EL PASO NATURAL GAS 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 1-2700

EL PASO NATURAL GAS COMPANY
(Exact Name of Registrant as Specified in Its Charter)

DELAWARE 74-0608280
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)

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

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 [X] No [ ].

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 STOCK 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 March 15, 2004:
1,000

EL PASO NATURAL GAS COMPANY MEETS THE CONDITIONS OF GENERAL INSTRUCTION
I(1)(a) AND (b) TO FORM 10-K AND IS THEREFORE FILING THIS REPORT WITH A REDUCED
DISCLOSURE FORMAT AS PERMITTED BY SUCH INSTRUCTION.

DOCUMENTS INCORPORATED BY REFERENCE: NONE

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EL PASO NATURAL GAS COMPANY

TABLE OF CONTENTS

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* We have not included a response to this item in this document since no
response is required pursuant to the reduced disclosure format permitted by
General Instruction I to Form 10-K.

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

/d = per day MMcf = million cubic feet
BBtu = billion British thermal units MMDth = million dekatherm
Bcf = billion cubic feet Tcfe = trillion cubic feet equivalent

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" or "ours", we are describing El Paso
Natural Gas Company and/or our subsidiaries.

i

PART I

ITEM 1. BUSINESS

GENERAL

We are a Delaware corporation incorporated in 1928, and an indirect wholly
owned subsidiary of El Paso Corporation (El Paso). Our primary business is the
interstate transportation of natural gas. We conduct our business activities
through two pipeline systems, each of which is discussed below.

The EPNG system. The El Paso Natural Gas system consists of approximately
10,600 miles of pipeline with a winter sustainable west-flow capacity of 4,650
MMcf/d (including 120 MMcf/d related to our Phase I Line 2000 Power-up expansion
which went into service on February 27, 2004) and approximately 800 MMcf/d of
east-end deliverability. EPNG is currently expanding its Line 2000 system which
extends from West Texas to the Arizona and California border and is expected to
increase capacity by an additional 200 MMcf/d by mid-2004. During 2003, 2002 and
2001, average throughput on the EPNG system was 3,874 BBtu/d, 3,799 BBtu/d and
4,253 BBtu/d. This system delivers natural gas from the San Juan, Permian and
Anadarko Basins to California, which is our single largest market, as well as
markets in Arizona, Nevada, New Mexico, Oklahoma, Texas and northern Mexico.

The Mojave system. The Mojave Pipeline system consists of approximately
400 miles of pipeline with a design capacity of approximately 400 MMcf/d. During
2003, 2002 and 2001, average throughput on the Mojave system was 192 BBtu/d, 266
BBtu/d and 283 BBtu/d. This system connects with the EPNG and Transwestern
transmission systems at Topock, Arizona, the Kern River Gas Transmission Company
transmission system in California and extends to customers in the vicinity of
Bakersfield, California.

REGULATORY ENVIRONMENT

Our interstate natural gas transmission systems are regulated by the
Federal Energy Regulatory Commission (FERC) under the Natural Gas Act of 1938
and the Natural Gas Policy Act of 1978. Our systems operate under FERC-approved
tariffs that establish rates, terms and conditions for service to our customers.
Generally, the FERC's authority extends to:

- rates and charges for natural gas transportation;

- certification and construction of new facilities;

- extension or abandonment of facilities;

- maintenance of accounts and records;

- relationships between pipeline and energy affiliates;

- terms and conditions of services;

- depreciation and amortization policies;

- acquisition and disposition of facilities; and

- initiation and discontinuation of services.

The fees or rates established under our tariffs are a function of our costs
of providing service to our customers, including a reasonable return on our
invested capital. Approximately 93 percent of our transportation services
revenue is attributable to a capacity reservation (demand charge) paid by firm
customers. These firm shippers are obligated to pay a monthly demand charge,
regardless of the amount of natural gas they transport, for the term of their
contracts. The remaining 7 percent of our transportation services revenue is
attributable to charges based solely on the volumes of gas actually transported
on our pipeline systems. Consequently, our financial results have historically
been relatively stable; however, they can

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be subject to volatility due to factors such as weather, changes in natural gas
prices and market conditions, regulatory actions, competition and the
credit-worthiness of our customers.

Our interstate pipeline systems are also subject to federal, state and
local pipeline safety and environmental statutes and regulations. We have
continuing programs designed to keep all of our facilities in compliance with
pipeline safety and environmental requirements. We believe that our systems are
in material compliance with the applicable requirements.

A discussion of significant rate and regulatory matters is included in Part
II, Item 8, Financial Statements and Supplementary Data, Note 10, and is
incorporated herein by reference.

MARKETS AND COMPETITION

We serve major markets in the southwestern United States and California as
well as northern Mexico. These have recently been among the fastest growing
regions in the U.S. and Mexico; therefore the market demand for natural gas
distribution as well as gas-fired electric generation capacity has experienced
considerable growth. While this demand growth has slowed somewhat from the
levels in 2000-2002, we expect it to continue at a slower rate. Our markets
consist of distribution and industrial companies, electric generation companies,
natural gas producers, other interstate and intrastate natural gas pipelines,
and natural gas marketing and trading companies. We provide transportation
services in both our natural gas supply and market areas. Our pipeline systems
connect with multiple pipelines that provide our shippers with access to diverse
sources of supply and various natural gas markets serviced by these pipelines.

The combined capacity of all pipeline companies serving the California
market is approximately 8.5 Bcf/d and we provide approximately 39 percent of
this capacity. In 2003, the demand for interstate pipeline capacity to
California averaged 4.9 Bcf/d, equivalent to approximately 57 percent of the
total interstate pipeline capacity serving that state. Natural gas shipped to
California across our system represented approximately 28 percent of the natural
gas consumed in the state in 2003.

A number of large natural gas consumers are electric utility companies who
use natural gas to fuel electric power generation facilities. Electric power
generation is the fastest growing demand sector of the natural gas market. The
potential consequences of proposed and ongoing restructuring and deregulation of
the electric power industry are currently unclear. Restructuring and
deregulation potentially benefit the natural gas

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industry by creating more demand for natural gas turbine generated electric
power, but this effect is offset, in varying degrees, by increased efficiency in
generation and the use of surplus electric capacity as a result of open market
access.

Our existing contracts mature at various times and in varying amounts of
throughput capacity. Our ability to extend our existing contracts or re-market
expiring capacity at maximum rates is dependent on competitive alternatives, the
regulatory environment at the federal, state and local levels and market supply
and demand factors at the relevant dates these contracts are extended or expire.
The duration of new or re-negotiated contracts will be affected by current
prices, competitive conditions and judgments concerning future trends and
volatility.

ENVIRONMENTAL

A description of our environmental activities is included in Part II, Item
8, Financial Statements and Supplementary Data, Note 10, and is incorporated
herein by reference.

EMPLOYEES

As of March 9, 2004, we had approximately 740 full-time employees, none of
whom are subject to collective bargaining arrangements.

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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 businesses, 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 businesses. We
believe that our properties are adequate and suitable for the conduct of our
business in the future.

ITEM 3. LEGAL PROCEEDINGS

The fifteen California cases discussed in Part II, Item 8, Financial
Statements and Supplementary Data, Note 10, include five filed in the Superior
Court of Los Angeles County (Continental Forge Company, et al. v. Southern
California Gas Company, et al., filed September 25, 2000*; Berg v. Southern
California Gas Company, et al., filed December 18, 2000*; County of Los Angeles
v. Southern California Gas Company, et al., filed January 8, 2002**; The City of
Los Angeles, et al. v. Southern California Gas Company, et al. and The City of
Long Beach, et al. v. Southern California Gas Company, et al., both filed March
20, 2001*); two filed in the Superior Court of San Diego County (John W.H.K.
Phillip v. El Paso Merchant Energy; and John Phillip v. El Paso Merchant Energy,
both filed December 13, 2000*); and two filed in the Superior Court of San
Francisco County (Sweetie's et al. v. El Paso Corporation, et al., filed March
22, 2001*; and California Dairies, Inc., et al. v. El Paso Corporation, et al.,
filed May 21, 2001***); and one filed in the Superior Court of the State of
California, County of Alameda (Dry Creek Corporation v. El Paso Natural Gas
Company, et al. filed December 10, 2001**); and six filed in the Superior Court
of Los Angeles County (The City of San Bernardino v. Southern California Gas
Company, et al.; The City of Vernon v. Southern California Gas Company; The City
of Upland v. Southern California Gas Company, et al.; Edgington Oil Company v.
Southern California Gas Company, et al.; World Oil Corp. v. Southern California
Gas Company, et al., filed December 27, 2002**; The City of Culver City v.
Southern California Gas, et al., filed April 11, 2002); The State of Nevada et
al v. El Paso Corporation, El Paso Natural Gas Company, et. al. filed November
2002 in the District Court for Clark County, Nevada**; Gus N. Bustamante v. The
McGraw-Hill Companies filed in the Superior Court of California, County of Los
Angeles in November 2002**.
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* We have been dismissed from these cases and judgment has been entered. An
appeal of that judgment is pending.
** Cases to be dismissed in conjunction with final approval of the Western
Energy Settlement.
*** We have been dismissed from this case in a settlement separate from the
Western Energy Settlement.

More details on the above cases, and a description of our other legal
proceedings is included in Part II, Item 8, Financial Statements and
Supplementary Data, Note 10, and is incorporated herein by reference.

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

Item 4, Submission of Matters to a Vote of Security Holders, has been
omitted from this report pursuant to the reduced disclosure format permitted by
General Instruction I to Form 10-K.

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 a subsidiary
of El Paso and, accordingly, our stock is not publicly traded.

We pay dividends on our common stock from time to time from legally
available funds that have been approved for payment by our Board of Directors.
In 2002, we declared and paid to El Paso a non-cash dividend of non-regulated
assets in the amount of $19 million. There were no common stock dividends
declared during 2003.

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During late 2003 and early 2004, El Paso issued a total of 26.4 million
shares of common stock pursuant to the Western Energy Settlement (WES). A
discussion of the WES is included in Item 8, Financial Statements and
Supplementary Data, Notes 3 and 10. El Paso contributed to us gross proceeds of
approximately $195 million from the sales of its common stock, which we in turn
funded to an escrow account for the benefit of the settling parties in the WES.

ITEM 6. SELECTED FINANCIAL DATA

Item 6, Selected Financial Data, has been omitted from this report pursuant
to the reduced disclosure format permitted by General Instruction I to Form
10-K.

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

The information required by this Item is presented in a reduced disclosure
format pursuant to General Instruction I to Form 10-K. The notes to our
consolidated financial statements contain information that is pertinent to the
following analysis, including a discussion of our significant accounting
policies.

GENERAL

Our business is the interstate transportation of natural gas. Our
interstate natural gas transportation systems face varying degrees of
competition from other pipelines, as well as from alternative energy sources
used to generate electricity, such as hydroelectric power, nuclear, coal and
fuel oil. We are regulated by the FERC which regulates the rates we can charge
our customers. These rates are a function of our costs of providing services to
our customers, including a reasonable return on our invested capital. As a
result, our financial results have historically been relatively stable; however,
they can be subject to volatility due to factors such as weather, changes in
natural gas prices and market conditions, regulatory actions, competition and
the credit-worthiness of our customers. In addition, our ability to extend our
existing customer contracts or re-market expiring contracted capacity at maximum
rates is dependent on competitive alternatives, the regulatory environment and
supply and demand factors at the relevant dates these contracts are extended or
expire.

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RESULTS OF OPERATIONS

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. We exclude interest and debt expense from
this measure so that our management can evaluate our operating results without
regard to our financing methods. We believe the discussion of our results of
operations based on EBIT is useful to our investors because it allows them to
more effectively evaluate the operating performance of our business 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. The following is a reconciliation of
our operating income to our EBIT and our EBIT to our net income for the years
ended December 31:

OPERATING RESULTS (EBIT)

Our EBIT for the year ended December 31, 2003 was $252 million higher than
in 2002. The increase in EBIT was primarily the result of a decrease in
operating expenses due to a net decrease of $272 million in Western Energy
Settlement charges incurred in 2003 as compared to 2002. For a further
discussion of the Western Energy Settlement, see Item 8, Financial Statements
and Supplementary Data, Notes 3 and 10. In addition, our EBIT in 2003 was higher
due to bad debt expense in 2002 of $12 million related to the bankruptcy of
Enron Corp. and reduced corporate and legal charges of $8 million in 2003. Our
EBIT results were negatively impacted by a decrease of $35 million in operating
revenues in 2003 related to the expiration of capacity contracts which we were
prohibited from remarketing due to various FERC orders and obligations to make
capacity available to our former full requirement customers until our Line 2000
Power-up project is phased-in during 2004. Each of the capacity related items
discussed below had no impact on our operating expenses in 2003. Property
additions in 2003 resulted in higher depreciation expense and ad valorem taxes
of $8 million and higher other income from allowances for equity funds used
during construction in 2003 of $7 million. We also had higher expenses related
to natural gas used in operations in excess of amounts recovered from customers
of $11 million resulting in a negative impact on our 2003 EBIT.

As discussed above and in Item 8, Financial Statements and Supplementary
Data, Note 10, the FERC issued various orders related to the allocation of
capacity on our EPNG system. These orders impacted our 2003 revenues and will
continue to impact our future results. Based on these orders:

- Reservation charges will be credited to our firm shippers if we fail to
schedule the shipper's confirmed volumes (except in the case of force
majeure, in which case partial credits will be given);

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- We must refrain from entering into any new contracts unless we can
demonstrate that we have capacity available to provide the new service;

- We refrained from remarketing turned-back capacity under contracts
terminating or expiring between May 31, 2002 and May 1, 2003, because
that capacity was allocated to our full requirement (FR) shippers; and

- We are adding additional compression to our Line 2000 project increasing
the capacity by 320 MMcf/d without the opportunity to recover these costs
in our rates until our next rate case which will be effective January 1,
2006.

As a result, we were unable to remarket approximately 471 MMDth/d of
turned-back capacity, of which approximately 200 MMDth/d relates to capacity
rejected by Enron Corp. in May 2002 in its bankruptcy proceeding and the
remaining 271 MMDth/d relates to contracts that expired within the time frame
specified under these orders. By order, this 471 MMDth/d of capacity was made
available to converting full requirement shippers without an increase in their
reservation charge obligation until January 1, 2006. At that time, we will seek
to recover these costs by adjusting our rates. Prior to the rejection and
expiration of this capacity, we were earning revenues on this capacity (net of
revenue credits) of approximately $3.5 million per month.

In July 2003, the FERC (i) reaffirmed its decision that our full
requirements contracts must be converted to contract demand contracts effective
September 1, 2003, (ii) supported our position relative to the maximum amount of
capacity we can make available to our shippers and (iii) confirmed that we have
honored our obligations under our existing rate settlement, our contracts, the
FERC's regulations and our certificates. We were required to establish a pool of
110 MMcf/d for use by our full requirement shippers until our Line 2000
expansion project is phased into service which is expected to occur by the end
of the first quarter of 2004. Effective September 1, 2003, we acquired this
capacity, primarily on a permanent basis, and will be at risk for remarketing
this capacity. We estimate this will reduce our revenues for the first six
months of 2004 by approximately $3.9 million as compared to the first six months
of 2003.

In addition, we had risk sharing mechanisms under our most recent rate case
settlement. This risk sharing period expired on December 31, 2003. Under these
risk sharing mechanisms, we collected cash from our customers, refunded a
portion of the cash received as required by the mechanisms and then recognized
the difference as revenues over the risk sharing period. We estimate that the
expiration of the risk sharing mechanisms will decrease our annual revenues by
approximately $22 million. See Item 8, Financial Statements and Supplementary
Data, Note 10, for a further discussion of our risk sharing mechanisms.

INTEREST AND DEBT EXPENSE

Interest and debt expense for the year ended December 31, 2003, was $18
million higher than in 2002. The increase in interest expense resulted from the
issuances of $300 million of long-term 8.375% notes in June 2002 and $355
million of long-term 7.625% notes in July 2003, and decreases in interest
capitalized on construction projects due to a lower capitalization base in 2003.
These increases were partially offset by decreases in commercial paper interest
expense due to the discontinuation of commercial paper borrowings in the fourth
quarter of 2002.

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AFFILIATED INTEREST INCOME

Affiliated interest income for the year ended December 31, 2003, was $2
million lower than in 2002 due to lower average advances to El Paso under the
cash management program in 2003 offset by higher short-term rates in 2003 on
which we earned interest. The average advance balance due from El Paso of $1.2
billion in 2002 decreased to $996 million in 2003. The average short-term
interest rates increased from 1.9% in 2002 to 2% in 2003.

INCOME TAXES

Our effective tax rates were different than the statutory rate of 35
percent in all periods, primarily due to state income taxes. For a
reconciliation of the statutory rate to the effective rates, see Item 8,
Financial Statements and Supplementary Data, Note 6.

Included in our deferred tax assets as of December 31, 2003 was $200
million related to the Western Energy Settlement. Proposed tax legislation has
been introduced in the U.S. Senate which would disallow deductions for certain
settlements made to or on behalf of governmental entities. If enacted, this tax
legislation could impact the deductibility of the Western Energy Settlement and
could result in a write-off of some or all of the associated deferred tax
assets. In such event, our tax expense would increase.

LIQUIDITY AND CAPITAL RESOURCES

LIQUIDITY

Our liquidity needs have been provided by cash flow from operating
activities and the use of El Paso's cash management program. 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 or El Paso provides cash to
us. We have historically provided cash advances to El Paso, and we reflect these
net advances to our parent as investing activities in our statement of cash
flows. As of December 31, 2003, we had receivables from El Paso of $779 million
as a result of this program. These receivables are due upon demand; however, we
do not anticipate settlement within twelve months. As of December 31, 2003 these
receivables were classified as non-current notes receivable from affiliates in
our balance sheet. We believe that cash flows from operating activities will be
adequate to meet our short-term capital and debt servicing requirements for
existing operations. However, as a result of recent announcements by El Paso
related to a revision of its estimates of its natural gas and oil reserves, our
ability to borrow or recover the amounts advanced under El Paso's cash
management program could be impacted. See Item 8, Financial Statements and
Supplementary Data, Note 2 for a discussion of these matters. Our cash flows for
the years ended December 31 were as follows:

In a series of credit rating agency actions beginning in 2002, and
contemporaneously with the downgrades of the senior unsecured indebtedness of El
Paso, our senior unsecured indebtedness was downgraded to below investment grade
and is currently rated B1 by Moody's (with a negative outlook and under review
for a

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possible downgrade) and B- by Standard & Poor's (with a negative outlook). These
downgrades will increase our cost of capital and collateral requirements and
could impede our access to capital markets in the future.

CAPITAL EXPENDITURES

Our capital expenditures during the periods indicated are listed below:

Under our current plan, we expect to spend between approximately $120
million and $175 million in each of the next three years for capital
expenditures to maintain the integrity of our pipelines and ensure the reliable
delivery of natural gas to our customers. In addition, we have budgeted to spend
between approximately $10 million and $70 million in each of the next three
years to expand the capacity of our pipeline systems contingent upon customer
commitments to the projects. We expect to fund our maintenance and expansion
capital expenditures using a combination of internally generated funds and
external financing.

DEBT

As of December 31, 2003, we had long-term debt outstanding of $1,109
million, net of a $6 million discount, none of which matures within the next
five years. For a discussion of our debt and other credit facilities, see Item
8, Financial Statements and Supplementary Data, Note 9, which is incorporated
herein by reference.

COMMITMENTS AND CONTINGENCIES

For a discussion of our commitments and contingencies, see Item 8,
Financial Statements and Supplementary Data, Note 10, which is incorporated
herein by reference.

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.

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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 the
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," "plan," "budget" and similar
expressions will generally identify forward-looking statements. Our
forward-looking statements, whether written or oral, are expressly qualified by
these cautionary statements and any other cautionary statements that may
accompany those 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 BUSINESS

OUR SUCCESS DEPENDS ON FACTORS BEYOND OUR CONTROL.

Our business is the transportation of natural gas for third parties. As a
result, the volume of natural gas involved in these activities depends on the
actions of those third parties, and is beyond our control. Further, the
following factors, most of which are beyond our control, may unfavorably impact
our ability to maintain or increase current transmission volumes and rates, to
renegotiate existing contracts as they expire, or to remarket unsubscribed
capacity:

- future weather conditions, including those that favor alternative energy
sources such as hydroelectric power;

- price competition;

- drilling activity and supply availability of natural gas;

- expiration and/or turn back of significant contracts;

- service area competition;

- changes in regulation and actions of regulatory bodies;

- credit risk of our customer base;

- increased cost of capital;

- opposition to energy infrastructure development, especially in
environmentally sensitive areas;

- adverse general economic conditions;

- expiration and/or renewal of existing interests in real property
associated with our pipeline; and

- unfavorable movements in natural gas and liquids prices.

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THE REVENUES OF OUR PIPELINE BUSINESSES ARE GENERATED UNDER CONTRACTS THAT MUST
BE RENEGOTIATED PERIODICALLY.

Our revenues are generated under transportation contracts which expire
periodically and must be renegotiated and extended or replaced. We cannot assure
that we will be able to extend or replace our contracts when they expire or that
the terms of any renegotiated contracts will be as favorable as the existing
contracts. For example, Southern California Gas Company, our largest customer,
filed a proposal in January 2004 with the California Public Utilities Commission
asking for permission to give notice to terminate certain of its transportation
agreements with us by February 25, 2005, with the intent of negotiating to
reduce their capacity holdings on our pipeline system as part of an effort to
diversify their capacity holdings. The outcome of this proceeding is uncertain
at this time. For a further discussion of these matters, see Part I, Item 1,
Business -- Markets and Competition.

In particular, our ability to extend and/or replace transportation
contracts could be adversely affected by factors we cannot control, including:

- competition by other pipelines, including the proposed construction by
other companies of additional pipeline capacity or LNG terminals in
markets served by us;

- changes in state regulation of local distribution companies, which may
cause them to negotiate short-term contracts or turn back their capacity
when their contracts expire;

- reduced demand and market conditions in the areas we serve;

- the availability of alternative energy sources or gas supply points; and

- regulatory actions.

If we are unable to renew, extend or replace these contracts or if we renew
them on less favorable terms, we may suffer a material reduction in our revenues
and earnings.

FLUCTUATIONS IN ENERGY COMMODITY PRICES COULD ADVERSELY AFFECT OUR BUSINESS.

Revenues generated by our contracts depend on volumes and rates, both of
which can be affected by the prices of natural gas. Increased natural gas prices
could result in a reduction of the volumes transported by our customers, such as
power companies who, depending on the price of fuel, may not dispatch gas fired
power plants. Increased prices could also result from industrial plant shutdowns
or load losses to competitive fuels as well as local distribution companies'
loss of customer base. The success of our operations is subject to continued
development of additional oil and natural gas reserves in the vicinity of our
facilities and our ability to access additional suppliers from interconnecting
pipelines to offset the natural decline from existing wells connected to our
systems. A decline in energy prices could precipitate a decrease in these
development activities and could cause a decrease in the volume of reserves
available for transmission on our system. If natural gas prices in the supply
basins connected to our pipeline systems are higher on a delivered basis to our
off-system markets than delivered prices from other natural gas producing
regions, our ability to compete with other transporters may be negatively
impacted. Fluctuations in energy prices are caused by a number of factors,
including:

- regional, domestic and international supply and demand;

- availability and adequacy of transportation facilities;

- energy legislation;

- federal and state taxes, if any, on the transportation of natural gas;

- abundance of supplies of alternative energy sources; and

- political unrest among oil-producing countries.

THE AGENCIES THAT REGULATE US AND OUR CUSTOMERS AFFECT OUR PROFITABILITY.

Our pipeline businesses are regulated by the FERC, the U.S. Department of
Transportation, and various state and local regulatory agencies. Regulatory
actions taken by those agencies have the potential to adversely

11

affect our profitability. In particular, the FERC regulates the rates we are
permitted to charge our customers for our services. If our tariff rates were
reduced in a future rate proceeding, if our volume of business under our
currently permitted rates was decreased significantly or if we were required to
substantially discount the rates for our services because of competition, our
profitability and liquidity could be reduced.

Further, state agencies and local governments that regulate our local
distribution company customers could impose requirements that could impact
demand for our services.

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.

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.

Although we believe we have established appropriate reserves for
liabilities, including clean up costs, we could be required to set aside
additional reserves in the future due to these uncertainties, and these amounts
could be material. For additional information, see Item 8, Financial Statements
and Supplementary Data, Note 10.

WE FACE UNCERTAINTY RELATED TO EXPIRING REAL PROPERTY INTERESTS RELATED TO OUR
PIPELINE.

Nearly 900 miles of the north mainline of our pipeline system are currently
located on property inside the Navajo Nation. We currently pay approximately
$2.3 million per year for the real property interests, such as easements, leases
and rights-of-way, located on Navajo Nation trust lands. These real property
interests are scheduled to expire in October 2005. We are beginning negotiations
with the Navajo Nation to renew these interests. The outcome of this process is
uncertain but we may incur future costs arising from potential litigation or
increased right-of-way fees.

OUR OPERATIONS ARE SUBJECT TO OPERATIONAL HAZARDS AND UNINSURED RISKS.

Our operations are subject to the inherent risks normally associated with
those operations, including pipeline ruptures, explosions, pollution, release of
toxic substances, fires and adverse weather conditions, and other hazards, each
of which could result in damage to or destruction of our facilities or damages
to persons and property. In addition, our operations face possible risks
associated with acts of aggression on our assets. If any of these events were to
occur, we could suffer substantial losses.

While we maintain insurance against many of these risks to the extent and
in amounts that we believe are reasonable, our financial condition and
operations could be adversely affected if a significant event occurs that is not
fully covered by insurance.

ONE CUSTOMER CONTRACTS FOR A SUBSTANTIAL PORTION OF OUR FIRM TRANSPORTATION
CAPACITY.

For 2003, contracts with Southern California Gas Company were substantial.
For additional information on our contracts with Southern California Gas
Company, see Part I, Item 1, Business -- Markets and

12

Competition and Part II, Item 8, Financial Statements and Supplementary Data,
Note 14. The loss of this customer or a decline in its credit-worthiness could
adversely affect our results of operations, financial position and cash flow.

ONGOING LITIGATION AND INVESTIGATIONS REGARDING US AND EL PASO COULD
SIGNIFICANTLY ADVERSELY AFFECT OUR BUSINESS.

A listing of legal proceedings is included in Part I, Item 3, Legal
Proceedings. A description of our legal proceedings and investigations is
included in Part II, Item 8, Financial Statements and Supplementary Data, Note
10.

RISKS RELATED TO OUR AFFILIATION WITH EL PASO

El Paso files reports, proxy statements and other information with the SEC
under the Securities Exchange Act of 1934, as amended. Each prospective investor
should consider this information and the matters disclosed therein in addition
to the matters described in this report. Such information is not incorporated by
reference herein.

OUR RELATIONSHIP WITH EL PASO AND ITS FINANCIAL CONDITION SUBJECTS US TO
POTENTIAL RISKS THAT ARE BEYOND OUR CONTROL.

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 (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 B1 by Moody's (with a negative outlook and under review
for a possible downgrade) and B- by Standard & Poor's (with a negative outlook).
These downgrades will increase our cost of capital and collateral requirements,
and could impede our access to capital markets. As a result of these downgrades,
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 2003 Long-Range Plan that, among other things,
defines, El Paso's future businesses, targets significant debt reduction and
establishes financial goals. An inability to meet these objectives could
adversely affect El Paso's liquidity position, and in turn affect our financial
condition.

Pursuant to El Paso's cash management program, surplus cash is made
available to El Paso in exchange for an affiliated receivable. In addition, we
conduct commercial transactions with some of our affiliates. As of December 31,
2003, we have net receivables of approximately $770 million from El Paso and its
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. However, 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 13.

Furthermore, in February 2004, El Paso announced that it had completed a
review of its estimates of natural gas and oil reserves. As a result of this
review, El Paso announced that it was reducing its proved natural gas and oil
reserves by approximately 1.8 Tcfe. El Paso also announced that this reserve
revision would result in a 2003 charge of approximately $1 billion if the full
impact of the revision was taken in that period. In March 2004, El Paso provided
an update and stated that the revisions would likely result in a restatement of
its historical financial statements, the timing and magnitude of which are still
being determined. El Paso has retained a law firm to conduct an internal
investigation, which is ongoing. Also, as a result of the reduction in reserve
estimates, several class action suits have been filed against El Paso and
several of its subsidiaries, but not against us. The reduction in reserve
estimates may also become the subject of an SEC investigation or

13

separate inquiries by other governmental regulatory agencies. These
investigations and lawsuits may further negatively impact El Paso's credit
ratings and place further demands on its liquidity. See Item 8, Financial
Statements and Supplementary Data, Note 2 for a further discussion of the
possible impacts of this announcement.

WE MAY BE SUBJECT TO A CHANGE OF CONTROL UNDER CERTAIN CIRCUMSTANCES.

One of our subsidiaries is one of many subsidiary guarantors of El Paso's
$3 billion revolving credit facility. In connection with its guarantee of the $3
billion revolving credit facility, the subsidiary pledged as collateral its
ownership of Mojave Pipeline, its sole asset. In addition, in connection with
its guarantee of El Paso's $3 billion revolving credit facility, our direct
parent, El Paso EPNG Investments, L.L.C. pledged as collateral its equity
interests in us. As a result, our ownership is subject to change if El Paso's
lenders under the $3 billion revolving credit facility exercise rights over
their collateral. El Paso EPNG Investments' equity in us and our ownership of
the above-referenced subsidiary also collateralizes approximately $1 billion of
other financing arrangements, including leases, letters of credit and other
facilities.

A DEFAULT UNDER EL PASO'S $3 BILLION REVOLVING CREDIT FACILITY BY ANY PARTY
COULD ACCELERATE OUR FUTURE BORROWINGS, IF ANY, UNDER THE FACILITY AND OUR
LONG-TERM DEBT, WHICH COULD ADVERSELY AFFECT OUR LIQUIDITY POSITION.

We are a party to El Paso's $3 billion revolving credit facility. We are
only liable, however, for our borrowings under the facility, which were zero as
of December 31, 2003. Under the facility, a default by El Paso, or any other
party, could result in the acceleration of all outstanding borrowings under the
facility, including the borrowings of any non-defaulting party. El Paso's
revisions to its reserve estimates would likely result in a restatement of its
historical financial statements. Any such material restatement would result in
an event of default under El Paso's revolving credit facility, which could
result in the acceleration of any outstanding borrowings by El Paso, and would
preclude us from borrowing under the facility in the future. The acceleration of
our future borrowings, if any, under the credit facility, or the inability to
borrow under the credit facility, could adversely affect our liquidity position
and, in turn, our financial condition.

Furthermore, the indentures governing our long-term debt include
cross-acceleration provisions. Therefore, if we borrow $25 million or more under
the credit facility and such borrowings are accelerated for any reason,
including the default of another party, our long-term debt could also be
accelerated. The acceleration of our long-term debt could also adversely affect
our liquidity position and, in turn, our financial condition.

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 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.

14

WE ARE A WHOLLY OWNED DIRECT SUBSIDIARY OF EL PASO EPNG INVESTMENTS, L.L.C., A
DIRECT SUBSIDIARY OF EL PASO.

As we are an indirect subsidiary of El Paso, 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.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our primary market risk is exposure to changing interest rates. The table
below shows the carrying value and related weighted average effective interest
rates of our interest bearing securities, by expected maturity dates, and the
fair value of those securities. The carrying amounts of short-term borrowings
are representative of fair values because of the short-term maturity of these
instruments. The fair values of our fixed rate long-term debt securities have
been estimated based on quoted market prices for the same or similar issues.

15

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

EL PASO NATURAL GAS COMPANY

CONSOLIDATED STATEMENTS OF INCOME
(IN MILLIONS)

See accompanying notes.

16

EL PASO NATURAL GAS COMPANY

CONSOLIDATED BALANCE SHEETS
(IN MILLIONS, EXCEPT SHARE AMOUNTS)

See accompanying notes.

17

EL PASO NATURAL GAS COMPANY

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN MILLIONS)

See accompanying notes.

18

EL PASO NATURAL GAS COMPANY

CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY
(IN MILLIONS, EXCEPT SHARE AMOUNTS)

See accompanying notes.

19

EL PASO NATURAL GAS COMPANY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation and Principles of Consolidation

Our consolidated financial statements include the accounts of all
majority-owned, controlled subsidiaries after the elimination of all significant
intercompany accounts and transactions. We consolidate entities when we have the
ability to control the operating and financial decisions and policies of that
entity. Our financial statements for prior periods include reclassifications
that were made to conform to the current year presentation. Those
reclassifications had no impact on reported net income or stockholder's equity.

Use of Estimates

The preparation of financial statements in conformity with U.S. generally
accepted accounting principles 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.

Regulated Operations

Our natural gas systems are subject to the jurisdiction of the FERC in
accordance with the Natural Gas Act of 1938 and the Natural Gas Policy Act of
1978, and we currently apply the provisions of Statements of Financial
Accounting Standards (SFAS) No. 71, Accounting for the Effects of Certain Type
of Regulation. We perform an annual study to assess the ongoing applicability of
SFAS No. 71. The accounting required by SFAS No. 71 differs from the accounting
required for businesses that do not apply its provisions. Transactions that are
generally recorded differently as a result of applying regulatory accounting
requirements include capitalizing an equity return component on regulated
capital projects, post retirement employee benefit plans, and other costs
included in, or expected to be included in, future rates.

Cash and Cash Equivalents

We consider short-term investments with an original maturity of less than
three months to be cash equivalents.

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 an outstanding receivable balance. We regularly review
collectibility and establish or adjust our allowance as necessary using the
specific identification method.

Materials and Supplies

We value materials and supplies at the lower of cost or market value with
cost determined using the average cost method.

Natural Gas Imbalances

Natural gas imbalances occur when the actual amount of natural gas
delivered from or received by a pipeline system differs from the contractual
amount scheduled to be delivered or received. We value these imbalances due to
or from shippers and operators at the end of year actual or appropriate market
index price. Imbalances are settled in cash or made up in kind, subject to the
contractual terms of settlement.

20

Imbalances due from others are reported in our balance sheet as either
accounts receivable from customers or accounts receivable from affiliates.
Imbalances owed to others are reported on the balance sheet as either trade
accounts payable or accounts payable to affiliates. In addition, all imbalances
are classified as current.

Property, Plant and Equipment

Our property, plant and equipment is recorded at its original cost of
construction or, upon acquisition, at either the fair value of the assets
acquired or the cost to the entity that first placed the asset in service. We
capitalize direct costs, such as labor and materials, and indirect costs, such
as overhead and an allowance for funds used during construction for our
regulated business as allowed by FERC. We capitalize the major units of property
replacements or improvements and expense minor items. Included in our pipeline
property balances are additional acquisition costs which represent the excess
purchase costs associated with purchase method business combinations allocated
to our regulated interstate systems. These costs are amortized on a
straight-line basis over 36 years, and we do not recover these excess costs in
our rates. As of December 31, 2003, we had unamortized additional acquisition
costs of $69 million net of accumulated amortization of $82 million.

We use the composite (group) method to depreciate regulated property, plant
and equipment. Under this method, assets with similar lives and other
characteristics are grouped and depreciated as one asset. For aircraft, we apply
the depreciation rates to the total cost of the group until its net book value
equals its salvage value. For all other property, plant and equipment we
depreciate the asset to zero. Currently, our depreciation rates vary from 2 to
33 percent. Using these rates, the average remaining depreciable lives of these
assets range from one to 40 years.

When we retire regulated property, plant and equipment, we charge
accumulated depreciation and amortization for the original cost, plus the cost
to remove, sell or dispose, less its salvage value. We do not recognize a gain
or loss unless we sell an entire operating unit. We include gains or losses on
dispositions of operating units in income. On non-regulated property, plant and
equipment, we record a gain or loss in income for the difference between the net
book value relative to the proceeds received, if any, when the asset is sold or
retired.

At December 31, 2003 and 2002, we had approximately $218 million and $146
million of construction work in progress included in our property, plant and
equipment.

As a FERC-regulated company, we capitalize a carrying cost (an allowance
for funds used during construction, or AFUDC) on funds invested in our
construction of long-lived assets. This carrying cost consists of a return on
the investment financed by debt and a return on the investment financed by
equity. The debt portion is calculated based on our average cost of debt. Debt
amounts capitalized during the years ended December 31, 2003, 2002 and 2001,
were $3 million, $6 million and $9 million. These amounts are included as an
offset to interest expense in our income statement. The equity portion is
calculated using the most recent FERC approved equity rate of return. The equity
amount capitalized for the year ended December 31, 2003, was $4 million
(exclusive of any tax related impacts). Equity amounts capitalized for the year
ended December 31, 2002 and 2001 were immaterial. These amounts are included as
other non-operating income on our income statement. Capitalized carrying costs
for debt and equity financed construction are reflected as an increase in the
cost of the asset on our balance sheet.

Asset Impairments

We evaluate our assets for impairment when events or circumstances indicate
that a long-lived asset's carrying value may not be recovered. These events
include market declines, changes in the manner in which we intend to use an
asset or decisions to sell an asset and adverse changes in the legal or business
environment such as adverse actions by regulators. At the time we decide to exit
an activity or sell a long-lived asset or group of assets, we adjust the
carrying value of those assets downward, if necessary, to the estimated sales
price, less costs to sell. We also classify these asset or assets as either held
for sale or as discontinued operations, depending on whether the asset or assets
have independently determinable cash flows.
21

Revenue Recognition

Our revenues consist primarily of demand and throughput-based
transportation services. We recognize demand revenues on firm contracted
capacity monthly over the contract period regardless of the amount of capacity
that is actually used. For throughput-based services, we record revenues when
physical deliveries of natural gas are made at the agreed upon delivery point.
Revenues are generally based on the thermal quantity of gas delivered or
subscribed at a price specified in the contract or tariff. We are subject to
FERC regulations and, as a result, revenues we collect may be refunded in a
final order of a pending rate proceeding or as a result of a rate settlement. We
establish reserves for these potential refunds.

Through 2003, we also recorded risk sharing revenues related to our most
recent rate settlement. The majority of the risk sharing amounts were collected
in advance from our customers. These collections were initially deferred and are
then amortized over the risk sharing period as specified in our tariff. See Note
10 for a further discussion of our rate settlement and these risk sharing
provisions.

Environmental Costs and Other Contingencies

We record environmental liabilities when our environmental assessments
indicate that remediation efforts are probable, and the costs can be reasonably
estimated. We recognize a current period expense when clean-up efforts do not
benefit future periods. We capitalize costs that benefit more than one
accounting period, except in instances where separate agreements or legal and
regulatory guidelines dictate otherwise. Estimates of our liabilities are based
on currently available facts, existing technology and presently enacted laws and
regulations taking into account the likely effects of inflation and other
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 (EPA) 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, rate
recovery, government sponsored and other 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
of the range of probable loss.

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 or 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 the 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) each
company in a taxable income position will accrue a current expense equivalent to
its federal and state income taxes, and (ii) each company in a tax loss position
will accrue a benefit to the extent its deductions, including general business
credits, can be utilized in the consolidated returns. El Paso pays all
consolidated U.S. federal and state income taxes directly to the appropriate
taxing jurisdictions and, under a separate tax billing agreement, El Paso may
bill or refund its subsidiaries for their portion of these income tax payments.
22

2. LIQUIDITY

In February 2004, El Paso announced that it had completed a review of its
estimates of natural gas and oil reserves. As a result of this review, El Paso
announced that it was reducing its proved natural gas and oil reserves by
approximately 1.8 Tcfe. El Paso also announced that this reserve revision would
result in a 2003 charge of approximately $1 billion if the full impact of the
revision was taken in that period. In March 2004, El Paso provided an update and
stated that the revision would likely result in a restatement of its historical
financial statements, the timing and magnitude of which are still being
determined.

A material restatement of El Paso's prior period financial statements may
result in an "event of default" under El Paso's revolving credit facility and
various other financing transactions; specifically under the provisions of the
facility related to representations and warranties on the accuracy of its
historical financial statements and its debt to total capitalization ratio. El
Paso has received waivers on its revolving credit facility and two other
transactions. These waivers have a condition that provides for the expiration of
the waiver in thirty days, unless El Paso successfully receives waivers on other
specified transactions within that time period. El Paso is pursuing these
additional waivers and expects to receive them. However, if El Paso is unable to
obtain these additional waivers, and there is an existing event of default, El
Paso could be required to immediately repay the amounts outstanding under the
revolving credit facility, and El Paso and we would be precluded from borrowing
under this facility. We currently have no outstanding borrowings under the
facility, have never borrowed under the facility and do not believe we will need
to borrow from the facility in the future. In addition, based upon a review of
the covenants and indentures of our other outstanding indebtedness, we do not
believe that a default on the revolving credit facility would constitute an
event of default on our other debt securities.

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, we either provide
cash to El Paso or El Paso provides cash to us. We have historically provided
cash to El Paso under this program, and as of December 31, 2003, we had a cash
advance receivable from El Paso of $779 million, classified as a non-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. Furthermore, we would still be
required to repay affiliated company payables. Non-cash write-downs that cause
our debt to EBITDA (as defined in our agreements) ratio to fall below 5 to 1
could prohibit us from incurring additional debt. However, this non-cash equity
reduction would not result in an event of default under our existing debt
securities. In addition, based on our current estimates of cash flows, we do not
believe we will need to seek repayment of all or part of these advances in the
next year.

El Paso's ownership in us and our ownership in Mojave Pipeline Company
serve as collateral under El Paso's revolving credit facility and other of El
Paso's borrowings. If El Paso's lenders under this facility or those borrowings
were to exercise their rights to this collateral, our ownership could change and
our ownership interests in Mojave could be liquidated. However, this change of
control and liquidation would not constitute an event of default under our
existing debt securities.

If, as a result of the events described above, 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.

Finally, we have cross-acceleration provisions in our long-term debt that
state that should we incur an event of default under which borrowings in excess
of $25 million are accelerated, our long-term debt

23

could also be accelerated. The acceleration of our long-term debt would
adversely affect our liquidity position and, in turn, our financial condition.

3. WESTERN ENERGY SETTLEMENT

As a result of the Western Energy Settlement discussed in Note 10, we
recorded an initial pretax charge and obligation of $412 million in 2002. Upon
entering the definitive agreements and during the remainder of 2003, we recorded
an additional obligation and a net pretax charge in 2003 of approximately $127
million. The additional charge was primarily a result of changes in the value of
the common stock to be issued in connection with the definitive settlement
agreements and changes in the timing of settlement payments. During 2003, we
also recorded accretion expense on the discounted Western Energy Settlement
obligation of $9 million and paid other charges of $4 million both of which are
included as part of operation and maintenance expense in our income statement.
As of December 31, 2003, our total Western Energy settlement obligation was $538
million, all of which is reflected as a current liability since we estimate the
finalization of the settlement in the next twelve months. As of December 31,
2003, $10 million of the total obligation had been paid to certain settling
parties.

El Paso established an escrow account for amounts funded by us and its
affiliates until final approval of the settlement agreements. As of December 31,
2003, total amounts in this account were $443 million, which is reflected as
restricted cash in our balance sheet and as an investing activity in our
statement of cash flows. We funded $322 million of this account by using the
majority of the net proceeds from the issuance of $355 million in senior notes
in July 2003. Additionally, during the fourth quarter of 2003, El Paso issued a
total of 17.6 million shares of its common stock on our behalf for $121 million,
the proceeds from which were placed in the escrow account. In January 2004, El
Paso issued the remaining 8.8 million shares for approximately $74 million,
which was also placed in the escrow account. Future payments from this account,
upon final approval of the settlement agreements, will be reflected as a
reduction of our cash flow from operations.

4. ACQUISITIONS AND DIVESTITURES

In August 2003, we announced the purchase of Copper Eagle Gas Storage,
L.L.C., which is developing a natural gas storage project located outside of
Phoenix, Arizona. We purchased Copper Eagle from Arizona Gas Storage, L.L.C. and
APACS Holding L.L.C. Arizona Gas Storage is owned by our affiliate, GulfTerra
Energy Partners, L.P. The purchase price was $12 million, and under the current
terms of the purchase agreement, we paid $2.5 million in cash at the closing. In
the fourth quarter of 2003, we made a payment of $2.3 million. The remaining
balance at December 31, 2003 of $7 million is scheduled to be paid in three
quarterly installments ending September 2004. We also acquired land for
approximately $9 million that will allow for further development of that
project.

During 2003, we sold a non-pipeline asset with a net book value of
approximately $38 million. Net proceeds from the sale were approximately $38
million, including approximately $8 million from our parent, and no gain or loss
was recognized on the sale.

5. MERGER-RELATED COSTS

During the year ended December 31, 2001, we incurred merger-related costs
of $98 million associated with El Paso's 2001 merger with The Coastal
Corporation and the relocation of our headquarters from El Paso, Texas to
Colorado Springs, Colorado. Our merger-related costs include employee severance,
retention and transition costs for severed employees totaling $6 million that
occurred as a result of El Paso's merger-related workforce reduction and
consolidation. All employee severance, retention and transition costs have been
paid. Merger-related costs also include estimated net lease payments on a
non-cancelable lease for office space and facility-related costs of $92 million
to close our offices in El Paso and relocate our headquarters to Colorado
Springs. These charges were accrued in 2001 at the time we completed our
relocations and closed these offices. As of December 31, 2003, we have paid $40
million of the accrual leaving a remaining balance of $52 million. The amounts
accrued will be paid over the term of the applicable

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non-cancelable lease agreements. Future developments, such as our ability to
terminate the lease or to recover lease costs through sub-leases, could impact
the accrued amounts.

6. INCOME TAXES

The following table reflects the components of income taxes included in net
income for each of the three years ended December 31:

Our income taxes included in net income differ 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:

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

Included in deferred tax assets are amounts related to the Western Energy
Settlement. Proposed tax legislation has been introduced in the U.S. Senate
which would disallow deductions for certain settlements made to or on behalf of
governmental entities. If enacted, this tax legislation could impact the
deductibility of the expenses related to the Western Energy Settlement and could
result in a write-off of some or all of the associated deferred tax assets.

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Under El Paso's tax accrual policy, we are allocated the tax effects
associated with our employees' non-qualified dispositions of employee stock
purchase plan stock, the exercise of non-qualified stock options and the vesting
of restricted stock as well as restricted stock dividends. This allocation
increased taxes payable by $1 million in 2003 and reduced taxes payable by $1
million in 2002 and $4 million in 2001. These tax effects are included in
additional paid-in capital in our balance sheet.

As of December 31, 2003, we had approximately $17 million of alternative
minimum tax credits and $1 million of net operating loss carryovers available to
offset future regular tax liabilities. The alternative minimum tax credits
carryover indefinitely. The net operating loss carryover period ends in 2021.
Usage of these carryovers is subject to the limitations provided under Sections
382 and 383 of the Internal Revenue Code as well as the separate return
limitation year rules of IRS regulations.

7. FINANCIAL INSTRUMENTS

The carrying amounts and estimated fair values of our financial instruments
are as follows at December 31:

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

(1) We estimated the fair value of debt with fixed interest rates based on
quoted market prices for the same or similar issues.

As of December 31, 2003 and 2002, the carrying amounts of cash and cash
equivalents, short-term borrowings, and trade receivables and payables are
representative of fair value because of the short-term maturity of these
instruments.

8. REGULATORY ASSETS AND LIABILITIES

Our regulatory assets and regulatory liabilities as of December 31, 2003
and 2002 are presented below.

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

(1) This amount is not included in our rate base on which we earn a current
return.

(2) Amounts are included as other non-current assets and liabilities in our
balance sheet.

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9. DEBT AND OTHER CREDIT FACILITIES

Debt

Our long-term debt outstanding consisted of the following at December 31:

In June 2002, we issued $300 million aggregate principal amount 8.375%
notes due 2032. Proceeds were approximately $296 million, net of issuance costs.

In July 2003, we issued $355 million of senior unsecured notes with an
annual interest rate of 7.625% due 2010. Net proceeds were approximately $347
million. In November 2003, we retired $200 million of 6.75% notes due 2003.

None of the principal amounts of our long-term debt matures in the next 5
years.

Our long-term debt contains cross-acceleration provisions, the most
restrictive of which is a $25 million cross-acceleration clause. If triggered,
repayment of our long-term debt, could be accelerated.

Letters of Credit

In 2001, we issued $3 million of letters of credit for an unconsolidated
affiliate, $2 million of which matures in April 2005. We cancelled $1 million of
these letters of credit in January 2004, undrawn.

Other Financing Arrangements

In April 2003, El Paso entered into a new $3 billion revolving credit
facility, with a $1.5 billion letter of credit sublimit, which matures on June
30, 2005. The credit facility has a borrowing cost of LIBOR plus 350 basis
points, letter of credit fees of 350 basis points and a commitment fee of 75
basis points on the unused portion of the facility. This facility replaced El
Paso's previous $3 billion revolving credit facility. El Paso's $1 billion
revolving credit facility which matured in August 2003, and approximately $1
billion of other El Paso financing arrangements (including leases, letters of
credit and other facilities) were also amended to conform El Paso's obligations
under those arrangements to the new credit facility. We, along with El Paso and
our affiliates, ANR Pipeline Company, Tennessee Gas Pipeline Company (TGP) and
Colorado Interstate Gas Company (CIG), are borrowers under El Paso's $3 billion
revolving credit facility, and El Paso's equity in several of its subsidiaries,
including its equity in us and our equity in Mojave Pipeline Company,
collateralize the credit facility and the other financing arrangements. We are
only liable for amounts we directly borrow. As of December 31, 2003, $850
million was outstanding and $1.2 billion in letters of credit were issued under
the $3 billion revolving credit facility, none of which were borrowed by or
issued on behalf of us. See Note 2 for a discussion regarding El Paso's possible
default on the $3 billion revolving credit facility.

We were jointly and severally liable for any outstanding amounts under El
Paso's $1 billion revolving credit facility through its maturity in August 2003,
and under El Paso's $3 billion revolving credit facility through August 2003.

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Under the new $3 billion revolving credit facility and other indentures, we
are subject to a number of restrictions and covenants. The most restrictive of
these include (i) limitations on the incurrence of additional debt, based on a
ratio of debt to EBITDA (as defined in the agreements); (ii) limitations on the
use of proceeds from borrowings; (iii) limitations, in some cases, on
transactions with our affiliates; (iv) limitations on the incurrence of liens;
(v) potential limitations on our ability to declare and pay dividends; and (vi)
potential limitations on our ability to participate in the El Paso cash
management program discussed in Note 13. For the year ended December 31, 2003,
we were in compliance with these covenants.

10. COMMITMENTS AND CONTINGENCIES

Legal Proceedings

Western Energy Settlement. On June 26, 2003, El Paso announced that it had
executed a Master Settlement Agreement, or MSA, to resolve the principal
litigation relating to the sale or delivery of natural gas and/or electricity to
or in the Western United States. The MSA settles California lawsuits in state
court, the California Public Utilities Commission (CPUC) proceeding at the FERC,
and the California Attorney General investigation discussed herein. Parties to
the settlement agreements include private class action litigants in California;
the governor and lieutenant governor of California; the attorneys general of
California, Washington, Oregon and Nevada; the CPUC; the California Electricity
Oversight Board; the California Department of Water Resources; Pacific Gas and
Electric Company (PG&E), Southern California Edison Company, five California
municipalities and six non-class private plaintiffs. We are a party to the MSA
and, as such, will bear a portion of the costs and obligations of the
settlements, as discussed more fully below. For a discussion of the charges
taken in connection with the Western Energy Settlement, see Note 3.

The MSA is in addition to the Joint Settlement Agreement, or JSA, announced
earlier in June 2003 where we agreed to provide structural relief to the
settling parties. In the JSA, we agreed to do the following:

- Subject to the conditions in the settlement, provide 3.29 Bcf/d of
primary firm pipeline capacity on our system to California delivery
points during a five year period from the date of settlement, and not add
any firm incremental load to our system that would prevent us from
satisfying our obligation to provide this capacity;

- Construct a new $173 million, 320 MMcf/d, Line 2000 Power-up expansion
project, and forgo recovery of the cost of service of this expansion
until our next rate case before the FERC;

- Clarify the rights of Northern California shippers to recall some of our
system capacity (Block II capacity) to serve markets in PG&E's service
area; and

- With limited exceptions, bar any of our affiliated companies from
obtaining additional firm capacity on our pipeline system during a five
year period from the effective date of the settlement.

In connection with the JSA, a Stipulated Judgment will be filed with the
United States District Court for the Central District of California. This
Stipulated Judgment provides for the enforcement of some of the obligations
contained in the JSA.

In the MSA, we agreed to the following terms:

- We admitted to no wrongdoing;

- We would make cash payments totaling $93.5 million for the benefit of the
parties to the definitive settlement agreements subsequent to the signing
of these agreements. This amount represents the originally announced $100
million cash payment less credits for amounts that have been paid to
other settling parties;

- We agreed to pay amounts equal to the proceeds from the issuance of
approximately 26.4 million shares by El Paso of El Paso common stock on
behalf of the settling parties. In this transaction, El Paso sold its
common stock and provided the proceeds from the issuance to us through an
equity contribution to satisfy this obligation; and

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- We would eliminate the originally announced 20-year obligation to pay $22
million per year in cash by depositing $250 million in escrow for the
benefit of the settling parties within 180 days of the signing of the
definitive settlement agreements. This prepayment eliminates any
collateral that might have been required on the $22 million per year
payment over the next 20 years.

As of December 31, 2003, $443 million had been deposited into an escrow
account for the benefit of the settling parties related to the items discussed
above. In January 2004, we deposited an additional $74 million in the escrow
account (see Note 3).

El Paso Merchant Energy L.P. (EPME), our affiliate, was also a party to the
settlement agreements and, along with El Paso, is obligated to provide a total
of $1,027 million (on an undiscounted basis) under these agreements. Of this
amount, $2 million will be paid by El Paso upon final approval of the definitive
settlement agreements, $125 million represents a contractual price discount that
will be realized over the remaining 30-month life of an existing power contract
between EPME and one of the settling parties, and $900 million will be paid by
EPME or El Paso in installments over the next 20 years. The long-term payment
obligation is a direct obligation of El Paso and EPME and will be supported by
collateral posted by El Paso's affiliates in amounts specified by the settlement
agreements. We have guaranteed the payment of these obligations in the event El
Paso and EPME fail to pay these amounts.

In June 2003, in anticipation of the execution of the MSA, El Paso, the
CPUC, PG&E, Southern California Edison Company, and the City of Los Angeles
filed the JSA described above with the FERC in resolution of specific
proceedings before that agency. In November 2003, the FERC approved the JSA with
minor modifications. Our east of California shippers have filed a request for
rehearing and the matter is currently pending before the FERC.

We were named as a defendant in fifteen purported class action, municipal
or individual lawsuits, filed in California state courts. These suits contend
that we acted improperly to limit the construction of new pipeline capacity to
California and/or to manipulate the price of natural gas sold into the
California marketplace. In December 2003, the California State Court in San
Diego dismissed us from seven of the fifteen class action suits and entered
judgment approving the MSA. The judgment was appealed. This appeal will delay
the effective date of the settlement. Seven other cases will be dismissed after
the MSA becomes effective. The fifteenth lawsuit was settled in May 2003.

In November 2002, a lawsuit was filed in the Superior Court of California,
County of Los Angeles against us, as well as numerous other unrelated entities,
alleging the creation of artificially high natural gas index prices via the
reporting of false price and volume information. This purported class action on
behalf of California consumers alleges various unfair business practices and
seeks restitution, disgorgement of profits, compensatory and punitive damages,
and civil fines. This lawsuit will be resolved upon approval of the Western
Energy Settlement.

In September 2001, we received a civil document subpoena from the
California Attorney General, seeking information said to be relevant to the
Attorney General's ongoing investigation into the high electricity prices in
California. This proceeding will be resolved upon approval of the Western Energy
Se