Nov. 26, 2002 — Moody’s Investors Service downgraded the debt ratings of El Paso Corporation (EP, senior unsecured debt from Baa3 to Ba2) and its subsidiaries. Moody’s also assigned a senior implied rating of Ba1 to EP. The rating outlook is negative.
The downgrades reflect: 1) EP’s weak cash flows and uncertain prospects for their improvement in the near term; 2) debt levels that remain high relative to the company’s cash flows, despite sizable retirements and repayments this year; 3) the likelihood that capital expenditures will continue to exceed cash flow from operations and that the company will rely on asset sales to meet the shortfall and to further reduce its debt; and 4) execution risks related to EP’s efforts to scale back and refocus its merchant energy activities, including exiting energy trading, consolidating the power business of its Electron affiliate, divesting its petroleum businesses, and furthering its LNG strategy.
The rating differential between EP’s Ba2 senior unsecured and Ba1 senior implied ratings indicates the structural subordination of the holding company debt to a substantial amount of subsidiary debt.
The negative outlook reflects the uncertainties related to the pending ruling by the Federal Energy Regulatory Commission (FERC) regarding the alleged exercise of market power and violations of marketing affiliate rules and other FERC regulations.
While the ultimate impact of these proceedings will not be known for some time, they could potentially bring about other litigation and proceedings that negatively affect EP’s financial position, liquidity, or business operations and lead to a rating action. EP and its subsidiaries are also subjects of numerous government investigations and lawsuits that potentially could have material impact.
The ratings consider potential calls on cash as a result of the effects of collateral calls, ratings triggers, and other demands on liquidity that may result from the downgrade. The estimates of cash calls used in our analysis are based on estimates provided to us by EP’s management.
Moody’s notes that stress liquidity is very difficult to estimate, and that few merchant energy companies have been able to furnish accurate estimates regarding potential calls on cash. The negative outlook reflects the possibility that the ratings could be adjusted downward if actual liquidity requirements prove much higher than EP’s expectations.
EP’s cash flow-to-debt measures remain weak. For the nine months ended September 30, its annualized retained cash flow-to-debt (adjusted to include minority interest obligations, operating leases, letters of credit, guarantees related to debt and other activities, and commitments under its LNG time charter agreements) was roughly 7% after changes in working capital and price risk management activities and about 4% before changes in working capital changes and price risk management activities.
The slight improvement in third quarter cash flows over the depressed levels in the first half of this year was due to positive working capital changes from returns of margin payments and other items that fluctuate over time.
Cash usage patterns for working capital and price risk management may change as EP exits energy trading. Although price risk management activities consumed substantial cash this year, it is unclear how the exit would affect future working capital patterns, as about $800 million of such working capital usage so far this year was related to hedging E&P production.
E&P remains a core activity for EP, and it is uncertain how much working capital may be required in hedging gas production in the future, although the company is reducing the proportion of its hedged production.
EXECUTION RISKS IN MODIFYING MERCHANT ACTIVITIES
EP has deemed as its core businesses the vertically integrated natural gas operations (pipeline, E&P, field services) that make up its relatively predictable non-merchant activities. Going forward, pipelines and E&P are together expected to generate well over 90% of EP’s “core” EBITDA, with field services accounting for the balance.
With the prospects for merchant energy likely to remain difficult for some time, EP is shifting away from many of the merchant activities that were its growth engines of the past few years. These shifts include exiting the energy trading business through the formation of Travis Energy, a bankruptcy-remote entity that will serve as the liquidating vehicle for most of EP’s trading contracts. There is significant execution risk in establishing such an entity, which is the first of its kind.
In the first quarter of 2003, EP will consolidate its Electron affiliate, which has been its vehicle to grow its domestic power business. EP has an extensive power portfolio, and the earnings from it will comprise most of its merchant energy business in the near future. There is an element of repeatability in fees received under long-term power supply contracts.
However, some variability in cash flow may come from its few merchant plants, ongoing contract restructuring activities, and asset sales. Event risk also exists as EP considers strategic alternatives for its power assets. While a substantial amount of debt will be consolidated onto EP’s balance sheet, Moody’s recognizes that much of it is project finance debt that is non-recourse to the company.
Petroleum and other businesses have posted heavy losses this year, and many of the related assets will likely be divested. The timing of such sales, as well as the financial impact of the businesses prior to sale, are uncertain. EP retains numerous joint ventures in telecom, international power, and other businesses, and these may be subject to impairments.
It may take some time to exit many of these investments given difficult industry conditions, volatile capital markets, and a glut of energy and other assets being sold by other companies. LNG is a growth business, which will take some time to develop. The company will incur upfront costs and debt obligations until this business begins to generate revenues.
Given a capital spending program that will likely exceed cash flows and a significant amount of upcoming debt maturities, EP will continue to need asset sales to supplement its liquidity. Access to the capital markets at favorable terms is uncertain given the current volatility, and may continue to be difficult until there is a favorable resolution to the FERC proceedings. The company has paid off all its commercial paper and has about $1 billion of cash available as a liquidity cushion.
The company has a $3 billion 364-day bank facility expiring in May 2003 and a $1 billion term loan expiring in August 2003. The 364-day facility has a one-year term-out option, which, if exercised, could potentially provide liquidity through May 2004. EP has approximately $2 billion of maturing debt in 2003, $1 billion of which is the Electron debt due in March. The company is concentrating its asset sales efforts in this quarter and the next in order to prefund the retirement of the Electron debt.
The company expects to have sold almost $4 billion of asset sales by year-end, and plans to sell $2 billion more in 2003 to repay debt and to supplement its operating cash flows. EP draws financial flexibility from a large base of tangible assets that potentially could be sold, as well as from a highly discretionary capex program that can be scaled back if necessary.
In addition to assigning a senior implied rating of Ba1 to El Paso Corporation, Moody’s changed the company’s ratings as follows:
El Paso Corporation – Senior unsecured debt from Baa3 to Ba2, bank credit facility from Baa3 to Ba2, subordinated from Ba1 to Ba3, senior unsecured shelf from (P)Baa3 to (P)Ba2, subordinate shelf from (P)Ba1 to (P)Ba3, preferred shelf from (P)Ba2 to (P)B1, commercial paper from Prime-3 to Not Prime;
El Paso CGP Company – Senior secured from Baa2 to Baa3, senior unsecured from Baa3 to Ba2, subordinated from Ba1 to Ba3;
ANR Pipeline Company – Senior unsecured from Baa2 to Ba1, long-term issuer rating from Baa2 to Ba1;
Colorado Interstate Gas Company – Senior unsecured from Baa2 to Ba1, long-term issuer rating from Baa2 to Ba1;
Coastal Finance I — Trust preferred stock from Ba1 to Ba3;
El Paso Natural Gas Company – Senior unsecured from Baa2 to Ba1, long-term issuer rating from Baa2 to Ba1, commercial paper from Prime-3 to Not Prime;
El Paso Tennessee Pipeline Co. – Senior unsecured from Baa3 to Ba2, preferred stock from Ba2 to B1, senior unsecured shelf from (P)Baa3 to (P)Ba2, preferred shelf from (P)Ba2 to (P)B1;
Tennessee Gas Pipeline Company – Senior unsecured from Baa2 to Ba1, commercial paper from Prime-3 to Not Prime;
Sonat Inc. — Senior unsecured from Baa3 to Ba2;
Southern Natural Gas Company – Senior unsecured from Baa2 to Ba1;
El Paso Energy Capital Trust I — Trust preferred stock from Ba1 to Ba3;
El Paso Capital Trust II — Shelf from (P)Baa3/(P)Ba1 to (P)Ba2/(P)Ba3;
El Paso Capital Trust III — Shelf from (P)Baa3/(P)Ba1 to (P)Ba2/(P)Ba3;
Limestone Electron Trust – Senior unsecured guaranteed notes from Baa3 to Ba2;
Gemstone Investor Limited – Senior unsecured guaranteed notes from Baa3 to Ba2.
Based in Houston, Texas, El