EL PASO PRODUCTION HOLDING CO - 10-K Annual Report

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-K

(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003

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

EL PASO PRODUCTION HOLDING COMPANY
(Exact name of Registrant as Specified in Its Charter)

DELAWARE 76-0659544
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)

EL PASO BUILDING 77002
1001 LOUISIANA STREET (Zip Code)
HOUSTON, TEXAS
(Address of Principal Executive Offices)

TELEPHONE NUMBER: (713) 420-2600

SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE

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 if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [ ] No [X].

STATE THE AGGREGATE MARKET VALUE OF THE VOTING AND NON-VOTING COMMON EQUITY
HELD BY NON-AFFILIATES OF THE REGISTRANT.

None.

INDICATE THE NUMBER OF SHARES OUTSTANDING OF EACH OF THE REGISTRANT'S
CLASSES OF COMMON STOCK, AS OF THE LATEST PRACTICABLE DATE.

Common Stock, par value $1 per share. Shares outstanding on September 30,
2004: 1,000

DOCUMENTS INCORPORATED BY REFERENCE: NONE

EL PASO PRODUCTION HOLDING COMPANY

TABLE OF CONTENTS

Below is a list of terms that are common to our industry and used throughout
this document:

/d = per day
Bbl = barrels
BBtu = billion British thermal units
Bcf = billion cubic feet
Bcfe = billion cubic feet of natural gas
equivalents
MBbls = thousand barrels
Mcf = thousand cubic feet
Mcfe = thousand cubic feet of natural gas
equivalents
MMBbls = million barrels
MMBtu = million British thermal units
MMcf = million cubic feet
MMcfe = million cubic feet of natural gas
equivalents
Tcfe = trillion cubic feet of natural gas
equivalents

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

RESTATEMENT OF HISTORICAL FINANCIAL INFORMATION

In February 2004, we completed the December 31, 2003 reserve estimation
process of our proved natural gas and oil reserves. The results of this process
indicated that a significant downward revision to our proved reserve estimates
of 0.9 Tcfe was needed. In August 2004, we also determined that the accounting
for two derivative transactions entered into with El Paso Merchant Energy, L.P.,
(El Paso Merchant Energy), a wholly-owned subsidiary of El Paso Corporation (El
Paso), our parent, to hedge our anticipated natural gas production during 2000
and 2002 had not been properly applied. After investigations into the factors
that caused these issues, we determined that a material portion of the downward
reserve revisions should be reflected in historical periods and that the
historical accounting for the two production hedge transactions should be
corrected. Accordingly, we have restated our historical financial information
for the years from 1999 to 2002 and for the first nine months of 2003.

In the restatement for our reserve revisions, an investigation determined
that certain personnel used aggressive, and at times, unsupportable methods to
book proved reserves. In some instances, certain personnel provided historical
proved reserve estimates that they knew or should have known were incorrect at
the time they were reported. The investigation also found that we did not, in
some cases, maintain adequate documentation and records to support historically
booked proved natural gas and oil reserves.

In August 2004, El Paso announced that it would be required to further
restate its historical financial statements for the manner in which it accounted
for hedges of its natural gas production and other hedging transactions. We have
historically hedged a significant portion of our anticipated natural gas
production with El Paso Merchant Energy and as part of El Paso's restatement,
the transactions we conducted with El Paso Merchant Energy were evaluated for
their proper accounting. While substantially all of the hedge transactions we
entered into with El Paso Merchant Energy continue to qualify as hedges given
our status as a separate registrant from El Paso, we identified two derivatives
that were not entered into at observable market prices and therefore not
properly accounted for at their fair market value at the time they were
initially entered into and subsequently settled. Both derivatives were entered
into in 2000, and were originally accounted for as hedges. The first transaction
settled during 2000 resulting in a gain of $6 million. The second transaction
settled during 2002 resulting in a loss of $4 million. Upon determining that an
adjustment was required, we restated our historical financial statements to
adjust the value of the transactions to their fair market value at their
inception, and adjust each accounting period for the impacts of this adjustment
through the date of settlement.

As a result of these conclusions, we restated our historical proved natural
gas and oil reserve estimates, the financial information derived from those
estimates, and the financial information related to our historical accounting
for the two hedge transactions for the periods from 1999 through 2002 and the
nine months ended September 30, 2003. The total cumulative impact of these
restatements was a reduction of our previously reported stockholder's equity as
of September 30, 2003 of approximately $387 million. The cumulative impact
related solely to the restatement of our historical reserve estimates, as the
restatement for the hedging matter had no overall impact on total stockholder's
equity during the restatement period. The restatements had no impact on our
overall cash flows. However, we have reclassified amounts in our historical
statements of cash flows to reflect amounts provided to El Paso under its cash
management program as investing activities instead of financing activities. For
further discussion of the cash management program, see Part II, Financial
Statements and Supplementary Data, Note 11. These restated amounts have been
reflected only in this Annual Report on Form 10-K, and we did not revise the
financial statements included in our registration statement on Form S-4 for the
impacts of the restatements. Consequently, you should not rely on historical
information contained in those prior filings since this filing replaces and
revises those historically reported amounts.

For a further discussion of the impact of the restatements on our selected
financial information, see Part II, Item 6, Selected Financial Data; for a more
detailed discussion of the factors leading to the restatements, the restatement
methods used and the financial impacts of the restatements, see Item 8,
Financial Statements and Supplementary Data, Note 1; and, for a discussion of
control weaknesses that contributed to these issues and changes we have made or
are in the process of making to our control procedures, see Item 9A, Controls
and Procedures.

1

PART I

ITEM 1. BUSINESS

GENERAL

We are a Delaware corporation formed in 1999 as a wholly-owned direct
subsidiary of El Paso. We are engaged in the exploration for, and the
acquisition, development and production of natural gas, oil, condensate and
natural gas liquids. We operate primarily in Alabama, Louisiana, New Mexico,
Oklahoma, Texas and the Gulf of Mexico. During 2003, daily production exceeded
600 MMcfe/d, and our proved reserves at December 31, 2003, were approximately
1.5 Tcfe.

As part of El Paso's Long-Range Plan announced in December 2003, we will
focus on developing production opportunities from our asset base, which is
solely in the United States. We own 1.5 Tcfe, or 58 percent, of El Paso's
overall 2.6 Tcfe of proved reserves. Our strategy emphasizes a disciplined
capital investment approach, focused on maximizing volumes, minimizing costs and
optimizing cash flow per unit produced.

In June 2004, we announced a back-to-basics plan for our business. This
plan emphasizes strict capital discipline designed to improve capital efficiency
through the use of standardized risk analysis, a heightened focus on cost
control, and a rigorous process for booking proved natural gas and oil reserves.
This back-to-basics approach is expected to stabilize production by improving
the production mix across our operating areas and generate more predictable
returns.

Our operations are divided into three areas: onshore, offshore and coal
seam. The onshore area includes operations in two regions: Texas and Central.
The Texas region includes our operations along the Texas Gulf Coast. Our major
fields in the Texas region include North Monte Christo and Samano. The Central
region includes our operations in north Louisiana. Our major fields in the
Central region include Holly, Bear Creek, North Shongaloo, Ada/Sibley/West
Bryceland, and King's Dome. The offshore area includes our interest in the Gulf
of Mexico primarily in state and federal waters along the coast of Texas and
Louisiana. Our major fields in the offshore area include South Timbalier
189/204, Ewing Bank 1003, East Cameron 81/84, Jim Bob Mountain and Mound Point,
West Delta 137, and West Cameron 46/47. The coal seam area consists of
operations in the Black Warrior basin in Alabama, the Arkoma basin in eastern
Oklahoma and the Raton basin in Colorado and New Mexico. Our major fields in the
coal seam area include White Oak Creek, Short Creek, Blue Creek West, Brookwood,
Oklahoma, and Vermejo Park Ranch. In each of our operating areas, we have
extensive acreage and/or seismic holdings which allow us to be competitive.

Natural Gas and Oil Reserves

The tables below provide information on our proved reserves at December 31,
2003. Reserve information in these tables is based on the reserve report dated
January 1, 2004, prepared internally by us. Ryder Scott Company and Huddleston &
Co., Inc., independent petroleum engineering firms, performed independent
reserve estimates for 94 percent and 6 percent of our properties. The total
estimate of proved reserves prepared independently by Ryder Scott Company and
Huddleston & Co., Inc. was within five percent of our internally prepared
estimates. This information is consistent with estimates of reserves filed with
other federal agencies except for differences of less than five percent
resulting from actual production, acquisitions, property sales, necessary
reserve revisions and additions to reflect actual experience.

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The table below summarizes our estimated proved reserves as of December 31,
2003, and our 2003 production by area.

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(1) Net proved reserves exclude royalties and interests owned by others
(including net profits interest) and reflects contractual arrangements and
royalty obligations in effect at the time of the estimate.

(2) Includes oil, condensate and natural gas liquids.

There are considerable uncertainties inherent in estimating quantities of
proved reserves and in projecting future rates of production and the timing of
development expenditures, including many factors beyond our control,
particularly where such reserves are not currently producing or developed. The
reserve data represents only estimates. Reservoir engineering is a subjective
process of estimating underground accumulations of natural gas and oil that
cannot be measured in an exact manner. The accuracy of any reserve estimate is a
function of the quality of available data and of engineering and geological
interpretations and judgment. As a result, estimates of different engineers
often vary. Estimates are subject to revision based upon a number of factors,
including reservoir performance, prices, economic conditions and government
restrictions. In addition, results of drilling, testing and production
subsequent to the date of an estimate may justify revision of that estimate.
Reserve estimates are often different from the quantities of natural gas and oil
that are ultimately recovered. The meaningfulness of reserve estimates is highly
dependent on the accuracy of the assumptions on which they were based. In
general, the volume of production from the natural gas and oil properties we own
declines as reserves are depleted. Except to the extent we conduct successful
exploration and development activities or acquire additional properties
containing proved reserves, or both, our proved reserves will decline as
reserves are produced.

In addition, during 2003, we sold reserves totaling approximately 323 Bcfe
to various third parties. The reserves sold were located primarily in Oklahoma,
Texas and the Gulf of Mexico. See Part II, Item 8, Financial Statements and
Supplementary Data, Note 13, for a further discussion of our reserves.

3

Acreage and Wells

The following table details our gross and net interest in developed and
undeveloped onshore, offshore and coal seam lease and mineral acreage at
December 31, 2003. Any acreage in which our interest is limited to owned
royalty, overriding royalty and other similar interests is excluded.

- ---------------

(1) Gross interest reflects the total acreage we participated in, regardless of
our ownership interests in the acreage.

(2) Net interest is the aggregate of the fractional working interest that we
have in our gross acreage.

The net developed acreage is concentrated primarily in the Gulf of Mexico
(49 percent), Oklahoma (14 percent), Louisiana (13 percent), New Mexico (10
percent), and Alabama (8 percent). As of December 31, 2003, our net undeveloped
acreage was primarily in New Mexico (28 percent), the Gulf of Mexico (25
percent) and Louisiana (14 percent). Approximately 18 percent, 11 percent and 6
percent of our total net undeveloped acreage is held under leases that have
remaining primary terms expiring in 2004, 2005 and 2006. During 2003, we sold
approximately 298,090 net acres located primarily in Oklahoma, Texas, and the
Gulf of Mexico.

The following table details our gross and net interest in productive
onshore, offshore and coal seam natural gas and oil wells and the number of
wells being drilled at December 31, 2003:

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(1) Gross interest reflects the total number of wells we participated in,
regardless of our ownership interests in the wells.

(2) Net interest is the aggregate of the fractional working interest that we
have in our gross wells.

During 2003, we sold approximately 450 net productive wells located
primarily in Oklahoma, Texas and the Gulf of Mexico. At December 31, 2003, we
operated 1,802 of the 1,870 net productive wells.

The following table details our net exploratory and development wells
drilled for each of the three years ended December 31. As a result of the
restatement of our proved natural gas and oil reserves, some wells drilled that
were previously reported as development wells have been reclassified as
exploratory wells for the years 2002 and 2001. See Part II, Item 8, Financial
Statement and Supplementary Data, Note 1 for a further discussion of this
restatement.

- ---------------

(1) Net interest is the aggregate of the fractional working interest that we
have in our gross wells drilled.

4

The information above should not be considered indicative of future
drilling performance, nor should it be assumed that there is any correlation
between the number of productive wells drilled and the amount of natural gas and
oil that may ultimately be recovered.

Net Production, Sales Prices, Transportation and Production Costs

The following table details our net production volumes, average sales
prices received, average transportation costs, average production costs and
average production taxes associated with the sale of natural gas and oil for
each of the three years ended December 31. See Part II, Item 7, Management's
Discussion and Analysis of Financial Condition and Results of Operations for a
further discussion of our volumes, prices and production costs.

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(1) Prices are stated before transportation costs.

(2) Our hedging activities are conducted with our affiliate, El Paso Merchant
Energy.

(3) The amount for 2002 has been restated as a result of our hedge restatement.

(4) Production costs include lease operating costs and production related taxes
(including ad valorem and severance taxes).

Acquisition, Development and Exploration Expenditures

The following table details information regarding the costs incurred in our
acquisition, development and exploration activities for each of the three years
ended December 31. As a result of the restatement of our proved natural gas and
oil reserves, some costs that were previously reported as development costs have
been

5

reclassified as exploratory drilling costs for the years 2002 and 2001. See Part
II, Item 8, Financial Statements and Supplementary Data, Notes 1 and 13, for a
further discussion of this restatement.

The amounts we spent to develop proved undeveloped reserves that were
included in our reserve reports as of January 1, 2003, 2002 and 2001, were
approximately $160 million, $150 million and $28 million.

REGULATORY AND OPERATING ENVIRONMENT

Our natural gas and oil activities are regulated at the federal, state and
local levels. These regulations include, but are not limited to, the drilling
and spacing of wells, conservation, forced pooling and protection of correlative
rights among interest owners. We are also subject to governmental safety
regulations in the jurisdictions in which we operate.

Our operations under federal natural gas and oil leases are regulated by
the statutes and regulations of the U.S. Department of the Interior that
currently impose liability upon lessees for the cost of environmental impacts
resulting from their operations. Royalty obligations on all federal leases are
regulated by the Minerals Management Service, which has promulgated valuation
guidelines for the payment of royalties by producers. These laws and regulations
relating to the protection of the environment affect our natural gas and oil
operations through their effect on the construction and operation of facilities,
drilling operations, production or the delay or prevention of future offshore
lease sales. We believe that our operations are in material compliance with the
applicable requirements. In addition, El Paso maintains insurance on our behalf
for sudden and accidental spills and oil pollution liability.

Our business has operating risks normally associated with the exploration
for and production of natural gas and oil, including blowouts, cratering,
pollution and fires, each of which could result in damage to life or property.
Offshore operations may encounter usual marine perils, including hurricanes and
other adverse weather conditions, governmental regulations and interruption or
termination by governmental authorities based on environmental and other
considerations. Customary with industry practices, El Paso maintains insurance
coverage on our behalf with respect to potential losses resulting from these
operating hazards.

MARKETS AND COMPETITION

We primarily sell our natural gas and oil to third parties through El Paso
Merchant Energy at spot market prices subject to customary adjustments. As part
of El Paso's strategic Long-Range Plan announced in December 2003, we will
continue to sell our natural gas and oil production to third parties through El
Paso Merchant Energy. We sell our natural gas liquids at market prices under
monthly or long-term contracts subject to customary adjustments. We also engage
in hedging activities with El Paso Merchant Energy on a portion of our natural
gas and oil production to stabilize our cash flows and reduce the risk of
downward commodity price movements on sales of our production. This is achieved
primarily through natural gas and oil swaps. In August 2004, El Paso announced
that it would be required to further restate its historical financial

6

statements for the manner in which it accounted for hedges of its natural gas
production and other hedging transactions. We have historically hedged a
significant portion of our anticipated natural gas production with El Paso
Merchant Energy, and as part of El Paso's restatement, the transactions we
conducted with El Paso Merchant Energy were evaluated for their proper
accounting. While substantially all of the hedge transactions we entered into
with El Paso Merchant Energy continue to qualify as hedges given our status as a
separate registrant from El Paso, we identified two derivatives that were not
entered into at observable market prices and therefore not properly accounted
for at their fair market value at the time they were initially entered into and
subsequently settled. Both derivatives were entered into in 2000, and were
originally accounted for as hedges. The first transaction settled during 2000
resulting in a gain of $6 million. The second transaction settled during 2002
resulting in a loss of $4 million. Upon determining that an adjustment was
required, we restated our historical financial statements to adjust the value of
the transactions to their fair market value at their inception, and adjust each
accounting period for the impacts of this adjustment through the date of
settlement. The restatement had no impact on our cash flows.

The natural gas and oil business is highly competitive in the search for
and acquisition of additional reserves and in the sale of natural gas, oil and
natural gas liquids. Our competitors include major and intermediate sized
natural gas and oil companies, independent natural gas and oil operators and
individual producers or operators with varying scopes of operations and
financial resources. Competitive factors include price, contract terms and
quality of service. Ultimately, our future success in the production business
will be dependent on our ability to find or acquire additional reserves at costs
that allow us to remain competitive.

ENVIRONMENTAL

A description of our environmental activities is included in Part II, Item
8, Financial Statements and Supplementary Data, Note 8, and is incorporated
herein by reference.

EMPLOYEES

As of September 15, 2004 we had approximately 802 full-time employees, none
of whom are subject to collective bargaining arrangements.

EXECUTIVE OFFICERS OF THE REGISTRANT

Our executive officers as of September 15, 2004 are listed below.

Ms. Stewart has served as our President since February 2004 and as a
Director since April 2004. Ms. Stewart was Executive Vice President of Business
Development and Exploration and Production Services for Apache Corporation from
1995 to February 2004. From 1984 to 1995, Ms. Stewart worked in various
positions for Apache Corporation.

Mr. Leland has served as our Executive Vice President and Chief Financial
Officer since January 2004 and as a Director since April 2004. Mr. Leland served
as Chief Operating Officer of GulfTerra Energy Partners, L.P. (GulfTerra) from
January 2003 to December 2003, as Senior Vice President and Controller of
GulfTerra from July 2000 to December 2002 and as Vice President and Controller
of GulfTerra from August 1998 to July 2000. Mr. Leland also served as Vice
President of El Paso Field Services Company from September 1997 to April 2004.
He served as Director of Business Development for El Paso Field Services Company
from September 1994 to September 1997. For more than five years prior, Mr.
Leland served in various capacities in the finance and accounting functions of
El Paso.

7

ITEM 2. PROPERTIES

A description of our properties is included in Item 1, Business, and is
incorporated herein by reference.

We believe that we have satisfactory title to the properties owned and used
in our business, subject to liens for taxes not yet payable, liens incident to
minor encumbrances, liens for credit arrangements and easements and restrictions
that do not materially detract from the value of these properties, our interests
in these properties, or the use of these properties in our business. We believe
that our properties are adequate and suitable for the conduct of our business in
the future.

ITEM 3. LEGAL PROCEEDINGS

A description of our legal proceedings is included in Part II, Item 8,
Financial Statements and Supplementary Data, Note 8, and is incorporated herein
by reference.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

All of our common stock, par value $1 per share, is owned by El Paso and,
accordingly, our stock is not publicly traded.

ITEM 6. SELECTED FINANCIAL DATA

The information for the years from 1999 until 2002 and for the first nine
months of 2003 has been restated for revisions to our natural gas and oil
reserves and to correct the manner in which we accounted for two transactions
related to hedges of our anticipated natural gas production. For a further
discussion of these restatements and the restatement amounts related to 2003,
2002 and 2001, see Item 8, Financial Statements and Supplementary Data, Note 1.
See the notes to the table below for the impact of these restatements on 2000
and 1999. In addition, the following historical selected financial data should
be read together with Item 7, Management's Discussion and Analysis of Financial
Condition and Results of Operations and Item 8, Financial Statements and
Supplementary Data included in this Annual Report on Form 10-K. These selected
historical results are not necessarily indicative of results to be expected in
the future.

- ---------------

(1) In February 2004, we completed our assessment of our December 31, 2003
proved natural gas and oil reserves estimates. The assessment indicated a
downward revision to our proved reserves estimates of 0.9 Tcfe was needed.
Upon completion of an investigation into the factors that caused this
significant revision, we determined that a material portion of the revision
should be reflected in the historical periods included in this Annual Report
on Form 10-K. As a result, we restated our historical financial statements
for all periods to reflect the impacts of the restated reserve estimates on
the financial statement amounts. In August 2004, we also determined that we
had not properly accounted for two transactions related to historical hedges
of our natural gas production. Following further reviews into this matter,
we determined that a further restatement of our financial statements would
be required. The total cumulative impact of the restatements on total
stockholder's equity as of September 30, 2003 (the most recent balance sheet
filed) was a reduction of approximately $387 million which includes a
reduction to beginning stockholder's equity as of January 1, 2001 of
approximately $503 million. The cumulative impact through September 30,
2003, related solely to the restatement for reserves, as the restatement for
the hedges had no overall impact on total stockholder's equity during the
restatement period. Of the cumulative impact as of January 1, 2001, $498
million related to the restatement for reserves and $5 million related to
the restatement for the hedges. See Item 8, Financial Statements and
Supplementary Data, Note 1, for a further discussion of our restatement
processes as well as the financial impact of the restatement on 2001, 2002
and 2003. The financial impacts on 1999 and 2000 of the restatement were as
follows:

The restated stockholder's equity at December 31, 1999 includes an increase
in income of $241 million, net of tax, due to a reduced ceiling test charge
and lower depletion expense in 1999 as well as an adjustment to beginning
retained earnings of $554 million that would have occurred in periods prior
to January 1, 1999 as a result of our restated reserve levels. As discussed
in Item 8, Financial Statements and Supplementary Data, Note 1, we restated
our reserve estimates for the periods from December 31, 2000 to September 30,
2003 using a reserve reconstruction approach. For each quarter from December
31, 1998 through the third quarter of 2000, we estimated reserves using an
approach that involved the use of a "reserve over production ratio" based on
the reconstructed December 31, 2000 reserve estimates. The reserve over
production ratio provided the estimated life of reserves based on production
levels. We applied that ratio to the actual historical period production
levels to calculate historical reserves for each period. In determining the
reserve over production ratio to use for each period, historical prices at
the end of each quarter were considered, since at different pricing levels,
more or less reserves are economical to produce, which also impacts capital
cost, operating cost and revenue assumptions in determining cash flows that
will be derived from reserves. These overall quarterly reserve levels were
then used to recalculate the associated net future cash flows for each
quarter during those periods. Ceiling test charges and depreciation,
depletion and amortization rates were then determined based on these restated
estimated reserve levels and related net future cash flows. Finally, we
assessed the reasonableness of our initial adjustment as of December 31, 1998
based on historical prices and our historical capitalized cost prior to that
time. Based on that assessment, we believe the amount recorded as a retained
earnings adjustment on January 1, 1999 reasonably reflects the financial
statement impact of our restated reserve levels that would have occurred
prior to that time. We believe the approach used to reconstruct our
historical reserve estimates was reasonable in light of the information
available to us and the circumstances surrounding our restatement. See Item
8, Financial Statements and Supplementary Data, Note 1, for a further
discussion of the methodologies used to restate our natural gas and oil
reserves and the reasons for the differences in the methods used in computing
our restated reserves.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

Our Management's Discussion and Analysis includes forward-looking
statements that are subject to risks and uncertainties. Actual results may
differ substantially from the statements we make in this section due to a number
of factors that are discussed beginning on page 21. The historical financial
information in this section has been restated to reflect the downward revision
of our proved natural gas and oil reserves, to correct

9

the manner in which we accounted for two transactions related to hedges of our
anticipated natural gas production and to reclassify our historical statements
of cash flows for amounts provided to El Paso under the cash management program.
The restatements are further discussed in Item 8, Financial Statements and
Supplementary Data, Note 1.

GENERAL

We conduct natural gas and oil exploration and production activities. Our
operating results are driven by a variety of factors including the ability to
locate and develop economic natural gas and oil reserves, extract those reserves
with minimal production costs, sell the products at attractive prices and
operate at a low total cost level. Our production operations are located solely
within the United States and we own 58 percent of El Paso's overall proved
natural gas and oil reserves. In mid-2003, El Paso changed its management team,
electing a new Chief Executive Officer. Following an assessment period by this
management team, El Paso announced its Long-Range Plan that established the
roadmap for its future and strategic direction. Among other things, this plan
established certain goals for us and other El Paso businesses, including asset
rationalization activities to fit competencies to key basins, increased focus on
cost leadership, and increase efficiency of capital expenditures. As a result of
the assessment performed by El Paso's management, El Paso appointed Lisa Stewart
as the President of Production and Non-regulated Operations in February 2004.
Ms. Stewart will manage El Paso's production, midstream, power and marketing
businesses, including our assets. In June 2004, we announced a back-to-basics
plan for our business. This plan emphasizes strict capital discipline designed
to improve capital efficiency through the use of standardized risk analysis, a
heightened focus on cost control, and a rigorous process for booking proved
natural gas and oil reserves. This back-to-basics approach is expected to
stabilize production by improving the production mix across our operating areas
and generate more predictable returns.

LIQUIDITY AND CAPITAL RESOURCES

LIQUIDITY

We rely on cash generated from our internal operations and advances from El
Paso through its cash management program as our primary sources of liquidity, as
well as 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 are 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 the assets
and the number of interested buyers.

Under El Paso's cash management program, depending on whether we have
short-term cash surpluses or requirements, we either provide cash to El Paso,
subject to limitations under our indenture, or El Paso provides cash to us. As
of December 31, 2003, we had receivables from El Paso under the cash management
program of $688 million, of which $393 million is classified as current assets
on our balance sheet. 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, their requirements to repay debt and other financing obligations and
the cash demands from other parts of its business. In addition, we conduct
commercial transactions with some of our affiliates, including conducting
hedging activities with, and selling a portion of the natural gas we produce to
El Paso Merchant Energy. As of December 31, 2003, we have receivables of
approximately $58 million from El Paso affiliates. El Paso provides cash
management and other corporate services for us. If El Paso is unable to meet its
liquidity needs, there can be no assurance that we will be able to access cash
under the cash management program or that our affiliates would pay their
obligations to us. In that event, we could be required to write-off some amount
of these advances, which could have a material impact on our stockholder's
equity and we might still be required to satisfy affiliated company payables.
Our inability to recover any

10

intercompany receivables owed to us could adversely affect our ability to repay
our outstanding indebtedness. For a further discussion of these matters, see
Item 8, Financial Statements and Supplementary Data, Note 11.

If El Paso were subject to voluntary or involuntary bankruptcy proceedings,
El Paso and its other subsidiaries and their creditors could attempt to make
claims against us, including claims to substantively consolidate our assets and
liabilities with those of El Paso and its other subsidiaries. We believe that
claims to substantively consolidate us with El Paso and/or its other
subsidiaries would be without merit. However, there is no assurance that El Paso
and/or its other subsidiaries or their creditors would not advance such a claim
in a bankruptcy proceeding. If we were to be substantively consolidated in a
bankruptcy proceeding with El Paso and/or its other subsidiaries, there could be
a material adverse effect on our financial condition and our liquidity.

We believe we will generate sufficient funds through our operations, asset
sales and repayments by El Paso of advances under the cash management program to
meet all of our cash needs as discussed below.

As discussed in Item 8, Financial Statements and Supplementary Data, Note
1, we have restated our historical financial statements to reflect 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
amounts provided to El Paso under the cash management program, which has
resulted in or will result in a delay in filing our Forms 10-Q for the quarterly
periods ended March 31, 2004, June 30, 2004 and September 30, 2004. Our
indenture includes covenants that require us to file financial statements within
specified time periods. Non-compliance with such covenants does not constitute
an automatic event of default. Instead, the debt is subject to acceleration
after any applicable cure periods have lapsed and the indenture trustee or the
holders of at least 25 percent of the outstanding principal amount of debt under
our indenture provide notice that the principal and accrued interest has been
declared due and payable. In July 2004, we entered into an agreement approved by
a majority of the holders of our 7.75% senior unsecured notes due June 1, 2013.
The agreement provides for a waiver of the breach of our covenant to timely file
our financial statements and is effective until December 31, 2004. In connection
with the waiver, we have 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).

Our cash flows for the years ended December 31 were as follows:

In order to improve El Paso's liquidity position, we have taken steps to
reduce our cash needs for 2004, including implementing cost savings plans and
reducing our overall capital spending program. We also continued to sell assets
in 2003 to supplement El Paso's liquidity. In March 2003, we sold properties in
the Mid-Continent region of Oklahoma and Texas for approximately $450 million.

Cash Flows from Operating Activities

Overall, cash generated from operating activities decreased by $155 million
from 2002. This decrease was a result of asset sales in 2003 and 2002 and
changes in operating assets and liabilities year over year, offset by increases
in the net prices received from the sale of our natural gas and oil production
in 2003.

11

Cash Flows from Investing Activities

Net cash used in our investing activities was $634 million for the year
ended December 31, 2003. Our investing activities consisted primarily of capital
expenditures of $815 million paid in 2003, a portion of which related to
projects started and accrued in prior years, and cash advances to El Paso under
the cash management program of $326 million, offset by net proceeds from sales
of assets and investments of $501 million. In October 2003, we entered into
agreements with two separate third parties whereby they agreed to contribute
capital for the drilling and completion of a specific package of wells in
exchange for a net profits interest in each well. We do not record reserves or
capitalized costs attributable to the conveyed interest. In 2003, we received
funds of approximately $76 million from these third parties under these
agreements which supplemented our overall capital program. Additional wells will
be drilled under these agreements in 2004, and we expect to receive additional
funds in 2004 under these agreements to supplement our 2004 capital program. As
of August 31, 2004, we had capital expenditures of approximately $265 million
and have received an additional $65 million under these agreements. See Item 8,
Financial Statements and Supplementary Data, Note 13, for a further discussion
of these agreements.

Our capital expenditures were $726 million and $1.4 billion for the years
ended December 31, 2003 and 2002. Under our current plan, we expect to spend
approximately $400 million to $450 million in each of the next two years for
capital expenditures 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. Additionally, our third party capital
program will be used to supplement our 2004 capital budget.

Our operating results are dependent on replacing producing reserves through
capital expenditures on acquisition, development and exploration projects. We
continually evaluate our capital expenditure program which is subject to change
based on market conditions. We will continue to pursue strategic acquisitions of
properties and the development of projects subject to acceptable returns.

Cash Flows from Financing Activities

Net cash used in our financing activities was $107 million for the year
ended December 31, 2003. Cash used in our financing activities primarily
included dividends paid to El Paso of $1.3 billion related to the Red River
refinancing, offset by cash provided from the issuance of long-term debt of $1.2
billion in connection with this refinancing. See Item 8, Financial Statements
and Supplementary Data, Notes 7 and 11 for a further discussion of the Red River
refinancing transaction.

DEBT

As of December 31, 2003, we had long-term debt outstanding of $1.2 billion
which matures June 1, 2013. The debt has an interest rate of 7.75% payable
semi-annually in arrears on June 1 and December 1. For further discussion of our
debt and restrictive covenants, see Item 8, Financial Statements and
Supplementary Data, Note 7.

12

CONTRACTUAL OBLIGATIONS

The following table summarizes our contractual obligations as of December
31, 2003, for each of the years presented (in millions):

RESERVES AND COSTS

In February 2004, we completed the December 31, 2003 reserve estimation
process of our proved natural gas and oil reserves. These estimates were
prepared internally by us. Ryder Scott Company and Huddleston & Co., Inc.,
independent petroleum engineering firms, performed independent reserve estimates
of our proved reserves for 94 percent and 6 percent of our properties. The total
estimate of proved reserves prepared by these engineers was within five percent
of our internally prepared estimates.

The proved reserve estimate as of December 31, 2003 indicated a 0.9 Tcfe
downward revision of our proved natural gas and oil reserves was needed. The
downward revisions related primarily to our coal seam, Texas onshore and
offshore Gulf of Mexico regions. Due to the significance of the reserve
revision, the Audit Committee of El Paso's Board of Directors engaged a law firm
to conduct an independent investigation into the reasons for the revisions. The
investigation concluded that a material portion of these revisions related to
prior periods, and as a result, we restated our historical reserve estimates and
the historical financial information derived from these estimates. This reserve
restatement involved utilizing the reserve estimate prepared as of December 31,
2003 and then reconstructing historical reserve data using actual historical
production data and re-engineered sales of proved reserves. Following this
reserve reconstruction and the recalculation of the discounted future net cash
flows, ceiling test calculations, depletion rates, earnings from unconsolidated
affiliates, gains and losses on asset sales and income taxes were recomputed for
each period restated. See Item 8, Financial Statements and Supplementary Data,
Notes 1 and 13 for a discussion of the restatement of our natural gas and oil
reserves. The restatement will result in a lower depletion rate and reduced
exposure to ceiling test charges in the future than would have been the case
absent the restatement.

During 2003 and 2002, we sold a total of approximately 510 Bcfe of proved
reserves in multiple sales transactions with various third parties. The sale of
these reserves, normal production declines, mechanical failures on certain
producing wells and disappointing drilling results, have resulted in our total
equivalent production levels declining each quarter of 2003. For 2003, our total
equivalent production has declined approximately 46 Bcfe or 17 percent as
compared to 2002. In addition, since our depletion rate is determined under the
full cost method of accounting, we expect a higher depletion rate as a result of
higher finding and development costs, coupled with a significantly lower reserve
base. For the first and second quarters of 2004, our unit of production
depletion rate was approximately $1.72 per Mcfe and $1.80 per Mcfe. We expect
this rate to be approximately $1.87 per Mcfe for the third quarter of 2004. See
Item 8, Financial Statements and Supplementary Data, Note 13, for a discussion
of our natural gas and oil reserves. For the first eight months of 2004, daily
production has averaged approximately 480 MMcfe/d with the month of August 2004
averaging approximately 425 MMcfe/d. Our future trends in production and our
depreciation, depletion and amortization rates will be dependent upon the amount
of capital allocated to us, the level of success in our drilling programs and
future sales activities relating to our proved reserves.

13

PRODUCTION HEDGING

We have historically engaged in hedging activities with El Paso Merchant
Energy, primarily through fixed-for-floating natural gas and oil swaps, on our
natural gas and oil production to stabilize cash flows and reduce the risk of
downward commodity price movements on our sales. Because this hedging strategy
only partially limits our exposure to changes in commodity prices, we can
experience significant volatility in our reported results of operations,
financial position and cash flows from period to period. During 2003, we did not
enter into any new hedges on our future production. Below are the hedging
positions on our anticipated natural gas production as of December 31, 2003:

In May 2004, we entered into the following additional hedges on our future
natural gas production:

RESULTS OF OPERATIONS

Our historical results were restated to reflect the impacts of downward
revisions to our reserve estimates and to correct the manner in which we
accounted for two transactions related to hedges of our anticipated natural gas
production. See Item 8, Financial Statements and Supplementary Data, Note 1, for
a further discussion of this restatement.

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.

14

The following is a reconciliation of our operating income to our EBIT and
our EBIT to our net income for each of the three years ended December 31:

- ---------------

(1) Amounts restated include operating revenues, operating expenses, earnings
from unconsolidated affiliates, income taxes and related subtotals and
totals.

15

Below are our operating results and an analysis of these results for each
of the three years ended December 31:

- ---------------

(1) Amounts restated include operating revenues, depreciation, depletion, and
amortization, gain on long-lived assets and other charges, earnings from
unconsolidated affiliates and related subtotals and totals. Additionally,
average realized natural gas prices including hedges and unit of production
depletion costs have been restated.

(2) Production costs include lease operating costs and production related taxes
(including ad valorem and severance taxes).

(3) Includes gain on long-lived assets, restructuring costs and asset
impairments.

(4) Transportation costs are included in operating expenses on our consolidated
statements of income.

(5) Prices are stated before transportation costs.

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Year Ended December 31, 2003 Compared to Year Ended December 31, 2002

For the year ended December 31, 2003, EBIT was $181 million lower than in
2002. The decrease was primarily due to a $209 million gain recognized on the
sale of certain east Texas properties in the first quarter of 2002 and higher
general and administrative costs in 2003. Offsetting these decreases were higher
revenues due to higher natural gas prices partially offset by lower production
volumes and increased hedge losses in 2003.

Operating Revenues. The following table describes the variance in revenue
between 2003 and 2002 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.

Our 2003 operating revenues increased $46 million as compared to 2002
primarily due to higher market prices for natural gas and oil, offset by lower
production volumes and an unfavorable impact from our hedging program.
Production volume declines were primarily due to the sale of properties in
Texas, Oklahoma, and offshore Gulf of Mexico as well as normal production
declines in our Texas onshore and offshore Gulf of Mexico regions and mechanical
failures in certain producing wells in our offshore Gulf of Mexico region.

Average realized natural gas prices in 2003, excluding hedges, were $2.31
per Mcf higher than in 2002, an increase of 71 percent. However, partially
offsetting these revenue increases were $330 million of hedge losses in 2003 as
compared to $48 million in 2002 relating to our natural gas hedge positions.
These hedging losses represent the difference between our hedge price and the
market price at the time the hedge positions were settled. We expect to continue
to incur hedge losses in 2004 based on current market prices for natural gas
relative to the prices at which our natural gas production is hedged.

The increase in other revenue of $19 million was primarily due to a higher
mark-to-market adjustment of derivative positions that no longer qualify as cash
flow hedges.

Operating Expenses. Total operating expenses were $232 million higher in
2003 as compared to 2002 primarily due to a gain on the sale of east Texas
properties in 2002 and higher general and administrative costs in 2003. However,
these higher costs were slightly offset by lower depreciation, depletion, and
amortization expenses.

In the first quarter of 2002, we recorded a $209 million gain on the sale
of certain natural gas and oil properties in east Texas as the reserves sold
significantly altered the relationship between capitalized costs and proved
reserves in our full cost pool.

Depreciation, depletion and amortization expense decreased by $17 million
in 2003 as compared to 2002 primarily due to lower production volumes in 2003
due to the asset sales, normal production declines and mechanical failures in
certain producing wells mentioned above. These lower production volumes reduced
our depreciation, depletion and amortization expenses by $66 million. This
decrease was partially offset by an increase of $40 million from higher
depletion rates as a result of higher finding and development costs in 2003 and
a lower reserve base due to asset sales. We also incurred $7 million in 2003 for
the accretion of our liability for asset retirement obligations.

Despite reductions in total production volumes in 2003 as a result of the
asset sales noted above, total production costs were relatively consistent with
2002 levels. However, our production cost per equivalent unit in 2003 increased
by 20 percent or $0.08 per Mcfe primarily as a result of higher production taxes
in 2003 due

17

to higher natural gas and oil prices excluding hedges, and higher tax credits
taken in 2002 on high cost natural gas wells.

General and administrative expenses were $30 million higher than in 2002,
or an increase of $0.17 per Mcfe. The increase was primarily due to higher
corporate overhead allocations from El Paso, net of fees billed to others. We
expect to lower general and administrative expenses primarily due to staff
reductions in the first quarter of 2004 as we reorganize our business under new
management. Additionally, El Paso announced plans to reduce its corporate
expenses as part of its Long-Range Plan, which is expected to reduce the amount
of future corporate overhead allocations we receive from El Paso.

Year Ended December 31, 2002 Compared to Year Ended December 31, 2001

For the year ended December 31, 2002, EBIT was $270 million higher than in
2001. The increase was primarily due to a $209 million gain recognized on our
east Texas sale in 2002 and higher revenues as a result of higher production
volumes. Partially offsetting these increases were higher depreciation,
depletion and amortization expenses.

Operating Revenues. The following table describes the variance in revenue
between 2002 and 2001 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.

Our 2002 operating revenues increased by $245 million as compared to 2001.
Production volume increases in natural gas and oil, condensate, and liquids were
primarily due to increased production in the offshore Gulf of Mexico and coal
seam regions.

Average realized natural gas prices in 2002, excluding hedges, were $1.08
per Mcf lower than in 2001, a decrease of 25 percent. However, we incurred
hedging losses of only $48 million in 2002 as compared to $328 million in hedge
losses in 2001 on our natural gas hedge positions primarily due to the
significant decrease in natural gas prices relative to our hedged prices.

Operating Expenses. Total operating expenses were $55 million lower in
2002 as compared to 2001 primarily due to a $209 million gain recognized on our
east Texas sale in 2002. This decrease was partially offset by higher
depreciation, depletion and amortization costs, production costs, and general
and administrative expenses.

During the first quarter of 2002, we recognized a gain on the sale of
natural gas and oil properties in east Texas as the reserves sold significantly
altered the relationship between capitalized costs and proved reserves in our
full cost pool.

Depreciation, depletion and amortization expense increased in 2002 by $136
million as compared to 2001. Higher depletion rates due to higher finding and
development costs in 2002 and a lower reserve base due to asset sales caused an
increase of $77 million while the increase in production volumes caused an
increase of $58 million.

Production costs increased by $11 million in 2002 compared to 2001 due to
higher production volumes. However, our production cost per equivalent unit
decreased from $0.45 per Mcfe in 2001 to $0.40 per Mcfe in 2002 primarily as a
result of lower production taxes due to lower natural gas prices excluding
hedges and tax credits related to high cost natural gas wells.

18

General and administrative expenses increased by $14 million from 2001
primarily due to higher corporate overhead allocations from El Paso, net of fees
billed to others, and a decrease in costs capitalized to the full cost pool.

AFFILIATED INTEREST INCOME

Affiliated interest income for the year ended December 31, 2003 increased
$5 million compared to 2002 primarily due to higher interest rates earned on our
notes receivable from El Paso and on our temporary investments.

Affiliated interest income for the year ended December 31, 2002, was
essentially unchanged as compared to 2001 as the higher outstanding balances on
our notes receivable from El Paso was offset by lower interest rates.

INTEREST EXPENSE

Interest expense for the year ended December 31, 2003 increased $70 million
compared to 2002 due to the Red River refinancing in March 2003 and the issuance
in May 2003 of $1.2 billion of senior unsecured notes. See Item 8, Financial
Statements and Supplementary Data, Notes 7 and 11, for further discussion of the
Red River refinancing and the debt issuance.

INCOME TAXES

Income tax expense for the year ended December 31, 2003 was $88 million,
resulting in an effective tax rate of 40 percent. Income tax for the year ended
December 31, 2002 was $161 million, resulting in an effective tax rate of 35
percent. Income tax expense for the year ended December 31, 2001 was $62
million, resulting in an effective tax rate of 32 percent. Differences in our
effective tax rates from the statutory tax rate of 35 percent were primarily a
result of earnings from unconsolidated affiliates where we anticipated receiving
dividends, and state income taxes. The overall 2003 effective tax rate was
higher as compared to 2002 and 2001 primarily due to state income taxes on the
sale of the Oklahoma properties. See Item 8, Financial Statements and
Supplementary Data, Note 4, for a reconciliation of the statutory rate of 35
percent to the effective rates.

COMMITMENTS AND CONTINGENCIES

For a discussion of our commitments and contingencies, see Item 8,
Financial Statements and Supplementary Data, Note 8, incorporated herein by
reference.

CRITICAL ACCOUNTING POLICIES

Our critical accounting policies are those accounting policies that involve
the use of complicated processes, assumptions and/or judgments in the
preparation of our financial statements. We have discussed the development and
selection of our critical accounting policies and related disclosures with the
Audit Committee of El Paso's Board of Directors and have identified the
following critical accounting policies for the current year.

Accounting for Natural Gas and Oil Producing Activities. We use the full
cost method to account for our natural gas and oil producing activities. Under
this accounting method, we capitalize substantially all of the costs incurred in
connection with the acquisition, development, and exploration of natural gas and
oil reserves in full cost pools maintained by geographic areas, regardless of
whether reserves are actually discovered.

The process of estimating natural gas and oil reserves, particularly proved
undeveloped and proved non-producing reserves, is very complex, requiring
significant judgment in the evaluation of all available geological, geophysical,
engineering and economic data. As of December 31, 2003, of our total proved

19

reserves, 35 percent were undeveloped and 10 percent were developed, but
non-producing. In addition, the data for a given field may also change
substantially over time as a result of numerous factors, including additional
development activity, evolving production history and a continual reassessment
of the viability of production under changing economic conditions. As a result,
material revisions to existing reserve estimates occur from time to time.
Although every reasonable effort is made to ensure that reserve estimates
reported represent the most accurate assessments possible, the subjective
decisions and variances in available data for various fields increase the
likelihood of significant changes in these estimates. If all other factors are
held constant, an increase in estimated proved reserves decreases our unit of
production depletion rate. Higher reserves can also reduce the likelihood of
ceiling test impairments. For further discussions of our reserves, as well as
the restatement of our historical financial statements as a result of downward
revisions to our reserve estimates, see Part I, Item 1, Business and Item 8,
Financial Statements and Supplementary Data, Notes 1 and 13.

Under the full cost accounting method, we are required to conduct quarterly
impairment tests of our capitalized costs in each of our full cost pools. This
impairment test is referred to as a ceiling test. Our total capitalized costs,
net of related income tax effects, are limited to a ceiling based on the present
value of future net revenues using end of period spot prices, discounted at 10
percent, plus the lower of cost or fair market value of unproved properties, net
of related income tax effects. If these discounted revenues are not equal to or
greater than total capitalized costs, we are required to write-down our
capitalized costs to this level. Our ceiling test calculations include the
effects of derivative instruments we have designated as, and that qualify as
cash flow hedges of our anticipated future natural gas and oil production.

The ceiling test calculation assumes that the price in effect on the last
day of the quarter is held constant over the life of the reserves, even though
actual prices of natural gas and oil are volatile and change from period to
period. We attempt to realize more determinable cash flows through the use of
hedges, but a decline in commodity prices can impact the results of our ceiling
test and may result in write-downs.

Price Risk Management Activities. We record the derivative instruments
used in our price risk management activities at their fair values in our balance
sheet. We estimate the fair value of our derivative instruments using exchange
prices, third party pricing data and valuation techniques that incorporate
specific contractual terms, statistical and simulation analysis and present
value concepts. One of the primary assumptions used to estimate the fair value
our derivative instruments is pricing. Our pricing assumptions are based upon
price curves derived from actual prices observed in the market, pricing
information supplied by a third party valuation specialist and independent
pricing sources and models that rely on this forward pricing information. Other
significant assumptions that we use in determining the fair value of our
derivative instruments are those related to time value, anticipated market
liquidity, and credit risk of our counterparties. The assumptions and
methodologies that we use to determine the fair values of our derivatives may
differ from those used by our derivative counterparties. These differences can
be significant and could impact our future operating results as we settle these
derivative positions.

For further details on these and our other significant accounting policies,
and the estimates, assumptions and judgments we use in applying these policies,
see Item 8, Financial Statements and Supplementary Data, Note 2.

NEW ACCOUNTING PRONOUNCEMENTS ISSUED BUT NOT YET ADOPTED

As of December 31, 2003, there were a number of accounting standards and
interpretations that had been issued, but not yet adopted by us. Based on our
assessment of those standards, we do not believe there are any that could have a
material impact on us.

20

RISK FACTORS AND CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR"
PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

This report contains or incorporates by reference forward-looking
statements within the meaning of the Private Securities Litigation Reform Act of
1995. Where any forward-looking statement includes a statement of the
assumptions or bases underlying the forward-looking statement, we caution that,
while we believe these assumptions or bases to be reasonable and in good faith,
assumed facts or bases almost always vary from the actual results, and
differences between assumed facts or bases and actual results can be material,
depending upon the circumstances. Where, in any forward-looking statement, we or
our management express an expectation or belief as to future results, that
expectation or belief is expressed in good faith and is believed to have a
reasonable basis. We cannot assure you, however, that the statement of
expectation or belief will result or be achieved or accomplished. The words
"believe," "expect," "estimate," "anticipate" and similar expressions will
generally identify forward-looking statements. All of our forward-looking
statements, whether written or oral, are expressly qualified by these cautionary
statements and any other cautionary statements that may accompany such
forward-looking statements. In addition, we disclaim any obligation to update
any forward-looking statements to reflect events or circumstances after the date
of this report.

With this in mind, you should consider the risks discussed elsewhere in
this report and other documents we file with the Securities and Exchange
Commission (SEC) from time to time and the following important factors that
could cause actual results to differ materially from those expressed in any
forward-looking statement made by us or on our behalf.

RISKS RELATED TO OUR LIQUIDITY

WE HAVE SIGNIFICANT DEBT WHICH HAS IMPACTED AND WILL CONTINUE TO IMPACT OUR
FINANCIAL CONDITION, RESULTS OF OPERATIONS AND LIQUIDITY.

We have debt of approximately $1.2 billion as of December 31, 2003 and have
significant debt service obligations. If our ability to generate or access cash
becomes significantly restrained, our financial condition and future results of
operations could be adversely affected. See Item 8, Financial Statements and
Supplementary Data, Note 7, for a further discussion of our debt.

A BREACH OF THE COVENANTS APPLICABLE TO OUR LONG-TERM DEBT COULD AFFECT OUR
ABILITY TO BORROW FUNDS AND COULD ACCELERATE OUR DEBT.

Our long-term debt indenture contains restrictive covenants and a $25
million cross-acceleration provision. A breach of any of these covenants could
accelerate our long-term debt. If acceleration were to occur, we may not be able
to repay such long-term debt.

As discussed in Item 8, Financial Statements and Supplementary Data, Note
1, we have restated our historical financial statements to reflect 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
amounts provided to El Paso under the cash management program, which has
resulted in or will result in a delay in filing our Forms 10-Q for the quarterly
periods ended March 31, 2004, June 30, 2004 and September 30, 2004. Our
indenture includes covenants that require us to file financial statements within
specified time periods. Non-compliance with such covenants does not constitute
an automatic event of default. Instead, the debt is subject to acceleration
after any applicable cure periods have lapsed and the indenture trustee or the
holders of at least 25 percent of the outstanding principal amount of debt under
our indenture provide notice that the principal and accrued interest has been
declared due and payable. In July 2004, we entered into an agreement approved by
a majority of the holders of our 7.75% senior unsecured notes due June 1, 2013.
The agreement provides for a waiver of the breach of our covenant to timely file
our financial statements and is effective until December 31, 2004. In connection
with the waiver, we have agreed to modify the covenants under our indenture with
respect to affiliated party transactions. In particular, the agreement prohibits
certain affiliated

21

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).

WE ARE A WHOLLY-OWNED DIRECT SUBSIDIARY OF EL PASO AND ITS FINANCIAL CONDITION
SUBJECTS US TO POTENTIAL RISKS THAT ARE BEYOND OUR CONTROL.

El Paso has substantial control over:

- our payment of dividends;

- decisions on our financings and our capital raising activities;

- mergers or other business combinations;

- our acquisitions or dispositions of assets; and

- our participation in El Paso's cash management program.

El Paso may exercise such control in its interests and not necessarily in
the interests of us or the holders of our long-term debt. Because of the control
that El Paso has over our operations, subject to limitations in our indenture
covering our $1.2 billion 7.75% senior unsecured notes due in June 2013, there
is a risk that we could enter into transactions with El Paso and its affiliates
that might be on terms that are different than the terms that would be agreed to
if we had an independent board of directors.

Due to our relationship with El Paso, adverse developments or announcements
concerning El Paso could adversely affect our financial condition, even if we
have not suffered any similar development. The senior unsecured indebtedness of
El Paso has been downgraded to below investment grade, currently rated Caa1 by
Moody's Investor Service (with a negative outlook and under review for a
possible downgrade) and CCC+ by Standard & Poor's (with a negative outlook). Our
senior unsecured indebtedness is rated B3 by Moody's Investor Service (with a
negative outlook and under review for a possible downgrade) and B- by Standard &
Poor's (with a negative outlook). Further downgrades of our credit ratings could
increase our cost of capital and collateral requirements, and could impede our
access to capital markets. As a result of its downgrades over the last two
years, El Paso has realized substantial demands on its liquidity. These
downgrades are a result, at least in part, of the outlook generally for the
consolidated businesses of El Paso and its needs for liquidity.

El Paso has embarked on its Long Range Business Plan that defines El Paso's
future business, targets significant debt reduction, establishes financial goals
and aligns compensation with shareholder interests. An inability to meet these
objectives could adversely affect El Paso's liquidity position, and in turn
affect our financial condition.

We participate in El Paso's cash management program, which matches cash
surpluses and needs for its participating affiliates. Pursuant to El Paso's cash
management program, our surplus cash is made available to El Paso, subject to
limitations in our indenture, in exchange for an affiliated receivable. In
addition, we conduct commercial transactions with some of our affiliates. As of
December 31, 2003, we have receivables of approximately $746 million from El
Paso and its affiliates including $688 million related to the cash management
program. El Paso provides cash management and other corporate services for us.
If El Paso is unable to meet its liquidity needs, there can be no assurance that
we will be able to access cash under the cash management program, or that our
affiliates would pay their obligations to us and we might still be required to
satisfy affiliated company payables. Our inability to recover any intercompany
receivables owed to us could adversely affect our ability to repay our
outstanding indebtedness. For a further discussion of these matters, see Item 8,
Financial Statements and Supplementary Data, Note 11.

WE COULD BE SUBSTANTIVELY CONSOLIDATED WITH EL PASO IF EL PASO WERE FORCED TO
SEEK PROTECTION FROM ITS CREDITORS IN BANKRUPTCY.

If El Paso were the subject of voluntary or involuntary bankruptcy
proceedings, El Paso and its other subsidiaries and their creditors could
attempt to make claims against us, including claims to substantively consolidate
our assets and liabilities with those of El Paso and its other subsidiaries. The
equitable doctrine of

22

substantive consolidation permits a bankruptcy court to disregard the
separateness of related entities and to consolidate and pool the entities'
assets and liabilities and treat them as though held and incurred by one entity
where the interrelationship between the entities warrants such consolidation. We
believe that any effort to substantively consolidate us with El Paso and/or its
other subsidiaries would be without merit. However, we cannot assure you that El
Paso and/or its other subsidiaries or their respective creditors would not
attempt to advance such claims in a bankruptcy proceeding or, if advanced, how a
bankruptcy court would resolve the issue. If a bankruptcy court were to
substantively consolidate us with El Paso and/or its other subsidiaries, there
could be a material adverse effect on our financial condition and liquidity.

RISKS RELATED TO LEGAL AND REGULATORY MATTERS

ONGOING LITIGATION AND INVESTIGATIONS RELATED TO OUR RESERVE ESTIMATES AND
FINANCIAL STATEMENTS RESTATEMENTS COULD SIGNIFICANTLY ADVERSELY AFFECT OUR
BUSINESS.

In May 2004, El Paso completed an independent investigation of the reasons
for or cause of the significant revisions to our natural gas and oil reserves.
Following this investigation, we announced that we would reduce our proved
natural gas and oil reserve estimates as of December 31, 2003 and, as a result
restate our historical financial statements. As a result of the reduction in
reserve estimates, several class action lawsuits were filed against El Paso and
several of its subsidiaries. The reserve revisions are also the subject of
investigations by the SEC and the U.S. Attorney, any of which may result in
significant fines to El Paso. These investigations and lawsuits, and possible
future claims based on these same facts, may further negatively impact El Paso's
and our credit ratings and place further demands on El Paso's and our liquidity.
We cannot provide assurance at this time that the effects and results of these
or other investigations or of the class action lawsuits will not be material to
our financial condition, results of operations and liquidity.

WE ARE SUBJECT TO COMPLEX LAWS AND REGULATIONS, INCLUDING ENVIRONMENTAL AND
SAFETY REGULATIONS THAT CAN NEGATIVELY AFFECT THE COST, MANNER OR FEASIBILITY
OF DOING BUSINESS.

Our operations and facilities are subject to certain federal, state, and
local laws and regulations relating to the exploration for, and development,
production and transportation of, natural gas and oil, as well as environmental
and safety matters. Additionally, current or future tax policies, rates, and
drilling or production incentives by federal, state, and local governments
impact our operations and the ability to operate profitably.

Under these laws and regulations, we could be liable for:

- personal injuries;

- property and natural resource damages;

- oil spills and releases or discharges of hazardous materials;

- well reclamation costs;

- remediation and clean-up costs and other governmental sanctions, such as
fines and penalties; and

- other environmental damages.

Existing laws or regulations, as currently interpreted or reinterpreted in
the future, or future laws or regulations could harm our business, results of
operations and financial condition. Increased federal or state regulations,
including environmental regulations, could limit or restrict the ability to
drill natural gas or oil wells, reduce operational flexibility, or increase
capital and operating costs. We may be required to make large and unanticipated
capital expenditures to comply with environmental and other governmental
regulations. In addition, our operations could be significantly delayed or
curtailed and our costs of operations could significantly increase as a result
of regulatory requirements or restrictions. We are unable to predict the
ultimate cost of compliance with these requirements or their effect on our
operations.

23

COSTS OF ENVIRONMENTAL LIABILITIES, REGULATIONS AND LITIGATION COULD EXCEED
OUR ESTIMATES.

Our operations are subject to various environmental laws and regulations.
These laws and regulations obligate us to install and maintain pollution
controls and to clean up various sites at which regulated materials may have
been disposed of or released. We are also party to legal proceedings involving
environmental matters pending in various courts and agencies.

Compliance with environmental laws and regulations can require significant
costs, such as costs of clean-up and damages arising out of contaminated
properties, and failure to comply with environmental laws and regulations may
result in fines and penalties being imposed. It is not possible for us to
estimate reliably the amount and timing of all future expenditures related to
environmental matters because of:

- the uncertainties in estimating clean up costs;

- the discovery of new sites or information;

- the uncertainty in quantifying liability under environmental laws that
impose joint and several liability on all potentially responsible
parties;

- the nature of environmental laws and regulations; and

- the possible introduction of future environmental laws and regulations.

Our current environmental liabilities and related reserves are immaterial.
However, we could be required to set aside reserves in the future due to these
uncertainties, and these amounts could be material. For additional information
concerning our environmental matters, see Item 8, Financial Statements and
Supplementary Data, Note 8.

RISKS RELATED TO OUR BUSINESS

NATURAL GAS AND OIL PRICES ARE VOLATILE. A SUBSTANTIAL DECREASE IN NATURAL GAS
AND OIL PRICES COULD ADVERSELY AFFECT OUR FINANCIAL RESULTS.

Our future financial condition, revenues, results of operations, cash
flows, future rate of growth and the carrying value of our natural gas and oil
properties depend primarily upon the prices we receive for our natural gas and
oil production. Natural gas and oil prices historically have been volatile and
are likely to continue to be volatile in the future, especially given current
world geopolitical conditions. The prices for natural gas and oil are subject to
a variety of additional factors that are beyond our control. These factors
include:

- the level of consumer demand for, and the supply of, natural gas and oil;

- commodity processing, gathering and transportation availability;

- the level of imports of, and the price of, foreign natural gas and oil;

- the ability of the members of the Organization of Petroleum Exporting
Countries to agree to and maintain oil price and production controls;

- domestic governmental regulations and taxes;

- the price and availability of alternative fuel sources;

- weather conditions;

- market uncertainty;

- political conditions or hostilities in natural gas and oil producing
regions;

- worldwide economic conditions; and

- decreased demand for the use of natural gas and oil because of market
concerns about global warming or changes in governmental policies and
regulations due to climate change initiatives.

24

Further, because approximately 93 percent of our proved reserves at
December 31, 2003 were natural gas reserves, we are substantially more sensitive
to changes in natural gas prices than we are to changes in oil prices. Declines
in natural gas and oil prices would not only reduce revenue, but could reduce
the amount of natural gas and oil that we can produce economically and, as a
result, could adversely affect our financial results. Changes in natural gas and
oil prices can have a significant impact on the calculation of our full cost
ceiling test. A significant decline in natural gas and oil prices could result
in a downward revision of our reserves and a write-down in the carrying value of
our natural gas and oil properties which could be substantial, and would
negatively impact our net income and stockholder's equity.

OUR USE OF HEDGING ARRANGEMENTS HAS RESULTED IN FINANCIAL LOSSES AND MAY
ADVERSELY AFFECT OUR FUTURE RESULTS OF OPERATIONS OR LIQUIDITY.

To reduce our exposure to fluctuations in the prices of natural gas and
oil, we may use futures, swaps and option contracts traded on the New York
Mercantile Exchange (NYMEX), over-the-counter options and price and basis swaps
with other natural gas merchants and financial institutions. We also enter into
hedging arrangements with El Paso Merchant Energy. As of December 31, 2003, we
had hedged approximately 75,393 BBtus of our anticipated natural gas production
for 2004 at a NYMEX Henry Hub price of $3.12 per MMBtu before regional price
differentials and transportation costs. In addition, we have hedged
approximately 79,341 BBtus at $3.16 per MMBtu of our 2005 anticipated natural
gas production, and 83,661 BBtus at $3.28 per MMBtu of our 2006 anticipated
natural gas production. We have also hedged additional volumes at various prices
through 2012. At December 31, 2003 the fair value of these hedges was a loss of
$443 million, which is included in liabilities from price risk management
activities on our balance sheet. Hedging arrangements expose us to risk of
financial loss in some circumstances, including when:

- expected production is less than the amount hedged;

- the counterparty to the hedging contract defaults on its contract
obligations; or

- there is a change in the expected differential between the underlying
price in the hedging agreement and actual prices received.

For the years ended December 31, 2003, 2002 and 2001, we recognized losses
resulting in lower operating revenues and operating cash flows of $338 million,
$50 million, and $338 million as a result of our natural gas and oil hedging
arrangements.

In addition, these hedging arrangements may limit the benefit we would
receive from increases in the prices for natural gas and oil. The use of
derivatives also may require the posting of cash collateral with counterparties
which can impact working capital when commodity prices change. El Paso provides
us with gas marketing and hedging services and we currently do not post cash
collateral with counterparties.

ESTIMATING OUR RESERVES, PRODUCTION AND FUTURE NET CASH FLOW IS DIFFICULT.

Estimating quantities of proved natural gas and oil reserves is a complex
process that involves significant interpretations and assumptions. It requires
interpretations of available technical data and various estimates, including
estimates based upon assumptions relating to economic factors, such as future
commodity prices, production costs, severance and excise taxes, capital
expenditures and workover and remedial costs, and the assumed effect of
governmental regulation. As a result, our reserve estimates are inherently
imprecise. Also, the use of a 10 percent discount factor for estimating the
value of our reserves, as prescribed by the SEC, may not necessarily represent
the most appropriate discount factor, given actual interest rates and risks to
which our business or the natural gas and oil industry, in general, are subject.
Any significant variations from the interpretations or assumptions used in our
estimates or changes of conditions could cause the estimated quantities and net
present value of our reserves to differ materially.

The reserve data included in this report represents estimates. You should
not assume that the present values referred to in this report represent the
current market value of our estimated natural gas and oil reserves. The timing
of the production and the expenses from the development and production of
natural gas and oil properties will affect both the timing of actual future net
cash flows from our proved reserves and their

25

present value. Changes in the present value of these reserves could cause a
write-down in the carrying value of our natural gas and oil properties, which
could be substantial and would negatively affect our net income and
stockholder's equity.

As of December 31, 2003, approximately 35 percent of our estimated proved
reserves were undeveloped. Recovery of undeveloped reserves requires significant
capital expenditures and successful drilling operations. The reserve data
assumes that we can and will make these expenditures and conduct these
operations successfully, but future events, including changes in commodity
prices, may cause these assumptions to change. In addition, estimates of
undeveloped reserves and proved but non-producing reserves are subject to
greater uncertainties than estimates of producing reserves.

THE SUCCESS OF OUR BUSINESS DEPENDS UPON OUR ABILITY TO REPLACE RESERVES THAT
WE PRODUCE.

Unless we successfully replace the reserves that we produce, our reserves
will decline, eventually resulting in a decrease in natural gas and oil
production and lower revenues and cash flows from operations. We historically
have replaced reserves through both drilling and acquisitions. The business of
exploring for, developing or acquiring reserves requires substantial capital
expenditures. Historically, we have funded our capital expenditures in part
through contributions from El Paso. El Paso has no commitment to fund our future
capital needs and in the future may elect not to or may be unable to do so. In
response to the current liquidity concerns of El Paso, we have reduced our 2004
capital expenditure budget significantly. If El Paso's liquidity situation
worsens, we could be forced to further reduce our 2004 or future capital
expenditures. Our operations require continued access to sufficient capital to
fund drilling programs to develop and replace a reserve base with rapid
depletion characteristics. If we do not continue to make significant capital
expenditures, or if our outside capital resources become limited, we may not be
able to replace the reserves that we produce, which would negatively affect our
future revenues, cash flows and results of operations.

WE FACE COMPETITION FROM THIRD PARTIES TO ACQUIRE AND DEVELOP RESERVES.

The natural gas and oil business is highly competitive in the search for
and acquisition of reserves. We must identify and precisely locate prospective
geologic structures and drill and successfully complete wells in those
structures in a timely manner. Our ability to expand our leased land positions
in desirable areas is impacted by intensely competitive leasing conditions.
Competition for reserves and producing natural gas and oil properties is intense
and many of our competitors have financial and other resources that are
substantially greater than those available to us. Our competitors include the
major and independent natural gas and oil companies, individual producers, gas
marketers and major pipeline companies, as well as participants in other
industries supplying energy and fuel to industrial, commercial and individual
consumers. If we are unable to compete effectively in the acquisition and
development of reserves, our future profitability may be negatively impacted.
Ultimately, our future success in the production business is dependent on our
ability to find or acquire additional reserves at costs that allow us to remain
competitive.

Our affiliate, El Paso CGP Company (El Paso CGP), formerly known as The
Coastal Corporation, is a wholly-owned direct subsidiary of El Paso. El Paso
CGP, through its subsidiaries, engages in the exploration for and the
acquisition, development and production of natural gas and oil, primarily in
North America and in the Gulf of Mexico. Because El Paso CGP is very active
onshore in the United States and offshore in the Gulf of Mexico, we may pursue
opportunities that are also being pursued by El Paso CGP. We and El Paso CGP do
not have an agreement regarding the allocation of business opportunities.

In addition, our officers, directors and personnel also provide services to
El Paso CGP and its subsidiaries pursuant to our shared services arrangement and
therefore share their time and services between us and El Paso CGP. These
persons may therefore have conflicts of interest between us and El Paso CGP.

OUR NATURAL GAS AND OIL DRILLING AND PRODUCING OPERATIONS INVOLVE MANY RISKS
AND MAY NOT BE PROFITABLE.

Our operations are subject to all the risks normally incident to the
operation and development of natural gas and oil properties and the drilling of
natural gas and oil wells, including well blowouts, cratering and explosions,
pipe failure, fires, formations with abnormal pressures, uncontrollable flows of
natural gas, oil,
26

brine or well fluids, release of contaminants into the environment and other
environmental hazards and risks. The nature of the risks is such that some
liabilities could exceed our insurance policy limits, or, as in the case of
environmental fines and penalties, cannot be insured. As a result, we could
incur substantial costs that could adversely affect our future results of
operations, cash flows or financial condition.

In addition, in our drilling operations we are subject to the risk that we
will not encounter commercially productive reservoirs as evidenced by our lack
of success in recent exploratory programs. New wells drilled by us may be
unproductive, or we may not recover all or any portion of our investment in
those wells. Drilling for natural gas and oil can be unprofitable, not only
because of dry holes but also due to wells that are productive but do not
produce sufficient net reserves to return a profit at then realized prices after
deducting drilling, operating and other costs.

OUR DRILLING OPERATIONS MAY BE DELAYED OR CANCELED AS A RESULT OF FACTORS
BEYOND OUR CONTROL, RESULTING IN SIGNIFICANT COSTS TO US.

Our drilling operations may be curtailed, delayed or canceled as a result
of numerous factors that are beyond our control, including:

- unexpected drilling conditions;

- title problems;

- pressure or irregularities in formations;

- equipment failures or accidents;

- adverse weather conditions;

- compliance with environmental and other governmental requirements; and

- costs of, or shortages or delays in the availability of, drilling rigs,
oil field equipment, qualified personnel and services.

A delay or curtailment of our operations due to these or other factors can
result in significant costs or significant reductions in revenue to us. These
types of shortages or cost increases could significantly decrease our profit
margin, cash flow and operating results or restrict our ability to drill the
wells and conduct the operations which we currently have planned and budgeted.
Future drilling, production and development costs have a major impact on our
ability to earn adequate returns on invested capital and to generate positive
cash flow.

WE ARE VULNERABLE TO RISKS ASSOCIATED WITH OPERATING IN THE GULF OF MEXICO.

Our operations and financial results could be significantly impacted by
conditions in the Gulf of Mexico because we explore and produce in that area. As
a result of this activity, we are vulnerable to the risks associated with
operating in the Gulf of Mexico, including those relating to:

- adverse weather conditions;

- oil field service costs and availability;

- compliance with environmental and other laws and regulations;

- remediation and other costs resulting from oil spills or releases of
hazardous materials; and

- failure of equipment or facilities.

Further, production of reserves from reservoirs in the shallow waters of
the Gulf of Mexico shelf generally declines more rapidly than from reservoirs in
many other producing regions of the world. This results in recovery of a
relatively higher percentage of reserves from properties in the Gulf of Mexico
during the initial few years of production, and as a result, our reserve
replacement needs from new prospects may be greater

27

there than for our operations elsewhere. Also, our revenues and return on
capital will depend significantly on prices prevailing during these relatively
short production periods.

OUR GROWTH MAY BE DEPENDENT UPON SUCCESSFUL ACQUISITIONS WHICH ARE SUBJECT TO
MANY UNCERTAINTIES AND COULD SUBJECT US TO SIGNIFICANT UNKNOWN LIABILITIES.

Acquisitions of exploration and production companies, producing properties
and undeveloped properties have been an important part of our historical growth.
We expect acquisitions will also contribute to our future growth. Successful
acquisitions require an assessment of a number of factors, many of which are
beyond our control. These factors include recoverable reserves, exploration or
development potential, future natural gas and oil prices, operating costs and
potential environmental and other liabilities. Our assessments are based on
factors that are inherently uncertain. If we are unable to continue making
successful acquisitions, the growth of our company may be negatively impacted.

In connection with our acquisitions we are often not entitled to
contractual indemnification for preclosing liabilities, including environmental
liabilities associated with acquired properties. Normally, we acquire interests
in properties on an "as is" basis with limited remedies for breaches of
representations and warranties. We may not be able to become sufficiently
familiar with the properties to fully assess their deficiencies and
capabilities. Our review prior to signing a definitive purchase agreement may be
even more limited. We could incur significant unknown liabilities, including
environmental liabilities, or experience losses due to title defects, in our
acquisitions for which we have limited or no contractual remedies or insurance
coverage.

28

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We use derivative financial instruments and energy related contracts to
manage market risks associated with natural gas and oil. Our primary market risk
exposures are those related to changing commodity prices. Our market risks are
monitored by El Paso's Corporate Risk Management Committee to ensure compliance
with the stated risk management policies approved by the Audit Committee of El
Paso's Board of Directors. This Committee operates independently from us.

COMMODITY PRICE RISK

We have market risks related to the natural gas and oil we produce. Our
primary commodity price risk is that natural gas prices decline, which will
impact our forecasted sales of our natural gas production. We attempt to
mitigate market risk associated with these significant physical transactions
primarily through the use of derivative swap contracts which require payments to
(or receipts from) counterparties based on the difference between a fixed and a
variable price for a commodity.

The table below presents the hypothetical sensitivity to changes in fair
values arising from immediate selected potential changes in the quoted market
prices of the derivative commodity instruments we use to mitigate these market
risks that were outstanding at December 31, 2003 and 2002. Any gain or loss on
these derivative commodity instruments would be substantially offset by a
corresponding gain or loss on the hedged commodity positions, which are not
included in the table.

Currently, we hedge our natural gas production with El Paso Merchant
Energy. As a result, we are not required to provide collateral for our
derivative positions.

INTEREST RATE RISK

The fair value of our fixed rate debt is sensitive to changes in interest
rates. As of December 31, 2003, our 7.75% long-term debt due in June 2013 had a
fair value of $1,182 million and a carrying value of $1,200 million. As of
September 10, 2004, the fair value of the debt was approximately $1,185 million.
The fair value of the long-term debt has been estimated based on quoted market
prices for the same or similar issues.

29

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEX TO FINANCIAL STATEMENTS

Below is an index to the financial statements and notes contained in Item
8, Financial Statements and Supplementary Data.

30

EL PASO PRODUCTION HOLDING COMPANY

CONSOLIDATED STATEMENTS OF INCOME
(IN MILLIONS)

See accompanying notes.

31

EL PASO PRODUCTION HOLDING COMPANY

CONSOLIDATED BALANCE SHEETS
(IN MILLIONS, EXCEPT SHARE AMOUNTS)

See accompanying notes.

32

EL PASO PRODUCTION HOLDING COMPANY

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN MILLIONS)

- ---------------

(1) Cash flows from operating, investing and financing activities were restated.
However, the total cash flows were unaffected. See Note 1 for a further
discussion.

See accompanying notes.

33

EL PASO PRODUCTION HOLDING COMPANY

CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY
(IN MILLIONS, EXCEPT SHARES OF COMMON STOCK)

See accompanying notes.

34

EL PASO PRODUCTION HOLDING COMPANY

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(IN MILLIONS)

See accompanying notes.

35

EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. RESTATEMENT OF HISTORICAL FINANCIAL STATEMENTS

During 2004, we identified several issues that resulted in a restatement of
the amounts we had previously reported in our historical financial statements
for the periods from 1999 to 2002 and for the first nine months of 2003. These
restatements related to revisions to our historical estimates of our proved
natural gas and oil reserves, the financial information derived from those
estimates, and the manner in which we accounted for two hedges of our natural
gas production. In addition, we restated our historical consolidated statement
of cash flows for amounts provided to El Paso under its cash management program.
Each of these restatements is discussed below.

In February 2004, we completed the December 31, 2003 reserve estimation
process of our proved natural gas and oil reserves. At the same time, our
independent reserve engineers completed their estimates of our proved reserves.
Overall, our internally prepared reserve estimates were within 5 percent of the
total of the estimates of our independent reserve engineers. The proved reserve
estimates as of December 31, 2003 indicated that a 0.9 Tcfe downward revision in
our proved natural gas and oil reserves was needed. Given the size of this
revision, the Audit Committee of El Paso's Board of Directors initiated an
independent investigation to be conducted by an outside law firm to determine
the factors that contributed to this significant downward revision. The scope of
the investigation included (1) assessing the reasons for the downward revisions,
(2) evaluating the internal controls associated with the booking of reserves,
(3) suggesting any recommendations with regard to improvements in internal
controls or internal control processes and (4) recommending any remedial actions
that may be required. The investigation included the completion of more than 200
interviews and the review of more than 100,000 documents. Based on the
investigation results, we concluded that a material portion of the negative
reserve revisions should have been reflected in periods prior to 2003 and would
require a restatement of the historical reserve estimates included in our
supplemental natural gas and oil operations data. Quantities of proved natural
gas and oil reserves are used in determining financial statement amounts,
including ceiling test charges, depletion expense and gains and losses on
property sales. The restatement of our historical reserve estimates required the
restatement of the financial statement information derived from such estimates.
The investigation found that certain personnel used aggressive, and at times,
unsupportable methods to book proved reserves. In some instances, certain
personnel provided historical proved reserve estimates that they knew or should
have known were incorrect at the time they were reported. The investigation also
found that we did not, in some cases, maintain adequate documentation and
records to support historically booked reserves. Based on the results of the
investigation, we (a) reviewed alternatives with respect to the method or
methods to be used to restate our reserve amounts in prior periods and (b)
assessed and implemented remedial actions related to our management structure,
internal control environment and internal control processes.

In August 2004, El Paso announced that it would be required to further
restate its historical financial statements for the manner in which it accounted
for hedges of its natural gas production and other hedging transactions. We have
historically hedged a significant portion of our anticipated natural gas
production with El Paso Merchant Energy, and as part of El Paso's restatement,
the transactions we conducted with El Paso Merchant Energy were evaluated for
their proper accounting. While substantially all of the hedge transactions we
entered into with El Paso Merchant Energy continue to qualify as hedges given
our status as a separate registrant from El Paso, we identified two derivatives
that were not entered into at observable market prices and therefore not
properly accounted for at their fair market value at the time they were
initially entered into and subsequently settled. Both derivatives were entered
into in 2000, and were originally accounted for as hedges. The first transaction
settled during 2000 resulting in a gain of $6 million. The second transaction
settled during 2002 resulting in a loss of $4 million. Upon determining that an
adjustment was required, we restated our historical financial statements to
adjust the value of the transactions to their fair market value at their
inception, and adjust each accounting period for the impacts of this adjustment
through the date of settlement. The restatement had no impact on our cash flows.

36

EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

We have also reclassified $271 million and $237 million in our statements
of cash flows for the years ended December 31, 2002 and 2001 to reflect these
amounts provided to El Paso under the cash management program as cash flows from
investing activities. These amounts were recorded as cash flows from financing
activities in our historical statements of cash flows.

Reserve Restatement Methodology

Because of concerns over our historical documentation supporting reserves
and the aggressive, and sometimes unsupportable methods that were used in
booking proved reserves, the methodology we adopted to restate our reserves for
the years ended December 31, 2001, 2002 and the nine months ended September 30,
2003, was a reserve reconstruction approach. Under this method, we utilized the
estimated proved reserves as of December 31, 2003 that were derived from our
review completed in February 2004, and then determined historical reserves by
adjusting these reserves for actual historical production data and other known
data to determine the reconstructed estimates of reserves at each period end.
The basic assumption underlying our methodology was that the December 31, 2003
reserve report represented the most recent, reliable and available information
and was our best "estimate" of proved reserves. That report, therefore, became
the basis of our historical reserve reconstruction. We then created a
reconstruction process by adding actual production volumes in prior periods, on
a well by well basis, with adjustments for assets sold (the more significant
sales were re-evaluated by one of our independent reserve engineers since the
proved reserves that were sold were not in the December 31, 2003 reserve report
and needed to be re-evaluated given the findings in the investigation) and other
known information during the period such as cost and capital spending during the
restatement period.

We applied the methodology described above back to December 31, 2000.
However, for periods prior to December 31, 2000, which were necessary to
determine the impact of the reserve restatement on beginning stockholder's
equity as of January 1, 2001, we did not have access to the necessary detailed
electronic records to apply this methodology. This was due, in part to some of
the documentation issues identified in the investigation, and numerous changes
to our personnel immediately following our past mergers, which impacted our
ability to locate that historical documentation. As a result, we used our
December 31, 2000 reserve levels determined by the reconstruction approach
described above, as the foundation for estimating reserves and related future
cash flows (for ceiling test purposes) for periods prior to December 31, 2000.
This estimation approach involved the use of a "reserve over production ratio"
based on the reconstructed December 31, 2000 reserve estimates. The reserve over
production ratio provided the estimated life of reserves based on production
levels. We applied that ratio to the actual historical period production levels
to calculate estimated historical reserves for each period. In determining the
reserve over production ratio to use for each period, historical prices were
considered since at different pricing levels, varying levels of reserves are
economical to produce, which also impacted capital cost, operating cost and
revenue assumptions in determining cash flows that would be derived from the
reserves.

Overall, our restatement approach allowed us to recalculate reasonable
proved reserve estimates at the end of each quarter over the last five years.
Once we determined the historical reserve levels, we then calculated our
estimated future net cash flows at the end of each quarter. These revised
quarterly proved reserves and the resulting discounted net cash flows were then
used to perform the ceiling test, calculate our depreciation, depletion and
amortization rate, income taxes, evaluate gain or loss recognition on asset
sales and recompute earnings from unconsolidated affiliates. Finally, we
assessed the reasonableness of our overall approach based on historical prices
and historical capitalized cost leading up to the earliest period in which our
restatement was performed. Based on that assessment, we believe the amount
recorded as a retained earnings adjustment on January 1, 1999 reasonably
reflects the financial statement impact of our restated reserve levels that
would have occurred prior to that time.

37

EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

We believe the approach we used to restate our historical reserves is a
reasonable approach and is appropriate in these circumstances. It is based on a
current, thoroughly reviewed and well documented reserve study and reflects
actual historical data. However, it does have some limitations. First, the
restated reserve levels and reported earnings do not incorporate normal positive
or negative revisions in reserves that could have resulted for reasons such as
mechanical failures, changes in estimates or the impact of actual drilling
results on proved undeveloped reserves. These are normally occurring changes to
reserve estimates that because of the methodology we used, will not be reflected
during the year they actually occurred. Rather, they will be part of our
beginning retained earnings adjustments. Overall we believe their effects on our
reported results would be similar. Second, because we had to use a variation of
the reconstruction methodology for the years 1999 and 2000, to determine the
impact on our retained earnings at January 1, 2001, the restated reserves for
these periods may not be comparable to the reserve amounts that would have
resulted from an actual reconstruction and none of the periods would be
identical to a completely re-engineered approach. Overall, however, we believe
our approach, given the results of the investigation and documentation issues
discussed above, provides a reasonable approach to revising our historical
reserve data that presents our related financial statements in accordance with
generally accepted accounting principles.

We also considered other restatement methodologies such as re-engineering
specific production and reserve areas to determine, in hindsight, where previous
estimates should have been adjusted in specific periods. We rejected this
approach for several reasons. First, this method would not have produced, in our
view, a more accurate result than the method we adopted, particularly given our
concerns with respect to the timing of when the reserves were originally
recorded. Second, it was very difficult to make reasonable assessments of how
specific reserves should have been booked at a particular time without being
influenced by subsequent data, especially in light of the assumptions that had
already been made in the reserve estimation process. Third, the investigation
identified that (a) a large number of personnel were responsible for making
reserve estimates and that there was not a consistent or centralized approach
used in the reserve estimation process, including the assumptions used in the
process or the documentation generated in support of these assumptions and (b)
there was a lack of controls over inputs into the reserve data base. As a result
of such factors, the integrity of the data could not be reasonably relied upon
for a detailed re-engineering of reserves. Finally, the findings of the
independent investigation identified that there was inadequate detailed
historical, technical documentation to support the booking of certain reported
reserves. Consequently, without such detailed documentation, it would be
extremely difficult, and in some cases impossible, to determine with precision
the appropriate time that specific reserves should have been removed from the
proved reserves category.

Our reserve restatement methodology resulted in the following revisions to
our proved natural gas and oil reserves (Bcfe) (Unaudited):

The restatement of our proved reserves also impacted previously reported
items in our supplemental information on our natural gas and oil activities,
including the classification of costs incurred in natural gas and oil activities
between exploration or development cost. For a further discussion of our natural
gas and oil reserves, see Note 13, Supplemental Natural Gas and Oil Operations.

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EL PASO PRODUCTION HOLDING COMPANY

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Financial Impact of Restatements

The total cumulative impact of the restatements was a reduction of our
previously reported stockholder's equity as of September 30, 2003 of
approximately $387 million, which includes a reduction in beginning
stockholder's equity as of January 1, 2001 of approximately $503 million. Of the
reduction to beginning stockholder's equity, $498 million related to the
restatement of reserves and represents the impact of ceiling test charges,
changes in depreciation, depletion and amortization expense and adjustments to
the book basis of properties acquired from an affiliate in 2000 and prior years,
and $5 million related to a loss in 2000 on the restatement for the hedge
transactions.

As to the individual financial statement line items, our historical
financial statements for the years ended December 31, 2002 and 2001, for each of
the quarters in those years and for each of the quarters and the first nine
months of 2003 reflect the effects of the reserve restatement on (i) the
calculation of our historical depletion expense, (ii) the amounts of our
earnings from unconsolidated affiliates (iii) the amounts of gains or losses
recorded on long-lived assets sold, and (iv) the impact of income taxes.
Additionally, revenues and other comprehensive income have been restated for the
impact of the adjustment related to two historical hedges of our natural gas
production. Also, our historical statements of cash flows were restated to
reflect amounts provided to El Paso under its cash management program as
investing activities instead of financing activities. We did not amend our
financial statements included in our registration statement on Form S-4 and the
financial statements and related financial information contained in that report
should no longer be relied upon. A summary of the effects of the restatement on
reported amounts for the years ended December 31, 2002 and 2001, and for the
quarterly periods during the three year periods ended December 31, 2003 is
presented below. For the impact of the restatement on income taxes, see Note 4.
The quarterly period information for 2001 is being provided for supplemental
purposes only. Also, the information in the quarterly data below represents only
those income statement and balance sheet line items affected by the restatement.
For additional supplemental quarterly information, see Note 12, Supplemental
Selected Quarterly Financial Information (Unaudited).

- ---------------

(1) The impact on stockholder's equity for the year ended December 31, 2001
includes the restatement impacts on depreciation, depletion and amortization
during that year, as well as the adjustment to opening retained earnings for
the effects of the restatement on years prior to 2001.

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- ---------------

(1) Restated amounts include the effect of state income taxes of $13 million for
the quarter ended March 31, 2003 that were previously recorded in the
quarter ended September 30, 2003 related to natural gas and oil properties
sold in Oklahoma.

The restatement of our historical reserve estimates, our historical
financial information derived from those estimates, the restatement associated
with two hedge transactions and the reclassification of our historical
statements of cash flows for amounts provided to El Paso under the cash
management program, resulted in or will result in a delay in the filing of our
Forms 10-Q for the quarterly periods ended March 31, 2004, June 30, 2004 and
September 30, 2004. As a result, we obtained waivers, effective until December
31, 2004 relating to the defaults under our indenture as a result of these
delays. The filing of our 2004 Forms 10-Q will satisfy the conditions of the
waivers. See Note 7 for further discussion of the indenture.

The reserve restatement will result in a lower depletion rate and reduced
exposure to ceiling test charges in the future than would have been the case
absent the reserve restatement. In addition, neither of the restatements had an
impact on our total cash flows reported in historical periods.

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EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

2. SIGNIFICANT EVENTS AND ACCOUNTING POLICIES

SIGNIFICANT EVENTS

Liquidity

El Paso is a significant potential source of liquidity to us. We
participate in El Paso's cash management program. Under this program, depending
on whether we have short-term cash surpluses or requirements, El Paso provides
cash to us or we can 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 December 31, 2003, we had a receivable from El Paso of $688 million, of
which $393 million is classified as a current asset in our balance sheet. If El
Paso were unable to meet its liquidity needs, we would not have access to this
source of liquidity and there is no assurance that El Paso could repay the
entire amounts owed to us. In that event, we could be required to write-off some
amount of these advances, which could have a material impact on our
stockholder's equity and we would still be required to repay affiliated company
payables. In addition, based on our current estimates of cash flows, we believe
we will seek repayment of a portion of these advances in the next year.

If El Paso were subject to voluntary or involuntary bankruptcy proceedings,
El Paso and its other subsidiaries and their creditors could attempt to make
claims against us, including claims to substantively consolidate our assets and
liabilities with those of El Paso and its other subsidiaries. We believe that
claims to substantively consolidate us with El Paso and/or its other
subsidiaries would be without merit. However, there is no assurance that El Paso
and/or its other subsidiaries or their creditors would not advance such a claim
in a bankruptcy proceeding. If we were to be substantively consolidated in a
bankruptcy proceeding with El Paso and/or its other subsidiaries, there could be
a material adverse effect on our financial condition and our liquidity.

As discussed in Note 1, we restated our historical financial statements to
reflect a reduction in our historically reported natural gas and oil reserves,
to adjust two transactions related to our historical hedges of our natural gas
production to their fair market value and to reclassify our historical
statements of cash flows for amounts provided to El Paso under the cash
management program, which has resulted in or will result in a delay in filing
our Forms 10-Q for the quarterly periods ended March 31, 2004, June 30, 2004 and
September 30, 2004. Our indenture includes covenants that require us to file
financial statements within specified time periods. Non-compliance with such
covenants does not constitute an automatic event of default. Instead, the debt
is subject to acceleration after any applicable cure periods have lapsed and the
indenture trustee or the holders of at least 25 percent of the outstanding
principal amount of debt under our indenture provide notice that the principal
and accrued interest has been declared due and payable. In July 2004, we entered
into an agreement approved by a majority of the holders of our senior unsecured
notes. The agreement provides for a waiver of the breach of our covenant to
timely file our financial statements and is effective until December 31, 2004.
In connection with the waiver, we have 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).

SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

Our consolidated financial statements include the accounts of all
majority-owned, controlled subsidiaries after the elimination of all significant
intercompany accounts and transactions. Our financial statements for prior
periods include reclassifications that were made to conform to the current year
presentation. Those reclassifications did not impact our reported net income or
stockholder's equity.

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EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Principles of Consolidation

We consolidate entities when we have the ability to control the operating
and financial decisions and policies of an entity. Where we can exert
significant influence over, but do not control, those policies and decisions, we
apply the equity method of accounting. We use the cost method of accounting
where we are unable to exert significant influence over the entity. The
determination of our ability to control or exert significant influence over an
entity involves the use of judgment of the extent of our control or influence
and that of the other equity owners or participants of the entity.

Use of Estimates

The preparation of financial statements in conformity with accounting
principles generally accepted in the U.S. requires the use of estimates and
assumptions that affect the amounts we report as assets, liabilities, revenues
and expenses and our disclosures in these financial statements. Actual results
can, and often do, differ from those estimates.

Cash and Cash Equivalents

We consider short-term investments with an original maturity of less than
three months to be cash equivalents. We classify cash in bank accounts that is
unavailable for immediate withdrawal, that is subject to limitations on its use,
or that is considered a compensating balance as restricted cash. As of December
31, 2003, we had no restricted cash and at December 31, 2002, we had $6 million
of restricted cash classified as other current assets in our balance sheet.

Allowance for Doubtful Accounts

We establish provisions for losses on accounts receivable and for natural
gas imbalances due from shippers and operators if we determine that we will not
collect all or part of the outstanding balance. We regularly review
collectibility and establish or adjust our allowance as necessary using the
specific identification method.

Natural Gas and Oil Properties

We use the full cost method to account for our natural gas and oil
properties. Under the full cost method, substantially all productive and
nonproductive costs incurred in connection with the acquisition, development and
exploration of natural gas and oil reserves are capitalized. These capitalized
amounts include the costs of all unproved properties, internal costs directly
related to acquisitions, development and exploration activities, asset
retirement costs and capitalized interest. This method differs from the
successful efforts method of accounting for these activities. The primary
differences between these two methods are the treatment of exploratory dry hole
costs. These costs are generally expensed under successful efforts when the
determination is made that measurable reserves do not exist. Geological and
geophysical costs are also expensed under the successful efforts method. Under
the full cost method, both dry hole costs and geological and geophysical costs
are capitalized into the full cost pool, which is then periodically assessed for
recoverability as discussed below.

We amortize capitalized costs using the unit of production method over the
life of our proved reserves. Capitalized costs associated with unproved
properties are excluded from the amortizable base until these properties are
evaluated. Future development costs and dismantlement, restoration and
abandonment costs, net of estimated salvage values, are included in the
amortizable base. Beginning January 1, 2003, we began capitalizing into our full
cost pool asset retirement costs associated with our proved developed natural
gas and oil reserves pursuant to the adoption of Statements of Financial
Accounting Standards (SFAS) No. 143, Accounting for Asset Retirement Obligations
as discussed below.

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EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Our capitalized costs, net of related income tax effects, are limited to a
ceiling based on the present value of future net revenues using end of period
spot prices discounted at 10 percent, plus the lower of cost or fair market
value of unproved properties, net of related income tax effects. If these
discounted revenues are not equal to or greater than total capitalized costs, we
are required to write-down our capitalized costs to this level. We perform this
ceiling test calculation each quarter. Any required write-downs are included in
our income statement as a ceiling test charge. Our ceiling test calculations
include the effects of derivative instruments we have designated as cash flow
hedges of our anticipated future natural gas and oil production.

When we sell or convey interests(including net profits interest) in our
natural gas and oil properties, we reduce our reserves for the amount
attributable to the sold or conveyed interest. We do not recognize a gain or
loss on sales of our natural gas and oil properties, unless those sales would
significantly alter the relationship between capitalized costs and proved
reserves. We treat sales proceeds on non-significant sales as an adjustment to
the cost of our properties.

For the year ended December 31, 2003, we capitalized $12 million related to
interest on our long-term financing. Prior to the issuance of our senior
unsecured notes, no amounts were capitalized in 2002 and 2001. Our accrued
capitalized costs and other accrued operating expenses are included in other
accounts payable on our balance sheet.

Property, Plant and Equipment (Other than Natural Gas and Oil Properties)

Our, property, plant and equipment, excluding our assets accounted for
under the full cost method, is recorded at its original cost of construction or,
upon acquisition, at the fair value of the assets acquired. We capitalize the
major units of property replacements or improvements and expense minor items. We
depreciate our property, plant and equipment using the straight-line method over
the remaining useful lives of the assets ranging from one to 15 years.

Asset Impairments on Other Than Natural Gas and Oil Properties

We apply the provisions of SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets, to account for asset impairments related to
non-full cost pool assets. Under this standard, we evaluate an asset for
impairment when events or circumstances indicate that its carrying value may not
be recovered. These events include market declines, changes in the manner in
which we intend to use an asset, decisions to sell an asset and adverse changes
in the legal or business environment such as adverse actions by regulators. When
an event occurs, we evaluate the recoverability of the asset's carrying value
based on its ability to generate future cash flows on an undiscounted basis.
When we decide to exit or sell a long-lived asset or group of assets, we adjust
the carrying value of these assets downward, if necessary, to the estimated
sales price, less costs to sell. We also reclassify the asset or assets as
either held-for-sale or as discontinued operations, depending on, among other
criteria, whether we will have any continuing involvement in the cash flows of
those assets after they are sold.

Revenue Recognition

Our revenues are derived primarily through physical sales of natural gas,
oil and natural gas liquids produced. Revenues from sales of these products are
recorded upon the passage of title using the sales method, net of any royalty
interests or other profit interests in the produced product. When actual natural
gas sales volumes exceed our entitled share of sales volumes, an overproduced
imbalance occurs. To the extent the overproduced imbalance exceeds our share of
the remaining estimated proved natural gas reserves for a given property, we
record a liability. Costs associated with the transportation and delivery of
production are included in cost of sales.

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EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Environmental Costs and Other Contingencies

We record liabilities when our environmental assessments indicate that
remediation efforts are probable, and the costs can be reasonably estimated. We
recognize a current period expense for the liability when clean-up efforts do
not benefit future periods. We capitalize costs that benefit more than one
accounting period. Estimates of our liabilities are based on currently available
facts, existing technology and presently enacted laws and regulations taking
into consideration the likely effects of societal and economic factors, and
include estimates of associated legal costs. These amounts also consider prior
experience in remediating contaminated sites, other companies' clean-up
experience and data released by the Environmental Protection Agency or other
organizations. These estimates are subject to revision in future periods based
on actual costs or new circumstances and are included in our balance sheet in
other current and long-term liabilities at their undiscounted amounts. We
evaluate recoveries from insurance coverage or government sponsored programs
separately from our liability and, when recovery is assured, we record and
report an asset separately from the associated liability in our financial
statements.

We recognize liabilities for other contingencies when we have an exposure
that, when fully analyzed, indicates it is both probable that an asset has been
impaired or that a liability has been incurred and the amount of impairment or
loss can be reasonably estimated. Funds spent to remedy these contingencies are
charged against a reserve, if one exists, or expensed. When a range of probable
loss can be estimated, we accrue the most likely amount or at least the minimum
within the range of probable loss.

Price Risk Management Activities

We engage in hedging activities on our natural gas and oil production to
obtain more determinable cash flows and to mitigate the risk of downward price
movements on sales of these commodities. We do this through natural gas and oil
swaps with our affiliate, El Paso Merchant Energy.

We account for our derivative instruments under SFAS No. 133 Accounting for
Derivative Instruments and Hedging Activities. Under SFAS No. 133, these
derivatives are reflected in our balance sheet at their fair value as assets and
liabilities from price risk management activities. We classify our derivatives
as either current or non-current assets or liabilities based on our overall
position by counterparty and their anticipated settlement date.

The settlement of derivatives used in our hedging activities are reflected
as revenues in our income statements. Cash inflows and outflows associated with
the settlement of our derivative instruments are recognized in operating cash
flows, and any receivables and payables resulting from these settlements are
reported as affiliate receivables or payables on our balance sheet.

Income Taxes

We report current income taxes based on our taxable income, and we provide
for deferred income taxes to reflect estimated future tax payments and receipts.
Deferred taxes represent the tax impacts of differences between the financial
statement and tax bases of assets and liabilities and carryovers at each year
end. We account for tax credits under the flow-through method, which reduces the
provision for income taxes in the year the tax credits first become available.
We reduce deferred tax assets by a valuation allowance when, based on our
estimates, it is more likely than not that a portion of those assets will not be
realized in a future period. The estimates utilized in recognition of deferred
tax assets are subject to revision, either up or down, in future periods based
on new facts or circumstances.

El Paso maintains a tax accrual policy to record both regular and
alternative minimum taxes for companies included in its consolidated federal and
state income tax returns. The policy provides, among other things, that (i) our
taxable income position will accrue a current expense equivalent to our federal
and state income taxes, and (ii) our tax loss position will accrue a benefit to
the extent our deductions, including general

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EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

business credits, can be utilized in El Paso's consolidated returns. El Paso
pays all consolidated U.S. federal and state income tax directly to the
appropriate taxing jurisdictions and, under a separate tax billing agreement, El
Paso bills or refunds us for our portion of these income taxes.

Accounting for Asset Retirement Obligations

On January 1, 2003, we adopted SFAS No. 143, which requires that we record
a liability for retirement and removal costs of long-lived assets used in our
business. This liability is recorded at its estimated fair value, with a
corresponding increase to property, plant and equipment. This increase in
property, plant and equipment is then depreciated over the remaining useful life
of the long-lived asset to which that liability relates. An ongoing expense is
also recognized for changes in the value of the liability as a result of the
passage of time, which we record in depreciation, depletion and amortization
expense in our income statement. In the first quarter of 2003, we recorded a
benefit as a cumulative effect of accounting change of approximately $1 million,
net of income taxes, related to our adoption of SFAS No. 143. We also recorded
property, plant and equipment of $78 million and asset retirement obligations of
$76 million as of January 1, 2003. Our asset retirement obligations are
associated with our natural gas and oil wells and related infrastructure. We
have obligations to plug wells when production on those wells is exhausted, and
we abandon them. We currently forecast that these obligations will be met at
various times, generally over the next ten years, based on the expected
productive lives of the wells and the estimated timing of plugging and
abandoning those wells. The net asset retirement liability as of January 1, 2003
and December 31, 2003, reported in other current and non-current liabilities in
our balance sheet, and the changes in the net liability for the year ended
December 31, 2003, were as follows:

Our changes in estimate represent changes to the expected amount and timing
of payments to settle our asset retirement obligations. These changes primarily
result from obtaining new information about the timing of our obligations to
plug our natural gas and oil wells and the costs to do so. Had we adopted SFAS
No. 143 as of January 1, 2001, our aggregate current and non-current retirement
liabilities on that date would have been approximately $68 million and our
income from continuing operations and net income for the years ended December
31, 2002 and 2001, would have been lower by $5 million in each year.

3. ACQUISITIONS AND DIVESTITURES

Acquisitions

In December 2003, we purchased natural gas and oil properties from
affiliates of El Paso for $27 million. In May 2003, we acquired a gas gathering
system through a contribution from El Paso of $26 million. In July 2002, we
acquired Vermejo Mineral Corporation from a third party for approximately $140
million. These acquisitions were accounted for as purchases and the purchase
prices were assigned to natural gas and oil properties in our full cost pool. In
March 2002, we acquired natural gas and oil properties located in south Texas
from an affiliate of El Paso CGP for $396 million and the Prince offshore
platform from GulfTerra for $190 million. For more information on our 2002
affiliate acquisitions, see Note 11.

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EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Divestitures

In March 2003, we sold natural gas and oil properties located in Oklahoma,
Texas, and offshore Gulf of Mexico for approximately $450 million, and we did
not recognize a gain or loss on the reserves sold. In March 2002, we sold
natural gas and oil properties located in east and south Texas for approximately
$382 million. We recognized a $209 million gain on the sale of the east Texas
properties as the reserves sold significantly altered the relationship between
capitalized costs and proved reserves in our full cost pool. In addition in
2002, we recognized a $2 million gain on the sale of non-full cost pool assets.
We completed these sales as part of El Paso's plan to improve its liquidity and
respond to changing market conditions.

In March 2003, we distributed our ownership interests in El Paso Energy Oil
Transmission L.L.C., El Paso Energy Minerals, L.L.C., and El Paso Energy
Minerals Leasing, L.L.C. to El Paso CGP. At the time of these distributions, our
combined investment in these subsidiaries was $24 million. In April 2003, we
sold our interest in Noric Holdings I, see Note 11.

As further discussed in Note 13, during 2003 we sold interests in certain
natural gas and oil wells in exchange for the payment of a portion of our
drilling and completion costs on such wells.

4. INCOME TAXES

Pretax income from continuing operations for the periods ended December 31,
2003, 2002 and 2001, was $218 million, $464 million and $195 million.

The following table reflects the components of income tax expense included
in income from continuing operations before cumulative effect of accounting
change for each of the three years ended December 31:

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EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Our income tax expense, included in income from continuing operations
before cumulative effect of accounting change, differs from the amount computed
by applying the statutory federal income tax rate of 35 percent for the
following reasons for each of the three years ended December 31:

- ---------------

(1) State income taxes for 2003 include the effect of properties sold in
Oklahoma.

The following are the components of our net deferred tax asset as of
December 31:

Under El Paso's tax allocation policy, we are allocated the tax effects
associated with sales of stock by employees under an employee stock purchase
plan, the exercise of non-qualified stock options and the vesting of restricted
stock, as well as dividends on restricted stock. This allocation increased the
deferred taxes payable by $5 million in 2003 and decreased the deferred taxes
payable by $2 million in 2002 and $6 million in 2001. These tax effects are
included in additional paid-in capital in our balance sheets.

The election to capitalize and amortize intangible drilling costs, under
Section 59(e) of the Internal Revenue Code, for tax years 2002 and 2003, caused
the deferred tax associated with property, plant and equipment to change from a
liability in 2002 to an asset in 2003.

As of December 31, 2003, we had available net operating loss carryforwards
of approximately $366 million. The net operating loss carryforward periods end
in the years 2017 through 2023. We also have

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EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

alternative minimum tax carryforwards of approximately $23 million, which are
carried forward indefinitely. Usage of our federal carryover is subject to the
limitations provided under Sections 382 and 383 of the Internal Revenue Code as
well as separate return limitation year rules of IRS regulations.

5. FINANCIAL INSTRUMENTS AND PRICE RISK MANAGEMENT ACTIVITIES

The following table presents the carrying amounts and estimated fair values
of our financial instruments as of December 31:

As of December 31, 2003 and 2002, the carrying amounts of cash and cash
equivalents, and trade receivables and payables represented fair value because
of the short-term nature of these instruments. We estimated the fair value of
debt with fixed interest rates based on quoted market prices for the same or
similar issues.

Our derivative contracts are recorded in our financial statements at fair
value. The best indication of fair value is quoted market prices. However, when
quoted market prices are not available, we estimate the fair value of those
derivatives. Due to major industry participants exiting or reducing their
trading activities in 2002 and 2003, the availability of reliable commodity
pricing data from market-based sources that we used in estimating the fair value
of our derivatives was significantly limited for certain locations and for
longer time periods. Consequently, we use a combination of commodity prices from
market-based sources and other forecasted settlement prices from an independent
pricing source to develop forward pricing data beyond a current two-year period,
which we then use to estimate the value of settlements in future periods based
on the contractual settlement quantities and dates. For forward pricing data
within two years, we use commodity prices from market-based sources such as the
NYMEX.

We use derivative financial instruments to hedge the cash flow impact of
our market price risk exposures on our forecasted transactions related to our
natural gas and oil production. A majority of our commodity sales are at spot
market prices. We can use futures, forward contracts and swaps to limit our
exposure to fluctuations in the commodity markets with the objective of
realizing a fixed cash flow stream from these activities. Changes in derivative
fair values that are designated as cash flow hedges are deferred in accumulated
other comprehensive income to the extent that they are effective and are not
included in income until the hedged transactions occur and are recognized in
earnings. The ineffective portion of a cash flow hedge's change in value is
recognized immediately in earnings as a component of operating revenues in our
income statement.

We formally document all relationships between hedging instruments and
hedged items, as well as our risk management objectives, strategies for
undertaking various hedge transactions and our methods for assessing and testing
correlation and hedge ineffectiveness. All hedging instruments are linked to the
hedged asset, liability, firm commitment or forecasted transaction. We also
assess whether these derivatives are highly effective in offsetting changes in
cash flows or fair values of the hedged items. We discontinue hedge accounting
prospectively if we determine that a derivative is no longer highly effective as
a hedge or if we decide to discontinue the hedging relationship.

On January 1, 2001, we adopted SFAS No. 133 and recorded a cumulative
effect adjustment of $662 million, net of income taxes, in accumulated other
comprehensive income to recognize the fair value of all derivatives designated
as hedging instruments. The majority of the initial charge related to hedging
cash

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EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

flows from anticipated sales of natural gas for 2001 and 2002. During the year
ended December 31, 2001, $475 million, net of income taxes, of this initial
transition adjustment was reclassified to earnings as a result of hedged sales
during the year.

As of December 31, 2003 and 2002, the value of cash flow hedges included in
accumulated other comprehensive income was a net unrealized loss of $268 million
and $224 million, net of income taxes. We estimate that unrealized losses of
$119 million, net of income taxes, will be reclassified from accumulated other
comprehensive income during 2004. Reclassifications occur upon physical delivery
of the hedge commodity and the corresponding expiration of the hedge. The
maximum term of our cash flow hedges is 9 years; however, most of our cash flow
hedges expire within the next 36 months.

For the years ended December 31, 2003, 2002 and 2001, we recognized a net
loss of $5 million, $7 million and $1 million, net of income taxes, related to
the ineffective portion of all cash flow hedges.

In May 2002, we announced a plan to reduce the volumes of natural gas that
we had hedged. We removed the hedging designation on derivatives that had a fair
value loss of $20 million at December 31, 2002. This amount, net of income taxes
of $7 million, has been reflected in accumulated other comprehensive income and
was reclassified to income as the original hedged transactions settled in 2003.

In August 2004, we determined that two hedge transactions entered into
during 2000 had not been initially recorded at their fair value. As a result, we
restated our historical financial statements to adjust these transactions to
fair market value. See Note 1 for a further discussion of this restatement.

6. PROPERTY, PLANT AND EQUIPMENT

Presented below are capitalized costs of natural gas and oil properties
that are not being amortized, pending determination as to the existence of
proved reserves.

During 2003, 2002 and 2001, our weighted average unit of production
depletion rate on our natural gas and oil properties per Mcfe was $1.59, $1.42
and $1.14.

7. DEBT AND OTHER CREDIT FACILITIES

In March 2003, El Paso obtained a $1.2 billion, London Interbank Offered
Rate (LIBOR) plus 4.25% bridge loan, collateralized by substantially all of our
natural gas and oil reserves. El Paso loaned $913 million of the proceeds to
several of our subsidiaries. These subsidiaries subsequently distributed the
amounts to El Paso to retire the net balance of $913 million on El Paso's Red
River financing arrangement. Prior to repayment of the Red River financing, the
cash generated from our assets was restricted for amortization requirements on
the Red River arrangement. See Note 11 for a further discussion of the Red River
financing arrangement.

On May 20, 2003, we issued $1.2 billion of 7.75% senior unsecured notes due
June 1, 2013 and received net proceeds of $1.17 billion. We used these proceeds
to repay our obligation to El Paso in conjunction with the refinancing of its
Red River financing arrangement as discussed above.

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EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The 7.75% senior unsecured notes due June 1, 2013 are fully and
unconditionally guaranteed by our wholly-owned subsidiary guarantors on a joint
and several basis. There are no independent assets or operations at the holding
company level, and our subsidiaries, other than the subsidiary guarantors, are
minor.

Under the indenture covering the senior unsecured notes we and our
Restricted Subsidiaries (as defined in the indenture) are subject to a number of
restrictions and covenants. These include (i) limitations on the incurrence of
additional debt if there is a default or our Consolidated Coverage Ratio (as
defined in the indenture) is below 2.0 to 1.0, (ii) limitations on dividends
that can be made based on Free Cash Flow and Net Cash Proceeds (each as defined
in the indenture) (there are no restrictions on the amount of dividends that our
Restrictive Subsidiaries can make to us), (iii) limitations on asset sales, (iv)
limitations on affiliate transactions, (v) limitations on liens securing debt
and (vi) limitations on providing cash to El Paso under its cash management
program. As of December 31, 2003, we were in compliance with these covenants.

As discussed in Note 1, we restated our historical financial statements to
reflect a reduction in our historically reported natural gas and oil reserves,
to adjust two transactions related to historical hedges of our natural gas
production to fair market value, and to reclassify our historical statements of
cash flows for amounts provided to El Paso under the cash management program,
which has resulted in or will result in a delay in filing our Forms 10-Q for the
quarterly periods ended March 31, 2004, June 30, 2004 and September 30, 2004.
Our indenture includes covenants that require us to file financial statements
within specified time periods. Non-compliance with such covenants does not
constitute an automatic event of default. Instead, the debt is subject to
acceleration after any applicable cure periods have lapsed and the indenture
trustee or the holders of at least 25 percent of the outstanding principal
amount of debt under our indenture provide notice that the principal and accrued
interest has been declared due and payable. In July 2004, we entered into an
agreement approved by a majority of the holders of our senior unsecured notes.
The agreement provides for a waiver of the breach of our covenant to timely file
our financial statements and is effective until December 31, 2004. In connection
with that 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).

8. 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

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EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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 on April 10, 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.

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. El Paso has no ownership interest in the mine. However, we are a 50
percent stockholder in Black Warrior Methane Corporation, which was involved in
the extraction of methane from the mine, and which is a named defendant in 22 of
the lawsuits filed to date. In addition, we have been added as a defendant in
several of the cases. There has been no substantive discovery conducted to date.

Reserve Revisions. In March 2004, El Paso received a subpoena from the SEC
requesting documents relating to El Paso's previously announced reserve
revision. El Paso and its Audit Committee have also received federal grand jury
subpoenas for documents regarding the reserve revision. We are assisting El Paso
and the Audit Committee in their efforts to cooperate with the SEC and the U.S.
Attorney 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 December
31, 2003, we had approximately $4 million accrued for all outstanding legal
matters.

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 December
31, 2003, we had no accrual for remediation costs and associated onsite, offsite
and groundwater technical studies or for related environmental legal costs.

Air Permit Violation. On March 21, 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

51

EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

liabilities in the future. As this information becomes available, or other
relevant developments occur, we will 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.

Lease Obligations

We lease office space and various equipment under operating lease
agreements. As of December 31, 2003, the annual minimum lease payments under
non-cancelable future operating lease commitments were approximately $1 million
for the years 2004 through 2006 and less than $1 million annually thereafter.
Rental expense charged to operations was less than $1 million for the years
ended December 31, 2003 and 2002 and $2 million for the year ended December 31,
2001.

Other Commercial Commitments

We have various commercial commitments at December 31, 2003 primarily
related to transportation obligations of approximately $22 million in 2004, $14
million in 2005, $10 million in 2006, $9 million in 2007, $17 million in 2008
and $33 million in total thereafter.

9. RETIREMENT BENEFITS

Pension and Retirement Benefits

El Paso maintains a primary pension plan that is a defined benefit plan
that covers substantially all of our U.S. employees and provides benefits under
a cash balance formula.

El Paso also maintains a defined contribution plan covering all of our U.S.
employees. Prior to May 1, 2002, El Paso matched 75 percent of participant basic
contributions up to 6 percent, with the matching contribution being made to the
plan's stock fund which participants could diversify at any time. After May 1,
2002, the plan was amended to allow for matching contributions to be invested in
the same manner as that of participant contributions. Effective March 1, 2003,
El Paso suspended the matching contribution, but reinstituted it again at a rate
of 50 percent of participant basic contributions up to 6 percent on July 1,
2003. Effective July 1, 2004, El Paso increased the matching contribution to 75
percent of participant basic contributions up to 6 percent. As a result of El
Paso not being current on its SEC filings, the Plan Committee temporarily
suspended participants from making future contributions to or transferring other
investment funds to the El Paso Corporation Stock Fund effective June 25, 2004.
This temporary suspension does not affect the participant's ability to maintain
or transfer the investment that they may currently have in the El Paso
Corporation Stock Fund. Participants may continue to sell stock currently held
in the El Paso Corporation Stock Fund at their discretion (subject to any
insider trading restrictions). As soon as El Paso completes its required SEC
filings and is in compliance with the SEC requirements, participants will be
able to invest in the El Paso Corporation Stock Fund again. El Paso is
responsible for benefits accrued under its plan and allocates the related costs
to its affiliates.

Other Postretirement Benefits

El Paso provides limited postretirement life insurance benefits for current
and retired employees. El Paso is responsible for benefits accrued under its
plan and allocates the related costs to its affiliates. We do not provide
subsidized postretirement medical benefits.

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EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

10. SUPPLEMENTAL CASH FLOW INFORMATION

The following table contains supplemental cash flow information for each of
the three years ended December 31:

There have been no income tax settlements with our parent under our tax
sharing agreement. We expect to settle accrued income taxes with our parent
beginning in 2004.

11. INVESTMENTS IN UNCONSOLIDATED AFFILIATES AND RELATED PARTY TRANSACTIONS

Investments in Unconsolidated Affiliates

Noric L.L.C. In April 2003, we sold our interest in Noric Holdings I, our
consolidated subsidiary, to an affiliate of El Paso for less than $1 million.
Our investment in Noric Holdings I, at the time of the sale, was $148 million.
Because this sale involved entities under the common control of El Paso, we
recorded the difference between the cash consideration and book value of the
investment as a dividend. As a result of this sale, we no longer have an
investment in Noric, L.L.C., an investment of Noric Holdings I. Our investment
in Noric, L.L.C. was accounted for using the equity method. Prior to its sale in
2003, our investment in Noric, L.L.C. was $119 million. For the years ended
December 31, 2003, 2002 and 2001, we recognized $9 million, $14 million and $19
million in equity earnings from this unconsolidated affiliate.

Summarized income statement and balance sheet information of our
proportionate share of our investment in Noric L.L.C. for the years ended
December 31, 2003, 2002 and 2001 and as of
December 31, 2003 and 2002 is described below. The following information has
been restated as a result of our reserve revisions and the reserve revisions by
El Paso CGP, our affiliate:

- ---------------

(1) Includes operating results data through April 2003.

Clydesdale Associates, L.P. In April 2003, we sold our interest in
Clydesdale Associates, L.P. (Clydesdale), in which we had a 2 percent net
ownership interest. We accounted for this investment using the cost method of
accounting. Prior to the sale, our investment was $25 million. For the years
ended December 31, 2003, 2002 and 2001, we received $0.3 million, $1 million and
$11 million, in dividends from Clydesdale, which are reflected on our statements
of income as earnings from unconsolidated affiliates. In May 2002, we were
notified by Clydesdale that it had distributed cash of $8 million in excess
earnings to us

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EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

because of a change in the pro-rata allocation between us and other investors.
We returned the excess earnings and reflected this transaction on our statement
of income as a reduction in earnings from unconsolidated affiliates.

Black Warrior Transmission Corporation. We hold a 50 percent ownership
interest in Black Warrior Transmission Corporation and account for this
investment using the equity method of accounting. Our investment was $6 million
and $7 million as of December 31, 2003 and 2002. We recognized equity earnings
of less than $1 million for each of the years ended December 31, 2003, 2002 and
2001 from this unconsolidated affiliate.

Related Party Transactions

Affiliate Receivables and Payables

We sell our natural gas primarily to affiliates of El Paso at spot-market
prices. Accounts receivable due from affiliates at December 31, 2003 and 2002,
was $58 million and $90 million. Accounts payable due to affiliates at December
31, 2003 and 2002, was $7 million and $10 million. These affiliate receivables
and payables were created during the normal course of business. Additionally, we
recorded a $118 million income tax payable to affiliate as of December 31, 2003
and a $91 million income tax receivable from affiliate as of December 31, 2002,
for our allocated portion of El Paso's tax accrual (see Note 2).

Cash Management Program and Other Affiliate Transactions

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 December 31, 2003 and 2002,
we had receivables from El Paso of $688 million, and $431 million. As of
December 31, 2003, we classified $295 million as non-current notes receivables
from affiliates.

Our affiliate El Paso CGP, through its subsidiaries, engages in the
exploration for and the acquisition, development and production of natural gas
and oil. We do not have an agreement with El Paso CGP or its subsidiaries
regarding the allocation of business opportunities and therefore we may pursue
opportunities that are also being pursued by El Paso CGP's subsidiaries.

In addition, our officers, directors and personnel also provide services to
El Paso CGP and its subsidiaries pursuant to our shared services arrangement and
therefore share their time and services between us and El Paso CGP.

We are allocated a portion of El Paso's corporate overhead which covers
charges related to management, legal, financial, tax, consultative
administrative and other services, including employee benefits, annual incentive
bonuses, rent, insurance, and information technology. The allocation of these
expenses is based upon the relative size of our EBIT, gross property and
payroll. For the years ended December 31, 2003, 2002 and 2001, we were allocated
$117 million, $104 million and $68 million, which is reflected in our statements
of income as operation and maintenance expense.

We allocate a portion of El Paso's corporate overhead allocated to us and
our general corporate overhead to affiliates of El Paso CGP for management,
legal, accounting, financial, tax, consulting, administrative, and other
services. For the years ended December 31, 2003, 2002 and 2001, amounts
allocated to El Paso CGP were $122 million, $141 million and $98 million. This
allocation is reflected on our statements of income as a reduction in operations
and maintenance expense.

GulfTerra, an equity investment in which El Paso has a general and limited
partner ownership, is a publicly traded master limited partnership that provides
natural gas and oil gathering, transportation, processing, storage, and other
related services to us. For the years ended December 31, 2003, 2002 and 2001,

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EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

GulfTerra provided services of $4 million, $17 million and $10 million. During
2002, we acquired the Prince offshore platform from GulfTerra for $190 million
with funds El Paso provided through a capital contribution.

We also contract for services with El Paso Field Services Company and El
Paso's regulated interstate pipelines. These companies provide transportation,
gathering, processing, and treating for our natural gas, oil, condensate, and
liquids production to us. For the years ended December 31, 2003, 2002 and 2001,
El Paso Field Services Company provided services of $1 million, $3 million and
$1 million. For the years ended December 31, 2003, 2002 and 2001, El Paso's
regulated interstate pipelines, including Tennessee Gas Pipeline Company and
Colorado Interstate Gas Company, provided services of $10 million, $13 million
and $5 million.

We are a party to a master hedging contract with El Paso Merchant Energy
that conducts energy trading activities. Pursuant to that agreement, we hedge
our production with El Paso Merchant Energy.

Red River Financing

During 1999, El Paso formed various companies for the purpose of generating
funds for El Paso to invest in capital projects and other assets. At December
31, 2002, two of our subsidiaries, Sabine River Investors VII, L.L.C. and Sabine
River Investors VIII, L.L.C., had each loaned $75 million to El Paso as demand
loans. These amounts were reflected as notes receivable from affiliates in our
balance sheets and carried an interest rate based on LIBOR plus 0.5 % per year,
which was 2.3 % at December 31, 2002. In the first quarter of 2003, in
conjunction with the Red River transactions as further discussed in Note 7, we
contributed $56 million for a partial payment of El Paso's Red River financing
arrangement and we made a $150 million dividend of our receivable to El Paso.

During March 2002, we acquired natural gas and oil properties located in
south Texas from an affiliate of El Paso CGP for $396 million in cash in order
to maintain an adequate collateral balance for our Red River financing. These
properties were acquired to replace comparable properties in south and east
Texas that were sold to third parties. The acquisition of these properties
involved a series of investments, contributions and sales through various
affiliated legal entities. We provided an additional $3.9 million in cash to
complete the acquisition. Because this property acquisition involved entities
under the common control of El Paso, we recorded the acquired properties at
their El Paso CGP carryover basis net book value of $130 million, along with an
associated deferred tax asset of $91 million. The $171 million difference
between the cash consideration price and the carryover basis of the acquired
properties was reflected as a dividend. As a result of proved natural gas and
oil reserve revisions by El Paso CGP, the carryover basis of the net book value
of the acquired properties was restated from the original contribution amount of
$343 million to $130 million. The dividend and the associated deferred taxes
related to this transaction were also restated. Our total stockholder's equity
decreased by $138 million as a result of this restatement.

55

EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following table presents the revenues and net income of the previously
separate business entities and the combined amounts presented in these audited
financial statements. Adjustments to revenues and expenses were made to add the
impact of this transaction to prior periods. The adjustments we have made in
these statements require us to use estimates and assumptions based on currently
available information. We believe our estimates and assumptions are reasonable,
however actual results may differ from the estimates and assumptions used.

Mustang Financing

Prior to their sale in 2003, we had ownership interests in several
companies, including a 62 percent equity interest in Noric Holdings I, an 8.2
percent voting interest in Clydesdale Associates, L.P. and a 62 percent
effective interest in Noric, L.L.C. (an investment of Noric Holding I), that El
Paso formed in 2000 for the purpose of generating funds for El Paso to invest in
capital projects and other assets.

We consolidated Noric Holdings I and reflected the portion we did not own
as a minority interest in our balance sheets and in our statements of income.
For the years ended December 31, 2003, 2002 and 2001, the minority interest
expense was $3 million, $3 million and $4 million. Additionally, as of December
31, 2002, Noric Holdings I had a $36 million long-term note receivable from El
Paso which was repaid in 2003.

Dividends

During 2003, 2002 and 2001, we paid dividends of $1.6 billion, $298 million
and $22 million to El Paso, of which $320 million in 2003 were non-cash
dividends. These dividends are primarily related to the Red River transactions
discussed above and in Note 7.

Acquisitions and Divestitures

During 2002 and 2003, we acquired and sold properties to various
affiliates. For further discussion of these transactions, see Note 3.

56

EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

12. SUPPLEMENTAL SELECTED QUARTERLY FINANCIAL INFORMATION (UNAUDITED)

Financial information by quarter, as restated to reflect the impacts of the
restatements as further described in Note 1 is summarized below:

13. SUPPLEMENTAL NATURAL GAS AND OIL OPERATIONS (UNAUDITED)

We are engaged in the exploration for, and the acquisition, development and
production of natural gas, oil, condensate and natural gas liquids. We primarily
operate in Alabama, Arkansas, Louisiana, New Mexico, Oklahoma, Texas and the
Gulf of Mexico. Financial and natural gas and oil reserve information as
restated to reflect the impacts of revisions of our natural gas and oil reserves
as further described in Note 1 is summarized below.

Capitalized costs relating to natural gas and oil producing activities and
related accumulated depreciation, depletion and amortization were as follows at
December 31:

- ---------------

(1) As of January 1, 2003 we adopted SFAS No. 143, Accounting for Asset
Retirement Obligations. Included in our net capitalized costs at December
31, 2003 are SFAS No. 143 asset values of $47 million. Prior year amounts do
not reflect these costs as they were adjusted through a one-time cumulative
adjustment which is further discussed in Note 2.

57

EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Costs incurred in natural gas and oil producing activities, whether
capitalized or expensed, were as follows at December 31:

- ---------------

(1) Excludes $76 million that was paid by third parties under net profits
interest agreements as described beginning on page 60.

(2) In January 2003 we adopted SFAS No. 143. Prior period presentation was not
adjusted as amounts were adjusted through a one-time cumulative adjustment
of approximately $1 million, net of taxes, which is further discussed in
Note 2.

(3) We have reclassified some of our development costs to exploration cost as a
result of the restatement of our proved natural gas and oil reserves.

In our January 1, 2004 reserve report, the amounts estimated to be spent in
2004, 2005 and 2006 to develop our booked proved undeveloped reserves are $221
million, $191 million and $131 million.

Presented below is an analysis of the capitalized costs of natural gas and
oil properties by year of expenditure that are not being amortized as of
December 31, 2003, pending determination of proved reserves. Capitalized
interest of $10 million for the year ended December 31, 2003 is included in the
table below (in millions).

Projects presently excluded from amortization are in various stages of
evaluation. The majority of these costs are expected to be included in the
amortization calculation in the years 2004 through 2007. Total depreciation,
depletion and amortization expense per Mcfe, was $1.68, $1.45, and $1.18 in
2003, 2002, and 2001. In January 2003 we adopted SFAS No. 143, which is further
discussed in Note 2. Accretion expense per Mcfe attributable to asset retirement
obligations accrued pursuant to SFAS No. 143 was $0.03 in 2003, which is
included in our depreciation, depletion and amortization expense.

58

EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Net quantities of proved developed and undeveloped reserves of natural gas
and liquids, including condensate and crude oil, and changes in these reserves
at December 31, 2003, are presented below. All of our proved properties and
reserves are located in the United States. Information in this table is based on
the reserve report dated January 1, 2004, prepared internally by us. Ryder Scott
Company and Huddleston & Co., Inc., independent petroleum engineering firms,
performed independent reserve estimates for 94 percent and 6 percent of our
properties. The total estimate of proved reserves prepared independently by
Ryder Scott Company and Huddleston & Co., Inc. was within five percent of our
internally prepared estimate for 2003 presented in the table below. The
information at December 31, 2003 is consistent with estimates of reserves filed
with other federal agencies except for differences of less than five percent
resulting from actual production, acquisitions, property sales, necessary
reserve revisions and additions to reflect actual experience. Reserve
information as of and for the years ended December 31, 2001 and 2002 in the
following table has been restated (for a further discussion of our reserve
restatement, see Note 1).

- ---------------

(1) Includes oil, condensate, and natural gas liquids. Our year end 2003 natural
gas liquids were 4,828 MBbls.

(2) Net proved reserves exclude royalties and interests owned by others
(including net profits interest) and reflects contractual arrangements and
royalty obligations in effect at the time of the estimate.

(3) Revisions reflect a number of items such as product price changes and
changes in product differentials.

(4) Sales of reserves in place include 17,363 MMcf of natural gas and 779 MBbls
of liquids conveyed to third parties under net profits interest agreements
as described beginning on page 60.

59

EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

There are considerable uncertainties inherent in estimating quantities of
proved reserves and in projecting future rates of production and the timing of
development expenditures, including many factors beyond our control,
particularly where such reserves are not currently producing or developed. The
reserve data represents only estimates. Reservoir engineering is a subjective
process of estimating underground accumulations of natural gas and oil that
cannot be measured in an exact manner. The accuracy of any reserve estimate is a
function of the quality of available data and of engineering and geological
interpretations and judgment. As a result, estimates of different engineers
often vary. Estimates are subject to revision based upon a number of factors,
including reservoir performance, prices, economic conditions and government
restrictions. In addition, results of drilling, testing and production
subsequent to the date of an estimate may justify revision of that estimate.
Reserve estimates are often different from the quantities of natural gas and oil
that are ultimately recovered. The meaningfulness of reserve estimates is highly
dependent on the accuracy of the assumptions on which they were based. In
general, the volume of production from natural gas and oil properties we own
declines as reserves are depleted. Except to the extent we conduct successful
exploration and development activities or acquire additional properties
containing proved reserves, or both, our proved reserves will decline as
reserves are produced. There have been no major discoveries or other events,
favorable or adverse, that may be considered to have caused a significant change
in the estimated proved reserves since December 31, 2003.

In 2003, we entered into agreements to sell interests in a maximum of 82
wells to a subsidiary of Lehman Brothers (Lehman) and a wholly-owned subsidiary
of Nabors Industries, Ltd. (Nabors). As the wells are developed, these parties
will pay 70 percent of the drilling and completion costs in exchange for 70
percent of the net profits of the wells sold. As each well is commenced, these
parties receive an overriding royalty interest in the form of a net profits
interest in each well, under which they are entitled to receive 70 percent of
the aggregate net profits of all wells until they have recovered 117.5 percent
of their aggregate investment in the wells. Upon this recovery, the net profits
interest will convert to a proportionately reduced 2 percent overriding royalty
interest in the wells for the remainder of the wells' productive life. We do not
guarantee a return or the recovery of their costs or any return on their
investment. All parties to the agreements have the right to cease participation
in the agreements at any time. Upon ceasing participation in the agreements,
they will continue to receive their net profits interest on wells previously
started, but will relinquish their right to participate in any future wells. As
of December 31, 2003, we sold interests in 18 wells with proved reserves of
17,363 MMcf of natural gas and 779 MBbls of liquids to them under these
agreements. They have paid $76 million of drilling and completion costs and were
paid $1 million of the revenues net of negligible operating expenses associated
with these wells for the year ended December 31, 2003.

60

EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Results of operations from producing activities by fiscal year were as
follows at December 31:

- ---------------

(1) Production costs include lease operating costs and production related taxes
(including ad valorem and severance taxes).

(2) In January 2003, we adopted SFAS No. 143, which is further discussed in Note
2. Our 2003 depreciation, depletion and amortization includes accretion
expense for SFAS 143 asset retirement obligations of $7 million.

(3) Amounts restated include net revenues, depreciation, depletion, and
amortization expense, gain on long-lived assets and income tax expense.

The standardized measure of discounted future net cash flows relating to
proved natural gas and oil reserves at December 31 follows:

- ---------------

(1) Excludes $739 million and $599 million of future net cash outflows
attributable to hedging activities as of December 31, 2003 and 2002 and $290
million of future net cash inflows attributable to hedging activities as of
December 31, 2001.

For the calculations in the preceding table, estimated future cash inflows
from estimated future production of proved reserves were computed using year-end
commodity prices, adjusted for transportation and other charges. At December 31,
2003, the prices used were $31.41 per Bbl of oil, $5.81 per Mcf of gas and
$27.07 per Bbl of natural gas liquids. We may receive amounts different than the
standardized measure of discounted cash flow for a number of reasons, including
price changes and the effects of our hedging activities.

We do not rely upon the standardized measure when making investment and
operating decisions. These decisions are based on various factors including
probable and proved reserves, different price and cost assumptions, actual
economic conditions, capital availability, and corporate investment criteria.

61

EL PASO PRODUCTION HOLDING COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following are the principal sources of change in the standardized
measure of discounted future net cash flows (in millions):

- ---------------

(1) This disclosure reflects changes in the standardized measure calculation
excluding the effects of hedging activities.

62

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholder of
El Paso Production Holding Company:

In our opinion, the accompanying consolidated financial statements listed
in the Index appearing under Item 15(a)1 present fairly, in all material
respects, the financial position of El Paso Production Holding Company and its
subsidiaries (the "Company") at December 31, 2003 and 2002, and the results of
their operations and their cash flows for each of the three years in the period
ended December 31, 2003 in conformity with accounting principles generally
accepted in the United States of America. In addition, in our opinion, the
financial statement schedule listed in the Index appearing under Item 15(a)2
presents fairly, in all material respects, the information set forth therein
when read in conjunction with the related consolidated financial statements.
These financial statements and the financial statement schedule are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements and the financial statement schedule based
on our audits. We conducted our audits of these statements in accordance with
the standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

As discussed in Note 1, the December 31, 2002 and 2001 consolidated
financial statements have been restated to reflect the financial statement
impacts of the revisions in the Company's estimates of its proved natural gas
and oil reserves, to change the accounting for certain derivatives primarily
associated with hedges of the Company's anticipated natural gas production, and
to reclassify certain cash flows.

See Note 2 for a discussion regarding the Company and its parent's
liquidity position.

As discussed in Note 2 to the consolidated financial statements, the
Company adopted Statement of Financial Accounting Standards No. 143, Accounting
for Asset Retirement Obligations, effective January 1, 2003, and Statement of
Financial Accounting Standards No. 133, Accounting for Derivative Instruments
and Hedging Activities, as amended, effective January 1, 2001.

/s/ PRICEWATERHOUSECOOPERS LLP

Houston, Texas
September 28, 2004

63

SCHEDULE II

EL PASO PRODUCTION HOLDING COMPANY
VALUATION AND QUALIFYING ACCOUNTS

YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
(IN MILLIONS)

64

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

ITEM 9A. CONTROLS AND PROCEDURES

In February 2004, we completed the annual review of our December 31, 2003
natural gas and oil reserve estimates. As a result of this review, we reduced
our proved natural gas and oil reserve estimates by approximately 0.9 trillion
cubic feet. In May 2004, we announced that, after further review and the
completion of an independent investigation into the factors that led to this
significant reserve adjustment, we believed that this reserve adjustment related
to prior periods and the financial statement amounts derived from these
estimates would require a restatement of our prior period financial statements.
The results of this independent investigation indicated that, during the period
from the beginning of 1999 and into 2003, certain employees used aggressive and,
at times, unsupportable methods to book proved reserves. In addition, the
investigation concluded that certain employees provided proved reserve estimates
that they knew or should have known were incorrect at the time they were
reported. In August 2004, we also determined we had not properly accounted for
two transactions relating to hedges of our anticipated natural gas production.
Consequently, we have restated our historical financial information for the
years from 1999 through 2002 and for the first nine months of 2003 to properly
reflect the reserve adjustments in historical periods and to correct the
accounting for two transactions relating to our natural gas production hedges.
This restatement, as well as specific information regarding its impact, is
discussed in Item 8, Financial Statements and Supplementary Data, Note 1.

We have identified deficiencies in our internal controls that did not
prevent the overstatement of our natural gas and oil reserves. These
deficiencies, which we believe constituted a material weakness in our internal
controls over financial reporting, included a weak control environment
surrounding the booking of our natural gas and oil reserves, inadequate controls
over system access, inadequate documentation of policies and procedures, and
ineffective controls to monitor compliance with existing policies and
procedures.

Our management, at the direction of El Paso's Board of Directors, is
actively working to improve the control environment and to implement controls
and procedures that will ensure the integrity of our reserve booking process. As
a first step in that process, individuals have been added to El Paso's Board of
Directors and executive management team with extensive experience in the natural
gas and oil industry, and with experience in the preparation of natural gas and
oil reserve estimates. In addition, we have completed the implementation of the
following controls:

- Formation of an internal committee to provide oversight of the reserve
estimation process, which will be staffed with appropriate technical,
financial reporting and legal expertise;

- Continued use of an independent third-party engineering firm that will be
selected by and report annually to the Audit Committee of El Paso's Board
of Directors with a subsequent report by the Audit Committee to El Paso's
full Board of Directors;

- Formation of a centralized reserve reporting function, staffed primarily
with newly hired personnel that have extensive industry experience, that
is separated from the operating divisions and reports to our President;

- Restriction of security access to the reserve system to the centralized
reporting staff; and

- Revisions in our documentation of the procedures and controls for
estimating proved reserves.

We expect to have the following additional controls fully in place by
December 31, 2004:

- Improved training regarding SEC guidelines for booking proved reserves;
and

- Enhanced internal audit reviews.

65

In a review of the events that led to the inaccurate accounting for two
transactions relating to our natural gas production hedges, we identified
weaknesses in our controls to monitor factors that could impact our accounting
decisions. Additionally, we determined that we did not establish or communicate
formal policies or procedures governing the execution of our hedge positions to
the relevant people responsible for executing the transactions. Collectively, we
believe these deficiencies constituted a material weakness in our internal
controls. In the future, we will take steps to ensure that the factors on which
we rely are validated and adequately evidenced. In addition, we will, where
necessary, formalize policies and procedures to ensure consistent and
appropriate execution of transactions. Finally, we will implement monitoring
activities, where necessary, to ensure ongoing compliance where factors could
change that would impact our accounting conclusions. We believe that all of
these remedial actions will be implemented by December 31, 2004.

During 2003, we initiated a project to ensure compliance with Section 404
of the Sarbanes-Oxley Act of 2002 (SOX), which will apply to us at December 31,
2005. This project entailed a 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, which was
substantially concluded by December 2003, we initiated an internal review or
"walk-through" of these financial processes by the financial management
responsible for those processes to evaluate the design effectiveness of the
controls identified to mitigate the risk of material misstatements occurring in
our financial statements. We have also initiated a detailed process to evaluate
the operating effectiveness of our controls over financial reporting. This
process involves testing the controls for effectiveness, including a review and
inspection of the documentary evidence supporting the operation of the controls
on which we are placing reliance.

As a result of our efforts to ensure compliance with Section 404 of SOX, we
have also become aware of deficiencies in our internal controls over financial
reporting in other areas. The deficiencies we have identified include inadequate
change management and security access to our information systems, lack of
segregation of duties related to manual journal entry preparation and
procurement activities, lack of formal documentation of policies and procedures,
informal evidence to substantiate monitoring activities were adequately
performed and untimely preparation and review of volume and account
reconciliations. Although we have not formally assessed the materiality of each
deficiency identified, we believe that the deficiencies in the aggregate
constitute a material weakness in our internal controls.

We are actively remediating these deficiencies and have already implemented
our action plans for the following:

- Developing and implementing standard information system policies to
govern change management and security access to our information systems
across the company;

- Modifying systems and procedures to ensure appropriate segregation of
responsibilities for manual journal entry preparation;

- Formalizing our account reconciliation policy and timely completing all
material account
reconciliations; and

- Developing and implementing formal training to educate company personnel
on management's responsibilities mandated by SOX Section 404, the
components of the internal control framework on which we rely and the
relationship to our company values including accountability, stewardship,
integrity and excellence.

We are in the process of implementing the following action plans and expect
to have them fully implemented by December 31, 2004:

- Modifying systems and/or procedures to ensure appropriate segregation of
responsibilities for
procurement activities;

- Implementing an account reconciliation tool to facilitate the monitoring
of compliance with our account reconciliation policy;
66

- Evaluating, formalizing and communicating required policies and
procedures;

- Implementing appropriate monitoring activities to ensure compliance with
the company's policies and procedures; and

- Reviewing the finance and accounting staffing.

Many of the deficiencies in our internal controls that we have identified
are likely the result of significant changes the company has undergone during
the past five years as a result of major acquisitions and reorganizations. We
currently have company-wide efforts underway to formalize and improve our
internal controls and effectively remediate all of the deficiencies described
above. We have also performed additional analysis and procedures related to the
deficiencies identified and have concluded that the deficiencies have not
resulted in any material errors in these financial statements. As we continue
our Section 404 compliance efforts, including the testing of the effectiveness
of our internal controls, we may identify additional deficiencies in our system
of internal controls over financial reporting that either individually or in the
aggregate may represent a material weakness requiring additional remediation
efforts. We did not make any changes to our internal controls over financial
reporting during the quarter ended December 31, 2003, that have materially
affected, or are reasonably likely to materially affect, our internal controls
over financial reporting. However, as we discussed above, since December 31,
2003, we have made significant changes to our internal controls.

We have communicated to El Paso's Audit Committee and to our external
auditors the deficiencies identified to date in our internal controls over
financial reporting as well as the remediation efforts that we have underway. El
Paso's management, with the oversight of its Audit Committee, is committed to
effectively remediating known deficiencies as expeditiously as possible and
continuing its extensive efforts to comply with Section 404 of SOX by December
31, 2005.

El Paso undertook, in a separate evaluation under the supervision of its
principal executive and principal financial officers, and with the participation
of other members of its management, a review of our disclosure controls and
procedures. Disclosure controls and procedures include, without limitation,
controls and procedures designed to ensure that information required to be
disclosed by us in the reports that we file or submit under the Securities
Exchange Act of 1934 is accumulated and communicated to our management,
including our principal executive and principal financial officers, or persons
performing similar functions, as appropriate to allow timely decisions regarding
required disclosure. As a result of the deficiencies and material weaknesses
identified above, we concluded that our disclosure controls and procedures were
ineffective as of December 31, 2003. To address the deficiencies and material
weaknesses described above, we significantly expanded our disclosure controls
and procedures to include additional analysis and other post-closing procedures
to ensure our disclosure controls and procedures were effective over the
preparation of these financial statements.

ITEM 9B. OTHER INFORMATION

None.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The following table sets forth certain information as of September 15,
2004, regarding our executive officers and directors. Directors are elected
annually by our parent and hold office until their successors are elected and
duly qualified. Each executive officer has been elected to serve until his
successor is duly

67

appointed or elected or until his earlier removal or resignation from office.
Information regarding our executive officers may be found in Part I, Item I,
Business, and is incorporated herein by reference.

Ms. Stewart has served as our President since February 2004 and as a
Director since April 2004. Ms. Stewart was Executive Vice President of Business
Development and Exploration and Production Services for Apache Corporation from
1995 to February 2004. From 1984 to 1995, Ms. Stewart worked in various
positions for Apache Corporation.

Mr. Leland has served as our Executive Vice President and Chief Financial
Officer since January 2004 and as a Director since April 2004. Mr. Leland served
as Chief Operating Officer of GulfTerra from January 2003 to December 2003, as
Senior Vice President and Controller of GulfTerra from July 2000 to December
2002 and as Vice President and Controller of GulfTerra from August 1998 to July
2000. Mr. Leland also served as Vice President of El Paso Field Services Company
from September 1997 to April 2004. He served as Director of Business Development
for El Paso Field Services Company from September 1994 to September 1997. For
more than five years prior, Mr. Leland served in various capacities in the
finance and accounting functions of El Paso.

There are no family relationships among any of our executive officers or
directors, and, unless described herein, no arrangement or understanding exists
between any executive officer and any other person pursuant to which he or she
was or is to be selected as an officer or a director.

We are a wholly-owned direct subsidiary of El Paso and rely on El Paso for
certain support services. As a result, we do not have a separate corporate audit
committee or audit committee financial expert. Also, we have not adopted a
separate code of ethics. However, our executives are subject to El Paso's Code
of Business Conduct which is available for your review at El Paso's website,
www.elpaso.com.

ITEM 11. EXECUTIVE COMPENSATION

Compensation of Executive Officers. This table and narrative text
discusses the compensation paid in 2003, 2002 and 2001, as required by SEC
rules, for Messrs. Erskine and Bartley who each served as our President (acting
as our "Chief Executive Officer") during 2003. We had no other executive
officers during 2003. The compensation reflected for each individual was for
their services provided in all capacities to El Paso and its subsidiaries
including us. This table also identifies the principal capacity in which each of
the executives named in this Annual Report on Form 10-K served us during fiscal
year 2003.

SUMMARY COMPENSATION TABLE

- ---------------

(1) The amounts in this column for Mr. Bartley in 2002 and 2001 include
perquisite and benefit allowances. Except as noted, the total value of the
perquisites and other personal benefits received by the other executives
named in this Annual Report on Form 10-K in fiscal years 2003, 2002 and 2001
is not included in this column since it was below the Securities and
Exchange Commission's reporting threshold.

68

(2) The amounts in this column reflect the market value of restricted El Paso
common stock on the date of grant. The shares of restricted stock were
awarded as part of the named executive's 2001 annual bonus and vested four
years from the date of grant. At December 31, 2003, Messrs. Erskine and
Bartley held a total of 42,316 and 19,598 shares of restricted stock,
respectively, having a market value on such date of $346,568 and $160,508,
respectively.

(3) The compensation reflected in this column for fiscal year 2003 also includes
El Paso's contributions to the El Paso Retirement Savings Plan and a
supplemental company match for the Retirement Savings Plan under the El Paso
Supplemental Benefits Plan. Specifically, these amounts for fiscal year 2003
were $3,750 and $8,025 for Mr. Erskine; and $6,529 and $5,550 for Mr.
Bartley, respectively. In addition, for Mr. Erskine in 2003, the amount
reflects a payment in the amount of $2,717,910 in consideration for the
release of El Paso and its affiliates from Mr. Erskine's employment
agreement with The Coastal Corporation (Coastal).

(4) Messrs. Erskine and Bartley became employees of El Paso Production in
February 2001. Accordingly, 2001 information for Messrs. Erskine and Bartley
is for the period from February 1, 2001 through December 31, 2001.

EL PASO CORPORATION OPTION EXERCISES AND YEAR-END VALUE TABLE

This table sets forth information concerning El Paso stock option exercises
and the fiscal year-end values of the unexercised stock options, provided on an
aggregate basis, for each of the executives named in this Annual Report on Form
10-K.

AGGREGATED OPTION EXERCISES IN 2003
AND FISCAL YEAR-END OPTION VALUES

- ---------------

(1) The figures presented in these columns have been calculated based upon the
difference between $8.205, the fair market value of El Paso's common stock
on December 31, 2003, for each in-the-money stock option, and its exercise
price. No cash is realized until the shares received upon exercise of an
option are sold. Neither executive named in this Annual Report on Form 10-K
had stock appreciation rights that were outstanding on December 31, 2003.

EL PASO CORPORATION PENSION PLAN

El Paso provides pension benefits under a cash balance plan formula that
defines participant benefits in terms of a hypothetical account balance.
Effective April 1, 2001, an initial account balance was established for each
Coastal employee who was a participant in Coastal's primary plan on March 31,
2001 due to the merger of Coastal's primary plan into El Paso's pension plan.
Prior to the pension plan merger, Coastal participants received pension benefits
under a plan (the "Prior Coastal Plan") that defined monthly benefits based on
final average earnings and years of service. The initial account balance was
equal to the present value of the Prior Coastal Plan benefit as of March 31,
2001.

At the end of each calendar quarter, participant account balances are
increased by an interest credit based on 5-Year Treasury bond yields, subject to
a minimum interest credit of 4% per year, plus a pay credit equal to a
percentage of salary and bonus. The pay credit percentage is based on the sum of
age plus service at the end of the prior calendar year according to the
following schedule:

69

Under El Paso's pension plan and applicable Internal Revenue Code
provisions, compensation in excess of $200,000 cannot be taken into account and
the maximum payable benefit in 2003 was $160,000. Any excess benefits otherwise
accruing under El Paso's pension plan are payable under El Paso's Supplemental
Benefits Plan. Participants will receive benefits in the form of a lump sum
payment under the Supplemental Benefits Plan unless a valid irrevocable election
was made to receive payment in a form other than lump sum prior to June 1, 2004.

Participants with a Prior Coastal Plan benefit (including Messrs. Erskine
and Bartley) are provided pension benefits that equal the greater of the cash
balance formula benefit or the Coastal Prior Plan benefit accrued through the
date of their termination. The Coastal Prior Plan benefit is computed as
follows: [(2% of the participant's average annual earnings during his five years
of highest earnings for each year of projected service at age 65 (up to a total
of 30 years)) minus (1.5% of estimated social security benefit for each year of
projected service at age 65 (up to a total of 33.333 years)] multiplied by
credited service at termination divided by projected service at age 65.

Credited service as of December 31, 2003 is shown in the table below.
Amounts reported under Salary and Bonus for each executive named in the Summary
Compensation Table approximate earnings as defined under the pension plan.

Estimated annual benefits payable from the pension plan and El Paso
Supplemental Benefits Plan upon retirement at the normal retirement age (age 65)
for each named executive is reflected below (based on assumptions that, for each
named executive, cash balances are credited with interest at a rate of 4% per
annum):

- ---------------

(1) Prior Coastal Plan benefit for Messrs. Erskine and Bartley are greater than
their projected cash balance benefits at age 65.

(2) The amount reflected for Mr. Erskine is his vested pension benefit amount
under both the El Paso Supplemental Benefits Plan and the tax-qualified
pension plan as of his termination date of December 31, 2003, payable
commencing at age 65.

(3) The amount reflected for Mr. Bartley is his vested pension benefit amount
under both the El Paso Supplemental Benefits Plan and the tax-qualified
pension plan as of his termination date of February 29, 2004, payable
commencing at age 65. Mr. Bartley received his El Paso Supplemental Benefits
Plan benefit in a lump sum of $104,512 minus amounts withheld for taxes.

EMPLOYMENT CONTRACTS, TERMINATION OF EMPLOYMENT, CHANGE
IN CONTROL ARRANGEMENTS AND DIRECTOR INDEMNIFICATION AGREEMENTS

EMPLOYMENT AGREEMENT

FORMER EMPLOYEES

Rodney D. Erskine. As part of El Paso's merger with Coastal, Coastal
entered into an employment agreement with Mr. Erskine effective January 29,
2001. The employment agreement was for a term of two years. On December 31,
2002, Mr. Erskine entered into an agreement to terminate that employment
agreement. Under this termination agreement, both El Paso and its affiliates and
Mr. Erskine were released from their obligations under the employment agreement
and Mr. Erskine received a lump-sum payment in the amount of approximately $2.7
million in consideration for the release. Pursuant to the termination agreement,
if Mr. Erskine voluntarily terminated his employment with El Paso before
December 31, 2003, he would have been subject to a noncompetition provision
through December 31, 2003. The noncompetition provision did not apply if Mr.
Erskine's employment was terminated as a result of a "change in control" or if
Mr. Erskine

70

terminated his employment for "good reason." As part of his termination of
employment, Mr. Erskine entered into an Agreement and General Release with El
Paso effective December 31, 2003 which provided severance benefits due to him
under El Paso's severance pay plans in the amount of two times base salary and
target bonus.

BENEFIT PLANS

El Paso Severance Pay Plan. The El Paso Severance Pay Plan is a
broad-based employee plan providing severance benefits following a "qualifying
termination" for all salaried employees of El Paso and certain of its
subsidiaries. The plan also includes an executive supplement, which provides
enhanced severance benefits for certain executive officers of El Paso and
certain of its subsidiaries, including Mr. Erskine. The enhanced severance
benefits available under the supplement include an amount equal to two times the
sum of the officer's annual salary, including annual target bonus amounts as
specified in the plan. A qualifying termination includes an involuntary
termination of the officer as a result of the elimination of the officer's
position or a reduction in force and a termination for "good reason" (as defined
under the plan). In the event the El Paso Severance Pay Plan is terminated, the
executive supplement will continue as a separate plan unless the action
terminating the El Paso Severance Pay Plan explicitly terminates the supplement.
The executive supplement of the El Paso Severance Pay Plan terminates on January
1, 2005, unless extended. In the event of a "change in control" (as defined in
the El Paso Key Executive Severance Protection Plan) of El Paso, participants
whose termination of employment entitles them to severance pay under the
executive supplement and the El Paso Key Executive Severance Protection Plan
will receive severance pay under the El Paso Key Executive Severance Protection
Plan, rather than under the executive supplement.

El Paso Key Executive Severance Protection Plan. This plan, initially
adopted in 1992, provides severance benefits following a "change in control" of
El Paso for certain officers of El Paso and certain of its subsidiaries,
including Messrs. Erskine and Bartley. The benefits of the plan include: (1) an
amount equal to three times the participant's annual salary, including maximum
bonus amounts as specified in the plan; (2) continuation of life and health
insurance for an 18-month period following termination; (3) a supplemental
pension payment calculated by adding three years of additional credited pension
service; (4) certain additional payments to the terminated employee to cover
excise taxes if the payments made under the plan are subject to excise taxes on
golden parachute payments; and (5) payment of legal fees and expenses incurred
by the employee to enforce any rights or benefits under the plan. Benefits are
payable for any termination of employment for a participant in the plan within
two years of the date of a change in control of El Paso, except where
termination is by reason of death, disability, for cause or instituted by the
employee for other than "good reason" (as defined in the plan). A change in
control of El Paso occurs if: (i) any person or entity becomes the beneficial
owner of 20% or more of El Paso's common stock; (ii) any person or entity (other
than El Paso) purchases the common stock by way of a tender or exchange offer;
(iii) El Paso stockholders approve a merger or consolidation, sale or
disposition or a plan of liquidation or dissolution of all or substantially all
of El Paso's assets; or (iv) if over a two year period a majority of the members
of the El Paso Board of Directors at the beginning of the period cease to be
directors. A change in control has not occurred if El Paso is involved in a
merger, consolidation or sale of assets in which the same stockholders of El
Paso before the transaction own 80% of the outstanding common stock after the
transaction is complete. This plan generally may be amended or terminated at any
time, provided that no amendment or termination may impair participants' rights
under the plan or be made following the occurrence of a change in control. This
plan is closed to new participants, unless the El Paso Board of Directors
determines otherwise.

El Paso Supplemental Benefits Plan. This plan provides for certain
benefits to officers and key management employees of El Paso and its
subsidiaries. The benefits include: (1) a credit equal to the amount that a
participant did not receive under El Paso's Pension Plan because the Pension
Plan does not consider deferred compensation (whether in deferred cash or
deferred restricted common stock) for purposes of calculating benefits and
eligible compensation is subject to certain Internal Revenue Code limitations;
and (2) a credit equal to the amount of El Paso's matching contribution to El
Paso's Retirement Savings Plan that cannot be made because of a participant's
deferred compensation and Internal Revenue Code limitations. The plan may not be
terminated so long as the El Paso Pension Plan and/or El Paso Retirement Savings
Plan

71

remain in effect. The management committee of this plan designates who may
participate and also administers the plan. Benefits under El Paso's Supplemental
Benefits Plan are paid upon termination of employment in a lump-sum payment. In
the event of a change in control (as defined under the El Paso Key Executive
Severance Protection Plan) of El Paso, the supplemental pension benefits become
fully vested and nonforfeitable.

El Paso Senior Executive Survivor Benefits Plan. This plan provides
certain senior executives of El Paso and its subsidiaries who are designated by
the plan administrator with survivor benefit coverage in lieu of the coverage
provided generally for employees under El Paso's group life insurance plan. The
amount of benefits provided, on an after-tax basis, is two and one-half times
the executive's annual salary. Benefits are payable in installments over 30
months beginning within 31 days after the executive's death, except that the
plan administrator may, in its discretion, accelerate payments.

El Paso Benefits Protection Trust Agreement. El Paso maintains a trust for
the purpose of funding certain of its employee benefit plans (including the El
Paso Key Executive Severance Protection Plan). The trust consists of a trustee
expense account, which is used to pay the fees and expenses of the trustee, and
a benefit account, which is made up of three subaccounts and used to make
payments to participants and beneficiaries in the participating plans. The trust
is revocable by El Paso at any time before a "threatened change in control"
(which is generally defined to include the commencement of actions that would
lead to a "change in control" (as defined under the El Paso Key Executive
Severance Protection Plan) of El Paso) as to assets held in the trustee expense
account, but is not revocable (except as provided below) as to assets held in
the benefit account at any time. The trust generally becomes fully irrevocable
as to assets held in the trust upon a threatened change in control. The trust is
a grantor trust for federal tax purposes, and assets of the trust are subject to
claims by El Paso's general creditors in preference to the claims of plan
participants and beneficiaries. Upon a threatened change in control, El Paso
must deliver $1.5 million in cash to the trustee expense account. Prior to a
threatened change in control, El Paso may freely withdraw and substitute the
assets held in the benefit account, other than the initially funded amount;
however, no such assets may be withdrawn from the benefit account during a
threatened change in control period. Any assets contributed to the trust during
a threatened change in control period may be withdrawn if the threatened change
in control period ends and there has been no threatened change in control. In
addition, after a change in control of El Paso occurs, if the trustee determines
that the amounts held in the trust are less than "designated percentages" (as
defined in the Trust Agreement) with respect to each subaccount in the benefit
account, the trustee must make a written demand on El Paso to deliver funds in
an amount determined by the trustee sufficient to attain the designed
percentages. Following a change in control and if the trustee has not been
requested to pay benefits from any subaccount during a "determination period"
(as defined in the Trust Agreement), El Paso may make a written request to the
trustee to withdraw certain amounts which were allocated to the subaccounts
after the change in control occurred. The trust generally may be amended or
terminated at any time, provided that no amendment or termination may result,
directly or indirectly, in the return of any assets of the benefit account to El
Paso prior to the satisfaction of all liabilities under the participating plans
(except as described above) and no amendment may be made unless El Paso, in its
reasonable discretion, believes that such amendment would have no material
adverse effect on the amount of benefits payable under the trust to
participants. In addition, no amendment may be made after the occurrence of a
change in control which would (i) permit El Paso to withdraw any assets from the
trustee expense account, (ii) directly or indirectly reduce or restrict the
trustee's rights and duties under the trust, or (iii) permit El Paso to remove
the trustee following the date of the change in control.

COMPENSATION PLANS

El Paso Production Companies Long-Term Incentive Plan. This plan provided
for a long-term incentive award in the form of a cash payment to officers and
key employees of El Paso Production, including Messrs. Erskine and Bartley at
the end of the performance cycle; provided, however, in the event (i) of an
initial offering of El Paso Production's common stock to the public or (ii) El
Paso Production is spun-off from El Paso during the performance cycle, any
awards under the plan are in the form of restricted common stock in El Paso
Production or the newly created entity. The amount of any awards under the plan
was based on

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El Paso Production's performance against a performance peer group. If a "change
in control" of El Paso Production occurs, all restrictions placed on awards
automatically lapse. A change in control has occurred following an initial
public offering if: (i) any person or entity other than El Paso or any of its
subsidiaries or affiliates becomes the beneficial owner of 20% or more of El
Paso Production's common stock; (ii) any person or entity (other than El Paso
Production, El Paso or any of their subsidiaries or affiliates) purchases the
common stock by way of a tender or exchange offer, (iii) El Paso Production's
stockholders approve a merger or consolidation, sale or disposition or a plan of
liquidation or dissolution of all or substantially all of its assets; or (iv) if
over a two year period a majority of the members of the El Paso Board of
Directors at the beginning of the period cease to be directors. A change in
control has not occurred if El Paso Production is involved in a merger,
consolidation or sale of assets in which the same stockholders of El Paso
Production before the transaction own 80% of the outstanding common stock after
the transaction is complete. Notwithstanding the above, (i) a change in control
has occurred upon (x) a qualifying change in control of El Paso provided El Paso
owns at least 80% of the outstanding common stock of El Paso Production at the
time of the qualifying change in control, or (y) El Paso sells or disposes
(other than pursuant to a public offering or spin-off of El Paso Production) of
all of its shares of El Paso Production and in the event of clause (y) the
participant's employment is terminated (other than a termination for cause or a
voluntary termination by the participant) within six months of such sale or
disposition and (ii) a change in control does not occur upon (x) a public
offering of El Paso Production's common stock or (y) any spin-off of El Paso
Production. A "qualifying change in control" is any change in control, as
defined above, except a change in control that results solely from a change to
the Board of Directors of El Paso. This plan was terminated effective December
31, 2003.

El Paso 2001 Omnibus Incentive Compensation Plan. This plan provides for
the grant to officers and key employees of El Paso and its subsidiaries of stock
options, stock appreciation rights, limited stock appreciation rights,
performance units and restricted stock. A maximum of 6,000,000 shares in the
aggregate may be subject to awards under this plan. The plan administrator
designates which employees are eligible to participate, the amount of any grant
and the terms and conditions (not otherwise specified in the plan) of such
grant. If a "change in control" (defined in substantially the same manner as
under the Key Executive Severance Protection Plan) of El Paso occurs: (1) all
outstanding stock options become fully exercisable; (2) stock appreciation
rights and limited stock appreciation rights become immediately exercisable; (3)
designated amounts of performance units become fully vested; (4) all
restrictions placed on awards of restricted stock automatically lapse; and (5)
the current year's target bonus amount becomes payable for each officer
participating in the plan within 30 days, assuming target levels of performance
were achieved by El Paso and the officer for the year in which the change in
control occurs, or the prior year if target levels have not been established for
the current year, except that no bonus amounts will become payable in connection
with a change in control that results solely from a change to the Board of
Directors of El Paso. The plan generally may be amended or terminated at any
time. Any amendment following a change in control that impairs participants'
rights requires participant consent.

El Paso 1999 Omnibus Incentive Compensation Plan and 1995 Omnibus
Compensation Plan -- Terminated Plans. These plans provided for the grant to
eligible officers and key employees of El Paso and its subsidiaries of stock
options, stock appreciation rights, limited stock appreciation rights,
performance units and restricted stock. These plans have been replaced by the El
Paso 2001 Omnibus Incentive Compensation Plan. Although these plans have been
terminated with respect to new grants, certain stock options and shares of
restricted stock remain outstanding under them. If a "change in control" of El
Paso occurs, all outstanding stock options become fully exercisable and
restrictions placed on restricted stock lapse. For purposes of the plans, the
term "change in control" has substantially the same meaning given such term in
the Key Executive Severance Protection Plan.

El Paso Strategic Stock Plan. This plan is an equity compensation plan
that has not been approved by the stockholders. This plan provides for the grant
of stock options, stock appreciation rights, limited stock appreciation rights
and shares of restricted stock to non-employee members of the Board of
Directors, officers and key employees of El Paso and its subsidiaries primarily
in connection with El Paso's strategic acquisitions. A maximum of 4,000,000
shares in the aggregate may be subject to awards under this plan. The plan

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administrator determines which employees are eligible to participate, the amount
of any grant and the terms and conditions (not otherwise specified in the plan)
of such grant. If a change in control, as defined earlier under the El Paso Key
Executive Severance Protection Plan, of El Paso occurs: (1) all outstanding
stock options become fully exercisable; (2) stock appreciation rights and
limited stock appreciation rights become immediately exercisable; and (3) all
restrictions placed on awards of restricted stock automatically lapse. The plan
generally may be amended or terminated at any time, provided that no amendment
or termination may impair participants' rights under the plan.

El Paso Omnibus Plan for Management Employees. This plan is an equity
compensation plan which has not been approved by the stockholders. This plan
provides for the grant of stock options, stock appreciation rights, limited
stock appreciation rights and shares of restricted stock to salaried employees
(other than employees covered by a collective bargaining agreement) of El Paso
and its subsidiaries. A maximum of 58,000,000 shares in the aggregate may be
subject to awards under this plan. If a change in control, as defined earlier
under the El Paso Key Executive Severance Protection Plan, of El Paso occurs:
(1) all outstanding stock options become fully exercisable; (2) stock
appreciation rights and limited stock appreciation rights become immediately
exercisable; and (3) all restrictions placed on awards of restricted stock
automatically lapse. The plan generally may be amended or terminated at any
time, provided that no amendment or termination may impair participants' rights
under the plan.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS

All of the common stock of El Paso Production is owned by El Paso
Corporation.

The following table sets forth, as of August 31, 2004, certain information
with respect to the following individuals to the extent they own shares of
common stock of El Paso, our parent.

- ---------------

* Less than 1%

(1) The individuals named in the table have sole voting and investment power
with respect to shares of El Paso common stock beneficially owned. In
addition, some shares of common stock reflected in this column for certain
individuals are subject to restrictions.

(2) The directors and executive officers have the right to acquire the shares of
common stock reflected in this column within 60 days of August 31, 2004,
through the exercise of stock options.

(3) Ms. Stewart's beneficial ownership excludes 216 shares of El Paso common
stock owned by her husband, of which Ms. Stewart disclaims any beneficial
ownership.

(4) Mr. Erskine's stock ownership is as of November 17, 2003, when Mr. Erskine
ceased to be a Section 16 insider.

(5) The number of shares of common stock of El Paso, other than shares Mr.
Bartley has the right to acquire through the exercise of stock options,
owned by Mr. Bartley is unknown, thus no amount is reflected for Mr. Bartley
in this column.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

We are currently a wholly owned subsidiary of El Paso. El Paso owns 100% of
our outstanding stock and has the right to elect all of our directors. We share
office space, personnel, and other administrative services with El Paso. In
addition, there are other shared personnel that may include officers who
function as both our representative and those of El Paso and its subsidiaries.
Some of these shared directors, officers and employees

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own and are awarded from time to time shares, or options to purchase shares, of
El Paso; accordingly, their financial interests may not always be aligned
completely with ours.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

AUDIT FEES

The audit fees for the years ended December 31, 2003 and 2002 of $450,000
and $325,000 were for professional services rendered by PricewaterhouseCoopers
LLP for the audits of our consolidated financial statements.

ALL OTHER FEES

No other audit-related, tax or other services were provided by our auditors
for the years ended December 31, 2003 and 2002.

POLICY FOR APPROVAL OF AUDIT AND NON-AUDIT FEES

We are a wholly-owned direct subsidiary of El Paso and do not have a
separate audit committee. El Paso's Audit Committee has adopted a pre-approval
policy for audit and non-audit services. For a description of El Paso's
pre-approval policies for audit and non-audit related services, see the El Paso
proxy statement once it is filed.

PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(A) THE FOLLOWING DOCUMENTS ARE FILED AS A PART OF THIS REPORT:

1. Financial statements.

The following consolidated financial statements are included in Part II,
Item 8 of this report:

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(B) REPORTS ON FORM 8-K:

We also furnished information to the SEC on Current Reports on Form 8-K
under Item 9, Regulation FD. Current Reports on Form 8-K under Item 9 are not
considered to be "filed" for purposes of Section 18 of the Securities Exchange
Act of 1934 and are not subject to the liabilities of that section, but are
filed to provide full disclosure under Regulation FD.

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EL PASO PRODUCTION HOLDING COMPANY

EXHIBIT LIST

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 asterisk;
all exhibits not so designated are incorporated herein by reference to a prior
filing as indicated. Exhibits designated with a "+" constitute a management
contract or compensatory plan or arrangement required to be filed as an exhibit
to this report pursuant to Item 14(c) of Form 10-K.

UNDERTAKING

We hereby undertake, pursuant to Regulation S-K, Item 601(b), paragraph
(4)(iii), to furnish to the Securities and Exchange Commission upon request all
constituent instruments defining the rights of holders of our long-term debt and
our consolidated subsidiaries 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.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, El Paso Production Holding Company has duly
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized on the 30th day of September 2004.

EL PASO PRODUCTION HOLDING COMPANY
Registrant

By /s/ LISA A. STEWART
------------------------------------
Lisa A. Stewart
President

Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, this report has been signed below by the following persons on behalf of
El Paso Production Holding Company and in the capacities and on the dates
indicated:

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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 asterisk;
all exhibits not so designated are incorporated herein by reference to a prior
filing as indicated. Exhibits designated with a "+" constitute a management
contract or compensatory plan or arrangement required to be filed as an exhibit
to this report pursuant to Item 14(c) of Form 10-K.