El Paso Corp.’s decision early this year to cut spending in U.S. exploration and production (E&P) and focus more on South Texas, the deepwater Gulf of Mexico and coalbed methane (CBM) has proven to be a challenge for management as it figures out how to make the best with the least amount of money possible.

Because its E&P has required a lot of cash, which is in short supply at El Paso, some analysts now suggest that the E&P unit could be spun off, sold or downsized by the end of 2004.

The strategic shift in El Paso’s low profile E&P unit (formerly Sonat Inc.) began last year as the corporation dropped its high-growth, high acquisition strategy. The E&P unit’s growth, while strong, has never returned much profit, but the acquisitions have been key in building gas-rich reserves throughout North America.

But with mounting debt and internal problems, El Paso has several times had to cut back its production forecast, the latest in August, when it slashed another 10% off its 2003 numbers. It now expects to produce between 450-470 Bcfe this year.

CreditSights analysts Dot Matthews and Andy DeVries noted that El Paso’s lower gas production is a concern going forward.

“As we have pointed out in the past, El Paso sold some of its lower-cost producing assets to get by the cash crunch, but postulated a lot of growth in E&P to support earnings and cash flow projections going forward,” said the analysts. “This meant increased capex spending, as the opportunities are in more expensive deepwater sites. We questioned whether EP could sustain the level of capital expenditure (capex) spending necessary to ramp up production to the levels EP was promising, and, it turns out, the company can’t.”

CreditSights analysts also noted that El Paso’s planned spending on drilling new wells will not offset asset sales, the declines at currently producing properties or any lost wells.

“Volumes year-to-date of 236 Bcfe are well below six month 2002 totals of 313 Bcfe, and El Paso reduced its estimate for full year production to 450-475 Bcfe. This is good and bad news. The good news is that El Paso will not be as dependent on E&P as we first thought. Pipelines made up most of pro forma earnings before interest and taxes…and we see that as a positive for credit quality in the future. The bad news is that El Paso has no way to make up this lost revenue going forward, as far as we can see.”

Not only is El Paso’s gas production declining, but it also is costing more to get the gas in deepwater. “In 2002, EP’s unit cost was $2.05/Mcfe, and EP estimated that cost would rise to, on average, $2.21 this year. In fact, First quarter unit costs were $2.55 and, year to date, they are $2.60, further lowering margins on the smaller amount of gas that is being produced.”

However, Rod Erskine, president of El Paso Production Co., noted that El Paso has sold nearly $1.9 billion worth of strategic E&P assets, which has led to the production decline. He said that even with the sales, its current production portfolio is strong.

In the deepwater, eight of the 11 wells drilled through August have been successful and are expected to ramp up by October, adding a potential 185 MMcfe/d to net production. Another five wells, if successful, will be on line by December. El Paso considers the deep shelf to be an important exploration region, and it holds several large discoveries that are close to existing infrastructure. El Paso’s decline rate in the deepwater has been a little less than 25%/year.

CBM now represents about 30% of El Paso’s proved reserves. It’s long-lived production and low risks also are profitable. Complementing El Paso’s other programs, the company has been expanding to new areas, and by the end of this year, CBM is expected total more than 1,900 Bcf of reserves, coming from growing operations in New Mexico’s Raton Basin, Alabama’s Black Warrior Basin and the Arkoma Basin of eastern Oklahoma.

Despite the highlights, the E&P unit still expects to have slow or flat growth for the foreseeable future. In 2002, capital spending in E&P was $2.4 billion. For 2003, the unit is expected to spend about $1.35 billion, and into 2004, it could drop to about $850 million. Production volumes still will grow with the $850 million budget, said Erskine, because there will be fewer assets to manage. A bigger problem will be knowing how much to spend for production in the volatile natural gas market, according to Erskine.

Rumors persist that El Paso may be considering a sale of the production unit to free up more cash and streamline its vast organization. Analysts with Credit Suisse First Boston (CSFB) said in a report this week that the E&P unit alone is worth $4.30 a share — which right now is more than half of El Paso’s share price — and “may be subject to spin-off or sale consideration.” El Paso Corp. is undervalued, said analyst Curt Launer, “in part due to the value of its exploration and production unit.”

CSFB values the E&P unit at $2.9 billion net of $3 billion in debt. “An analysis of the remainder of EP shows earnings of about $0.35 in ’04 (without E&P and interest on $3 billion in debt). This results in $5 per share of value at the average industry price-to-earnings ratio.”

Launer and his fellow analysts expect El Paso’s new CEO Doug Foshee, who took the reins this month, to “follow through with plans to sell international properties and concentrate on the CBM development plan. A decision as to the spin-off, sale or keeping of E&P is likely, in our view, in 2004. In our opinion, EP shareholders will be best served by maintaining the E&P unit as part of the consolidated company as long as the inherent value of the unit is better reflected in the share price.”

Gordon Howald, an analyst with Credit Lyonnaise Securities, also is concerned about the targets El Paso has set for itself, including its E&P operations. “The proof will be in the pudding,” he said. “I think it’s going to be challenging for the company to achieve a lot of the targets that it has set out for itself.”

El Paso’s long-term strategic plan is expected to be unveiled in the next two months, and so far, the company has been mum on its goals However, Erskine noted that for the next year to year and a half, E&P will constantly be changing the mix of its production portfolio.

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