Citing the uncertainty looming over the high-profile complaint case against El Paso Corp. at FERC, Moody’s Investors Service downgraded the senior unsecured debt ratings of the Houston-based energy corporation and its subsidiaries to junk, or Ba2 from Baa3 Tuesday, and also assigned a senior implied rating to El Paso of Ba1. It said the rating outlook for embattled El Paso was negative.

El Paso stock, which experienced an uptick late last week, was clobbered in the wake of Moody’s action, falling 19%, or $2.05, to close at around $8.63 a share Tuesday. El Paso Chairman and CEO William Wise criticized the rating agency’s move, saying it “largely ignored” the progress the company has made in past months with asset sales and improving its liquidity, and instead focused on the proceeding at the Federal Energy Regulatory Commission.

Moody’s said the downgrades reflected El Paso’s weak cash flows and uncertain prospects for their improvement in the near term; debt levels that remain high relative to the company’s cash flows, despite sizable retirements and repayments this year; the likelihood that capital expenditures will continue to exceed cash flow from operations and that the company will continue to rely on asset sales to meet the shortfall and to further reduce debt; and execution risks related to El Paso’s efforts to scale back and refocus its merchant energy activities, including exiting energy trading, consolidating the power business of the Electron affiliate, divesting its petroleum business and furthering its strategy for liquefied natural gas (LNG).

The differential between El Paso’s Ba2 senior unsecured and Ba1 senior implied ratings reflects the “structural subordination” of the El Paso holding company debt to a substantial amount of subsidiary debt, Moody’s said.

The negative outlook signals the “uncertainties” surrounding the financial fate of El Paso in the wake of a FERC administrative law judge’s ruling that subsidiary El Paso Natural Gas withheld substantial amounts of transportation capacity to California during the state’s energy crisis to ratchet up natural gas prices. The Commission is scheduled to hear oral arguments from El Paso and California regulators next Monday before making a final decision in the complaint case. FERC will have the option to either accept or reject in full or in part the judge’s ruling.

“While the ultimate impact of these proceedings will not be known for some time, they could potentially bring about other litigation and proceedings that negatively affect [El Paso’s] financial position,” Moody’s said. In addition, it cited the numerous federal government investigations into El Paso’s energy trading activities.

The negative outlook further reflects the “possibility that the ratings could be adjusted downward if actual liquidity requirements prove much higher than [El Paso’s] expectations,” according to the rating agency.

El Paso’s cash flow-to-debt measures currently remain weak, Moody’s said. For the nine months ended Sept. 30, the company’s annualized retained cash flow-to-debt (adjusted to include minority interest obligations, operating leases, letters of credit, guarantees related to debt and other activities, and commitments under its LNG time charter agreements) was roughly 7% after changes in working capital and price risk management activities and about 4% before the changes.

“Cash usage patterns for working capital and price risk management may change as [El Paso] exits energy trading. Although price risk management activities consumed substantial cash this year, it is unclear how the exit would affect future working capital patterns, as about $800 million of such working capital usage so far this year was related to hedging E&P production. E&P remains a core activity for [El Paso], and it is uncertain how much working capital may be required in hedging gas production in the future.”

Going forward, El Paso’s pipelines and E&P businesses combined are expected to generate well over 90% of the corporation’s “core” earnings before interest, taxes, depreciation and amortization (EBITDA), Moody’s said. It believes El Paso will assume “significant execution risk” in establishing Travis Energy as the entity to serve as the liquidating vehicle for most of its energy trading contracts.

In the first quarter of 2003, El Paso intends to consolidate its Electron affiliate, which has been its vehicle to grow its domestic power business. El Paso “has an extensive power portfolio, and the earnings from it will comprise most of its merchant energy business in the near future,” the rating agency said.

“Petroleum and other related businesses have posted heavy losses this year, and many of the related assets will likely be divested. The timing of such sales, as well as the financial impact of the businesses prior to the sale, are uncertain,” Moody’s noted. The company “retains numerous joint ventures in telecom, international power and other businesses, and these may be subject to impairments. It may take some time to exit many of these investments given difficult industry conditions, volatile capital markets, and a glut of energy and other assets being sold by other companies.”

LNG is a “growth business,” but it will take some time to develop, Moody’s believes. El Paso “will incur up-front costs and debt obligations until this business begins to generate revenues.”

With its capital spending likely to exceed cash flows, and a significant amount of debt maturities pending, Moody’s said El Paso will continue to need asset sales to supplement its liquidity. Access to the capital markets for El Paso at favorable terms is “uncertain” in light of the current volatility, and may continue to be difficult until there is a “favorable resolution” of the FERC complaint case, it noted. The company has paid off all of its commercial paper and has about $1 billion of cash available as a liquidity position.

El Paso has a $3 billion, 364-day bank facility expiring in May 2003 and a $1 billion term loan expiring in August 2003. The 364-day facility has a one-year term-out option which, if exercised, could potentially provide liquidity through May 2004, Moody’s said. At the same time, El Paso has about $2 billion of maturing debt in 2003, $1 billion of which is the Electron debt due in March. The company is concentrating its asset sales efforts in this quarter and the first quarter of 2003 to pre-fund the retirement of the Electron debt, the ratings agency said.

El Paso expects to sell nearly $4 billion of assets by year-end and $2 billion in 2003 to repay debt and to add to its operating cash flows. On the plus side, the company “draws financial flexibility from a large base of tangible assets that potentially could be sold, as well as from a highly discretionary capex program that can be scaled back if necessary,” Moody’s noted.

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