way El Paso manages off-balance sheet partnerships and books future earnings up front from restructured long-term bulk power sales agreements. The concerns were raised recently by former Coastal Corp. CEO and large El Paso shareholder Oscar Wyatt, who sent letters about the issues to El Paso, the Securities and Exchange Commission and members of Congress.

Wyatt charged that the accounting used for Utility Contract Funding transactions by El Paso’s Merchant Energy Group “discounted future earnings to report current earnings” (see Daily GPI, July 12). El Paso’s Project Electron involves buying up power plants, renegotiating the sales agreements with utility companies based on power market purchases and hedging, and then reselling those securitized income streams, much like banks do with home mortgages. The sales enabled El Paso to book the entire earnings from multiyear agreements up front (mark-to-market). Meanwhile, the power plants were placed under a partnership structure that initially allowed the company to shield itself from the debt. Wyatt questioned the use of a number of off-balance sheet partnerships to hide debt and other financial details.

El Paso Corp. subsequently made an 8-K filing with the Securities and Exchange Commission in which CEO William Wise defended his company’s transactions and partnerships in a point-by-point rebuttal.

El Paso also has decided to limit its mark-to-market activities to less than 10% of its annual recurring earnings going forward, noted UBS Warburg analyst Ronald J. Barone in defending the company. “In short, though these transactions are complex, we see legitimate accounting; no smoking gun; and are encouraged by the expected limited use of such transactions in its future earnings (which should increase its overall earnings quality).

“With these [newspaper] articles now on the table, we believe EP shares have one less hurdle to pass,” Barone added, still maintaining his “Strong Buy” on the company, particularly after it lost 23% of its value on Tuesday. “Overall, we believe El Paso would be worth materially more if it was shut down today than where it is currently trading — 5.3x what we view as a highly realistic recurring 2003 projection (without liquidity concerns that could derail that projection).”

In a statement issued Tuesday, S&P said it identified “no fundamental change in the credit quality of El Paso given heightened uncertainty over ‘wash trades’ in the industry or negative press from outside shareholders.” S&P discussed El Paso’s accounting methods, but found nothing new that would impact credit ratings.

The potential negative impact from any off-balance sheet items could hinder El Paso’s credit protection measures, S&P admitted, “but not to a level that warrants a change in the company’s rating or outlook.”

“El Paso is expected to maintain its strengthened financial profile even if the current industry turmoil passes,” S&P said. El Paso’s debt leverage and funds to interest converge ratios “are more than adequate for current ratings.” Treated as debt are El Paso’s Trinity River, Clydesdale and Gemstone minority interest structures ($2.3 billion); the approximate $2 billion of guarantees extended by El Paso (excluding the $1.95 billion of guarantees associated with Electron and Gemstone, which are already considered El Paso debt); and $400 million for the company’s LNG tanker commitment (the net present value of El Paso’s 50% share).

S&P reiterated that El Paso’s liquidity also is adequate, with $4 billion of credit facility capacity supporting the ability to issue up to $3 billion of commercial paper. “With the elimination of rating and stock price triggers on all but $300 million of the company’s financings, and the declaration to limit working capital investment in its merchant energy group to $1 billion, S&P believes that El Paso has an ample liquidity cushion.”

It estimates that El Paso needs $500 million of capital to adequately cover the company’s market, capital and operational risks of its energy trading and marketing unit, which S&P currently analyzes as a debt equivalent.

The ratings agency excluded “the company’s potential realization of energy trading and marketing cash flow from its ‘stress scenario,'” in which certain events negatively affect the company. “In the stress scenario, El Paso still maintains the ability to produce [funds to interest] coverage of more than 3x, with adjusted average debt leverage of about 60% by year-end 2002, which, along with the company’s large asset base, strong market presence, and quick actions to repeatedly stay ahead of the credit curve, are sufficient for the current ratings.”

S&P said it believes El Paso “will continue to maintain its strengthened financial profile and commitment to credit quality, and would further bolster itself, if necessary, to endure any additional credit concerns.”

It also said it does not expect the ongoing Federal Energy Regulatory Commission case over possible affiliate violations and fines concerning El Paso Natural Gas pipeline capacity to California will affect the parent company’s credit quality. “However, a decision more severe than a small fine or slight change in market or affiliate rules could potentially inflict greater harm than expected upon El Paso,” S&P added.

It also noted there are uncertainties regarding the outcome of several other events that could affect El Paso’s credit quality. The impact of a separate FERC case involving the pipeline, in which the company is being forced to change capacity contracting policies to ensure that there is fair and open access to capacity, also should be considered.

In addition, the growing body of evidence of various legal and ethical breaches of rules and conduct by certain companies within the energy industry, and increasing skepticism by regulators and politicians, could result in “a potentially harmful scenario [of] wide-reaching changes in regulation, operations, or financial returns of gas pipelines. Since El Paso’s pipelines produce the strongest and most stable cash flows throughout the enterprise, any sizable change in currently authorized returns or the ability to earn such return could cause a large fundamental disturbance in the company’s credit quality.”

However, S&P noted that El Paso has made significant progress in creating greater financial stability and maintaining its credit quality. “El Paso’s multiple equity issuances and growing pool of asset sale proceeds at a time when many of its peers still have not yet completed their equity sales in the face of extremely depressed equity prices in the sector, and when many companies have either just identified the assets they will sell or have just started the sales process, exemplifies why El Paso’s rating has held up in a storm of credit uncertainty in 2002,” S&P said.

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