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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 SEPTEMBER 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 December 15,
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........................................... 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
MMBtu = million British thermal units
MMcf = million cubic feet
MMcfe = million cubic feet of natural gas equivalents
TBtu = trillion British thermal units
</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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------- -----------------------
2003 (2003
2004 (RESTATED) 2004 (RESTATED)
---------- ---------- ---------- ----------
Operating revenues.................................. $168 $199 $580 $736
---- ---- ---- ----
Operating expenses
Cost of sales..................................... 9 12 30 39
Operation and maintenance......................... 39 41 124 133
Depreciation, depletion and amortization.......... 78 86 250 296
Taxes, other than income taxes.................... 1 8 11 27
---- ---- ---- ----
127 147 415 495
---- ---- ---- ----
Operating income.................................... 41 52 165 241
Earnings from unconsolidated affiliates............. -- -- -- 9
Affiliated interest income.......................... 3 3 12 7
Other expense, net.................................. -- -- -- (2)
Interest expense.................................... (20) (23) (59) (55)
---- ---- ---- ----
Income before income taxes.......................... 24 32 118 200
Income taxes........................................ 10 11 44 80
---- ---- ---- ----
Income from continuing operations................... 14 21 74 120
Cumulative effect of accounting change, net of
income taxes...................................... -- -- -- 1
---- ---- ---- ----
Net income.......................................... $ 14 $ 21 $ 74 $121
==== ==== ==== ====
</Table>
See accompanying notes.
1
EL PASO PRODUCTION HOLDING COMPANY
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN MILLIONS, EXCEPT SHARE AMOUNTS)
(UNAUDITED)
<Table>
<Caption>
SEPTEMBER 30, DECEMBER 31,
2004 2003
------------- -------------
ASSETS
Current assets
Cash and cash equivalents................................. $ 165 $ 34
Accounts and notes receivable
Customer, net of allowance of $5 in 2004 and $6 in
2003................................................... 63 66
Affiliates.............................................. 251 451
Other................................................... 4 4
Deferred income taxes..................................... 112 70
Other..................................................... 8 11
------ ------
Total current assets.................................. 603 636
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Property, plant and equipment, at cost
Natural gas and oil properties
Proved properties-full cost method...................... 7,220 7,074
Unevaluated costs excluded from amortization............ 240 252
Other..................................................... 128 123
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7,588 7,449
Less accumulated depreciation, depletion and
amortization............................................ 5,213 5,141
------ ------
Total property, plant and equipment, net.............. 2,375 2,308
------ ------
Other assets
Notes receivable from affiliates.......................... 398 295
Deferred income taxes..................................... 169 204
Other..................................................... 35 36
------ ------
602 535
------ ------
Total assets.......................................... $3,580 $3,479
====== ======
LIABILITIES AND STOCKHOLDER'S EQUITY
Current liabilities
Accounts payable
Trade................................................... $ 61 $ 63
Affiliates.............................................. 17 7
Other................................................... 25 79
Liabilities from price risk management activities......... 292 173
Income taxes payable to affiliate......................... 91 118
Other..................................................... 56 30
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Total current liabilities............................. 542 470
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Long-term debt.............................................. 1,200 1,200
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Other
Liabilities from price risk management activities......... 336 270
Other..................................................... 81 76
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417 346
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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......................................... 105 31
Accumulated other comprehensive loss...................... (384) (268)
------ ------
Total stockholder's equity............................ 1,421 1,463
------ ------
Total liabilities and stockholder's equity............ $3,580 $3,479
====== ======
</Table>
See accompanying notes.
2
EL PASO PRODUCTION HOLDING COMPANY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN MILLIONS)
(UNAUDITED)
<Table>
<Caption>
NINE MONTHS ENDED
SEPTEMBER 30,
----------------------------
2003
2004 (RESTATED)(1)
------------ -------------
Cash flows from operating activities
Net income................................................ $ 74 $ 121
Adjustments to reconcile net income to net cash from
operating activities
Depreciation, depletion and amortization............... 250 296
Deferred income tax expense (benefit).................. 59 (145)
Earnings from unconsolidated affiliates................ -- (9)
Other non-cash income items............................ 3 4
Asset and liability changes............................ (28) 204
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Net cash provided by operating activities......... 358 471
------- -------
Cash flows from investing activities
Capital expenditures...................................... (348) (579)
Net proceeds from the sale of assets and investments...... -- 504
Change in notes receivable from parent.................... 121 (373)
Change in restricted cash................................. -- 6
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Net cash used in investing activities............. (227) (442)
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Cash flows from financing activities
Net proceeds from the issuance of long-term debt.......... -- 1,169
Dividends to parent....................................... -- (1,236)
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Net cash used in financing activities............. -- (67)
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Change in cash and cash equivalents......................... 131 (38)
Cash and cash equivalents
Beginning of period....................................... 34 156
------- -------
End of period............................................. $ 165 $ 118
======= =======
</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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------- -----------------------
2003 2003
2004 (RESTATED) 2004 (RESTATED)
---------- ---------- ---------- ----------
Net income........................................... $ 14 $ 21 $ 74 $ 121
----- ----- ----- -----
Net gains (losses) from cash flow hedging activities:
Unrealized mark-to-market gains (losses) arising
during period (net of income taxes of $45 and
$127 in 2004 and $33 and $105 in 2003).......... (78) 55 (221) (177)
Reclassification adjustments for changes in initial
value to the settlement date (net of income
taxes of $18 and $60 in 2004 and $22 and $89 in
2003)........................................... 31 38 105 146
----- ----- ----- -----
Other comprehensive income (loss)............. (47) 93 (116) (31)
----- ----- ----- -----
Comprehensive income (loss).......................... $ (33) $ 114 $ (42) $ 90
===== ===== ===== =====
</Table>
See accompanying notes.
4
EL PASO PRODUCTION HOLDING COMPANY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION AND LIQUIDITY 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 September 30, 2004, and
for the quarters and nine months ended September 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 nine months ended September 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 statement of cash
flows for the manner in which we present 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 September 30, 2004, we had a receivable from El Paso of $567 million, of
which $169 million is classified as a current asset on our balance sheet. In
November 2004, El Paso entered into a new financing arrangement that extended
its existing $3 billion revolving credit facility. 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 November 2004, Moody's Investors Service changed its outlook on El
Paso's and our senior unsecured notes to stable.
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. As a result of the restatements discussed above, our 2003 Annual
Report on Form 10-K and Forms 10-Q for the quarterly periods ended March 31,
2004, June 30, 2004 and September 30, 2004 were not filed within the time
periods specified in our indenture. In July 2004, we entered into an agreement
approved by a majority of the holders of our 7.75% senior unsecured notes which
provided us an extension of time to file these financial statements through
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). With this filing, we are now in compliance with our financial
statement filing requirements.
5
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
(SFAS) 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, 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.
6
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 Company is named as a defendant in
the 22 cases filed to date. Plaintiffs have asserted a joint venture theory of
liability against JWR, Black Warrior and El Paso Production Company, 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 settlement discussions.
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
September 30, 2004, we had approximately $2 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 to assess our potential exposure, if any.
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 September
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. 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.
4. RESTRUCTURING COSTS
As a result of actions taken by El Paso in 2003 and 2004, we have incurred
restructuring costs of $12 million and $4 million during the nine months ended
September 30, 2004 and 2003. These restructuring costs consisted primarily of
employee severance payments, included in our operation and maintenance expense.
As of September 30, 2004, substantially all of these employee severance costs
have been paid.
5. 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
September 30, 2004 and December 31, 2003. We recognized equity earnings of less
than $1 million for the quarters and nine months ended September 30, 2004 and
2003 from our investment in Black Warrior Transmission. Included in our equity
earnings for the nine months ended September 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
September 30, 2004 and December 31, 2003, were $82 million and $58 million.
Payables due to affiliates at September 30, 2004 and December 31, 2003 were $17
million and $7 million. These affiliate receivables and payables were created in
the normal course of business. Additionally, we have income taxes payable to El
Paso of $91 million and $118 million at September 30, 2004 and December 31, 2003
for our allocated portion of El Paso's income taxes.
Cash Management Program. Subject to limitations in our indenture, 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 September 30, 2004 and December 31, 2003, we
had receivables from El Paso of $567 million and $688 million, of which $169
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 affiliates in the ordinary course of conducting our business. The following
table shows revenues and charges to/from our affiliates for the periods ended
September 30:
<Table>
<Caption>
NINE MONTHS
QUARTER ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------- -------------
2004 2003 2004 2003
----- ----- ----- -----
(IN MILLIONS)
Operating revenues.......................................... $104 $202 $331 $620
Operations and maintenance expenses from affiliates......... 34 33 84 111
Reimbursements of operating expenses charged to
affiliates................................................ 30 33 76 100
</Table>
During the nine months ended September 30, 2003, we recorded interest
expense of $23 million to El Paso related to the Red River refinancing
transactions discussed in our 2003 Annual Report on Form 10-K.
Hedge Transactions. 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 our operating revenues.
8
In September 2004, El Paso restated its financial statements for the manner
in which it accounted for certain hedges associated with our anticipated natural
gas production. While the restatement did not directly affect our financial
statements, its effects were that many of the financial instruments that hedge
commodity price risk in our financial statements did not qualify as hedges in El
Paso's consolidated financial statements. We have historically hedged a portion
of our anticipated natural gas and oil production with affiliates of El Paso,
and it has been El Paso's intent that these positions qualify as hedges in El
Paso's consolidated financial statements. As a result, we executed a series of
transactions in order to make our designated hedge relationships consistent with
El Paso's designated hedge relationships following the restatement.
On December 1, 2004, through these transactions, we replaced our existing
hedges on approximately 154 TBtu of natural gas with new hedge transactions at
the same volume and over the same time period. The combination of our original
hedges and the new transactions will not change the average price at which we
are hedged and will not have an impact on our realized prices. As a result,
these transactions will have the same impact on our accumulated other
comprehensive income balances, cash flow and income statement as our original
derivative positions that existed prior to December 1, 2004. However, these
transactions "locked in" a loss of approximately $520 million in accumulated
other comprehensive income that will be recognized in earnings as our original
hedged transactions settle through 2005 and 2006. We have also entered into a
service agreement with El Paso that provides for a reimbursement of 2.5 cents
per MMBtu in 2005 and 2006 for our expected administrative costs associated with
these transactions.
Dividends. During the nine months ended September 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 the manner in which we present amounts provided to
El Paso under its cash management program.
LIQUIDITY AND CAPITAL RESOURCES
LIQUIDITY UPDATE
Our primary sources of liquidity are the cash generated from our internal
operations and advances from El Paso through its cash management program.
Historically, 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 is 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
September 30, 2004, we had receivables from El Paso under the cash management
program of $567 million, of which $169 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. In November 2004, El Paso
entered into a new financing arrangement that extended its existing $3 billion
revolving credit facility. 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 November 2004, Moody's Investors Service changed its outlook on El
Paso's and our senior unsecured notes to stable.
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 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. As a result of the restatements discussed above, our 2003 Annual
Report on Form 10-K and Forms 10-Q for the quarterly periods ended March 31,
2004, June 30, 2004 and September 30, 2004 were not filed within the time
periods specified in our indenture. In July 2004, we entered into an agreement
approved by a majority of the holders of our 7.75% senior unsecured notes which
provided us an extension of time to file these financial statements through
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). With this filing, we are now in compliance with our financial
statement filing requirements.
10
Our cash flows for the nine months ended September 30 were as follows:
<Table>
<Caption>
2004 2003
----- -----
(IN MILLIONS)
Cash flows from operating activities........................ $ 358 $ 471
Cash flows from investing activities........................ (227) (442)
Cash flows from financing activities........................ -- (67)
</Table>
Cash Flows from Operating Activities
Overall, cash generated from our operating activities during the nine
months ended September 30, 2004 decreased by $113 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 $227 million for the nine
months ended September 30, 2004. Our investing activities consisted primarily of
capital expenditures of $348 million, offset by a $121 million collection of
note receivables from El Paso under its cash management program.
Under our current plan, we expect our capital expenditures to be 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 nine months ended September 30, 2004, our total equivalent
production declined approximately 51 Bcfe or 28 percent as compared to the same
period in 2003. This decline was caused by normal production declines and asset
sales in 2003 primarily in Oklahoma, Texas and offshore Gulf of Mexico. We
expect our fourth quarter production to average approximately 410 MMcfe/d and
our full year 2004 production to average approximately 455 MMcfe/d. Our expected
fourth quarter 2004 production levels will be negatively impacted by Hurricane
Ivan that occurred in September 2004 in the Gulf of Mexico. The hurricane caused
us to shut-in production and also caused damage to third party facilities that
process or transport our production. We continue to experience reduced
production levels in our offshore Gulf of Mexico operations as a result of the
damage to third party facilities and do not expect to return to full production
until mid-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. Our unit of production depletion rate was
$1.87 per Mcfe for the third quarter of 2004 and we expect this rate to remain
the same for the fourth quarter of 2004.
PRODUCTION HEDGING
We conduct hedging activities to stabilize cash flows and reduce the risk
of downward commodity price movements on our sales. We conduct these activities
through natural gas and oil derivatives on our natural gas and oil production
with El Paso Marketing. Because our 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.
In September 2004, El Paso restated its financial statements for the manner
in which it accounted for certain hedges associated with our anticipated natural
gas production. While the restatement did not directly affect our financial
statements, its effects were that many of the financial instruments that hedge
commodity price risk in our financial statements did not qualify as hedges in El
Paso's consolidated financial statements.
11
We have historically hedged a portion of our anticipated natural gas and oil
production with affiliates of El Paso, and it has been El Paso's intent that
these positions qualify as hedges in El Paso's consolidated financial
statements. As a result, we executed a series of transactions in order to make
our designated hedge relationships consistent with El Paso's designated hedge
relationships following the restatement.
On December 1, 2004, through these transactions, we replaced our existing
hedges on approximately 154 TBtu of natural gas with new hedge transactions at
the same volume and over the same time period. The combination of our original
hedges and the new transactions will not change the average price at which we
are hedged and will not have an impact on our realized prices. As a result,
these transactions will have the same impact on our accumulated other
comprehensive income balances, cash flow and income statement as our original
derivative positions that existed prior to December 1, 2004. However, these
transactions "locked in" a loss of approximately $520 million in accumulated
other comprehensive income that will be recognized in earnings as our original
hedged transactions settle through 2005 and 2006. We have also entered into a
service agreement with El Paso that provides for a reimbursement of 2.5 cents
per MMBtu in 2005 and 2006 for our expected administrative costs associated with
these transactions.
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 September 30:
<Table>
<Caption>
NINE MONTHS
QUARTER ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------- --------------
2004 2003 2004 2003
----- ----- ----- -----
(IN MILLIONS)
Operating revenues.......................................... $ 168 $ 199 $ 580 $ 736
Operating expenses.......................................... (127) (147) (415) (495)
----- ----- ----- -----
Operating income.......................................... 41 52 165 241
Earnings from unconsolidated affiliates..................... -- -- -- 9
Other expense, net.......................................... -- -- -- (2)
----- ----- ----- -----
EBIT...................................................... 41 52 165 248
Affiliated interest income.................................. 3 3 12 7
Interest expense............................................ (20) (23) (59) (55)
Income taxes................................................ (10) (11) (44) (80)
----- ----- ----- -----
Income from continuing operations........................... 14 21 74 120
Cumulative effect of accounting changes, net of income
taxes..................................................... -- -- -- 1
----- ----- ----- -----
Net income.................................................. $ 14 $ 21 $ 74 $ 121
===== ===== ===== =====
</Table>
12
Below are our operating results and an analysis of these results for the
periods ended September 30:
<Table>
<Caption>
QUARTER ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- ---------------------
2004 2003 2004 2003
-------- -------- --------- ---------
(IN MILLIONS, EXCEPT VOLUMES AND PRICES)
Operating revenues:
Natural gas............................................. $ 137 $ 160 $ 477 $ 604
Oil, condensate and liquids............................. 31 32 102 126
Other................................................... -- 7 1 6
------ ------ ------- -------
Total operating revenues........................ 168 199 580 736
Transportation and net product costs...................... (9) (12) (30) (39)
------ ------ ------- -------
Total operating margin.......................... 159 187 550 697
Operating expenses:
Depreciation, depletion and amortization................ (78) (86) (250) (296)
Production costs(1)..................................... (23) (28) (67) (81)
General and administrative expenses, net of capitalized
cost................................................. (18) (20) (55) (69)
Taxes, other than production and income taxes........... 2 (1) (1) (6)
Restructuring charges................................... (1) -- (12) (4)
------ ------ ------- -------
Total operating expenses(2)..................... (118) (135) (385) (456)
------ ------ ------- -------
Operating income........................................ 41 52 165 241
Earnings from unconsolidated affiliates................... -- -- -- 9
Other expense, net........................................ -- -- -- (2)
------ ------ ------- -------
EBIT...................................................... $ 41 $ 52 $ 165 $ 248
====== ====== ======= =======
Volumes, Prices and Costs per unit:
Natural gas
Volumes (MMcf)....................................... 33,182 43,438 109,542 152,465
====== ====== ======= =======
Average realized prices, including hedges
($/Mcf)(3)......................................... $ 4.13 $ 3.70 $ 4.35 $ 3.96
====== ====== ======= =======
Average realized prices, excluding hedges
($/Mcf)(3)......................................... $ 5.66 $ 5.06 $ 5.76 $ 5.79
====== ====== ======= =======
Average transportation costs ($/Mcf)................. $ 0.24 $ 0.18 $ 0.20 $ 0.19
====== ====== ======= =======
Oil, condensate and liquids
Volumes (MBbls)...................................... 839 1,260 3,225 4,599
====== ====== ======= =======
Average realized prices, including hedges
($/Bbl)(3)......................................... $36.84 $24.66 $ 31.74 $ 27.33
====== ====== ======= =======
Average realized prices, excluding hedges
($/Bbl)(3)......................................... $36.84 $26.03 $ 31.74 $ 28.74
====== ====== ======= =======
Average transportation costs ($/Bbl)................. $ 1.00 $ 1.46 $ 1.38 $ 1.20
====== ====== ======= =======
Production costs ($/Mcfe)
Average lease operating costs........................ $ 0.52 $ 0.41 $ 0.44 $ 0.33
Average production taxes............................. 0.10 0.13 0.08 0.12
------ ------ ------- -------
Total production costs(1).......................... $ 0.62 $ 0.54 $ 0.52 $ 0.45
====== ====== ======= =======
Average general and administrative costs ($/Mcfe)....... $ 0.48 $ 0.39 $ 0.43 $ 0.38
====== ====== ======= =======
Unit of production depletion cost ($/Mcfe).............. $ 1.87 $ 1.59 $ 1.79 $ 1.57
====== ====== ======= =======
</Table>
- ---------------
(1) Production costs include lease operating costs and production related taxes
(including ad valorem and severance taxes).
(2) Transportation and net product costs are included in operating expenses on
our consolidated statements of income.
(3) Prices are stated before transportation costs.
13
Third Quarter 2004 Compared to Third Quarter 2003
EBIT. For the quarter ended September 30, 2004, EBIT was $11 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 expenses.
Operating Revenues. The following table describes the variance in revenue
between the quarters ended September 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............................................. $20 $(52) $ 9 $(23)
Oil, condensate and liquids............................. 8 (11) 2 (1)
--- ---- --- ----
$28 $(63) $11 (24)
=== ==== ===
Other................................................... (7)
----
Total operating revenue variance..................................................... $(31)
====
</Table>
For the quarter ended September 30, 2004, operating revenues were $31
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, and
the impact of Hurricane Ivan.
We also recorded $7 million of mark-to-market earnings in 2003 on
derivatives that no longer qualified for hedge accounting because we sold the
properties in March 2002 that generated the natural gas that these derivatives
were hedging. These derivatives did not impact our operating revenues in 2004 as
they were settled in 2003.
Average realized natural gas prices for the third quarter of 2004,
excluding hedges, were $0.60 per Mcf higher than the same period in 2003, an
increase of 12 percent. In addition, hedging losses relating to our natural gas
hedge positions decreased from $59 million in 2003 to $50 million in 2004. We
expect to continue to incur hedging losses for the remainder of 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 $17 million lower for
the third quarter of 2004 as compared to the third quarter of 2003, primarily
due to lower depreciation, depletion, and amortization expenses and lower
production 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 $8
million in the third 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 $20 million. Partially
offsetting this decrease were higher depletion rates due to higher finding and
development costs which contributed an increase of $11 million.
Production costs decreased by $5 million in the third quarter of 2004 as
compared to the same period in 2003 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 $0.08 per Mcfe in the third quarter of
2004 compared to 2003 as average lease operating costs increased $0.11 per Mcfe
in 2004 primarily due to lower production volumes discussed above.
14
General and administrative expenses decreased by $2 million in the third
quarter of 2004 as compared to the same period in 2003. On a per unit basis, our
general and administrative costs increased $0.09 per Mcfe in the third quarter
of 2004 compared to 2003 primarily due to lower production volumes discussed
above. For the fourth quarter of 2004, we expect our overhead allocations from
El Paso to be approximately the same as the third quarter of 2004.
Nine Months Ended 2004 Compared to Nine Months Ended 2003
EBIT. For the nine months ended September 30, 2004, EBIT was $83 million
lower than the same period in 2003. The decrease is due primarily to lower
production volumes as a result of normal production declines and asset sales.
Partially offsetting these decreases to EBIT were lower operating expenses,
primarily due to lower depreciation, depletion and amortization expenses.
Operating Revenues. The following table describes the variance in revenue
between the nine months ended September 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............................................ $ (4) $(248) $125 $(127)
Oil, condensate and liquids............................ 10 (40) 6 (24)
---- ----- ---- -----
$ 6 $(288) $131 (151)
==== ===== ====
Other.................................................. (5)
-----
Total operating revenue variance.................................................... $(156)
=====
</Table>
For the nine months ended September 30, 2004, operating revenues were $156
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 normal production
declines, particularly in our offshore and south Texas regions, the sale of
properties in 2003 in Oklahoma, Texas, and offshore Gulf of Mexico, and the
impact of Hurricane Ivan.
Average realized natural gas prices for the nine months ended September 30,
2004, excluding hedges, were $0.03 per Mcf lower than the same period in 2003, a
decrease of one percent. However, more than offsetting the decrease in revenues
due to lower natural gas prices were $154 million of hedging losses in 2004 as
compared to $279 million in 2003 relating to our natural gas hedge positions. We
expect to continue to incur hedging losses for the remainder of 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 $71 million lower for
the first nine months of 2004 as compared to the first nine 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 $46
million for the first nine months of 2004 as compared to the same period in
2003. Lower production volumes in 2004 due to normal production declines and
asset sales discussed above reduced our depreciation, depletion, and
amortization expenses by $80 million. Partially offsetting this decrease were
higher depletion rates due to higher finding and development costs which
contributed an increase of $29 million.
Production costs decreased by $14 million for the first nine months of 2004
as compared to the same period in 2003, primarily due to a decrease of $11
million in production taxes resulting from lower production
15
volumes and high cost gas well tax credits in 2004 and decreased lease operating
costs of $3 million. On a per unit basis, production taxes decreased by $0.04
per Mcfe. However, our total production costs per Mcfe increased by $0.07 per
Mcfe for the first nine months of 2004 as compared to 2003 as average lease
operating costs increased $0.11 per Mcfe, primarily due to the lower production
volumes discussed above.
General and administrative expenses decreased by $14 million for the first
nine months of 2004 as compared to the same period in 2003, primarily due to
lower corporate overhead allocations from El Paso. The increase on a per unit
basis was due to lower production volumes. For the fourth quarter of 2004, we
expect our overhead allocations from El Paso to be approximately the same as the
third quarter of 2004.
EARNINGS FROM UNCONSOLIDATED AFFILIATES
Earnings from unconsolidated affiliates for the nine months ended September
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 nine months ended September 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 $566 million for the nine months of 2003 increased to
$627 million in 2004. The average short-term interest rate increased from 1.7%
in 2003 to 2.6% in 2004.
INTEREST EXPENSE
Interest expense for the nine months ended September 30, 2004, was $4
million higher than the same period in 2003. Prior to March 2003, we had no debt
outstanding. For the nine months ended September 30, 2004, we had outstanding
debt for the entire period. As a result, interest expense for the nine months
ended September 30, 2004 was higher than the same period of 2003. However,
partially offsetting this higher interest expense was the effect of a debt
refinancing in May 2003 in which we refinanced notes with an effective interest
rate of 9.75% with 7.75% senior unsecured notes.
INCOME TAXES
<Table>
<Caption>
QUARTER ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------- -----------------
2004 2003 2004 2003
---- ---- ---- ----
(IN MILLIONS EXCEPT FOR RATES)
Income taxes........................................... $10 $11 $44 $80
Effective tax rate..................................... 42% 34% 37% 40%
</Table>
Our effective tax rates for the quarters and nine months ended September
30, 2004 and 2003 were different than the statutory rate of 35 percent due to
the impact of state income taxes. Further impacting the effective tax rate for
the nine months ended September 30, 2003 were additional 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 2004, we have been reviewing our internal controls over financial
reporting as part of our compliance efforts under Section 404 of the
Sarbanes-Oxley Act (SOX), as well as in connection with investigations into
matters that required the restatement of our historical financial statements for
the periods from 1999 to 2002 and the first nine months of 2003. Our SOX review
is being performed consistent with the guidance for independent auditors
established by the Public Company Accounting Oversight Board in Auditing
Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed
in Conjunction with an Audit of Financial Statements. The project has entailed
the 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, financial management responsible for those
processes internally reviewed or "walked-through" these financial 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 involves testing the controls, including
a review and inspection of the documentation supporting the operation of the
controls on which we are placing reliance.
During our reviews, we identified a number of deficiencies in our internal
controls over financial reporting that we determined were material weaknesses in
our internal control structure. These deficiencies, which we have previously
disclosed, generally involved the control environment, information system
access, documentation and application of generally accepted accounting
principles, and deficiencies related to segregation of duties, account
reconciliations and change management over information systems. Our management,
with the oversight of El Paso's Audit Committee, has devoted considerable effort
to remediating the material weaknesses identified, and has made improvements in
our internal controls over financial reporting to address these weaknesses.
Specifically, in the quarter ending September 30, 2004, we implemented new
controls to improve our account reconciliation process, improve segregation of
duties and strengthen information system change management processes. We believe
that we have remediated the deficiencies in our internal controls related to all
of the material weaknesses previously identified. However, we continue to test
to determine whether the remediated controls are operating effectively. We
expect to complete this testing by early February 2005. We are currently
finalizing a framework upon which we will evaluate and classify the significance
of deficiencies identified in our testing process. This is an area that involves
judgment, and where interpretation and guidance continue to evolve. At this
time, we have identified a number of deficiencies and areas where we can improve
our internal controls. Following the completion of our testing procedures, we
will assess whether there are any remaining material weaknesses, represented by
either individually material deficiencies or an aggregation of significant
deficiencies.
Our disclosure controls and procedures are designed to provide reasonable
assurance that information required to be disclosed in our reports filed under
the Securities Exchange Act of 1934 is recorded, processed, summarized and
reported within the time periods specified in the SEC rules. Our disclosure
controls and procedures are also designed to ensure that such information is
accumulated and communicated to our management to allow timely decisions
regarding required disclosure. Because we have not completed the testing of many
of the processes and controls intended to remediate the control deficiencies
identified in our reviews and of internal controls, we were unable to conclude
that our disclosure controls and procedures were effective as of September 30,
2004. However, we did perform additional procedures to ensure that our
disclosure controls and procedures were effective over the preparation of these
financial statements.
18
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.
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: December 15, 2004 /s/ D. Mark Leland
--------------------------------------
D. Mark Leland
Executive Vice President,
Chief Financial Officer
and Director
(Principal Financial Officer)
Date: December 15, 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>