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El Paso


investors have a new reason to hitthe ceiling.

The company slashed its proved reserves -- andannounced yet another so-called ceiling testcharge -- after the market closed on Tuesday.Following an extensive third-party audit, the companyannounced a 41% cut in reserves that stunned all butthe gloomiest bears. The writedown also triggered a $1billion charge --

just thelatest in a series tied to underperforming assets -- that could be followed by evenbigger charges down the road.

Although El Paso had previously warned about a"material" hit to its reserves, the actual revisionproved even worse than many worst-case scenarios. Thesetback shows the risks of investing in a recoveryplay like El Paso, which just last month surged to a52-week high as Wall Street bet the company had shakenoff the missteps of the discredited former management.

"This was the most dramatic reserve revision thatwe have witnessed in our 15-plus-year career ofresearching the integrated natural gas/powercompanies," wrote Prudential analyst Carol Coale, whohas a neutral rating on El Paso's stock. "This time,those that were circulating a feared 2 Tcfe

trillioncubic feet of equivalent negative reserve revisionappeared to have the edge."

The market, looking for a reduction about halfthat size, instead learned that El Paso's provedreserves had fallen 1.8 Tcf to 2.6 Tcf during aconservative third-party audit. Only the most bearishanalysts had predicted such a big hit. Scott Soler ofMorgan Stanley -- who has a negative outlook on theentire merchant energy sector -- said El Paso'smassive writedown was "in line with

his expectationof 1.7 tcf or higher." But he also raised questionsabout the need for such a huge writedown with fuelprices so high.

The writedown "suggests to us that priormanagement had significantly overstated the productivecapacity of the company's gas reserves," wrote Soler,who has an underweight rating on the stock. And "thewritedown would be -- and still likely will be --much more significant should natural gas pricescorrect to more normal levels."

In the meantime, Soler warned of otherdisappointments to come. For starters, he doubts thatEl Paso can keep its promise to hit existingproduction targets after the material cut in reserves.He also questions whether the company can earn evenhalf the profits -- projected at 75 cents to $1.10 ashare -- it expects to deliver on an ongoing basis.

Energy giant slips

"Until the stock trades below $5 -- andwe develop more confidence in El Paso's ability toearn more than 35 cents to 40 cents in EPS andgenerate positive free cash flow -- we will likelyremain cautious on the stock," Soler stated.

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Soler predicted that El Paso could shed between $3and $5 a share in the coming weeks alone. The stockwas down 8.5% to $8.01 late Wednesday morning.

Coastal Waves

To be fair, many investors were looking for a bigwritedown of El Paso's reserves in south Texas and theGulf of Mexico. However, they viewed El Paso'sremaining reserves -- particularly its coal bedmethane assets -- as safely valued. But those assets,expected to play a crucial role in El Paso's recovery,accounted for more than one-quarter of Tuesday's hugerevision.

Coale said El Paso had "prematurely booked" thecoal bed methane reserves before securing necessarypermission to develop the assets. But she expressedgreater concern about the remaining writedowns. Inparticular, Coale cited a number of letdowns -- suchas depletion rates, low production, well failures andseismic misinterpretations -- associated with formerCoastal assets the company has failed to exploit.

"The most disconcerting factor in El Paso'sreserve revision to us is that the majority of thedestroyed value was performance-related," she wrote."In hindsight, it appears El Paso's acquisition ofCoastal Corp. -- and its prized South Texas andoffshore reserves -- was not a great fit once thecompany lost its flexible access to capital."

The ceiling test charges are an ongoing issue atEl Paso in part because of the company's accounting.Many major energy companies use "successful efforts"accounting, which requires them to expenseexploration-and-production losses at the time theyoccur. But some, including El Paso, avoid that hit toearnings by using the full-cost method, which allowsthem to capitalize expenses -- at the risk of massivewritedowns if fuel prices decline.

Looking ahead, El Paso could find it even tougherto fund its drilling program. Standard & Poor's quickly downgraded El Paso's credit, potentially raising the company's borrowing costs, after Tuesday's drastic cut in reserves. S&P now rates the company's credit at B-minus -- barely above the C category known for default risks -- and warned that further cuts could follow.

"The negative outlook reflects the daunting obstacles El Paso faces through 2006, as it attempts to achieve its reorganization plan," S&P stated. "Falling short on any of the plan's components or further weakness in the company's ability to produce operating cash flow from its core businesses could lead to lower ratings."

In the meantime, the company has alreadylost some crucial outside support for its drillingprogram. The first of two financial partners recentlyhalted funding for joint-venture projects that offeredEl Paso an affordable way to pursue drillingopportunities.

JP Morgan analyst Anatol Feygin is worried.

"We find this news particularly distressing sincethe $500 million in gross cap-ex to be spent betweentwo JVs offered El Paso the opportunity to exploitwhat were supposed to be 'low-hanging' prospects,"wrote Feygin, who has a neutral rating on the stock."Given the disappointing results at one of the JVs, wequestion whether the company will be able to pursuesimilar arrangements going forward."

Getting Drilled

In the meantime, Coale noted, El Paso facessignificantly higher drilling costs than most of itsindustry peers -- a drag that should continue forseveral years. As a result, Coale predicted that ElPaso's drilling program could face additionalslowdowns going forward.

Similarly, Soler insisted that El Paso'sproduction goals remain too optimistic. But at leastone Wall Street analyst decided to be upbeat. JohnEdwards of Deutsche Bank still believes that El Pasocan meet its production targets.

"Given El Paso's track record the last few years,one could argue that the proposition still posessignificant risk," wrote Edwards, who kept his buyrecommendation on the stock intact. "But at thisjuncture, the proposition strikes us as reasonable."

Even Coale, who slashed El Paso's target pricefrom $9 to $6, offered a few words of encouragement.

"In the company's defense, it is literallypursuing an 'out with the old, in with the new'strategy regarding its current management structure,and we cannot fault the new team with old mistakes,"she wrote. But "while we are inclined to believe thatEl Paso really has put the worst behind them -- thistime -- we admit with humility that we have writtenthis in research reports before."