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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER 333-106586
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EL PASO PRODUCTION HOLDING COMPANY
(Exact Name of Registrant as Specified in its Charter)
<Table>
DELAWARE 76-0659544
(State or Other Jurisdiction (I.R.S. Employer
of Incorporation or Organization) Identification No.)
EL PASO BUILDING
1001 LOUISIANA STREET 77002
HOUSTON, TEXAS (Zip Code)
(Address of Principal Executive Offices)
</Table>
Telephone Number: (713) 420-2600
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [ ] No [X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
Common stock, par value $1 per share. Shares outstanding on October 28,
2004: 1,000
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EL PASO PRODUCTION HOLDING COMPANY
TABLE OF CONTENTS
<Table>
<Caption>
CAPTION PAGE
------- ----
PART I -- Financial Information
Item 1. Financial Statements........................................ 1
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 9
Cautionary Statement Regarding Forward-Looking Statements... 15
Item 3. Quantitative and Qualitative Disclosures About Market
Risk...................................................... 15
Item 4. Controls and Procedures..................................... 16
PART II -- Other Information
Item 1. Legal Proceedings........................................... 19
Item 2. Unregistered Sales of Equity Securities and Use of
Proceeds.................................................. 19
Item 3. Defaults Upon Senior Securities............................. 19
Item 4. Submission of Matters to a Vote of Security Holders......... 19
Item 5. Other Information........................................... 19
Item 6. Exhibits.................................................... 19
Signatures.................................................. 20
</Table>
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Below is a list of terms that are common to our industry and used
throughout this document:
<Table>
/d = per day
Bbl = barrels
Bcfe = billion cubic feet of natural gas equivalents
MBbls = thousand barrels
Mcf = thousand cubic feet
Mcfe = thousand cubic feet of natural gas equivalents
MMcf = million cubic feet
MMcfe = million cubic feet of natural gas equivalents
</Table>
When we refer to natural gas and oil in "equivalents," we are doing so to
compare quantities of oil with quantities of natural gas or to express these
different commodities in a common unit. In calculating equivalents, we use a
generally recognized standard in which one Bbl of oil is equal to six Mcf of
natural gas. Oil includes natural gas liquids unless otherwise specified. Also,
when we refer to cubic feet measurements, all measurements are at a pressure of
14.73 pounds per square inch.
When we refer to "us", "we", "our", "ours", or "El Paso Production", we are
describing El Paso Production Holding Company and/or our subsidiaries.
i
PART I -- FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
EL PASO PRODUCTION HOLDING COMPANY
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(IN MILLIONS)
(UNAUDITED)
<Table>
<Caption>
QUARTER ENDED
MARCH 31,
-------------------
2003
2004 (RESTATED)
------ ----------
Operating revenues.......................................... $ 219 $ 303
------ ------
Operating expenses
Cost of sales............................................. 9 15
Operation and maintenance................................. 47 48
Depreciation, depletion and amortization.................. 93 112
Taxes, other than income taxes............................ 6 11
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155 186
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Operating income............................................ 64 117
Earnings from unconsolidated affiliates..................... -- 9
Affiliated interest income.................................. 5 2
Other expense, net.......................................... -- (2)
Interest expense............................................ (18) (5)
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Income before income taxes.................................. 51 121
Income taxes................................................ 18 54
------ ------
Income from continuing operations........................... 33 67
Cumulative effect of accounting change, net of income
taxes..................................................... -- 1
------ ------
Net income.................................................. $ 33 $ 68
====== ======
</Table>
See accompanying notes.
1
EL PASO PRODUCTION HOLDING COMPANY
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN MILLIONS, EXCEPT SHARE AMOUNTS)
(UNAUDITED)
<Table>
<Caption>
MARCH 31, DECEMBER 31,
2004 2003
--------- ------------
ASSETS
Current assets
Cash and cash equivalents................................. $ 125 $ 34
Accounts and notes receivable
Customer, net of allowance of $6 in 2004 and 2003....... 80 66
Affiliates.............................................. 458 451
Other................................................... 4 4
Deferred income taxes..................................... 88 70
Other..................................................... 8 11
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Total current assets.................................. 763 636
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Property, plant and equipment, at cost
Natural gas and oil properties
Proved properties-full cost method...................... 7,188 7,074
Unevaluated costs excluded from amortization............ 249 252
Other..................................................... 126 123
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7,563 7,449
Less accumulated depreciation, depletion and
amortization............................................ 5,231 5,141
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Total property, plant and equipment, net.............. 2,332 2,308
------- ------
Other assets
Notes receivable from affiliates.......................... 247 295
Deferred income taxes..................................... 196 204
Other..................................................... 35 36
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478 535
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Total assets.......................................... $ 3,573 $3,479
======= ======
LIABILITIES AND STOCKHOLDER'S EQUITY
Current liabilities
Accounts payable
Trade................................................... $ 81 $ 63
Affiliates.............................................. 42 7
Other................................................... 38 79
Liabilities from price risk management activities......... 223 173
Income tax payable to affiliate........................... 106 118
Other..................................................... 57 30
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Total current liabilities............................. 547 470
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Long-term debt.............................................. 1,200 1,200
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Other
Liabilities from price risk management activities......... 304 270
Other..................................................... 76 76
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380 346
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Commitments and contingencies
Stockholder's equity
Common stock, par value $1 per share; 1,000 shares
authorized and outstanding.............................. -- --
Additional paid-in capital................................ 1,700 1,700
Retained earnings......................................... 64 31
Accumulated other comprehensive loss...................... (318) (268)
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Total stockholder's equity............................ 1,446 1,463
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Total liabilities and stockholder's equity............ $ 3,573 $3,479
======= ======
</Table>
See accompanying notes.
2
EL PASO PRODUCTION HOLDING COMPANY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN MILLIONS)
(UNAUDITED)
<Table>
<Caption>
QUARTER ENDED
MARCH 31,
-----------------------
2003
2004 (RESTATED)(1)
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Cash flows from operating activities
Net income................................................ $ 33 $ 68
Adjustments to reconcile net income to net cash from
operating activities
Depreciation, depletion and amortization............... 93 112
Deferred income tax expense (benefit).................. 18 (135)
Earnings from unconsolidated affiliates................ -- (9)
Other non-cash income items............................ 6 11
Asset and liability changes............................ 36 119
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Net cash provided by operating activities......... 186 166
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Cash flows from investing activities
Capital expenditures...................................... (145) (221)
Net proceeds from the sale of assets and investments...... -- 501
Change in notes receivable from parent.................... 50 (387)
Change in restricted cash................................. -- (14)
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Net cash used in investing activities............. (95) (121)
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Cash flows from financing activities
Net proceeds from the issuance of long-term debt.......... -- 1,185
Dividends to parent....................................... -- (1,236)
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Net cash used in financing activities............. -- (51)
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Change in cash and cash equivalents......................... 91 (6)
Cash and cash equivalents
Beginning of period....................................... 34 156
------- -------
End of period............................................. $ 125 $ 150
======= =======
</Table>
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(1) Cash flows from operating, investing and financing activities have been
restated. However, only individual line items in cash flows from operating
activities were restated. Overall cash flows were unaffected.
See accompanying notes.
3
EL PASO PRODUCTION HOLDING COMPANY
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(IN MILLIONS)
(UNAUDITED)
<Table>
<Caption>
QUARTER ENDED
MARCH 31,
-------------------
2003
2004 (RESTATED)
----- ----------
Net income.................................................. $ 33 $ 68
----- -----
Net gains (losses) from cash flow hedging activities:
Unrealized mark-to-market losses arising during period
(net of income taxes of $49 in 2004 and $73 in 2003)... (85) (123)
Reclassification adjustments for changes in initial value
to the settlement date (net of income taxes of $21 in
2004 and $40 in 2003).................................. 35 66
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Other comprehensive loss............................. (50) (57)
----- -----
Comprehensive income (loss)................................. $ (17) $ 11
===== =====
</Table>
See accompanying notes.
4
EL PASO PRODUCTION HOLDING COMPANY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION AND SIGNIFICANT EVENTS UPDATE
We are a wholly-owned direct subsidiary of El Paso Corporation (El Paso).
We prepared this Quarterly Report on Form 10-Q under the rules and regulations
of the United States Securities and Exchange Commission (SEC). Because this is
an interim period filing presented using a condensed format, it does not include
all of the disclosures required by generally accepted accounting principles. You
should read this Quarterly Report on Form 10-Q along with our 2003 Annual Report
on Form 10-K, which includes a summary of our significant accounting policies
and other disclosures. The financial statements as of March 31, 2004, and for
the quarters ended March 31, 2004 and 2003, are unaudited. We derived the
balance sheet as of December 31, 2003, from the audited balance sheet filed in
our 2003 Annual Report on Form 10-K. Our results for the quarter ended March 31,
2003 have been restated to reflect the accounting impact of a reduction in our
historically reported proved natural gas and oil reserves and to reclassify our
historical statements of cash flows for amounts provided to El Paso under the
cash management program. These restatements are further discussed in our 2003
Annual Report on Form 10-K. In our opinion, we have made all adjustments which
are of a normal, recurring nature to fairly present our interim period results.
Due to the seasonal nature of our business, information for interim periods may
not be indicative of our results of operations for the entire year.
Liquidity Update
El Paso is a significant potential source of liquidity to us. We
participate in El Paso's cash management program. Under this program, depending
on whether we have short-term cash requirements or surpluses, El Paso provides
cash to us or we can provide cash to El Paso subject to limitations in our
indenture. We have historically provided cash to El Paso under this program, and
as of March 31, 2004, we had a receivable from El Paso of $638 million, of which
$391 million is classified as a current asset in our balance sheet. If El Paso
were unable to meet its liquidity needs, we would not have access to this source
of liquidity and there is no assurance that El Paso could repay the entire
amount owed to us. In that event, we could be required to write-off some amount
of these advances, which could have a material impact on our stockholder's
equity and, if demanded, we might still be required to repay affiliated company
payables. In addition, based on our current estimates of cash flows, we believe
we will seek repayment of a portion of these advances in the next twelve months.
If El Paso were subject to voluntary or involuntary bankruptcy proceedings,
El Paso and its other subsidiaries and their creditors could attempt to make
claims against us, including claims to substantively consolidate our assets and
liabilities with those of El Paso and its other subsidiaries. We believe that
claims to substantively consolidate us with El Paso and/or its other
subsidiaries would be without merit. However, there is no assurance that El Paso
and/or its other subsidiaries or their creditors would not advance such a claim
in a bankruptcy proceeding. If we were to be substantively consolidated in a
bankruptcy proceeding with El Paso and/or its other subsidiaries, there could be
a material adverse effect on our financial condition and our liquidity.
The restatements discussed above have resulted in or will result in a delay
in filing our Forms 10-Q for the quarterly periods ended June 30, 2004 and
September 30, 2004. Our indenture for our 7.75% senior unsecured notes due June
1, 2013 includes covenants that require us to file financial statements within
specified time periods. Non-compliance with such covenants does not constitute
an automatic event of default. Instead, the debt is subject to acceleration
after any applicable cure periods have lapsed and the indenture trustee or the
holders of at least 25 percent of the outstanding principal amount of debt under
our indenture provide notice that the principal and accrued interest has been
declared due and payable. In July 2004, we entered into an agreement approved by
a majority of the holders of our 7.75% senior unsecured notes which provides for
a waiver of the breach of our covenant to timely file our financial statements
and is effective until
5
December 31, 2004. In connection with the waiver, we have agreed to modify the
covenants under our indenture with respect to affiliated party transactions. In
particular, the agreement prohibits certain affiliated party transactions in
excess of $100 million if the transactions would have a negative effect on our
ratio of debt to proved reserves or our ratio of debt to EBITDA (as defined in
the indenture).
2. SIGNIFICANT ACCOUNTING POLICIES
Our accounting policies are consistent with those discussed in our 2003
Annual Report on Form 10-K.
Accounting for Asset Retirement Obligations
On January 1, 2003, we adopted Statement of Financial Accounting Standard
No. 143, Accounting for Asset Retirement Obligations. This standard required
that we record a liability for retirement and removal costs of long-lived assets
used in our business. In the first quarter of 2003, we recorded a charge as a
cumulative effect of an accounting change of approximately $1 million, net of
income taxes related to its adoption.
New Accounting Pronouncement Not Yet Adopted
In September 2004, the SEC issued Staff Accounting Bulletin No. 106. This
pronouncement will require companies that use the full cost method for
accounting for their oil and gas producing activities to include an estimate of
future asset retirement costs to be incurred as a result of future development
activities on proved reserves in their calculation of depreciation, depletion
and amortization. It will also require companies to exclude any future cash
outflows associated with settling asset retirement liabilities from their full
cost ceiling test calculation. This standard requires that companies disclose
the impact of their asset retirement obligations on their oil and gas producing
activities, ceiling test calculations and depreciation, depletion and
amortization calculations. We will adopt the provisions of this pronouncement in
the fourth quarter of 2004 and are currently evaluating its impact, if any, on
our consolidated financial statements.
3. DEBT
Our restrictive covenants are discussed in our 2003 Annual Report on Form
10-K. For an update of matters that have or could impact these covenants
including the restatement of our historical financial statements and associated
waivers obtained, see Note 1 of this Quarterly Report on Form 10-Q.
4. COMMITMENTS AND CONTINGENCIES
Legal Proceedings
Grynberg. A number of El Paso entities, including our subsidiary, El Paso
Production Company, are named defendants in actions filed in 1997 brought by
Jack Grynberg on behalf of the U.S. Government under the False Claims Act.
Generally, these complaints allege an industry-wide conspiracy to underreport
the heating value as well as the volumes of the natural gas produced from
federal and Native American lands, which deprived the U.S. Government of
royalties. The plaintiff in this case seeks royalties that he contends the
government should have received had the volume and heating value been
differently measured, analyzed, calculated and reported, together with interest,
treble damages, civil penalties, expenses and future injunctive relief to
require the defendants to adopt allegedly appropriate gas measurement practices.
No monetary relief has been specified in this case. These matters have been
consolidated for pretrial purposes (In re: Natural Gas Royalties Qui Tam
Litigation, U.S. District Court for the District of Wyoming, filed June 1997).
Discovery is proceeding. Our costs and legal exposure related to these lawsuits
and claims are not currently determinable.
Will Price (formerly Quinque). A number of El Paso entities, including our
subsidiary, El Paso Production Company, are named as defendants in Will Price et
al v. Gas Pipelines and Their Predecessors, et al., filed in 1999 in the
District Court of Stevens County, Kansas. Plaintiffs allege that the defendants
mismeasured natural gas volumes and heating content of natural gas on
non-federal and non-Native American lands and seek to recover royalties that
they contend they should have received had the volume and heating
6
value of natural gas produced from their properties been differently measured,
analyzed, calculated and reported, together with prejudgment and postjudgment
interest, punitive damages, treble damages, attorneys' fees, costs and expenses,
and future injunctive relief to require the defendants to adopt allegedly
appropriate gas measurement practices. No monetary relief has been specified in
this case. Plaintiffs' motion for class certification of a nationwide class of
natural gas working interest owners and natural gas royalty owners was denied on
April 10, 2003. Plaintiffs were granted leave to file a Fourth Amended Petition,
which narrows the proposed class to royalty owners in wells in Kansas, Wyoming
and Colorado and removes claims as to heating content. A second class action
petition has since been filed as to the heating content claims. Our costs and
legal exposure related to these lawsuits and claims are not currently
determinable.
Black Warrior Methane. In September 2001, an explosion at the Brookwood
Coal Mine #5 in Tuscaloosa, Alabama resulted in 13 fatalities and numerous other
injuries. El Paso has no ownership interest in the mine. However, we are a 50
percent stockholder in Black Warrior Methane Corporation, which was involved in
the extraction of methane from the mine, and which is a named defendant in 22 of
the lawsuits filed to date. In addition, we have been added as a defendant in
several of the cases. There has been no substantive discovery conducted to date.
Reserve Revisions. In March 2004, El Paso received a subpoena from the SEC
requesting documents relating to its December 31, 2003 natural gas and oil
reserve revisions. El Paso and its Audit Committee have also received federal
grand jury subpoenas for documents regarding these reserve revisions. We are
assisting El Paso and its Audit Committee in their efforts to cooperate with the
SEC's and the U.S. Attorney's investigations into this matter.
In addition to the above matters, we and our subsidiaries and affiliates
are named defendants in numerous lawsuits and governmental proceedings that
arise in the ordinary course of our business.
For each of our outstanding legal matters, we evaluate the merits of the
case, our exposure to the matter, possible legal or settlement strategies and
the likelihood of an unfavorable outcome. If we determine that an unfavorable
outcome is probable and can be estimated, we establish the necessary accruals.
As this information becomes available, or other relevant developments occur, we
will adjust our accrual amounts accordingly. While there are still uncertainties
related to the ultimate costs we may incur, based upon our evaluation and
experience to date, we believe our current reserves are adequate. As of March
31, 2004, we had approximately $3 million accrued for all outstanding legal
matters.
Environmental Matters
We are subject to federal, state and local laws and regulations governing
environmental quality and pollution control. These laws and regulations require
us to remove or remedy the effect on the environment of the disposal or release
of specified substances at current and former operating sites. As of March 31,
2004, we had no accrual for remediation costs and associated onsite, offsite and
groundwater technical studies or for related environmental legal costs.
Air Permit Violation. On March 21, 2003, the Louisiana Department of
Environmental Quality (LDEQ) issued a Consolidated Compliance Order and Notice
of Potential Penalty to our subsidiary, El Paso Production Company, alleging
that it failed to timely obtain air permits for specified oil and gas
facilities. El Paso Production Company requested an adjudicatory hearing on the
matter. The hearing has been stayed by agreement to allow El Paso Production
Company and LDEQ time to possibly settle this matter. The amount of any penalty
to be sought by LDEQ, if any, has not been specified.
It is possible that new information or future developments could require us
to reassess our potential exposure related to environmental matters. We may
incur significant costs and liabilities in order to comply with existing
environmental laws and regulations. It is also possible that other developments,
such as increasingly strict environmental laws and regulations and claims for
damages to property, employees, other persons and the environment resulting from
our current or past operations, could result in substantial costs and
liabilities in the future. As this information becomes available, or other
relevant developments occur, we will
7
adjust our accrual amounts accordingly. While there are still uncertainties
relating to the ultimate costs we may incur, based upon our evaluation and
experience to date, we believe no reserves are required at this time.
5. INVESTMENTS IN UNCONSOLIDATED AFFILIATES AND RELATED PARTY TRANSACTIONS
Investments in Unconsolidated Affiliates
Our investment in unconsolidated affiliate was $6 million at March 31, 2004
and December 31, 2003. Our investment consist of our equity ownership interest
in Black Warrior Transmission Corporation. We recognized equity earnings of less
than $1 million for the quarter ended March 31, 2004. Our 2003 equity earnings
of $9 million included income from our investments in Noric L.L.C. and
Clydesdale Associates, L.P. We sold our interest in Noric Holdings I in April
2003, which held these investments.
Related Party Transactions
Affiliate Receivables and Payables
We sell our natural gas primarily to affiliates of El Paso at spot-market
prices. Accounts receivable due from affiliates at March 31, 2004 and December
31, 2003, was $67 million and $58 million. Accounts payable due to affiliates at
March 31, 2004 and December 31, 2003 was $42 million and $7 million. These
affiliate receivables and payables were created in the normal course of
business. Additionally, we recorded a $106 million and $118 million income tax
payable to affiliate as of March 31, 2004 and December 31, 2003 for our
allocated portion of El Paso's income taxes.
Cash Management Program and Other Affiliate Transactions
We participate in El Paso's cash management program which matches
short-term cash surpluses and needs of its participating affiliates, thus
minimizing total borrowing from outside sources. At March 31, 2004 and December
31, 2003, we had receivables from El Paso of $638 million and $688 million, of
which $391 million and $393 million are classified as current notes receivables
from affiliates on our balance sheets. We also recognized affiliated interest
income of $5 million and $2 million for the quarters ended March 31, 2004 and
2003 on our advances to El Paso under the cash management program.
We enter into a number of transactions with our affiliates in the ordinary
course of conducting our business. The following table shows revenues and
charges to/from our affiliates for the quarters ended March 31:
<Table>
<Caption>
2004 2003
----- -----
(IN MILLIONS)
Operating revenues.......................................... $124 $140
Operations and maintenance expenses to affiliates........... 22 33
Operations and maintenance expenses from affiliates......... 24 39
</Table>
We are a party to a master hedging contract with El Paso Merchant Energy
L.P., (El Paso Merchant Energy), a wholly-owned subsidiary of El Paso. Pursuant
to that agreement, we hedge a portion of our natural gas production with El Paso
Merchant Energy. Realized gains and losses on these hedges are included in
operating revenues.
Dividends
During the first quarter of 2003, we paid dividends of $1.4 billion to El
Paso, of which $0.2 billion was non-cash. These dividends primarily related to
the Red River transaction discussed in our 2003 Annual Report on Form 10-K.
8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The information contained in Item 2 updates, and should be read in
conjunction with information disclosed in our 2003 Annual Report on Form 10-K,
and the financial statements and notes presented in Item 1 of this Quarterly
Report on Form 10-Q. As discussed in our 2003 Annual Report on Form 10-K, we
restated our historical financial statements to reflect the accounting impact of
a reduction in our historically reported proved natural gas and oil reserves, to
adjust two transactions related to historical hedges of our natural gas
production to their fair market value and to reclassify our historical
statements of cash flows for amounts provided to El Paso under the cash
management program.
LIQUIDITY AND CAPITAL RESOURCES
LIQUIDITY UPDATE
We rely on cash generated from our internal operations and advances from El
Paso through its cash management program as our primary sources of liquidity, as
well as asset sales and capital contributions from El Paso. We expect that our
future funding for working capital needs, capital expenditures, dividends and
debt service will continue to be provided from some or all of these sources.
Each of these sources are impacted by factors that influence the overall amount
of cash generated by us and the capital available to us. For example, cash
generated by our business operations may be impacted by changes in commodity
prices or demands for our commodities or services due to weather patterns,
competition from other providers or alternative energy sources. Liquidity
generated by future asset sales may depend on the overall economic conditions of
the industry served by these assets, the condition and location of the assets
and the number of interested buyers.
Under El Paso's cash management program, depending on whether we have
short-term requirements or cash surpluses, we either provide cash to El Paso,
subject to limitations under our indenture, or El Paso provides cash to us. As
of March 31, 2004, we had receivables from El Paso under the cash management
program of $638 million, of which $391 million is classified as current assets
on our balance sheet. Our ability to continue to rely on cash advances from El
Paso can be impacted by restrictive covenants in our indenture, El Paso's credit
standing, El Paso's requirements to repay debt and other financing obligations
and the cash demands from other parts of its business. In addition, we conduct
commercial transactions with some of our affiliates, including conducting
hedging activities with, and selling a portion of the natural gas we produce to
El Paso Merchant Energy. As of March 31, 2004, we have receivables of
approximately $67 million from El Paso affiliates. If El Paso is unable to meet
its liquidity needs, there can be no assurance that we will be able to access
cash under the cash management program or that our affiliates would pay their
obligations to us. In that event, we could be required to write-off some amount
of these advances, which could have a material impact on our stockholder's
equity and we might still be required to satisfy affiliated company payables if
demanded. Our inability to recover any intercompany receivables owed to us could
adversely affect our ability to repay our outstanding indebtedness.
If El Paso were subject to voluntary or involuntary bankruptcy proceedings,
El Paso and its other subsidiaries and their creditors could attempt to make
claims against us, including claims to substantively consolidate our assets and
liabilities with those of El Paso and its other subsidiaries. We believe that
claims to substantively consolidate us with El Paso and/or its other
subsidiaries would be without merit. However, there is no assurance that El Paso
and/or its other subsidiaries or their creditors would not advance such a claim
in a bankruptcy proceeding. If we were to be substantively consolidated in a
bankruptcy proceeding with El Paso and/or its other subsidiaries, there could be
a material adverse effect on our financial condition and our liquidity.
9
We believe we will generate sufficient funds through our operations, asset
sales and repayments by El Paso of advances under the cash management program to
meet all of our cash needs as discussed below.
The restatements discussed above resulted in or will result in a delay in
filing our Forms 10-Q for the quarterly periods ended June 30, 2004 and
September 30, 2004. Our indenture for our 7.75% senior unsecured notes due June
1, 2013, includes covenants that require us to file financial statements within
specified time periods. Non-compliance with such covenants does not constitute
an automatic event of default. Instead, the debt is subject to acceleration
after any applicable cure periods have lapsed and the indenture trustee or the
holders of at least 25 percent of the outstanding principal amount of debt under
our indenture provide notice that the principal and accrued interest has been
declared due and payable. In July 2004, we entered into an agreement approved by
a majority of the holders of our 7.75% senior unsecured notes which provides for
a waiver of the breach of our covenant to timely file our financial statements
and is effective until December 31, 2004. In connection with the waiver, we have
agreed to modify the covenants under our indenture with respect to affiliated
party transactions. In particular, the agreement prohibits certain affiliated
party transactions in excess of $100 million if the transactions would have a
negative effect on our ratio of debt to proved reserves or our ratio of debt to
EBITDA (as defined in the indenture).
Our cash flows for the quarters ended March 31 were as follows:
<Table>
<Caption>
QUARTER ENDED
-------------------
2004 2003
------ ----------
(IN MILLIONS)
Cash flows from operating activities........................ $ 186 $ 166
Cash flows from investing activities........................ (95) (121)
Cash flows from financing activities........................ -- (51)
</Table>
Cash Flows from Operating Activities
Overall, cash generated from our operating activities increased by $20
million from the first quarter of 2003. Decreases in operating cash flows due to
lower natural gas and oil production in 2004 as a result of asset sales in 2003
and normal production declines were more than offset by changes in the timing of
settlement of operating assets and liabilities quarter over quarter.
Cash Flows from Investing Activities
Net cash used in our investing activities was $95 million for the three
months ended March 31, 2004. Our investing activities consisted primarily of
capital expenditures of $145 million, offset by a partial repayment of $50
million from El Paso for amounts advanced to El Paso under the cash management
program.
Our capital expenditures were $303 million for the first nine months of
2004. Under our current plan, we expect to spend between $400 million and $450
million annually which will be funded through a combination of internally
generated funds and, if needed, repayment by El Paso of advances under the cash
management program. These capital expenditures will be spent on acquisition,
development, and exploration projects.
OPERATIONAL UPDATE
For the first quarter of 2004, our total equivalent production declined
approximately 19 Bcfe or 27 percent as compared to the same period in 2003. This
decline was caused by asset sales in 2003 primarily in Oklahoma, Texas and
offshore Gulf of Mexico and normal production declines. For the first nine
months of 2004, our production averaged approximately 470 MMcfe/d; however, for
the month of September 2004 daily production averaged approximately 386 MMcfe/d.
Our production levels are dependent upon the amount of capital allocated to us,
the level of success in our drilling programs and any future asset sales or
acquisitions. Based on the finding and development costs experienced in our 2004
drilling program, we expect our unit of production depletion rate to increase
from $1.72 per Mcfe during the first quarter 2004 to $1.80 per Mcfe for the
second quarter of 2004 and to $1.87 per Mcfe for the third quarter of 2004.
10
PRODUCTION HEDGING
We primarily conduct our hedging activities with El Paso Merchant Energy
through natural gas and oil derivatives on our natural gas and oil production to
stabilize cash flows and reduce the risk of downward commodity price movements
on our sales. Because this hedging strategy only partially reduces our exposure
to downward movements in commodity prices, our reported results of operations,
financial position and cash flows can be impacted significantly by movements in
commodity prices from period to period. For a further discussion of our hedging
program and additional hedges put in place in May 2004, refer to our 2003 Annual
Report on Form 10-K.
RESULTS OF OPERATIONS
Our management, as well as El Paso's management, uses earnings before
interest and income taxes (EBIT) to assess the operating results and
effectiveness of our business. We define EBIT as net income adjusted for (i)
items that do not impact our income from continuing operations, such as the
impact of accounting changes, (ii) income taxes, (iii) interest and debt expense
and (iv) affiliated interest income. Our business consists of consolidated
operations as well as investments in unconsolidated affiliates. We exclude
interest and debt expense from this measure so that our investors may evaluate
our operating results without regard to our financing methods. We believe EBIT
is helpful to our investors because it allows them to more effectively evaluate
the operating performance of both our consolidated business and our
unconsolidated investments using the same performance measure analyzed
internally by our management. EBIT may not be comparable to measurements used by
other companies. Additionally, EBIT should be considered in conjunction with net
income and other performance measures such as operating income or operating cash
flow.
The following is a reconciliation of our operating income to our EBIT and
our EBIT to our net income for each of the quarters ended March 31:
<Table>
<Caption>
2004 2003
----- -----
(IN MILLIONS)
Operating revenues.......................................... $ 219 $ 303
Operating expenses.......................................... (155) (186)
----- -----
Operating income.......................................... 64 117
Earnings from unconsolidated affiliates..................... -- 9
Other expense, net.......................................... -- (2)
----- -----
EBIT...................................................... 64 124
Affiliated interest income.................................. 5 2
Interest expense............................................ (18) (5)
Income taxes................................................ (18) (54)
----- -----
Income from continuing operations........................... 33 67
Cumulative effect of accounting changes, net of income
taxes..................................................... -- 1
----- -----
Net income.................................................. $ 33 $ 68
===== =====
</Table>
11
Below are our operating results and an analysis of these results for the
quarters ended March 31:
<Table>
<Caption>
2004 2003
--------- ---------
(IN MILLIONS, EXCEPT
VOLUMES AND PRICES)
Operating revenues:
Natural gas............................................... $ 179 $ 248
Oil, condensate and liquids............................... 40 58
Other..................................................... -- (3)
------- -------
Total operating revenues.......................... 219 303
Transportation and net product costs........................ (9) (15)
------- -------
Total operating margin............................ 210 288
Operating expenses:
Depreciation, depletion and amortization.................. (93) (112)
Production costs(1)....................................... (23) (30)
General and administrative expenses, net of capitalized
cost................................................... (19) (23)
Taxes, other than production and income taxes............. (2) (3)
Restructuring charges..................................... (9) (3)
------- -------
Total operating expenses(2)....................... (146) (171)
------- -------
Operating income.......................................... 64 117
Earnings from unconsolidated affiliates..................... -- 9
Other expense, net.......................................... -- (2)
------- -------
EBIT........................................................ $ 64 $ 124
======= =======
Volumes, Prices and Costs per unit:
Natural gas
Volumes (MMcf)......................................... 40,924 56,787
======= =======
Average realized prices including hedges ($/Mcf)(3).... $ 4.37 $ 4.37
======= =======
Average realized prices excluding hedges ($/Mcf)(3).... $ 5.70 $ 6.71
======= =======
Average transportation costs ($/Mcf)................... $ 0.16 $ 0.20
======= =======
Oil, condensate and liquids
Volumes (MBbls)........................................ 1,511 1,963
======= =======
Average realized prices including hedges ($/Bbl)(3).... $ 26.88 $ 29.31
======= =======
Average realized prices excluding hedges ($/Bbl)(3).... $ 26.87 $ 30.81
======= =======
Average transportation costs ($/Bbl)................... $ 1.30 $ 1.08
======= =======
Production costs ($/Mcfe)
Average lease operating costs.......................... $ 0.37 $ 0.33
Average production taxes............................... 0.08 0.12
------- -------
Total production costs(1)............................ $ 0.45 $ 0.45
======= =======
Average general and administrative costs ($/Mcfe)......... $ 0.38 $ 0.33
======= =======
Unit of production depletion cost ($/Mcfe)................ $ 1.72 $ 1.58
======= =======
</Table>
- ---------------
(1) Production costs include lease operating costs and production related
taxes (including ad valorem and severance taxes).
(2) Transportation costs are included in operating expenses on our
consolidated statements of income.
(3) Prices are stated before transportation costs.
EBIT. For the quarter ended March 31, 2004, EBIT was $60 million lower
than the same period in 2003. The decrease is due primarily to lower production
volumes as a result of asset sales and normal production declines. Partially
offsetting these decreases to EBIT were lower operating expenses primarily due
to lower depreciation, depletion and amortization.
12
Operating Revenues. The following table describes the variance in revenue
between the quarters ended March 31, 2004 and 2003 due to: (i) changes in
average realized market prices excluding hedges, (ii) changes in production
volumes, and (iii) the effects of hedges on our revenues.
<Table>
<Caption>
VARIANCE
---------------------------------------
PRODUCTION REVENUE VARIANCE ANALYSIS PRICES VOLUMES HEDGES TOTAL
- ------------------------------------ ------ ------- ------ -----
(IN MILLIONS)
Natural gas..................................... $(41) $(106) $78 $(69)
Oil, condensate and liquids..................... (6) (14) 2 (18)
Other........................................... 3
---- ----- --- ----
Total operating revenue variance.............. $(47) $(120) $80 $(84)
==== ===== === ====
</Table>
For the quarter ended March 31, 2004, operating revenues were $84 million
lower than the same period in 2003 primarily due to lower production volumes.
The decline in production volumes was primarily due to the sale of properties in
2003 in Oklahoma, Texas, and offshore Gulf of Mexico as well as normal
production declines.
Average realized natural gas prices for the first quarter of 2004,
excluding hedges, were $1.01 per Mcf lower than the same period in 2003, a
decrease of 15 percent. However, more than offsetting the decrease in revenues
due to lower natural gas prices were $55 million of hedging losses in 2004 as
compared to $133 million of hedging losses in 2003 relating to our natural gas
hedge positions. We expect to continue to incur hedging losses in 2004 based on
current market prices for natural gas relative to the prices at which our
natural gas production is hedged.
Operating Expenses. Total operating expenses were $25 million lower for
the first quarter of 2004 as compared to the first quarter of 2003 primarily due
to lower depreciation, depletion, and amortization expense, lower production
costs, and lower general and administrative expenses. However these lower costs
were partially offset by higher restructuring costs.
Total depreciation, depletion, and amortization expense decreased by $19
million in the first quarter of 2004 as compared to the same period in 2003.
Lower production volumes in 2004 due to the asset sales and other production
declines discussed above reduced our depreciation, depletion, and amortization
expenses by $29 million. Partially offsetting this decrease were higher
depletion rates due to higher finding and development costs which contributed an
increase of $8 million.
Production costs decreased by $7 million in the first quarter of 2004 as
compared to the same period in 2003 due to a decrease in production taxes
resulting from high cost gas well tax credits in the first quarter of 2004 and
due to lower commodity prices in 2004 compared to 2003. Production taxes
decreased $0.04 per Mcfe in 2004. However, our total production costs per Mcfe
remained the same between the first quarter of 2004 and 2003 as average lease
operating costs increased $0.04 per Mcfe in 2004 primarily due to lower
production volumes discussed above.
General and administrative expenses decreased $4 million in the first
quarter of 2004 as compared to the same period in 2003 primarily due to lower
corporate overhead allocations from El Paso, while the increase on a per unit
basis was due to lower production volumes.
EARNINGS FROM UNCONSOLIDATED AFFILIATES
Earnings from unconsolidated affiliates for the quarter ended March 31,
2004, was $9 million lower than the same period in 2003 due to the sale of our
interest in April 2003 of Noric Holdings I, which held our investments in Noric
L.L.C. and Clydesdale Associates, L.P.
INTEREST EXPENSE
Interest expense for the quarter ended March 31, 2004, was $13 million
higher than the same period in 2003 due to the issuance in May 2003 of $1.2
billion of 7.75% senior unsecured notes.
13
INCOME TAXES
<Table>
<Caption>
QUARTER ENDED
MARCH 31,
------------------
2004 2003
------ ------
(IN MILLIONS
EXCEPT FOR RATES)
Income taxes................................................ $18 $54
Effective tax rate.......................................... 35% 45%
</Table>
Our effective tax rate for the quarter ended March 31, 2003 was different
than the statutory rate of 35 percent primarily due to state income taxes on the
sale of Oklahoma properties.
COMMITMENTS AND CONTINGENCIES
See Item 1, Note 4, which is incorporated herein by reference.
14
CAUTIONARY STATEMENT REGARDING
FORWARD-LOOKING STATEMENTS
We have made statements in this document that constitute forward-looking
statements, as that term is defined in the Private Securities Litigation Reform
Act of 1995. Forward-looking statements include information concerning possible
or assumed future results of operations. The words "believe," "expect,"
"estimate," "anticipate" and similar expressions will generally identify
forward-looking statements. These statements may relate to information or
assumptions about:
- capital and other expenditures;
- dividends;
- capital structure;
- liquidity and cash flow;
- credit ratings;
- pending legal proceedings, claims and governmental proceedings, including
environmental matters;
- future economic performance;
- operating income;
- management's plans; and
- goals and objectives for future operations.
Forward-looking statements are subject to risks and uncertainties. While we
believe the assumptions or bases underlying the forward-looking statements are
reasonable and are made in good faith, we caution that assumed facts or bases
almost always vary from actual results, and these variances can be material,
depending upon the circumstances. We cannot assure you that the statements of
expectation or belief contained in the forward-looking statements will result or
be achieved or accomplished. Important factors that could cause actual results
to differ materially from estimates or projections contained in forward-looking
statements are described in our 2003 Annual Report on Form 10-K filed with the
SEC on September 30, 2004.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
This information updates, and you should read it in conjunction with,
information disclosed in our 2003 Annual Report on Form 10-K, in addition to the
information presented in Items 1 and 2 of this Quarterly Report on Form 10-Q.
There are no material changes in our quantitative and qualitative
disclosures about market risks from those reported in our 2003 Annual Report on
Form 10-K.
15
ITEM 4. CONTROLS AND PROCEDURES
During 2003, we initiated a project to ensure compliance with Section 404
of the Sarbanes-Oxley Act of 2002 (SOX), which will apply to us at December 31,
2005. This project entailed a detailed review and documentation of the processes
that impact the preparation of our financial statements, an assessment of the
risks that could adversely affect the accurate and timely preparation of those
financial statements, and the identification of the controls in place to
mitigate the risks of untimely or inaccurate preparation of those financial
statements. Following the documentation of these processes, which was
substantially concluded by December 2003, we initiated an internal review or
"walk-through" of these financial processes by the financial management
responsible for those processes to evaluate the design effectiveness of the
controls identified to mitigate the risk of material misstatements occurring in
our financial statements. We also initiated a detailed process to evaluate the
operating effectiveness of our controls over financial reporting. This process
involves testing the controls for effectiveness, including a review and
inspection of the documentary evidence supporting the operation of the controls
on which we are placing reliance.
In September 2004, we completed investigations surrounding matters that
gave rise to a restatement of our historical financial statements for the period
from 1999 to 2002 and the first nine months of 2003. These investigations
identified a number of internal control weaknesses which we reported as material
control weaknesses in our Annual Report on Form 10-K.
The following are the internal control deficiencies identified as a result
of our SOX implementation and from the independent reviews that led to the
restatements of our historical financial statements, which we have previously
disclosed:
- A weak control environment surrounding the booking of our proved natural
gas and oil reserves;
- Inadequate controls over access to our proved natural gas and oil reserve
system;
- Inadequate documentation of policies and procedures related to booking
proved natural gas and oil reserves;
- Inadequate documentation of accounting conclusions in prior periods
related to complex accounting standards;
- Lack of formal documentation and communication of policies and procedures
with respect to accounting matters;
- Ineffective monitoring activities to ensure compliance with existing
policies, procedures and accounting conclusions;
- Lack of formal evidence to substantiate monitoring activities were
adequately performed (e.g. monitoring activities, such as meetings and
report reviews, were not always documented in a way to objectively
confirm the monitoring activities occurred);
- Inadequate change management and security access to our information
systems (e.g., program developers were allowed to migrate system changes
into production, and passwords for some of our applications did not
adhere to the corporate policy for effective passwords);
- Lack of proper segregation of duties related to manual journal entry
preparation and procurement activities (e.g., our financial accounting
system was not designed to prevent the same person from posting an entry
that prepared the entry and a buyer of goods could also receive for the
goods); and
- Untimely preparation and review of volume and account reconciliations.
We have communicated to El Paso's Audit Committee and to our external
auditors the deficiencies identified to date in our internal controls over
financial reporting as well as the remediation efforts that we have underway. We
are committed to effectively remediating known deficiencies as expeditiously as
possible and
16
continue its extensive efforts to comply with Section 404 of SOX by December 31,
2005. Consequently, we have made the following changes to our internal controls:
- Added members to El Paso's Board of Directors, including its Audit
Committee and its executive management team with extensive experience in
the natural gas and oil industry;
- Formed a committee to provide oversight of the proved natural gas and oil
reserve estimation process, which is staffed with appropriate technical,
financial reporting and legal expertise;
- Continued use of an independent third-party reserve engineering firm,
selected by and reporting annually to the Audit Committee of El Paso's
Board of Directors to perform an independent assessment of our proved
natural gas and oil reserves;
- Formed a centralized proved natural gas and oil reserve evaluation and
reporting function staffed primarily with newly hired personnel that have
extensive industry experience that is separate from the operating
divisions and reports to our president;
- Restricted security access to the proved natural gas and oil reserve
system to the centralized reserve reporting staff;
- Revised our documentation of procedures and controls for estimating
proved natural gas and oil reserves;
- Enhanced internal audit reviews to monitor booking of proved natural gas
and oil reserves;
- Implemented standard information system policies and procedures to
enforce change management and segregation of responsibilities when
migrating programming changes to production, and strengthened security
policies and procedures around passwords for applications and databases;
- Modified systems and procedures to ensure appropriate segregation of
responsibilities for manual journal entry preparation and procurement
activities;
- Formalized our account reconciliation policy and timely completed all
material account reconciliations; and
- Developed and implemented formal training to educate company personnel on
management's responsibilities mandated by SOX Section 404, the components
of the internal control framework on which we rely and the relationship
to our company values including accountability, stewardship, integrity
and excellence.
We are in the process of implementing the following changes to our internal
controls and expect to have them implemented by December 31, 2004:
- Improved training regarding SEC guidelines for booking proved natural gas
and oil reserves;
- Formal communication of procedures for documenting accounting conclusions
involving interpretation of complex accounting standards, including
identification of critical factors that support the basis for our
conclusions;
- Evaluation, formalization and communication of required policies and
procedures;
- Improved monitoring activities to ensure compliance with policies,
procedures and accounting conclusions; and
- Review of the adequacy, proficiency and training of our finance and
accounting staff.
As we continue our SOX Section 404 compliance efforts, including the
testing of the effectiveness of our internal controls, we may identify
additional deficiencies in our system of internal controls that either
individually or in the aggregate may represent a material weakness requiring
additional remediation efforts.
We did not make any changes to our internal controls over financial
reporting during the quarter ended March 31, 2004, that have had a material
adverse affect or are reasonably likely to have a material adverse
17
affect on our internal controls over financial reporting. However, we have made
significant changes to improve our internal controls during the quarter ended
March 31, 2004, and subsequent to that date.
We also undertook a review of our overall disclosure controls and
procedures. Disclosure controls and procedures include, without limitation,
controls and procedures designed to ensure that information required to be
disclosed by us in the reports that we file or submit under the Securities
Exchange Act of 1934 is accumulated and communicated to our management,
including our principal executive and principal financial officers, or persons
performing similar functions, as appropriate to allow timely decisions regarding
required disclosure.
As a result of the deficiencies described above, we concluded that our
disclosure controls and procedures were not effective at March 31, 2004.
However, to address the deficiencies in our internal controls, we expanded our
disclosure controls and procedures to include additional analysis and other
post-closing procedures to ensure our disclosure controls and procedures were
effective over the preparation of these financial statements. Consequently, we
concluded that our disclosure controls and procedures over the preparation of
these financial statements were effective.
18
PART II -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
See Part I, Item 1, Financial Statements, Note 4, which is incorporated
herein by reference.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
a. Exhibits
Each exhibit identified below is filed as a part of this report. Exhibits
not incorporated by reference to a prior filing are designated by an "*". All
exhibits not so designated are incorporated herein by reference to a prior
filing as indicated.
<Table>
<Caption>
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
*31.A Certification of Chief Executive Officer pursuant to sec.
302 of the Sarbanes-Oxley Act of 2002.
*31.B Certification of Chief Financial Officer pursuant to sec.
302 of the Sarbanes-Oxley Act of 2002.
*32.A Certification of Chief Executive Officer pursuant to 18
U.S.C. sec. 1350 as adopted pursuant to sec. 906 of the
Sarbanes-Oxley Act of 2002.
*32.B Certification of Chief Financial Officer pursuant to 18
U.S.C. sec. 1350 as adopted pursuant to sec. 906 of the
Sarbanes-Oxley Act of 2002.
</Table>
Undertaking
We hereby undertake, pursuant to Regulation S-K, Item 601(b),
paragraph (4)(iii), to furnish to the U.S. Securities and Exchange
Commission, upon request, all constituent instruments defining the rights
of holders of our long-term debt not filed herewith for the reason that the
total amount of securities authorized under any of such instruments does
not exceed 10 percent of our total consolidated assets.
19
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
EL PASO PRODUCTION HOLDING COMPANY
Date: October 28, 2004 /s/ D. Mark Leland
--------------------------------------
D. Mark Leland
Executive Vice President,
Chief Financial Officer
and Director
(Principal Financial Officer)
Date: October 28, 2004 /s/ Gene T. Waguespack
--------------------------------------
Gene T. Waguespack
Senior Vice President,
Treasurer and Controller
(Principal Accounting Officer)
20
EXHIBIT INDEX
Each exhibit identified below is filed as a part of this report. Exhibits
not incorporated by reference to a prior filing are designated by an "*". All
exhibits not so designated are incorporated herein by reference to a prior
filing as indicated.
<Table>
<Caption>
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
*31.A Certification of Chief Executive Officer pursuant to sec.
302 of the Sarbanes-Oxley Act of 2002.
*31.B Certification of Chief Financial Officer pursuant to sec.
302 of the Sarbanes-Oxley Act of 2002.
*32.A Certification of Chief Executive Officer pursuant to 18
U.S.C. sec. 1350 as adopted pursuant to sec. 906 of the
Sarbanes-Oxley Act of 2002.
*32.B Certification of Chief Financial Officer pursuant to 18
U.S.C. sec. 1350 as adopted pursuant to sec. 906 of the
Sarbanes-Oxley Act of 2002.
</Table>