El Paso Takes Aim at Past Abuses

The energy company says current management isn't implicated in improper reserve bookings.
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El Paso

(EP)

has been talking big for years.

Since 1999, an internal audit found, the giant energy company has misled investors about the true value of its exploration-and-production assets. El Paso began overestimating its proved reserves -- or the energy it expects to commercially produce -- during a period of rapid growth that included two major acquisitions and transformed the company into a powerful E&P player. The aggressive bookings apparently ended only after the company replaced its top two production leaders late last year.

Now, El Paso is officially blaming former staffers for the massive 41% writedown in proven reserves that rattled the market --

and sent the company's shares spiraling -- less than three months ago.

"The review ... has found that, during the period from the beginning of 1999 through the end of 2003, certain employees used aggressive and, at times, unsupportable methods to book proved reserves," El Paso stated on Monday. "As announced earlier, investors should not rely on previously filed

financial reports."

The company said it plans to file its delayed first-quarter and 2003 financial reports, along with restatements for prior years, "as soon as possible." In the meantime, it has cleared current management of any wrongdoing. And it has announced no additional charges -- beyond a previously disclosed $1 billion hit -- as some in the market had feared.

After Monday's announcement, Goldman Sachs analyst David Maccarrone said he saw no new cause for alarm.

"We do not believe many investors will be surprised," wrote Maccarrone, who has a neutral recommendation on El Paso's stock. "Based on our view that El Paso's key issues are debt reduction and E&P production, we believe concerns about significant negative disclosures from the 10-K filing are overstated."

Some had warned that El Paso could face additional writedowns, totaling billions of dollars, if natural gas prices began to fall. But Lehman Brothers analyst Richard Gross noted last week that gas prices have remained "surprisingly resilient" since El Paso first recalculated its reserves in mid-February.

Still, investors were jittery on Monday. They pushed El Paso's stock down 2.1% to $6.86 in the morning session.

Growth Spurt

According to Monday's announcement, El Paso employees started issuing proved reserve estimates "that they knew or should have known were incorrect" around the time that El Paso set out to become the "pre-eminent natural gas company in North America."

In early 1999, El Paso announced that it was acquiring Sonat -- a company with a history of E&P writedowns of its own -- in a $6 billion transaction. It tapped Sonat CEO Ronald Kuehn, who had presided over the company's downturn, as its temporary nonexecutive chairman. It later rehired Kuehn to become its new "lead director," just ahead of a

historic proxy fight that nearly unseated the company's entire board last year.

On Monday, Kuehn said the independent review had found current management, at least, guilty of no wrongdoing.

"El Paso's board of directors fully accepts the findings of the independent review," Kuehn stated. "This process is an important milestone for all stakeholders, as we take the necessary steps to ensure the integrity of the company's reserve reporting process."

El Paso went on to list a series of new controls that "are either in place or being implemented at the company." It also pointed out that it has already replaced three crucial members of its senior management team -- the CEO and two production executives -- in an effort to restore the company's reputation.

Last year, El Paso hired former

Halliburton

(HAL) - Get Report

executive Doug Foshee to become its turnaround CEO. It also snagged respected

Apache

(APA) - Get Report

production chief Lisa Stewart to rebuild the struggling division formerly led by an executive inherited through yet another El Paso acquisition.

Coastal View

Just a week after reporting dismal third-quarter production results last year, El Paso abruptly announced that Rodney Erskine was

stepping down as leader of the company's E&P unit.

Erskine came to El Paso through a big 2000 merger with Coastal, where he had scored accolades for doubling the company's proved reserves and average daily production. But some of Coastal's E&P assets are now targeted for writedowns.

Shortly after El Paso dropped its writedown bombshell on the market earlier this year, Prudential analyst Carol Coale fretted over the underperforming Coastal assets.

"The most disconcerting factor in El Paso's reserve revision to us is that the majority of the destroyed value was performance-related," Coale wrote. "In hindsight, it appears El Paso's acquisition of Coastal Corp. -- and its prized South Texas and offshore reserves -- was not a great fit once the company lost its flexible access to capital."

Coastal was founded by legendary oilman Oscar Wyatt, who helped

steer the dissidents in last year's fight to oust El Paso's leadership. Wyatt is currently the lead shareholder in a class-action securities lawsuit pending against the company. But Selim Zilkha, the energy executive who formally led the proxy fight, has sold his massive stake in the company. Once El Paso's largest individual shareholder, Zilkha liquidated most of his position after last summer's losing proxy battle. He went on to sell the rest of his stock, the

Associated Press

reported, after El Paso announced its huge writedown in reserves.

News of the revision pushed El Paso's stock from around $9 -- where it was approaching a 52-week high -- to its current level of roughly $7 a share. Gross estimated El Paso's fair value at halfway between those two points, at $8, just ahead of Monday's news. He sees both progress and challenges when reviewing the company.

"From what we can see, management has done an admirable job in executing on the asset sale program and appear to be ahead of schedule in their efforts to raise cash for debt reduction," wrote Gross, who has an equal-weight rating on El Paso's shares. "But we still need to cross more t's and dot more i's. ... We are hopeful that some clarity will surface with the filing of El Paso's 10-K, which we expect sometime in May."