S&P analyst: El Paso fundamentals hold up amid industry uncertainty

By Ronda Fears

Nashville, Tenn., Aug. 2 - Despite the turmoil in the energy markets and challenges for El Paso Corp. itself, Standard & Poor's credit analyst William Ferara said the company's fundamental liquidity is holding up.

"In the face of the ongoing tumultuous energy markets, re-examining El Paso Corp.'s (BBB+/stable/A-2) fundamental credit quality has repeatedly proven necessary," Ferara said in a report Friday.

"At the same time, sifting through information that contains various degrees of headline, public perception, political and regulatory risk to assess the real risk has at times proven quite challenging."

That acknowledged, he said S&P identifies no fundamental change in the credit quality of El Paso from the heightened uncertainty over wash trades that has affected many companies in the industry or negative press from outside shareholders.

"S&P has repeatedly confirmed with El Paso that the company has not executed any wash trades," the analyst said.

Regulatory issues related to the company's natural gas pipelines have also created uncertainty for El Paso.

In the FERC investigation into natural gas pipeline capacity issues in California, a FERC administrative law judge found in October 2001 that there was no evidence that the company actually exercised market power in the California natural gas market but did violate some affiliate transaction rules.

"S&P's opinion has been that outside any significant turn of events or new information, the case is not expected to significantly affect credit quality," Ferara said.

"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."

In a separate case involving the El Paso Natural Gas pipeline, the company is being forced to change shipping policies, including the allocation of capacity on the pipeline to ensure that shippers have adequate capacity.

"Given the bankruptcy of Pacific Gas & Electric Co. and Enron, 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, a potentially harmful scenario could be wide-reaching changes in regulation, operations, or financial returns of gas pipelines," Ferara said.

"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."

But, he said, El Paso's decisive actions and the progression of initiatives since late 2001 to address the energy market's desire for greater financial stability and maintain its credit quality reflect a commitment to its current ratings.

"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," Ferara said.

The company has also eased concerns by eliminating rating and stock price triggers on $4 billion of financings and issuing guarantees for $2 billion of debt related to the Limestone and Gemstone share-trust structures, the analyst said.

"Comparatively speaking, El Paso's management has made certain that the company has repeatedly been on the favorable side of the phrase, 'A bird in the hand is worth two in the bush,'" Ferara said.

"Likewise, if El Paso had not taken so many actions to support its credit quality in the past seven months, the company's ratings and outlook most likely would not be what they are today.

"As a point of conservatism, even though the company has moved billions of debt off its books and infused billions of dollars of equity into its capital structure, any event that affects El Paso's credibility, even a tiny and insignificant wash-trade, could instantly affect the company's ratings or outlook."

S&P's assessment of El Paso's exploration and production group is that it has low investment-grade characteristics, he said.

El Paso's decision to increase its capital investment in this area means the company must maintain an even stronger balance sheet to produce the lower leverage ratios needed by E&P companies to withstand the greater volatility in the business, he added.

While El Paso's decision to downsize its merchant energy group resulted in an immediate positive for the company's credit stability, he said, the length of time in which the operations and risk of the business are scaled back will linger as a longer-term question, especially when greater certainty returns to the fundamentals of the trading and marketing business.

El Paso intends to focus primarily on trading and marketing activities related to its core natural gas businesses and to maintain its equity stakes in plants both domestically and internationally while curtailing less-strategic areas such as power trading and various international initiatives.

These actions will improve El Paso's financial stability and flexibility, he said, due to the trading unit's reduced need for capital and liquidity, and will produce a more stable, consolidated cash flow mix.

The company's liquidity is adequate, with $4 billion of credit facility capacity supporting the ability to issue up to $3 billion of commercial paper, Ferara said.

El Paso typically maintains commercial paper borrowings at or slightly above $1 billion (currently $400 million) and a cash and cash equivalents balance of a similar amount (currently $1.5 billion), he said.

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, he said S&P believes that El Paso has an ample liquidity cushion.

"El Paso is expected to maintain its strengthened financial profile even if the current industry turmoil passes.," Ferara said.

S&P's rating estimates assume that El Paso will produce about $3 billion to $3.5 billion of annually recurring funds flow from operations before changes in working capital in 2002 and 2003 from its hard assets, which equates to FFO-to-interest coverage ranging between 4.0 times and 5.0 times, he said.

The company's adjusted average debt leverage is expected to be about 50% by year-end 2002.

Both ratios, which are before certain analytical adjustments, are more than adequate for current ratings.

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

In a stress scenario, he said, "El Paso still maintains the ability to produce FFO-to-interest coverage of more than 3.0 times, 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."

"Importantly, S&P believes El Paso will continue to maintain its strengthened financial profile and commitment to credit quality," he added, "and would further bolster itself, if necessary, to endure any additional credit concerns."

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