Rumors of a possible Securities and Exchange Commission (SEC) inquiry, credit ratings downgrades and dire analyst forecasts pummeled El Paso Corp.’s share price on Wednesday, the day after the Houston-based company revised its proved oil and gas reserves downward by 41%. By market’s close, El Paso shares had fallen more than 17%, down $1.55 to stand at $7.26.

The drop in the share price followed the disclosure by El Paso late Tuesday that it was revising its proved reserves downward following an independent audit. It also warned that the changes would result in a write-down of at least $1 billion (see Daily GPI, Feb. 18).

Standard & Poor’s Ratings Services (S&P) in turn lowered its corporate credit rating on the company to “B-” from “B” to reflect the “larger-than-expected” write-down, while Moody’s Investors Service dropped the subsidiary ratings and placed the corporation on review for a possible downgrade. S&P noted that El Paso currently has about $24 billion in outstanding debt and other long-term obligations.

“The large revision to El Paso’s proved reserves…and the resulting ceiling-test write-down of about $1 billion is greater than what had been factored into the ratings,” S&P wrote. “While there is no immediate cash flow effect related to this action, it does suggest that future production and likely cash flow will be weakened in 2005 and beyond. The negative outlook will continue until further progress on the company’s long-range plan is accomplished.”

S&P noted that under its new business plan, El Paso is exiting several business lines over the next three years so that it can focus by 2006 on natural gas pipelines and exploration and production (E&P). However, “the greatest risk for El Paso is executing the planned transformation of its E&P operations, which are characterized by an extensive geographic scope, rapidly depleting production centered in mature basins, and intense capital needs to maintain and increase production levels.”

El Paso also will “likely incur additional equity write-downs stemming from future ceiling tests as natural gas prices fluctuate over time,” S&P wrote. “The calculation used to derive the current write-down used the year-end 2003 Nymex Henry Hub natural gas price of $6.03/Mcf, more than $2.00 above Standard & Poor’s natural gas price assumption of $3.75/Mcf for 2004. If El Paso had performed the ceiling test using a $5.00/Mcf natural gas price, equity would have been written down an additional $1.5 billion.”

Near-term liquidity is not a concern, said S&P, but “El Paso will struggle to produce enough cash flow to barely cover its debt service as it tackles the challenges in its plan. Ratings degradation will be stemmed through the timely execution of the plan especially in the improvement of the E&P segment and the sale of noncore assets to reduce debt.”

S&P’s negative outlook on El Paso “reflects the daunting obstacles” the company will face through 2006 as it attempts to achieve its reorganization plan. “Falling short on any of the plan’s components or further weakness in the company’s ability to produce operating cash flow from its core businesses could lead to lower ratings. The large reserve estimate revision also raises corporate governance concerns, and the outcome of the company’s internal investigation into the reserve reduction and any other repercussions from the write-down could result in further rating actions.”

Moody’s said it believes “new management will more carefully allocate drilling capital, pursue more conservative reserve booking policies, and may choose to deploy budgeted drilling capital instead to acquisitions of more stable production to add ballast to the productive base.”

Moody’s noted that the corporation and El Paso Production Co. have not reduced their 2004 production guidance, but “the revisions significantly impact asset coverage, place a greater burden of proof on 2004 capital productivity, place greater uncertainty on 2004/2005 production targets, and the hedging program substantially limits realized prices. Moody’s also observes that production is not expected to bottom until later in 2004.”

Financial analysts were equally hard on El Paso. Gordon Howald, a Credit Lyonnais analyst, wrote, “We expect litigation to be filed against El Paso in relation to this.” In a research report, El Paso’s ratings were cut to “sell” from “neutral,” and Howald also warned of more downward revisions to reserves.

“When Royal Dutch/Shell ‘stunned the market’ with its 20% reserve reduction, litigation soon followed. El Paso’s reserve revision dwarfs this in size.” However, “this is a major risk to El Paso…questions regarding a Securities and Exchange Commission (SEC) inquiry have surfaced. An SEC inquiry would be a major negative development.”

Credit Suisse First Boston (CSFB) was more charitable in its assessment. Analyst L. Philip Salles wrote, “On the positive side, El Paso did not revise its 2006 forecast of $1/per share. We believe this to be consistent with previously stated earnings per share guidance of $0.75-1.10 back in December 2003.”

CSFB also is conducting a review of El Paso’s drilling inventory and capital allocation. “We have previously discussed EP’s progress in repositioning itself and bringing its costs structure more in line to mirror a typical E&P company. A higher cost structure, higher finding costs and higher risk exploratory drilling is associated in part with recent merger and acquisitions.”

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