Standard and Poor’s Rating Service explained the reasons for assigning a “B” rating and negative outlook on both El Paso Corp. and The Williams Cos. Inc. in a new report released on Friday. The two companies have “consistently underperformed in terms of meeting financial target expectations” mainly because of the poor performance of their marketing and trading divisions, which despite being either significantly reduced, as in Williams’ case, or on the fast track toward being completely dissolved, as in El Paso’s case, could continue to be a draw on cash, S&P said.

“Over the past year and a half, both companies” financial metrics have deteriorated due to a combination of issues, many of which stem from their energy marketing and trading (EM&T) business units and the associated fear and skepticism these units caused in the financial markets,” said Standard & Poor’s credit analyst Jeffrey Wolinsky.

There remains significant concern about the potential cash drain caused by the EM&T business units. In addition, the companies have significant execution risk associated with their strategy of selling assets to meet liquidity needs, although Williams is much further along in this respect than is El Paso, S&P said in the report, titled “Energy Peer Comparison: The Williams Cos. Inc. and El Paso Corp.

From an overall business risk assessment, both companies carry the same business profile score of “6” on a “1” to “10” scale, with “1” representing the least risky and “10” representing the most risk, S&P said. Overall, Williams’ business profile is somewhat less risky than El Paso’s, but not significantly different to warrant a different profile score.

The companies’ assets can be broken into four major business units: EM&T, FERC-regulated natural gas pipelines, oil and gas exploration and production, and midstream gathering and processing.

The two companies’ EM&T units “suffered from some poorly timed investments, adverse market conditions, credit concerns and modest amount of noncash related earnings and various asset write downs and dispositions,” S&P said.

Williams’ EM&T business had a $292 million cash drain in the first quarter, but the company said it is expecting the unit to be cash positive in each successive quarter this year. The business had cut its volumes 75% in the first quarter and plans to maintain that volume level. Trading volumes for crude and refined products, natural gas and electricity are down 88%, 63% and 22% respectively. A revised trading policy also has set a value-at-risk (VaR) trading limit of $75 million, down from $200 million.

El Paso’s EM&T business unit generated about $1 billion more in operational losses than Williams’ EM&T unit in 2002. El Paso continues to reduce the size of its trading book in an attempt to exit energy trading entirely. Volumes and VaR have been reduced significantly. It sold its European trading business and its coal, currency and interest rate books and is focusing on marketing activities closely correlated with its domestic natural gas assets.

Williams has a smaller but less risky pipeline business, S&P said. After selling three of its gas pipelines in 2002 and 2003, Williams has two left: Transcontinental Gas Pipe Line and Northwest Pipeline Corp. S&P views those assets as credit positive and places at low risk business profile score of “3” on them.

In 2002, El Paso generated about $160 million more earnings before interest and taxes (EBIT) from its regulated pipelines than did Williams. El Paso wholly owns five pipelines that are material to credit: Tennessee Gas, ANR, El Paso Natural Gas, Colorado Interstate Gas and Southern Natural. S&P gives a business risk profile of “4” for each except CIG, which gets a “3.” El Paso also owns parts of several other pipelines, including Florida Gas and Great Lakes Gas Transmission.

Both companies were comparable in terms of EBIT generated from their exploration and production business. But the E&P business in general is significantly more risky than the pipeline business, according to S&P, because E&P revenues are fully exposed to commodity price volatility, and the E&P business is characterized by high depletion rates that force continued reinvestment. There also is significant competition. El Paso and Williams both have significant competitive advantages because of the substantial acreage they own and good prospects for reserve growth.

However, over the next two years, S&P views Williams E&P operation as having less risk than El Paso’s because Williams has more aggressively hedged its commodity prices, and its production will be growing from relatively low-risk sources. Williams also has adequate funds to complete its development plans. Longer term, however, Williams will be burdened with sharp production declines in its coal-bed methane properties, which will raise depletion risks.

El Paso’s reserves are about four times the size of Williams. But asset sales (1.8 Bcf of reserves) and a need to drastically curtail investment due to capital constraints at the parent company have significantly affected production and the unit’s financial strength, S&P said. “Due to El Paso’s need to continue to sell assets, the ultimate composition of the E&P group will not be fully known until the company regains a solid financial position and a clear direction for the group.”

However, El Paso’s E&P business has replaced reserves at a rapid rate. Its gathering lines are in good locations. And it has achieved excellent drilling success rates of 95%. But its reduction in hedged production exposes it to greater cash flow volatility and higher risk.

Although Williams business profile risk is slightly better than El Paso’s, its financial position is somewhat weaker, S&P said. “For example the average funds from operations (FFO) to interest coverage ratio for Williams was 1.9x, compared with El Paso’s average of 2.1x over a 12-month rolling period ended March 31. Other financial metrics that illustrate Williams’ weaker financial condition include debt to capital levels of 78% compared with El Paso’s 68%. However, on some financial metrics, Williams figures are comparable or somewhat stronger than El Paso’s,” S&P said, referring to FFO to total debt and net cash flow to total expenditures.

For more details from the S&P report, contact Jeffrey Wolinsky at (212) 438-2117.

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