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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 JUNE 30, 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 November 19,
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................................. 10
Cautionary Statement Regarding Forward-Looking Statements... 17
Item 3. Quantitative and Qualitative Disclosures About Market
Risk...................................................... 17
Item 4. Controls and Procedures..................................... 18
PART II -- Other Information
Item 1. Legal Proceedings........................................... 21
Item 2. Unregistered Sales of Equity Securities and Use of
Proceeds.................................................. 21
Item 3. Defaults Upon Senior Securities............................. 21
Item 4. Submission of Matters to a Vote of Security Holders......... 21
Item 5. Other Information........................................... 21
Item 6. Exhibits.................................................... 21
Signatures.................................................. 22
</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 SIX MONTHS ENDED
JUNE 30, JUNE 30,
----------------- -----------------
2003 (2003
2004 (RESTATED) 2004 (RESTATED)
---- ---------- ---- ----------
Operating revenues......................................... $193 $234 $412 $537
---- ---- ---- ----
Operating expenses
Cost of sales............................................ 12 12 21 27
Operation and maintenance................................ 38 44 85 92
Depreciation, depletion and amortization................. 79 98 172 210
Taxes, other than income taxes........................... 4 8 10 19
---- ---- ---- ----
133 162 288 348
---- ---- ---- ----
Operating income........................................... 60 72 124 189
Earnings from unconsolidated affiliates.................... -- -- -- 9
Affiliated interest income................................. 4 2 9 4
Other expense, net......................................... -- -- -- (2)
Interest expense........................................... (21) (27) (39) (32)
---- ---- ---- ----
Income before income taxes................................. 43 47 94 168
Income taxes............................................... 16 15 34 69
---- ---- ---- ----
Income from continuing operations.......................... 27 32 60 99
Cumulative effect of accounting change, net of income
taxes.................................................... -- -- -- 1
---- ---- ---- ----
Net income................................................. $ 27 $ 32 $ 60 $100
==== ==== ==== ====
</Table>
See accompanying notes.
1
EL PASO PRODUCTION HOLDING COMPANY
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN MILLIONS, EXCEPT SHARE AMOUNTS)
(UNAUDITED)
<Table>
<Caption>
JUNE 30, DECEMBER 31,
2004 2003
-------- ------------
ASSETS
Current assets
Cash and cash equivalents................................. $ 72 $ 34
Accounts and notes receivable
Customer, net of allowance of $5 in 2004 and $6 in
2003................................................... 73 66
Affiliates.............................................. 344 451
Other................................................... 4 4
Deferred income taxes..................................... 94 70
Other..................................................... 14 11
------ ------
Total current assets.................................. 601 636
------ ------
Property, plant and equipment, at cost
Natural gas and oil properties
Proved properties-full cost method...................... 7,326 7,074
Unevaluated costs excluded from amortization............ 238 252
Other..................................................... 127 123
------ ------
7,691 7,449
Less accumulated depreciation, depletion and
amortization............................................ 5,306 5,141
------ ------
Total property, plant and equipment, net.............. 2,385 2,308
------ ------
Other assets
Notes receivable from affiliates.......................... 343 295
Deferred income taxes..................................... 185 204
Other..................................................... 35 36
------ ------
563 535
------ ------
Total assets.......................................... $3,549 $3,479
====== ======
LIABILITIES AND STOCKHOLDER'S EQUITY
Current liabilities
Accounts payable
Trade................................................... $ 68 $ 63
Affiliates.............................................. 11 7
Other................................................... 39 79
Liabilities from price risk management activities......... 242 173
Income taxes payable to affiliate......................... 106 118
Other..................................................... 36 30
------ ------
Total current liabilities............................. 502 470
------ ------
Long-term debt.............................................. 1,200 1,200
------ ------
Other
Liabilities from price risk management activities......... 311 270
Other..................................................... 82 76
------ ------
393 346
------ ------
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......................................... 91 31
Accumulated other comprehensive loss...................... (337) (268)
------ ------
Total stockholder's equity............................ 1,454 1,463
------ ------
Total liabilities and stockholder's equity............ $3,549 $3,479
====== ======
</Table>
See accompanying notes.
2
EL PASO PRODUCTION HOLDING COMPANY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN MILLIONS)
(UNAUDITED)
<Table>
<Caption>
SIX MONTHS ENDED
JUNE 30,
--------------------
2003
2004 (RESTATED)(1)
---- -------------
Cash flows from operating activities
Net income................................................ $ 60 $ 100
Adjustments to reconcile net income to net cash from
operating activities
Depreciation, depletion and amortization............... 172 210
Deferred income tax expense (benefit).................. 35 (130)
Earnings from unconsolidated affiliates................ -- (9)
Other non-cash income items............................ -- 15
Asset and liability changes............................ (65) 138
---- -------
Net cash provided by operating activities......... 202 324
---- -------
Cash flows from investing activities
Capital expenditures...................................... (266) (399)
Net proceeds from the sale of assets and investments...... -- 509
Change in notes receivable from parent.................... 102 (275)
Change in restricted cash................................. -- 6
---- -------
Net cash used in investing activities............. (164) (159)
---- -------
Cash flows from financing activities
Net proceeds from the issuance of long-term debt.......... -- 1,169
Dividends to parent....................................... -- (1,236)
---- -------
Net cash used in financing activities............. -- (67)
---- -------
Change in cash and cash equivalents......................... 38 98
Cash and cash equivalents
Beginning of period....................................... 34 156
---- -------
End of period............................................. $ 72 $ 254
==== =======
</Table>
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(1) Cash flows from operating, investing and financing activities have been
restated. However, 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 SIX MONTHS ENDED
JUNE 30, JUNE 30,
----------------- ------------------
2003 2003
2004 (RESTATED) 2004 (RESTATED)
---- ---------- ----- ----------
Net income................................................. $ 27 $ 32 $ 60 $ 100
---- ----- ----- -----
Net gains (losses) from cash flow hedging activities:
Unrealized mark-to-market losses arising during period
(net of income taxes of $33 and $82 in 2004 and $65
and $138 in 2003)..................................... (58) (109) (143) (232)
Reclassification adjustments for changes in initial value
to the settlement date (net of income taxes of $21 and
$42 in 2004 and $27 and $67 in 2003).................. 39 42 74 108
---- ----- ----- -----
Other comprehensive loss............................ (19) (67) (69) (124)
---- ----- ----- -----
Comprehensive income (loss)................................ $ 8 $ (35) $ (9) $ (24)
==== ===== ===== =====
</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 June 30, 2004, and for the
quarters and six months ended June 30, 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 and six
months ended June 30, 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 its 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, and we
participate in its cash management program. Under this program, depending on
whether we have short-term cash requirements or surpluses, either El Paso
provides cash to us or we 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 June 30, 2004, we had a receivable from El Paso of $586 million, of which
$243 million is classified as a current asset in our balance sheet. Over the
next twelve months, we expect to use this current amount to fund the payment for
affiliated income taxes and fund our capital expenditures in excess of operating
cash flows. 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 Marketing, L.P., (El Paso Marketing) formerly known as El Paso Merchant
Energy L.P., a wholly-owned indirect subsidiary of El Paso. As of June 30, 2004,
we have receivables of approximately $101 million from El Paso affiliates. If El
Paso were 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, if demanded, we might still be required
to repay affiliated company payables. Our inability to recover any intercompany
receivables owed to us could adversely affect our ability to repay our
outstanding indebtedness. In November 2004, Moody's Investor Service changed its
outlook on El Paso's and our senior unsecured notes to stable.
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.
5
The restatements discussed above resulted in a delay in filing our Form
10-Q for the quarterly period ended September 30, 2004. The 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 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 benefit as a
cumulative effect of an accounting change of approximately $1 million, net of
income taxes related to the adoption of this standard.
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 of 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 these companies to exclude future cash
outflows associated with settling asset retirement liabilities from their full
cost ceiling test calculation. Finally, this standard will require disclosure of
the impact of a company's asset retirement obligations on its oil and gas
producing activities, ceiling test calculations and depreciation, depletion and
amortization calculations. We will adopt the provisions of this pronouncement in
the first quarter of 2005 and are currently evaluating its impact, if any, on
our consolidated financial statements.
3. 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,
6
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 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 in April 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. The mine is owned and operated by Jim Walter Resources (JWR). El Paso
has no ownership interest in the mine. However, we are a 50 percent stockholder
in Black Warrior Methane Corporation (Black Warrior), which was involved in the
extraction of methane from the mine, and which is a named defendant in 18 of the
lawsuits filed to date. El Paso Production Holding Company is named as defendant
in 17 of the cases filed to date. Plaintiffs have asserted a joint venture
theory of liability against JWR, Black Warrior and us, alleging that the
defendants have breached a duty to properly degasify the mine. We are being
defended as an additional insured under Black Warrior's insurance policy. Black
Warrior has also asserted that it qualifies as an insured under El Paso's
corporate insurance policy. The parties are engaged in discovery.
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 June 30,
2004, we had approximately $1 million accrued for all outstanding legal matters.
Other
During the third quarter of 2004, we discovered that the supplier of
electricity to our Raton field in New Mexico may have underbilled us for
electricity usage during the last two years. No claims have been asserted by the
electric provider and we are currently reviewing information concerning this
matter.
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 June 30,
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. In March 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.
7
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 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.
4. INVESTMENTS IN UNCONSOLIDATED AFFILIATES AND RELATED PARTY TRANSACTIONS
Investments in Unconsolidated Affiliates
We hold a 50 percent ownership interest in Black Warrior Transmission Corp.
(Black Warrior Transmission) and account for this investment using the equity
method of accounting. Our investment in this affiliate was $6 million at June
30, 2004 and December 31, 2003. We recognized equity earnings of less than $1
million for the quarters and six months ended June 30, 2004 and 2003 from our
investment in Black Warrior Transmission. Included in our equity earnings for
the six months ended June 30, 2003, were equity earnings of $9 million from our
investments in Noric L.L.C. and Clydesdale Associates, L.P. In April 2003, we
sold our interest in Noric Holdings I, 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. Receivables due from affiliates at
June 30, 2004 and December 31, 2003, were $101 million and $58 million. Payables
due to affiliates at June 30, 2004 and December 31, 2003 were $11 million and $7
million. These affiliate receivables and payables were created in the normal
course of business. Additionally, we recorded $106 million and $118 million
income taxes payable to an affiliate at June 30, 2004 and December 31, 2003 for
our allocated portion of El Paso's income taxes.
Cash Management Program. 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 June 30,
2004 and December 31, 2003, we had receivables from El Paso of $586 million and
$688 million, of which $243 million and $393 million are classified as current
notes receivables from affiliates on our balance sheets.
Affiliate Revenues and Expenses. 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
periods ended June 30:
<Table>
<Caption>
SIX MONTHS
QUARTER ENDED ENDED
JUNE 30, JUNE 30,
------------- -----------
2004 2003 2004 2003
----- ----- ---- ----
(IN MILLIONS)
Operating revenues.......................................... $103 $278 $227 $418
Operations and maintenance expenses from affiliates......... 26 39 50 78
Reimbursements of operating expenses charged to
affiliates................................................ 24 34 46 67
</Table>
We are a party to a master hedging contract with El Paso Marketing.
Pursuant to that agreement, we hedge a portion of our natural gas production
with El Paso Marketing. Realized gains and losses on these hedges are included
in operating revenues.
8
During the quarter and six months ended June 30, 2003, we recorded interest
expense of $17 million and $23 million to El Paso related to the Red River
refinancing transactions discussed in our 2003 Annual Report on Form 10-K.
Dividends. During the six months ended June 30, 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 refinancing transactions discussed in our
2003 Annual Report on Form 10-K.
9
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 its 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. We
have also relied on proceeds from 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 these assets and the number of interested buyers.
Under El Paso's cash management program, depending on whether we have
short-term cash requirements or surpluses, either El Paso provides cash to us or
we provide cash to El Paso, subject to limitations in our indenture. As of June
30, 2004, we had receivables from El Paso under the cash management program of
$586 million, of which $243 million is classified as current assets on our
balance sheet. Over the next twelve months, we expect to use this current amount
to fund the payment for affiliated income taxes and fund our capital
expenditures in excess of operating cash flows. 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 Marketing. As of June 30, 2004, we have
receivables of approximately $101 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, if demanded, we might still be required to repay
affiliated company payables. Our inability to recover any intercompany
receivables owed to us could adversely affect our ability to repay our
outstanding indebtedness. In November 2004, Moody's Investor Service changed its
outlook on El Paso's and our senior unsecured notes to stable.
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.
10
We believe we will generate sufficient funds through our operations, asset
sales and repayments by El Paso of advances under its cash management program to
meet all of our cash needs as discussed below.
The restatements discussed above resulted in a delay in filing our Form
10-Q for the quarterly period ended September 30, 2004. The 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 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 six months ended June 30 were as follows:
<Table>
<Caption>
2004 2003
----- -----
(IN MILLIONS)
Cash flows from operating activities........................ $ 202 $ 324
Cash flows from investing activities........................ (164) (159)
Cash flows from financing activities........................ -- (67)
</Table>
Cash Flows from Operating Activities
Overall, cash generated from our operating activities during the six months
ended June 30, 2004 decreased by $122 million from the same period of 2003.
Decreases in operating cash flows were due to lower natural gas and oil
production in 2004 as a result of asset sales in 2003 and normal production
declines as well as changes in the timing of settlement of operating assets and
liabilities period over period.
Cash Flows from Investing Activities
Net cash used in our investing activities was $164 million for the six
months ended June 30, 2004. Our investing activities consisted primarily of
capital expenditures of $266 million, offset by a $102 million collection of
note receivables from El Paso under its 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 its cash
management program. These capital expenditures will be spent on acquisition,
development, and exploration projects.
OPERATIONAL UPDATE
For the six months ended June 30, 2004, our total equivalent production
declined approximately 38 Bcfe or 30 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. Through
October 31, 2004, our production averaged approximately 464 MMcfe/d. However,
for the month of October 2004 daily production averaged approximately 403
MMcfe/d. Our September and October production levels were affected by hurricanes
in the Gulf of Mexico and, to a lesser extent, we believe these impacts will
continue through the first quarter of 2005. Our future production levels are
dependent upon the amount of capital allocated to us, the level of success in
our drilling programs and future asset sales or acquisitions. Based on the
results to date of our 2004 drilling program, our unit of production depletion
rate was $1.80 per Mcfe for the second quarter of 2004 and we expect our unit of
production rate to be $1.87 per Mcfe for the third and fourth quarters of 2004.
11
PRODUCTION HEDGING
We primarily conduct our hedging activities with El Paso Marketing 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 EBIT to net income for the periods
ended June 30:
<Table>
<Caption>
QUARTER ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------- ----------------
2004 2003 2004 2003
----- ----- ------ ------
(IN MILLIONS)
Operating revenues.......................................... $ 193 $ 234 $ 412 $ 537
Operating expenses.......................................... (133) (162) (288) (348)
----- ----- ----- -----
Operating income.......................................... 60 72 124 189
Earnings from unconsolidated affiliates..................... -- -- -- 9
Other expense, net.......................................... -- -- -- (2)
----- ----- ----- -----
EBIT...................................................... 60 72 124 196
Affiliated interest income.................................. 4 2 9 4
Interest expense............................................ (21) (27) (39) (32)
Income taxes................................................ (16) (15) (34) (69)
----- ----- ----- -----
Income from continuing operations........................... 27 32 60 99
Cumulative effect of accounting changes, net of income
taxes..................................................... -- -- -- 1
----- ----- ----- -----
Net income.................................................. $ 27 $ 32 $ 60 $ 100
===== ===== ===== =====
</Table>
12
Below are our operating results and an analysis of these results for the
periods ended June 30:
<Table>
<Caption>
QUARTER ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------- --------------------
2004 2003 2004 2003
-------- -------- -------- ---------
(IN MILLIONS, EXCEPT VOLUMES AND PRICES)
Operating revenues:
Natural gas.............................................. $ 161 $ 196 $ 340 $ 444
Oil, condensate and liquids.............................. 31 36 71 94
Other.................................................... 1 2 1 (1)
------ ------ ------ -------
Total operating revenues......................... 193 234 412 537
Transportation and net product costs....................... (12) (12) (21) (27)
------ ------ ------ -------
Total operating margin........................... 181 222 391 510
Operating expenses:
Depreciation, depletion and amortization................. (79) (98) (172) (210)
Production costs(1)...................................... (21) (23) (44) (53)
General and administrative expenses, net of capitalized
cost.................................................. (18) (26) (37) (49)
Taxes, other than production and income taxes............ (1) (2) (3) (5)
Restructuring charges.................................... (2) (1) (11) (4)
------ ------ ------ -------
Total operating expenses(2)...................... (121) (150) (267) (321)
------ ------ ------ -------
Operating income......................................... 60 72 124 189
Earnings from unconsolidated affiliates.................... -- -- -- 9
Other expense, net......................................... -- -- -- (2)
------ ------ ------ -------
EBIT....................................................... $ 60 $ 72 $ 124 $ 196
====== ====== ====== =======
Volumes, Prices and Costs per unit:
Natural gas
Volumes (MMcf)........................................ 35,436 52,240 76,360 109,027
====== ====== ====== =======
Average realized prices, including hedges
($/Mcf)(3).......................................... $ 4.53 $ 3.75 $ 4.44 $ 4.07
====== ====== ====== =======
Average realized prices, excluding hedges
($/Mcf)(3).......................................... $ 5.93 $ 5.42 $ 5.80 $ 6.09
====== ====== ====== =======
Average transportation costs ($/Mcf).................. $ 0.21 $ 0.20 $ 0.18 $ 0.20
====== ====== ====== =======
Oil, condensate and liquids
Volumes (MBbls)....................................... 875 1,376 2,386 3,339
====== ====== ====== =======
Average realized prices, including hedges
($/Bbl)(3).......................................... $35.26 $26.96 $29.95 $ 28.34
====== ====== ====== =======
Average realized prices, excluding hedges
($/Bbl)(3).......................................... $35.26 $28.31 $29.95 $ 29.78
====== ====== ====== =======
Average transportation costs ($/Bbl).................. $ 1.89 $ 1.15 $ 1.52 $ 1.11
====== ====== ====== =======
Production costs ($/Mcfe)
Average lease operating costs......................... $ 0.45 $ 0.29 $ 0.41 $ 0.31
Average production taxes.............................. 0.07 0.10 0.07 0.10
------ ------ ------ -------
Total production costs(1)........................... $ 0.52 $ 0.39 $ 0.48 $ 0.41
====== ====== ====== =======
Average general and administrative costs ($/Mcfe)........ $ 0.43 $ 0.43 $ 0.40 $ 0.38
====== ====== ====== =======
Unit of production depletion cost ($/Mcfe)............... $ 1.80 $ 1.55 $ 1.76 $ 1.56
====== ====== ====== =======
</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.
13
Second Quarter 2004 Compared to Second Quarter 2003
EBIT. For the quarter ended June 30, 2004, EBIT was $12 million lower than
the same period in 2003. The decrease is due primarily to lower production
volumes as a result of normal production declines. Partially offsetting these
decreases to EBIT were lower operating expenses primarily due to lower
depreciation, depletion and amortization expense.
Operating Revenues. The following table describes the variance in revenue
between the quarters ended June 30, 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............................................. $18 $ (91) $38 $(35)
Oil, condensate and liquids............................. 7 (14) 2 (5)
--- ----- --- ----
$25 $(105) $40 (40)
=== ===== ===
Other................................................... (1)
----
Total operating revenue variance..................................................... $(41)
====
</Table>
For the quarter ended June 30, 2004, operating revenues were $41 million
lower than the same period in 2003 primarily due to lower production volumes,
partially offset by higher natural gas and oil prices and a decrease in hedging
losses. The decline in production volumes was primarily due to normal production
declines, particularly in our offshore and south Texas regions.
Average realized natural gas prices for the second quarter of 2004,
excluding hedges, were $0.51 per Mcf higher than the same period in 2003, an
increase of nine percent. In addition, hedging losses relating to our natural
gas hedge positions decreased from $87 million in 2003 to $49 million in 2004.
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 $29 million lower for
the second quarter of 2004 as compared to the second quarter of 2003, primarily
due to lower depreciation, depletion, and amortization expenses, lower
production costs, and lower general and administrative expenses. We expect to
incur additional costs in the fourth quarter of 2004 related to the relocation
of our offices in Houston, Texas.
Total depreciation, depletion, and amortization expenses decreased by $19
million in the second quarter of 2004 as compared to the same period in 2003.
Lower production volumes in 2004 due to normal production declines reduced our
depreciation, depletion, and amortization expenses by $31 million. Partially
offsetting this decrease were higher depletion rates due to higher finding and
development costs which contributed an increase of $10 million.
Production costs decreased by $2 million in the second quarter of 2004 as
compared to the same period in 2003, primarily due to a decrease in production
taxes resulting from lower production volumes and high cost gas well tax credits
in 2004. Our lease operating costs were approximately the same for each quarter.
On a per unit basis, production taxes decreased by $0.03 per Mcfe. However, our
total production cost per Mcfe increased $0.13 per Mcfe in the second quarter of
2004 compared to 2003 as average lease operating costs increased $0.16 per Mcfe
in 2004 primarily due to the lower production volumes discussed above.
General and administrative expenses decreased $8 million in the second
quarter of 2004 as compared to the same period in 2003, primarily due to lower
corporate overhead allocations from El Paso. On a per unit basis, costs remained
the same. For the remainder of 2004, we will experience higher overhead
allocations from El Paso.
14
Six Months Ended 2004 Compared to Six Months Ended 2003
EBIT. For the six months ended June 30, 2004, EBIT was $72 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 expense.
Operating Revenues. The following table describes the variance in revenue
between the six months ended June 30, 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............................................ $(21) $(199) $116 $(104)
Oil, condensate and liquids............................ 1 (29) 5 (23)
---- ----- ---- -----
$(20) $(228) $121 (127)
==== ===== ====
Other.................................................. 2
-----
Total operating revenue variance.................................................... $(125)
=====
</Table>
For the six months ended June 30, 2004, operating revenues were $125
million lower than the same period in 2003 primarily due to lower production
volumes and lower natural gas prices, partially offset by a decrease in hedging
losses. 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, particularly in our offshore and south Texas
regions.
Average realized natural gas prices for the six months ended June 30, 2004,
excluding hedges, were $0.29 per Mcf lower than the same period in 2003, a
decrease of five percent. However, more than offsetting the decrease in revenues
due to lower natural gas prices were $104 million of hedging losses in 2004 as
compared to $220 million 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 $54 million lower for
the first six months of 2004 as compared to the first six months of 2003,
primarily due to lower depreciation, depletion, and amortization expenses, lower
production costs, and lower general and administrative expenses. However, these
lower costs were partially offset by higher restructuring costs in 2004, related
primarily to employee severance costs. We expect to incur additional costs in
the fourth quarter of 2004 related to the relocation of our offices in Houston,
Texas.
Total depreciation, depletion, and amortization expenses decreased by $38
million for the first six months of 2004 as compared to the same period in 2003.
Lower production volumes in 2004 due to asset sales and other production
declines discussed above reduced our depreciation, depletion, and amortization
expenses by $60 million. Partially offsetting this decrease were higher
depletion rates due to higher finding and development costs which contributed an
increase of $18 million.
Production costs decreased by $9 million for the first six months of 2004
as compared to the same period in 2003, primarily due to a decrease in
production taxes resulting from lower production volumes and high cost gas well
tax credits in 2004. Our lease operating costs were approximately the same in
each period. On a per unit basis, production taxes decreased by $0.03 per Mcfe.
However, our total production costs per Mcfe increased by $0.07 per Mcfe for the
first six months of 2004 as compared to 2003 as average lease operating costs
increased $0.10 per Mcfe due to the lower production volumes discussed above.
General and administrative expenses decreased $12 million for the first six
months of 2004 as compared to the same period in 2003, primarily due to lower
corporate overhead allocations from El Paso. The increase
15
on a per unit basis was due to lower production volumes. For the remainder of
2004, we will experience higher overhead allocations from El Paso.
EARNINGS FROM UNCONSOLIDATED AFFILIATES
Earnings from unconsolidated affiliates for the six months ended June 30,
2004, were $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.
AFFILIATED INTEREST INCOME
Affiliated interest income for the quarter ended June 30, 2004, was $2
million higher than the same period in 2003 due to higher interest rates on
average advances to El Paso under its cash management program, offset by lower
average balances of these advances. The average advance balance for the second
quarter of 2003 was $659 million and decreased to $612 million during the same
period in 2004. The average short-term interest rate for the second quarter
increased from 1.3% in 2003 to 2.3% during the same period in 2004.
Affiliated interest income for the six months ended June 30, 2004, was $5
million higher than the same period in 2003 due to higher interest rates and
higher average advances to El Paso under its cash management program. The
average advance balance of $511 million for the six months of 2003 increased to
$637 million in 2004. The average short-term interest rate increased from 1.4%
in 2003 to 2.5% in 2004.
INTEREST EXPENSE
Interest expense for the quarter ended June 30, 2004, was $6 million lower
than the same period in 2003. For the majority of the second quarter of 2003, we
recorded interest at an effective rate of 9.75%. In May 2003, this debt was
refinanced with notes having a rate of 7.75%. As a result, interest expense in
the second quarter of 2004 was at a rate of 7.75% versus a rate of 9.75% in the
same period of 2003.
Interest expense for the six months ended June 30, 2004, was $7 million
higher than the same period in 2003. Prior to March 2003, we had no debt
outstanding. For the six months ended June 30, 2004, we had outstanding debt for
the entire period. As a result, interest expense for the six months ended June
30, 2004 was higher than the same period of 2003. However, partially offsetting
this higher interest expense was the effect of the refinancing discussed above.
INCOME TAXES
<Table>
<Caption>
QUARTER ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
----------------- -----------------
2004 2003 2004 2003
---- ---- ---- ----
(IN MILLIONS EXCEPT FOR RATES)
Income taxes........................................... $16 $15 $34 $69
Effective tax rate..................................... 37% 32% 36% 41%
</Table>
Our effective tax rates for the quarters ended June 30, 2004 and 2003 and
the six months ended June 30, 2004 were different than the statutory rate of 35
percent due to the impact of state income taxes. The effective tax rate for the
six months ended June 30, 2003 was different than the statutory rate of 35
percent primarily due to state income taxes related to the sale of our Oklahoma
properties.
COMMITMENTS AND CONTINGENCIES
See Item 1, Note 3, which is incorporated herein by reference.
16
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.
17
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, 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 related to the
restatements of our historical financial statements, and those identified as a
result of our SOX implementation 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 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 passwords);
- Lack of 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 continue our extensive efforts to comply with Section 404 of SOX by
December 31, 2005. Consequently, we have made the following changes to our
internal controls during 2004:
- 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;
18
- 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 the 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 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 its 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, which we expect to have 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 six months ended June 30, 2004, that have had a material
adverse affect or are reasonably likely to have a material adverse affect on our
internal controls over financial reporting.
We also reviewed our overall disclosure controls and procedures for the
quarter ended June 30, 2004. 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
19
executive and principal financial officers, or persons performing similar
functions, as appropriate to allow timely decisions regarding required
disclosure.
As a result of the internal controls deficiencies described above, we
concluded that our disclosure controls and procedures were not effective at June
30, 2004. However, we expanded our procedures to include additional analysis and
other post-closing procedures to ensure that the disclosure controls and
procedures over the preparation of these financial statements were effective.
20
PART II -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
See Part I, Item 1, Financial Statements, Note 3, 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.
21
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: November 19, 2004 /s/ D. MARK LELAND
--------------------------------------
D. Mark Leland
Executive Vice President,
Chief Financial Officer
and Director
(Principal Financial Officer)
Date: November 19, 2004 /s/ GENE T. WAGUESPACK
--------------------------------------
Gene T. Waguespack
Senior Vice President,
Treasurer and Controller
(Principal Accounting Officer)
22
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>