Last summer,

El Paso

(EP)

constructed a specialpurpose entity that, in recent weeks, executed a series of transactions that essentially doubled the company's first-quarter earnings.

The entity, called Utility Contract Funding, orUCF, has no employees. It has no assets. Though ittechnically exists to sell electricity, it appears tofunction primarily as an accounting mechanism.

To date, UCF has yet to be officiallyadded to El Paso's growing list of off balance sheetaffiliates. (The latest list, published in El Paso's2001 annual report, stretches for 33 pages, havingdoubled in the past two years.)

At a time when many companies are trying tosimplify their businesses and their books, the UCFdeal illustrates El Paso's increasing reliance onaccounting vehicles that are even more complex thanthe industry norm. And it raises questions about howmuch that accounting -- rather than cash flow fromoperations -- is contributing to El Paso's bottomline.

The questions come at a time when El Paso shares have already lost more than 80% of their value in less than a year. The sustained selling continues as investors lose their dwindling confidence in an energy-trading sector under intense scrutiny by regulators and Justice Department investigators.

Confusing

To be fair, El Paso readily admits thattransactions like the recent UCF deal are complicated,confusing and far from common in the industry.

The company says it's virtually alone in itspursuit of -- and success with -- such transactions,making any comparison to its peers virtuallyimpossible. But in a nutshell, here's what makes thedeals both possible and attractive for El Paso.

Nearly a quarter-century ago, Congress set out tofuel new power plant construction by passing thePublic Utility Regulatory Policies Act of 1978. Inhindsight, many say, the law -- thoughwell-intentioned -- was flawed. Passed amid anationwide energy crisis, PURPA required publicutilities to lock in 20-year contracts with new powergenerators at prices that can now significantly exceedcompetitive market rates.

Enter the likes of El Paso. When El Paso acquiredCoastal last year, it inherited a $2.36 billion PURPAcontract with PSE&G, a New Jersey-based utility. Thatcontract was expected to generate profits of $1.6billion -- or about $100 million annually -- over thenext 15 years. But El Paso presented a so-called"win-win" proposal to PSE&G. Its subsidiary UCF wouldpay PSE&G an upfront fee of $102.4 million that theutility could pass on to its customers as savings. Inreturn, El Paso would receive an estimated cash infusion of$670 million -- the sum value of its new PURPAcontract with PSE&G.

Oscar Wyatt, Coastal's former chairman and ElPaso's largest individual shareholder, loudlycomplained.

"It is discounting its future earnings to reportcurrent earnings. ... This is particularly dangerousfor this corporation, as its management has publiclyannounced its plans to do more of these types oftransactions," Wyatt stated in a letter circulatedthis month to El Paso directors, lawmakers and federalregulators.

El Paso fiercely defended the business maneuver,saying the large cash injection will be used to paydown debt and pursue higher-return investments that,in the end, will leave the company stronger.

But for now, the impact to reported earnings isalready clear. During the first quarter of 2002, ElPaso's merchant energy segment delivered higher EBITthan any other segment.

Roughly 75% of those earnings stemmed from PURPArestructuring opportunities similar to the UCF deal.Without the PURPA deals, El Paso would have seen itsoverall EBIT shaved by nearly half.

And as Wyatt lamented, investors can expect thisreliance on PURPA deals to continue.

"The company continues to enjoy a high level ofactivity in this area and a substantial backlog ofadditional opportunities," El Paso said in itsfirst-quarter press release.

Concern

El Paso critics are not impressed.

"The company is seeking out these power plantswith lucrative contracts, then stripping away thecontracts to enhance current cash flow," one said.

Earlier this summer, bond analysts at SalomonSmith Barney also expressed concern about thisactivity. To begin, they criticized El Paso's ongoingreliance on merchant energy, which is expected togenerate one-fourth of the company's EBIT goingforward. They also noted, as revealed in El Paso's ownearnings release, that this segment's EBIT is"generated almost entirely through the restructuringof power purchase agreements," which are expected tocontribute at least $500 million in upcoming earnings.

"We view the PURPA restructuring as financingactivity, not operating cash flow," the report states.

But the analysts reserved their sternest criticismfor El Paso's heavy dependence on off balance sheetfinancing vehicles -- including those used in thecompany's PURPA restructuring deals.

Like many El Paso affiliates, UCF has a complexand somewhat mysterious ownership structure.

The entity is partly owned by El Paso itself. Theother part is owned by Mesquite Investors, which isindirectly owned by El Paso and Limestone ElectronTrust, another El Paso affiliate.

UCF is representative of numerous El Paso entitieswhose controlling ownership -- and thus ultimateresponsibility for debt -- is unclear.

Questioned repeatedly for a week, El Paso late Thursday finally issued a general defense of its PURPA restructuring business but left many detailed questions unanswered.

Critics were immediately suspicious.

"My hunch is that a number of these partnershipslisted off the balance sheet are special-purposeentities whose primary function is to keep debt off ofEl Paso's balance sheet," said Peter Cohan, aMassachusetts author and investment strategist with nofinancial stake in the stock.

By shifting more debt to its balance sheet, ElPaso would seriously jeopardize its investment-graderating, Cohan said.

In their June research note, the Salomon SmithBarney analysts warned of such a risk.

"El Paso is heavily leveraged with mediocrecoverage ratios (using both our and the company'scalculations) and has significant off balance sheetobligations and contingent liabilities," the reportstates.

The report goes on to indicate that El Paso hasbeen rewarded with an investment-grade rating that itprobably doesn't deserve. It concludes by stating: "Webelieve that El Paso has been granted significantlymore leeway than virtually all of its competitors."

Defenders

Standard & Poor's, for one, stood behind El Paso-- and its crucial investment-grade rating -- in thewake of this week's selloff, citing significantenhancements to the company's balance sheet.

Mark Easterbrook, an equity analyst at RBC CapitalMarkets, doesn't buy the recent criticism, either.

He acknowledges that energy trading has become oneof the riskiest sectors in the stock market. But heconsiders El Paso one of the less risky stocks of thebunch.

At the same time, he laments the lack ofcomprehensive information -- like that provided toratings agencies -- that could better shape hisanalysis.

"Companies divulge a lot of nonpublic informationto debt rating agencies that nobody else gets to see,"Easterbrook said. "We need to change the system sothat everybody gets better information."

Easterbrook, who doesn't own the stock, rates ElPaso outperform with an average risk rating.

John Olson, an analyst at Sanders Morris Harriswho does own the stock, rates El Paso an even higherstrong buy.

Both analysts acknowledged that El Paso carriesoff balance sheet liabilities but described them asfar less dangerous than the ones that toppled

Enron

.

"They do have some partnerships structuredsimilarly to the ones at Enron," Easterbrook admitted."But El Paso's assets are a lot more stable."

The company rushed to agree.

"We have hard assets -- including the largestpipeline system in North America," an El Pasospokesman said. "What did Enron have, except onepipeline and a bunch of trading?"

A CSFB analyst who didn't downgrade Enron until it was in the pennies has a

strong buy rating

on the stock.

Return of the JEDI

Actually, Enron had a financial stake in some ofEl Paso's very own subsidiaries.

El Paso's latest annual report lists Enron's JointEnergy Development Investments -- the infamous JEDI --entities as part owners in several El Pasoco-generation subsidiaries. It also reveals El Paso'sown stake in several JEDI partnerships.

After Enron filed for bankruptcy, one ElPaso-controlled JEDI partnership promptly changed itsname to East Coast Power Camden. Another El Paso-Enronventure, East Coast Power Holding, provides a rareglimpse into the murky world of off balance sheetaffiliates. A clear minority, this entity is requiredto file paperwork with the

Securities and ExchangeCommission

.

Cohan points to a December 2000 SEC filing withparticular alarm.

"It basically says that East Coast Power -- whichis mostly owned by El Paso and to some extent by Enron-- is selling an asset to Mesquite Investors, which ElPaso controls," Cohan said. "Simply put, this is asham transaction designed to shift the assets and therelated debt off of El Paso's books, even though ElPaso controls it."

Cohan also speculated at the reasons behind theJEDI name change.

"El Paso probably didn't want to be associatedwith Enron," he said. "It's what former Enronchief Jeffrey Skilling used to call'optics.'"

"When something doesn't look good, you just takeit away."