**UNITED STATES**

**SECURITIES ANDEXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 
| ý                                                | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**          |
|-------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------|
|                                                  |
| **For the quarterly period ended September 30, 2004** |
|                                                  |
| **OR**                                                |
| ** **                                            |
| o                                                     | ** ** | **TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**Commission File No. 1-10403**

 

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** **

**TEPPCO Partners,L.P.**

**(Exact name of Registrant as specified in its charter)**

 
| **Delaware**                                  | ** ** | **76-0291058**                               |
|-----------------------------------------------|------------|----------------------------------------------|
| **(State of Incorporation  or Organization)** | ** ** | **(I.R.S. Employer  Identification Number)** |

 

**2929 Allen Parkway**

**P.O. Box 2521**

**Houston, Texas 77252-2521**

(Address of principal executive offices, including zip code)

 

**(713) 759-3636**

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes  ý**** No o

 

Indicate by check mark whether the registrant is an accelerated filer (asdefined in Rule 12b-2 of the Exchange Act). Yes ý****No o

 

Indicate the number of shares outstanding of each of the issuer’s classesof common stock, as of the latest practicable date.  Limited Partner Units outstanding as of October28, 2004:   **62,998,554**.

 

 

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**TEPPCO PARTNERS, L.P.**

** **

**TABLE OF CONTENTS**

 
| **PART I. FINANCIAL INFORMATION**                                                                                               | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                      | ** ** |
| **Item 1. Financial Statements**                                                                                                | ** ** |
| **Consolidated Balance Sheets as of September 30,  2004 (unaudited) and December 31, 2003**                                     | ** ** |
| ** **                                                                                                                      | ** ** |
| **Consolidated  Statements of Income for the three months and nine months ended September 30,  2004 and 2003 (unaudited)** | ** ** |
| ** **                                                                                                                      | ** ** |
| **Consolidated  Statements of Cash Flows for the nine months ended September 30, 2004 and 2003 (unaudited)**               | ** ** |
| ** **                                                                                                                      | ** ** |
| **Consolidated  Statement of Partners’ Capital for the nine months ended September 30, 2004 (unaudited)**             | ** ** |
| ** **                                                                                                                      | ** ** |
| **Notes to the  Consolidated Financial Statements (unaudited)**                                                                 | ** ** |
| ** **                                                                                                                      | ** ** |
| **Item 2. Management’s  Discussion and Analysis of Financial Condition and Results of Operations**                         | ** ** |
| ** **                                                                                                                      | ** ** |
| **Forward-Looking  Statements**                                                                                                 | ** ** |
| ** **                                                                                                                      | ** ** |
| **Item 3. Quantitative and  Qualitative Disclosures About Market Risk**                                                         | ** ** |
| ** **                                                                                                                      | ** ** |
| **Item 4. Controls and Procedures**                                                                                             | ** ** |
| ** **                                                                                                                      | ** ** |
| **PART II. OTHER  INFORMATION**                                                                                                 | ** ** |
| ** **                                                                                                                      | ** ** |
| **Item 1. Legal Proceedings**                                                                                                   | ** ** |
| ** **                                                                                                                      | ** ** |
| **Item 6. Exhibits and  Reports on Form 8-K**                                                                                   | ** ** |
| ** **                                                                                                                      | ** ** |
| **Signatures**                                                                                                                  | ** ** |

 

i

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**PART I****. FINANCIALINFORMATION**

 

**Item 1****. Financial Statements**

 

**TEPPCO PARTNERS,  L.P.**

** **

**CONSOLIDATED BALANCE SHEETS**

**(in thousands)**

 
| ** **                                                                              | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                              | ** ** | **(Unaudited)**         | ** ** | ** **             | ** ** |
| **ASSETS**                                                                              | ** ** | ** **              | ** ** | ** **             | ** ** |
| Current assets:                                                                         |       |                    |       |                   |       |
| Cash and cash  equivalents                                                              |       | $                       | 9,625      |                   | $          | 29,469 |   |
| Accounts  receivable, trade (net of allowance for doubtful accounts of $125 and $4,700) |       | 511,746                 |       | 371,938                |       |
| Accounts  receivable, related parties                                                   |       | 18,271                  |       | 3,143                  |       |
| Inventories                                                                             |       | 29,184                  |       | 16,060                 |       |
| Other                                                                                   |       | 35,063                  |       | 32,208                 |       |
| Total current  assets                                                                   |       | 603,889                 |       | 452,818                |       |
| Property, plant  and equipment, at cost (net of accumulated                             |       |                    |       |                   |       |
| depreciation and  amortization of $390,921 and $345,357)                                |       | 1,668,997               |       | 1,619,163              |       |
| Equity  investments                                                                     |       | 375,188                 |       | 365,286                |       |
| Intangible  assets                                                                      |       | 414,520                 |       | 438,565                |       |
| Goodwill                                                                                |       | 16,944                  |       | 16,944                 |       |
| Other assets                                                                            |       | 53,425                  |       | 48,216                 |       |
| Total assets                                                                            |       | $                       | 3,132,963  |                   | $          | 2,940,992 |   |
| **LIABILITIES AND PARTNERS’  CAPITAL**                                             |       |                    |       |                   |       |
| Current  liabilities:                                                                   |       |                    |       |                   |       |
| Accounts payable  and accrued liabilities                                               |       | $                       | 531,428    |                   | $          | 359,660 |   |
| Accounts  payable, related parties                                                      |       | 18,150                  |       | 16,269                 |       |
| Accrued interest                                                                        |       | 12,659                  |       | 35,111                 |       |
| Other accrued  taxes                                                                    |       | 12,795                  |       | 9,941                  |       |
| Other                                                                                   |       | 46,022                  |       | 54,610                 |       |
| Total current  liabilities                                                              |       | 621,054                 |       | 475,591                |       |
| Senior Notes                                                                            |       | 1,128,620               |       | 1,129,650              |       |
| Other long-term  debt                                                                   |       | 325,500                 |       | 210,000                |       |
| Other  liabilities and deferred credits                                                 |       | 16,017                  |       | 16,430                 |       |
| Commitments and  contingencies                                                          |       |                    |       |                   |       |
| Partners’  capital:                                                                |       |                    |       |                   |       |
| Accumulated  other comprehensive loss                                                   |       | —                  |       | (2,902                 | )          |
| General  partner’s interest                                                        |       | (27,143                 | )          | (7,181                 | )          |
| Limited  partners’ interests                                                       |       | 1,068,915               |       | 1,119,404              |       |
| Total partners’  capital                                                           |       | 1,041,772               |       | 1,109,321              |       |
| Total liabilities  and partners’ capital                                           |       | $                       | 3,132,963  |                   | $          | 2,940,992 |   |

 

Seeaccompanying Notes to Consolidated Financial Statements.

 

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**TEPPCO PARTNERS, L.P.**

** **

**CONSOLIDATED STATEMENTS OF INCOME**

**(Unaudited)**

**(in thousands, except per Unitamounts)**

 
| ** **                                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                         | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Operating  revenues:                                               |       |                                  |       |                                 |       |   |   |   |   |
| Sales of  petroleum products                                       |       | $                                     | 1,359,954  |                                 | $          | 946,402 |   | $ | 3,774,874 |   | $ | 2,849,594 |   |
| Transportation –  Refined products                            |       | 43,386                                |       | 37,992                               |       | 113,294 |   | 102,688 |   |
| Transportation –  LPGs                                        |       | 16,071                                |       | 18,498                               |       | 58,572 |   | 62,676 |   |
| Transportation –  Crude oil                                   |       | 9,288                                 |       | 6,813                                |       | 28,164 |   | 20,777 |   |
| Transportation –  NGLs                                        |       | 10,430                                |       | 9,996                                |       | 31,022 |   | 29,335 |   |
| Gathering –  Natural gas                                      |       | 35,515                                |       | 34,081                               |       | 104,444 |   | 100,627 |   |
| Other                                                              |       | 15,366                                |       | 13,107                               |       | 52,265 |   | 41,231 |   |
| Total operating  revenues                                          |       | 1,490,010                             |       | 1,066,889                            |       | 4,162,635 |   | 3,206,928 |   |
|                                                               |       |                                  |       |                                 |       |   |   |   |   |
| Costs and  expenses:                                               |       |                                  |       |                                 |       |   |   |   |   |
| Purchases of  petroleum products                                   |       | 1,345,677                             |       | 932,546                              |       | 3,730,330 |   | 2,807,734 |   |
| Operating,  general and administrative                             |       | 61,235                                |       | 52,199                               |       | 167,095 |   | 141,224 |   |
| Operating fuel  and power                                          |       | 12,721                                |       | 10,413                               |       | 34,397 |   | 30,560 |   |
| Depreciation and  amortization                                     |       | 30,277                                |       | 22,562                               |       | 84,508 |   | 73,362 |   |
| Taxes – other  than income taxes                              |       | 3,868                                 |       | 3,904                                |       | 13,993 |   | 13,403 |   |
| Gains on sales  of assets                                          |       | (849                                  | )          | —                               |       | (1,071 | ) | (3,948 | ) |
| Total costs and  expenses                                          |       | 1,452,929                             |       | 1,021,624                            |       | 4,029,252 |   | 3,062,335 |   |
|                                                               |       |                                  |       |                                 |       |   |   |   |   |
| Operating income                                                   |       | 37,081                                |       | 45,265                               |       | 133,383 |   | 144,593 |   |
|                                                               |       |                                  |       |                                 |       |   |   |   |   |
| Interest expense  – net                                       |       | (17,131                               | )          | (20,537                              | )          | (53,190 | ) | (64,398 | ) |
| Equity earnings                                                    |       | 5,621                                 |       | 5,768                                |       | 22,854 |   | 17,728 |   |
| Other income  (expense) – net                                 |       | 284                                   |       | (5                                   | )          | 1,000 |   | 437 |   |
|                                                               |       |                                  |       |                                 |       |   |   |   |   |
| Net income                                                         |       | $                                     | 25,855     |                                 | $          | 30,491 |   | $ | 104,047 |   | $ | 98,360 |   |
|                                                               |       |                                  |       |                                 |       |   |   |   |   |
| Net Income  Allocation:                                            |       |                                  |       |                                 |       |   |   |   |   |
| Limited Partner  Unitholders                                       |       | $                                     | 18,396     |                                 | $          | 21,620 |   | $ | 74,032 |   | $ | 69,361 |   |
| Class B  Unitholder                                                |       | —                                |       | —                               |       | — |   | 1,806 |   |
| General Partner                                                    |       | 7,459                                 |       | 8,871                                |       | 30,015 |   | 27,193 |   |
| Total net income  allocated                                        |       | $                                     | 25,855     |                                 | $          | 30,491 |   | $ | 104,047 |   | $ | 98,360 |   |
|                                                               |       |                                  |       |                                 |       |   |   |   |   |
| Basic and  diluted net income per Limited Partner and Class B Unit |       | $                                     | 0.29       |                                 | $          | 0.36 |   | $ | 1.18 |   | $ | 1.21 |   |
|                                                               |       |                                  |       |                                 |       |   |   |   |   |
| Weighted average  Limited Partner and Class B Units outstanding    |       | 62,999                                |       | 60,517                               |       | 62,999 |   | 58,675 |   |

 

Seeaccompanying Notes to Consolidated Financial Statements.

 

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**TEPPCO PARTNERS, L.P.**

 

**CONSOLIDATED STATEMENTS OF CASHFLOWS**

**(Unaudited)**

**(in thousands)**

 
| ** **                                                                     | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                     | ** ** | **2004**                             | ** ** | **2003** |   |
| Cash flows from  operating activities:                                         |       |                                 |       |   |   |
| Net income                                                                     |       | $                                    | 104,047    |   | $ | 98,360 |   |
| Adjustments to  reconcile net income to cash provided by operating activities: |       |                                 |       |   |   |
| Depreciation and  amortization                                                 |       | 84,508                               |       | 73,362 |   |
| Earnings in  equity investments, net of distributions                          |       | 15,774                               |       | (6,988 | ) |
| Gains on sales  of assets                                                      |       | (1,071                               | )          | (3,948 | ) |
| Non-cash portion  of interest expense                                          |       | 177                                  |       | 4,223 |   |
| Increase in  accounts receivable                                               |       | (139,808                             | )          | (83,343 | ) |
| Increase in  inventories                                                       |       | (13,124                              | )          | (380 | ) |
| Increase in  other current assets                                              |       | (2,855                               | )          | (4,319 | ) |
| Increase in  accounts payable and accrued expenses                             |       | 135,446                              |       | 85,661 |   |
| Other                                                                          |       | (10,056                              | )          | 14,031 |   |
| Net cash  provided by operating activities                                     |       | 173,038                              |       | 176,659 |   |
|                                                                           |       |                                 |       |   |   |
| Cash flows from  investing activities:                                         |       |                                 |       |   |   |
| Proceeds from  the sales of assets                                             |       | 1,202                                |       | 8,531 |   |
| Acquisition of  assets                                                         |       | (3,421                               | )          | (5,459 | ) |
| Acquisition of  additional interest in Centennial Pipeline LLC                 |       | —                               |       | (20,000 | ) |
| Investment in  Centennial Pipeline LLC                                         |       | (1,500                               | )          | (3,000 | ) |
| Investment in  Mont Belvieu Storage Partners, L.P.                             |       | (19,364                              | )          | (250 | ) |
| Capital  expenditures, net                                                     |       | (110,900                             | )          | (103,903 | ) |
| Net cash used in  investing activities                                         |       | (133,983                             | )          | (124,081 | ) |
|                                                                           |       |                                 |       |   |   |
| Cash flows from  financing activities:                                         |       |                                 |       |   |   |
| Proceeds from  revolving credit facility                                       |       | 256,300                              |       | 382,000 |   |
| Repayments on  revolving credit facility                                       |       | (140,800                             | )          | (589,000 | ) |
| Issuance of  Senior Notes                                                      |       | —                               |       | 198,570 |   |
| Debt issuance  costs                                                           |       | —                               |       | (3,079 | ) |
| Issuance of  Limited Partner Units, net                                        |       | —                               |       | 287,554 |   |
| Repurchase and  retirement of Class B Units                                    |       | —                               |       | (113,814 | ) |
| General  Partner’s contribution                                           |       | —                               |       | 2 |   |
| Distributions  paid                                                            |       | (174,399                             | )          | (145,415 | ) |
| Net cash  provided by (used in) financing activities                           |       | (58,899                              | )          | 16,818 |   |
|                                                                           |       |                                 |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                          |       | (19,844                              | )          | 69,396 |   |
|                                                                           |       |                                 |       |   |   |
| Cash and cash  equivalents at beginning of period                              |       | 29,469                               |       | 30,968 |   |
| Cash and cash  equivalents at end of period                                    |       | $                                    | 9,625      |   | $ | 100,364 |   |
|                                                                           |       |                                 |       |   |   |
| **Non-cash  investing activities:**                                            |       |                                 |       |   |   |
| Net assets  transferred to Mont Belvieu Storage Partners, L.P.                 |       | $                                    | —     |   | $ | 61,042 |   |
|                                                                           |       |                                 |       |   |   |
| **Supplemental  disclosure of cash flows:**                                    |       |                                 |       |   |   |
| Cash paid for  interest (net of amounts capitalized)                           |       | $                                    | 75,498     |   | $ | 76,542 |   |

 

Seeaccompanying Notes to Consolidated Financial Statements.

 

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**TEPPCO PARTNERS, L.P.**

** **

**CONSOLIDATED STATEMENT OFPARTNERS’ CAPITAL**

**(Unaudited)**

**(in thousands, except Unitamounts)**

 
| ** **                                            | ** ** | **Outstanding  Limited  Partner  Units** | ** ** | **General  Partner’s  Interest** | ** ** | **Limited  Partners’  Interests** | ** ** | **Accumulated  Other  Comprehensive  Loss** | ** ** | **Total** | ** ** |
|-------------------------------------------------------|------------|------------------------------------------|------------|---------------------------------------|------------|----------------------------------------|------------|---------------------------------------------|------------|-----------|------------|
|                                                  |       |                                     |       |                                  |       |                                   |       |                                        |       |      |       |
| Partners’  capital at December 31, 2003          |       | 62,998,554                               |       | $                                     | (7,181     | )                                      | $          | 1,119,404                                   |       | $         | (2,902     | ) | $ | 1,109,321 |   |
| Adjustment to  issuance of Limited Partner Units, net |       | —                                   |       | —                                |       | (99                                    | )          | —                                      |       | (99       | )          |
| Net income on  cash flow hedges                       |       | —                                   |       | —                                |       | —                                 |       | 2,902                                       |       | 2,902     |       |
| Net income  allocation                                |       | —                                   |       | 30,015                                |       | 74,032                                 |       | —                                      |       | 104,047   |       |
| Cash  distributions                                   |       | —                                   |       | (49,977                               | )          | (124,422                               | )          | —                                      |       | (174,399  | )          |
|                                                  |       |                                     |       |                                  |       |                                   |       |                                        |       |      |       |
| Partners’  capital at September 30, 2004         |       | 62,998,554                               |       | $                                     | (27,143    | )                                      | $          | 1,068,915                                   |       | $         | —     |   | $ | 1,041,772 |   |

 

Seeaccompanying Notes to Consolidated Financial Statements.

 

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**TEPPCO PARTNERS, L.P.**

** **

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**(Unaudited)**

 

**NOTE 1.  ORGANIZATION AND BASIS OF PRESENTATION**

 

TEPPCO Partners, L.P. (the “Partnership”), a Delawarelimited partnership, is a master limited partnership formed in March 1990.  We operate through TE Products PipelineCompany, Limited Partnership (“TE Products”), TCTM, L.P. (“TCTM”) and TEPPCOMidstream Companies, L.P. (“TEPPCO Midstream”). Collectively, TE Products, TCTM and TEPPCO Midstream are referred to asthe “Operating Partnerships.”  TexasEastern Products Pipeline Company, LLC (the “Company” or “General Partner”), aDelaware limited liability company, serves as our general partner and owns a 2%general partner interest in us.  TheGeneral Partner is a wholly owned subsidiary of Duke Energy Field Services, LLC(“DEFS”), a joint venture between Duke Energy Corporation (“Duke Energy”) andConocoPhillips.  Duke Energy holds aninterest of approximately 70% in DEFS, and ConocoPhillips holds the remaininginterest of approximately 30%.  TheCompany, as general partner, performs all management and operating functionsrequired for us, except for the management and operations of certain of ourTEPPCO Midstream assets that are managed by DEFS on our behalf.  We reimburse the General Partner for allreasonable direct and indirect expenses incurred in managing us.

 

As used in this Report, “we,” “us,” “our,” and the “Partnership”mean TEPPCO Partners, L.P. and, where the context requires, include oursubsidiaries.

 

Theaccompanying unaudited consolidated financial statements reflect alladjustments that are, in the opinion of our management, of a normal andrecurring nature and necessary for a fair statement of our financial positionas of September 30, 2004, and the results of our operations and cash flows forthe periods presented.  The results ofoperations for the three months and nine months ended September 30, 2004, arenot necessarily indicative of results of our operations for the full year2004.  You should read these interimfinancial statements in conjunction with our consolidated financial statementsand notes thereto presented in the TEPPCO Partners, L.P. Annual Report on Form10-K for the year ended December 31, 2003. We have reclassified certain amounts from prior periods to conform withthe current presentation.

 

Weoperate and report in three business segments: transportation and storage ofrefined products,  liquefied petroleumgases (“LPGs”) and petrochemicals (“Downstream Segment”); gathering,transportation, marketing and storage of crude oil and distribution oflubrication oils and specialty chemicals (“Upstream Segment”); and gathering ofnatural gas, fractionation of natural gas liquids (“NGLs”) and transportationof NGLs (“Midstream Segment”).  Ourreportable segments offer different products and services and are managedseparately because each requires a different business strategy.

 

Ourinterstate transportation operations, including rates charged to customers, aresubject to regulations prescribed by the Federal Energy Regulatory Commission (“FERC”).  We refer to refined products, LPGs,petrochemicals, crude oil, NGLs and natural gas in this Report, collectively,as “petroleum products” or “products.”

 

**Net Income Per Unit**

 

Basicnet income per Limited Partner and Class B Unit (collectively, “Unit” or “Units”)is computed by dividing our net income, after deduction of the General Partner’sinterest, by the weighted average number of Units outstanding (a total of 63.0million and 60.5 million Units for the three months ended September 30, 2004and 2003, respectively, and 63.0 million and 58.7 million Units for the ninemonths ended September 30, 2004 and 2003, respectively).  The General Partner’s percentage interest in ournet income is based on its percentage of cash distributions from Available Cashfor each period (see Note 9. Partners’ Capital and Distributions).  The General Partner was allocated $7.5million (representing 28.85%) and $8.9 million (representing 29.09%) of our netincome for the three months ended September 30, 2004 and 2003, respectively,and $30.0 million (representing 28.85%) and $27.2 million (representing 27.65%)of our net income for the nine months ended September 30, 2004 and 2003,

 

5

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respectively.  The General Partner’s percentage interest inour net income increases as cash distributions paid per Unit increase, inaccordance with our limited partnership agreement.

 

Dilutednet income per Unit is similar to the computation of basic net income per Unit discussedabove, except that the denominator is increased to include the dilutive effectof outstanding Unit options by application of the treasury stock method.  For the three months and nine months ended September30, 2003, the denominator was increased by 12,677 Units and 10,813 Units,respectively.  For the three months and ninemonths ended September 30, 2004, diluted net income per Unit equaled basic netincome per Unit as the denominator was not changed because all remainingoutstanding Unit options were exercised during the third quarter of 2003.

 

**New Accounting Pronouncements**

** **

**In December 2003, the Financial Accounting Standards Board (“FASB”)revised FASB Interpretation No. 46, *Consolidation of VariableInterest Entities, an interpretation of ARB No. 51* (“FIN 46”).  FIN 46, issued by the FASB in January 2003,requires certain variable interest entities to be consolidated by the primarybeneficiary of the entity if the equity investors in the entity do not have thecharacteristics of a controlling financial interest or do not have sufficientequity at risk for the entity to finance its activities without additionalsubordinated financial support from other parties.  The revised statement, FASB InterpretationNo. 46(R), *Consolidation of Variable Interest Entities, aninterpretation of ARB No. 51* (“FIN 46(R)”), clarifies some of therequirements of FIN 46, eases some implementation problems that companiesexperienced implementing FIN 46, adds new scope exceptions and makes theprobability more likely for many companies that potential variable interestentities will be identified and consolidated. We adopted the new requirements detailed in FIN 46(R) as of March 31,2004.  In connection with our adoption ofFIN 46(R), we evaluated our investments in Centennial Pipeline LLC, SeawayCrude Pipeline Company and Mont Belvieu Storage Partners, L.P. and determined thatthese entities are not materially affected by our adoption of FIN 46(R), andthus we have accounted for them as equity method investments (see Note 7.Equity Investments).  Our adoption of FIN46(R) did not have an effect on our financial position, results of operationsor cash flows.**

** **

**On December 8, 2003, President Bush signed into law a billthat expands Medicare, primarily adding a prescription drug benefit forMedicare-eligible retirees starting in 2006. We anticipate that the benefits we pay after 2006 could be lower as aresult of the new Medicare provisions; however, at this time the retireemedical obligations and costs reported do not reflect any changes as a resultof this legislation.  Deferring the recognitionof the new Medicare provisions’ impact was permitted by FASB Staff Position (“FSP”)Nos. 106-1 and 106-2, *Accounting and DisclosureRequirements Related to the Medicare Prescription Drug, Improvement andModernization Act of 2003*, due to open questions about some of thenew Medicare provisions and a lack of authoritative accounting guidance aboutcertain matters.  The final accountingguidance could require changes to previously reported information.  We adopted the provisions of these FSPs inthe quarter ended September 30, 2004.  Thisregulation did not have a material adverse effect on our financial position,results of operations or cash flows.**

** **

**In December 2003, the FASB issued a revision to Statement ofFinancial Accounting Standards (“SFAS”) No. 132, *Employers’ Disclosures about Pensions and Other Post-RetirementBenefits*.  This revisionrequired that companies provide more details about their plan assets, benefitobligations, cash flows, benefit costs and other relevant information.  A description of investment policies andstrategies and target allocation percentages, or target ranges, for these assetcategories also is required in financial statements.  Cash flows will include projections of futurebenefit payments and an estimate of contributions to be made in the next yearto fund pension and other postretirement benefit plans.  In addition to expanded annual disclosures,the FASB is requiring companies to report the various elements of pension andother postretirement benefit costs on a quarterly basis.  The guidance is effective for fiscal yearsending after December 15, 2003, and for quarters beginning after December 15,2003.  We adopted**

 

6

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**the provisions ofthe revised SFAS 132 effective December 31, 2003, and certain provisionsregarding disclosure of information about estimated future benefit payments inthe first quarter of 2004.**

** **

**In April 2004, the Emerging Issues Task Force (“EITF”) reachedconsensus in EITF 03-06, *ParticipatingSecurities and the Two-Class Method under FASB Statement No. 128*, toclarify what is meant by a participating security as described in SFAS No. 128,*Earnings Per Share. *The consensus also providesguidance on applying the two-class method for computing earnings pershare.  The two-class method is anearnings allocation formula for computing earnings per share and is therequired method prescribed by SFAS 128 for companies with participatingsecurities or more than one class of common stock.  The consensus primarily affects companiesthat issue securities that are entitled to participate in dividends with commonshares and would cause affected companies to report lower earnings per shareamounts.  The consensus is to be appliedretroactively for periods beginning after March 31, 2004.  The adoption of EITF 03-06 did not have aneffect on our financial position, results of operations or cash flows.**

** **

**NOTE 2.  GOODWILL AND OTHER INTANGIBLE ASSETS**

 

**Goodwill**

 

Goodwillrepresents the excess of purchase price over fair value of net assets acquiredand is presented on the consolidated balance sheets net of accumulatedamortization.  We account for goodwillunder SFAS No. 142, *Goodwill and OtherIntangible Assets*,**which wasissued by the FASB in July 2001.  SFAS142 prohibits amortization of goodwill and intangible assets with indefiniteuseful lives, and instead requires testing for impairment at least annually.

 

To perform an impairment test of goodwill, we haveidentified our reporting units and have determined the carrying value of eachreporting unit by assigning the assets and liabilities, including the existinggoodwill and intangible assets, to those reporting units.  We then determine the fair value of eachreporting unit and compare it to the carrying value of the reporting unit.  We will continue to compare the fair value ofeach reporting unit to its carrying value on an annual basis to determine if animpairment loss has occurred.  There havebeen no goodwill impairment losses recorded since the adoption of SFAS 142.

 

AtSeptember 30, 2004, we have $16.9 million of unamortized goodwill and $25.5million of excess investment in our equity investment in Seaway Crude PipelineCompany (equity method goodwill).  Theexcess investment is included in our equity investments account at September30, 2004.  The following table presentsthe carrying amount of goodwill and equity method goodwill at September 30,2004, by business segment (in thousands):

 
| ** **              | ** ** | **Downstream  Segment** | ** ** | **Midstream  Segment** | ** ** | **Upstream  Segment** | ** ** | **Segments  Total** | ** ** |
|-------------------------|------------|-------------------------|------------|------------------------|------------|-----------------------|------------|---------------------|------------|
| Goodwill                |       | $                       | —     |                   | $          | 2,777                 |       | $                   | 14,167     |   | $ | 16,944 |   |
| Equity method  goodwill |       | —                  |       | —                 |       | 25,502                |       | 25,502              |       |
|                         |            |                         |            |                        |            |                       |            |                     |            |  |  |  |  |

 

**Other Intangible Assets**

 

Thefollowing table reflects the components of amortized intangible assets at September30, 2004, and December 31, 2003 (in thousands):

 

7

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| ** **                               | ** ** | **September 30, 2004**     | ** ** | **December 31, 2003**         | ** ** |
|------------------------------------------|------------|----------------------------|------------|-------------------------------|------------|
| ** **                               | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| Amortized  intangible assets:            |       |                       |       |                          |       |   |   |   |   |
| Gathering and  transportation agreements |       | $                          | 464,337    |                          | $          | (84,929 | ) | $ | 464,337 |   | $ | (62,436 | ) |
| Fractionation  agreement                 |       | 38,000                     |       | (12,350                       | )          | 38,000 |   | (10,925 | ) |
| Other                                    |       | 12,262                     |       | (2,800                        | )          | 11,270 |   | (1,681 | ) |
| Total                                    |       | $                          | 514,599    |                          | $          | (100,079 | ) | $ | 513,607 |   | $ | (75,042 | ) |

 

SFAS142 requires that intangible assets with finite useful lives be amortized overtheir respective estimated useful lives. If an intangible asset has a finite useful life, but the precise lengthof that life is not known, that intangible asset shall be amortized over thebest estimate of its useful life.  At aminimum, we will assess the useful lives and residual values of all intangibleassets on an annual basis to determine if adjustments are required.

 

Thevalue assigned to our intangible assets for natural gas gathering contracts isamortized on a unit-of-production basis, based upon the actual throughput ofthe system over the expected total throughput for the lives of thecontracts.  We update throughputestimates and evaluate the remaining expected useful life of the contractassets on a quarterly basis based on the best available information. Due toexpansions on the gathering systems at Jonah Gas Gathering Company (“Jonah”)and because of certain limited production forecasts obtained from producers onthe Jonah system related to the expansions, in the second quarter of 2003 weincreased our best estimate of future throughput on the Jonah system.  This increase in the estimate of futurethroughput extended the amortization period of Jonah’s natural gas gatheringcontracts by an estimated 9 years, increasing from approximately 16 years to approximately25 years.  The amortization of thecontracts related to the Val Verde Gas Gathering Company (“Val Verde”) assets,also amortized on a unit-of-production basis, is expected to averageapproximately 20 years.  Revisions to theseestimates may occur as additional production information is made available tous.

 

Thevalues assigned to our fractionation agreement and other intangible assets aregenerally amortized on a straight-line basis. Our fractionation agreement with DEFS is being amortized over itscontract period of 20 years.  Theamortization periods for our other intangible assets, which include non-competeand other agreements, range from 3 years to 15 years.

 

Amortizationexpense on intangible assets was $8.6 million and $8.1 million for the threemonths ended September 30, 2004 and 2003, respectively, and $25.0 million and $27.9million for the nine months ended September 30, 2004 and 2003, respectively.

 

AtSeptember 30, 2004, we have $33.4 million of excess investment in our equityinvestment in Centennial Pipeline LLC, which was created upon formation of thecompany (see Note 7.  EquityInvestments).  The excess investment isincluded in our equity investments account at September 30, 2004.  This excess investment is accounted for as anintangible asset with an indefinite life. We will assess the intangible asset for impairment on an annual basis.

 

Thefollowing table sets forth the estimated amortization expense of intangibleassets for the years ending December 31 (in thousands):

 

| 2004 |   | $      | 34,915 |   |
|------|--------|--------|--------|--------|
| 2005 |   | 34,319 |   |
| 2006 |   | 34,305 |   |
| 2007 |   | 35,306 |   |
| 2008 |   | 32,982 |   |

 

8

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**NOTE 3. PROPERTY, PLANT AND EQUIPMENT**

** **

Weevaluate impairment of long-lived assets in accordance with SFAS No. 144, *Accounting for the Impairment or Disposal of Long-Lived Assets*.  Long-lived assets are reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. Recoverability of the carrying amount of assets to be held and used ismeasured by a comparison of the carrying amount of the asset to future net cashflows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to berecognized is measured by the amount by which the carrying amount of the assetsexceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carryingamount or fair value less costs to sell.

 

Duringthe third quarter of 2004, we completed an evaluation of our marine terminalfacility in the Beaumont, Texas, area. The facility consists primarily of a barge dock, a ship dock, four storagetanks and various segments of connecting pipelines and is included in ourDownstream Segment.  The evaluation indicatedthat the docks and other assets at the facility needed extensive work tocontinue to be commercially operational. As a result, we performed an impairment test on the entire marine facilityand recorded a $4.4 million non-cash impairment charge, included indepreciation and amortization expense in our consolidated statements of income,for the excess carrying value over the fair value of the facility.

 

**NOTE 4. INTEREST RATE SWAPS**

** **

We entered into an interest rate swap agreement tohedge our exposure to increases in the benchmark interest rate underlying ourvariable rate revolving credit facility. This interest rate swap matured onApril 6, 2004.  We designated this swapagreement, which hedged exposure to variability in expected future cash flowsattributed to changes in interest rates, as a cash flow hedge. The swapagreement was based on a notional amount of $250.0 million.  Under the swap agreement, we paid a fixed rateof interest of 6.955% and received a floating rate based on a three-month U.S.Dollar LIBOR rate.  Because this swap wasdesignated as a cash flow hedge, the changes in fair value, to the extent theswap was effective, were recognized in other comprehensive income until thehedged interest costs were recognized in earnings.  On June 27, 2003, we repaid the amountsoutstanding under our revolving credit facility with borrowings under a newthree year revolving credit facility and canceled the old facility (see Note 8.  Debt). We redesignated this interest rate swap as a hedge of our exposure toincreases in the benchmark interest rate underlying the new variable raterevolving credit facility.  During the ninemonths ended September 30, 2004 and 2003, we recognized increases in interestexpense of $2.9 million and $10.7 million, respectively, related to thedifference between the fixed rate and the floating rate of interest on theinterest rate swap.

 

During 2003, we determined that we would repay aportion of the amount outstanding under the revolving credit facility withproceeds from our Unit offering in August 2003 (see Note 9.  Partners’ Capital and Distributions)resulting in a reduction of probable future interest payments under the creditfacility.  We reduced the outstandingbalance of the revolving credit facility at December 31, 2003, to $210.0million.  During the year ended December31, 2003, we recognized a loss of $1.0 million for the portion of thediscontinued hedge.  The total fair valueof the interest rate swap was a loss of approximately $3.9 million at December31, 2003.  The remaining $2.9 million ofother comprehensive income was transferred to earnings during the period fromJanuary 1, 2004, through the maturity of the interest rate swap on April 6,2004.

 

On October 4, 2001, TE Products entered into aninterest rate swap agreement to hedge its exposure to changes in the fair valueof its fixed rate 7.51% Senior Notes due 2028. We designated this swapagreement as a fair value hedge.  Theswap agreement has a notional amount of $210.0 million and matures in January2028 to match the principal and maturity of the TE Products Senior Notes.  Under the swap agreement, TE Products pays afloating

 

9

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rate of interest based on a three-month U.S. DollarLIBOR rate, plus a spread, and receives a fixed rate of interest of 7.51%.  During the nine months ended September 30,2004 and 2003, we recognized reductions in interest expense of $7.5 million and$7.4 million, respectively, related to the difference between the fixed rateand the floating rate of interest on the interest rate swap.  During the quarter ended September 30, 2004,we measured the hedge effectiveness of this interest rate swap and noted thatno gain or loss from ineffectiveness was required to be recognized.  The fair value of this interest rate swap wasa gain of approximately $3.9 million at September 30, 2004, and a gain ofapproximately $2.3 million at December 31, 2003.

** **

**On February 20, 2002, we entered into interest rate swapagreements, designated as fair value hedges, to hedge our exposure to changesin the fair value of our fixed rate 7.625% Senior Notes due 2012.  The swap agreements had a combined notionalamount of $500.0 million and matured in 2012 to match the principal andmaturity of the Senior Notes.  Under theswap agreements, we paid a floating rate of interest based on a U.S. DollarLIBOR rate, plus a spread, and received a fixed rate of interest of 7.625%.  On July 16, 2002, the swap agreements wereterminated resulting in a gain of approximately $18.0 million.  Concurrent with the swap terminations, weentered into new interest rate swap agreements, with identical terms as theprevious swap agreements; however, the floating rate of interest was based upona spread of an additional 50 basis points. In December 2002, the swap agreements entered into on July 16, 2002,were terminated, resulting in a gain of approximately $26.9 million.  The gains realized from the July 2002 andDecember 2002 swap terminations have been deferred as adjustments to thecarrying value of the Senior Notes and are being amortized using the effectiveinterest method as reductions to future interest expense over the remainingterm of the Senior Notes.  At September30, 2004, the unamortized balance of the deferred gains was $37.6 million.  In the event of early extinguishment of theSenior Notes, any remaining unamortized gains would be recognized in theconsolidated statement of income at the time of extinguishment.**

** **

**NOTE 5.  ACQUISITIONS AND DISPOSITIONS**

 

**Rancho Pipeline**

 

Inconnection with our acquisition of crude oil assets in 2000, we acquired anapproximate 23.5% undivided joint interest in the Rancho Pipeline, which was acrude oil pipeline system from West Texas to Houston, Texas.  In March 2003, the Rancho Pipeline ceasedoperations, and segments of the pipeline were sold to certain of the owners thatpreviously held undivided interests in the pipeline.  We acquired 241 miles of the pipeline inexchange for cash of $5.5 million and our interests in other portions of theRancho Pipeline.  We sold 183 miles ofthe segment we acquired to other entities for cash and assets valued atapproximately $8.5 million.  We recordeda net gain of $3.9 million on the transactions in the second quarter of 2003.  During the third quarter of 2004, we sold ourremaining interest in the original Rancho Pipeline system for a net gain of$0.4 million.  These gains are includedin the gains on sales of assets in our consolidated statements of income.

 

**Genesis Pipeline**

 

OnNovember 1, 2003, we purchased crude supply and transportation assets along theupper Texas Gulf Coast for $21.0 million from Genesis Crude Oil, L.P. andGenesis Pipeline Texas, L.P. (“Genesis”). The transaction was funded with proceeds from our August 2003 equityoffering (see Note 9.  Partners’ Capitaland Distributions).  We allocated thepurchase price, net of liabilities assumed, primarily to property, plant andequipment and intangible assets.  Theassets acquired included approximately 150 miles of small diameter trunk lines,26,000 barrels per day of throughput and 12,000 barrels per day of leasemarketing and supply business.  We are integratingthese assets into our South Texas pipeline system which will allow us toconsolidate gathering and marketing assets in key operating areas in a costeffective manner and will provide future growth opportunities.  Accordingly, the results of the acquisitionare included in the consolidated financial statements from November 1, 2003.

 

10

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Thefollowing table allocates the estimated fair value of the Genesis assetsacquired on November 1, 2003 (in thousands):

 
| Property, plant  and equipment |   | $      | 12,811 |   |
|--------------------------------|--------|--------|--------|--------|
| Intangible  assets             |   | 8,742  |   |
| Other                          |   | 144    |   |
| Total assets                   |   | 21,697 |   |
|                           |   |   |   |
| Total  liabilities assumed     |   | (687   | )      |
| Net assets  acquired           |   | $      | 21,010 |   |

 

**NOTE 6.  INVENTORIES**

 

Inventoriesare valued at the lower of cost (based on weighted average cost method) ormarket.  The costs of inventories did notexceed market values at September 30, 2004, and December 31, 2003.  The major components of inventories were asfollows (in thousands):

 
| ** **                                | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| Crude oil                                 |       | $                       | 13,832     |                   | $          | 1,303 |   |
| Refined products                          |       | 2,548                   |       | 6,632                  |       |
| LPGs                                      |       | 3,240                   |       | 517                    |       |
| Lubrication oils  and specialty chemicals |       | 3,925                   |       | 3,080                  |       |
| Materials and  supplies                   |       | 5,524                   |       | 4,528                  |       |
| Other                                     |       | 115                     |       | —                 |       |
| Total                                     |       | $                       | 29,184     |                   | $          | 16,060 |   |

** **

**NOTE 7.  EQUITYINVESTMENTS**

 

Through one of our indirect wholly owned subsidiaries,we own a 50% ownership interest in Seaway Crude Pipeline Company (“Seaway”).  The remaining 50% interest is owned byConocoPhillips.  Seaway owns a pipelinethat carries mostly imported crude oil from a marine terminal at Freeport,Texas, to Cushing, Oklahoma, and from a marine terminal at Texas City, Texas,to refineries in the Texas City and Houston, Texas, areas.  The Seaway Crude Pipeline Company PartnershipAgreement provides for varying participation ratios throughout the life of theSeaway partnership. From June 2002 through May 2006, we receive 60% of revenueand expense of Seaway.  Thereafter, wewill receive 40% of revenue and expense of Seaway.  During the nine months ended September 30,2004 and 2003, we received distributions from Seaway of $30.9 million and $10.7million, respectively.  During the threemonths ended September 30, 2004, we received a distribution from Seaway of$15.0 million.  No distributions werereceived in the corresponding quarter of 2003.

 

In August 2000, TE Products entered into agreementswith Panhandle Eastern Pipeline Company (“PEPL”), a former subsidiary of CMSEnergy Corporation, and Marathon Ashland Petroleum LLC (“Marathon”) to formCentennial Pipeline LLC (“Centennial”). Centennial owns an interstate refined petroleum products pipelineextending from the upper Texas Gulf Coast to central Illinois.  Through February 9, 2003, each participantowned a one-third interest in Centennial. On February 10, 2003, TE Products and Marathon each acquired anadditional 16.7% interest in Centennial from PEPL for $20.0 million each,increasing their ownership percentages in Centennial

 

11

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to 50% each. During the nine months ended September 30, 2004, TE Products invested anadditional $1.5 million in Centennial, which is included in the equityinvestment balance at September 30, 2004.

 

On January 1, 2003, TE Products and Louis DreyfusEnergy Services L.P. (“Louis Dreyfus”) formed Mont Belvieu Storage Partners,L.P. (“MB Storage”).  TE Products and LouisDreyfus each own a 50% ownership interest in MB Storage.  The purpose of MB Storage is to expandservices to the upper Texas Gulf Coast energy marketplace by increasingpipeline throughput and the mix of products handled through the existing systemand establishing new receipt and delivery connections.  MB Storage is a service-oriented, fee-basedventure with no commodity trading activity. TE Products operates the facilities for MB Storage.  Effective January 1, 2003, TE Productscontributed property and equipment with a net book value of $67.1 million to MBStorage.  Additionally, as of thecontribution date, Louis Dreyfus had invested $6.1 million for expansionprojects for MB Storage that TE Products was required to reimburse if theoriginal joint development and marketing agreement was terminated by eitherparty.  This deferred liability was alsocontributed and credited to the capital account of Louis Dreyfus in MB Storage.

 

TE Products receives the first $1.8 million perquarter (or $7.15 million on an annual basis) of MB Storage’s income beforedepreciation expense, as defined in the operating agreement.  Any amount of MB Storage’s annual incomebefore depreciation expense in excess of $7.15 million is allocated evenlybetween TE Products and Louis Dreyfus. Depreciation expense on assets each originally contributed to MB Storageis allocated between TE Products and Louis Dreyfus based on the net book valueof the assets contributed.  Depreciationexpense on assets constructed or acquired by MB Storage subsequent to formationis allocated evenly between TE Products and Louis Dreyfus. For the nine monthsended September 30, 2004, TE Products’ sharing ratio in the earnings of MBStorage was approximately 72.3%.  Duringthe nine months ended September 30, 2004, TE Products contributed $19.4 millionto MB Storage, of which $16.5 million was used to acquire storage assets inApril 2004.  During the three months and ninemonths ended September 30, 2004, TE Products received distributions of $2.8million and $7.7 million, respectively, from MB Storage.  No distributions were received during the threemonths and nine months ended September 30, 2003.

 

We use the equity method of accounting to account forour investments in Seaway, Centennial and MB Storage.  Summarized combined financial information forSeaway, Centennial and MB Storage for the nine months ended September 30, 2004and 2003, is presented below (in thousands): 

 
| ** ** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------|------------|--------------------------------------|------------|
| ** ** | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| Revenues   |       | $                                    | 115,843    |   | $ | 96,941 |   |
| Net income |       | 44,344                               |       | 30,947 |   |
|            |            |                                      |            |  |  |  |  |

 

Summarized combined balance sheet information forSeaway, Centennial and MB Storage as of September 30, 2004, and December 31,2003, is presented below (in thousands):

 
| ** **              | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------------|------------|-------------------------|------------|------------------------|------------|
| Current assets          |       | $                       | 64,580     |                   | $          | 56,243 |   |
| Noncurrent  assets      |       | 634,013                 |       | 609,215                |       |
| Current  liabilities    |       | 44,966                  |       | 43,177                 |       |
| Long-term debt          |       | 140,000                 |       | 140,000                |       |
| Noncurrent  liabilities |       | 19,862                  |       | 13,182                 |       |
| Partners’  capital |       | 493,765                 |       | 469,099                |       |
|                         |            |                         |            |                        |            |  |  |

 

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**Our investments in Seaway and Centennial include excess netinvestment amounts of $25.5 million and $33.4 million, respectively.  Excess investment is the amount by which ourinvestment balance exceeds our proportionate share of the net assets of theinvestment.**

** **

**NOTE 8.  DEBT**

## ** **

## **Short Term Credit Facilities**

 

OnApril 6, 2001, we entered into a 364-day, $200.0 million revolving creditagreement (“Short-term Revolver”).  Theinterest rate was based, at our option, on either the lender’s base rate plus aspread, or LIBOR plus a spread in effect at the time of the borrowings. Thecredit agreement contained certain restrictive financial covenant ratios.  On March 28, 2002, the Short-term Revolverwas extended for an additional period of 364 days, ending in March 2003.  The Short-term Revolver expired on March 27,2003.

## ** **

## **Senior Notes**

## ** **

On January 27, 1998, TE Products completed theissuance of $180.0 million principal amount of 6.45% Senior Notes due 2008 and$210.0 million principal amount of 7.51% Senior Notes due 2028 (collectivelythe “TE Products Senior Notes”).  The6.45% TE Products Senior Notes were issued at a discount of $0.3 million andare being accreted to their face value over the term of the notes.  The 6.45% TE Products Senior Notes due 2008are not subject to redemption prior to January 15, 2008.  The 7.51% TE Products Senior Notes due 2028,issued at par, may be redeemed at any time after January 15, 2008, at theoption of TE Products, in whole or in part, at a premium.

 

The TE Products Senior Notes do not have sinking fundrequirements.  Interest on the TEProducts Senior Notes is payable semiannually in arrears on January 15 and July15 of each year.  The TE Products SeniorNotes are unsecured obligations of TE Products and rank on a parity with allother unsecured and unsubordinated indebtedness of TE Products.  The indenture governing the TE ProductsSenior Notes contains covenants, including, but not limited to, covenantslimiting the creation of liens securing indebtedness and sale and leasebacktransactions.  However, the indenturedoes not limit our ability to incur additional indebtedness.  As of September 30, 2004, TE Products was incompliance with the covenants of the TE Products Senior Notes.

 

On February 20, 2002, we completed the issuance of$500.0 million principal amount of 7.625% Senior Notes due 2012.  The 7.625% Senior Notes were issued at adiscount of $2.2 million and are being accreted to their face value over theterm of the notes.  The Senior Notes maybe redeemed at any time at our option with the payment of accrued interest anda make-whole premium determined by discounting remaining interest and principalpayments using a discount rate equal to the rate of the United States Treasurysecurities of comparable remaining maturity plus 35 basis points.  The indenture governing our 7.625% SeniorNotes contains covenants, including, but not limited to, covenants limiting thecreation of liens securing indebtedness and sale and leasebacktransactions.  However, the indenturedoes not limit our ability to incur additional indebtedness.  As of September 30, 2004, we were incompliance with the covenants of these Senior Notes.

 

On January 30, 2003, we completed the issuance of$200.0 million principal amount of 6.125% Senior Notes due 2013.  The 6.125% Senior Notes were issued at adiscount of $1.4 million and are being accreted to their face value over theterm of the notes.  We used $182.0 millionof the proceeds from the offering to reduce the outstanding principal on our$500.0 million revolving credit facility to $250.0 million.  The balance of the net proceeds received wasused for general partnership purposes. The Senior Notes may be redeemed at any time at our option with thepayment of accrued interest and a make-whole premium determined by discountingremaining interest and principal payments using a discount rate equal to therate of the United States Treasury securities of

 

13

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comparable remaining maturity plus 35 basispoints.  The indenture governing our6.125% Senior Notes contains covenants, including, but not limited to,covenants limiting the creation of liens securing indebtedness and sale andleaseback transactions.  However, theindenture does not limit our ability to incur additional indebtedness.  As of September 30, 2004, we were incompliance with the covenants of these Senior Notes.

 

The following table summarizes the estimated fairvalues of the Senior Notes as of September 30, 2004, and December 31, 2003 (inmillions):

 
| ** **                                       | ** ** | **Face  Value** | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------------------|------------|-----------------|------------|-------------------------|------------|------------------------|------------|
| 6.45% TE Products Senior Notes, due January 2008 |       | $               | 180.0      |                    | $          | 193.8                  |       | $ | 192.7 |   |
| 7.625% Senior Notes, due February 2012           |       | 500.0           |       | 577.0                   |       | 559.0                  |       |
| 6.125% Senior Notes, due February 2013           |       | 200.0           |       | 210.7                   |       | 199.8                  |       |
| 7.51% TE Products Senior Notes, due January 2028 |       | 210.0           |       | 218.2                   |       | 217.4                  |       |
|                                                  |            |                 |            |                         |            |                        |            |  |  |  |

 

We have entered into interest rate swap agreements tohedge our exposure to changes in the fair value on a portion of the SeniorNotes discussed above (see Note 4. Interest Rate Swaps).

 

## **Other Long Term Debt and CreditFacilities**

 

On April 6, 2001, we entered into a $500.0 millionrevolving credit facility including the issuance of letters of credit of up to$20.0 million (“Three Year Facility”).  Theinterest rate was based, at our option, on either the lender’s base rate plus aspread, or LIBOR plus a spread in effect at the time of the borrowings.  The credit agreement for the Three YearFacility contained certain restrictive financial covenant ratios.  During the first quarter of 2003, we repaid$182.0 million of the outstanding balance of the Three Year Facility withproceeds from the issuance of our 6.125% Senior Notes on January 30, 2003.  On June 27, 2003, we repaid the outstandingbalance under the Three Year Facility with borrowings under a new creditfacility, and canceled the Three Year Facility.

 

On June 27, 2003, we entered into a $550.0 millionrevolving credit facility with a three year term, including the issuance ofletters of credit of up to $20.0 million (“Revolving Credit Facility”).  The interest rate is based, at our option, oneither the lender’s base rate plus a spread, or LIBOR plus a spread in effectat the time of the borrowings.  Thecredit agreement for the Revolving Credit Facility contains certain restrictivefinancial covenant ratios.  We borrowed$263.0 million under the Revolving Credit Facility and repaid the outstandingbalance of the Three Year Facility.  On September30, 2004, $325.5 million was outstanding under the Revolving Credit Facility ata weighted average interest rate of 2.5%. At September 30, 2004, we were in compliance with the covenants of thiscredit agreement.  On October 21, 2004,we amended our Revolving Credit Facility to (i) increase the facility size to$600.0 million, (ii) extend the term to October 21, 2009, (iii) remove certainrestrictive covenants, (iv) increase the available amount for the issuance ofletters of credit up to $100.0 million and (v) decrease the LIBOR rate spreadcharged at the time of each borrowing.

 

We entered into an interest rate swap agreement tohedge our exposure to increases in interest rates on a portion of the creditfacilities discussed above, which matured on April 6, 2004 (see Note 4.  Interest Rate Swaps).

 

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The following table summarizes the principal amountsoutstanding under our credit facilities as of September 30, 2004, and December31, 2003 (in thousands):

 
| ** **                                                              | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
|                                                                    |       |                    |       |                   |       |
| Credit Facilities:                                                      |       |                    |       |                   |       |
| Revolving Credit Facility, due June 2006                                |       | $                       | 325,500    |                   | $          | 210,000 |   |
| 6.45% TE Products Senior Notes, due January 2008                        |       | 179,899                 |       | 179,876                |       |
| 7.625% Senior Notes, due February 2012                                  |       | 498,382                 |       | 498,216                |       |
| 6.125% Senior Notes, due February 2013                                  |       | 198,809                 |       | 198,702                |       |
| 7.51% TE Products Senior Notes, due January 2028                        |       | 210,000                 |       | 210,000                |       |
| Total borrowings                                                        |       | 1,412,590               |       | 1,296,794              |       |
| Adjustment to carrying value associated with hedges of  fair value |       | 41,530                  |       | 42,856                 |       |
| Total Credit Facilities                                                 |       | $                       | 1,454,120  |                   | $          | 1,339,650 |   |

 

**NOTE 9.  PARTNERS’CAPITAL AND DISTRIBUTIONS**

 

**Equity Offerings**

 

OnApril 2, 2003, we sold in an underwritten public offering 3.9 million Units at$30.35 per Unit.  The proceeds from theoffering, net of underwriting discount, totaled approximately $114.5 million,of which approximately $113.8 million was used to repurchase and retire all ofthe 3.9 million previously outstanding Class B Units held by Duke EnergyTransport and Trading Company, LLC.  Wereceived approximately $0.7 million in proceeds from the offering in excess ofthe amount needed to repurchase and retire the Class B Units.

 

OnAugust 7, 2003, we sold in an underwritten public offering 5.0 million Units at$34.68 per Unit.  The proceeds from theoffering, net of underwriting discount, totaled approximately $166.0million.  On August 19, 2003, 162,900Units were sold upon exercise of the underwriters’ over-allotment optiongranted in connection with the offering on August 7, 2003.  Proceeds from the over-allotment sale, net ofunderwriting discount, totaled $5.4 million. Approximately $53.0 million of the proceeds was used to repayindebtedness under our revolving credit facility and $21.0 million was used tofund the acquisition of the Genesis assets (see Note 5.  Acquisitions and Dispositions).  The remaining amount was used primarily tofund revenue generating and system upgrade capital expenditures and for generalpartnership purposes.

## ** **

## **Quarterly Distributions ofAvailable Cash**

 

We make quarterly cash distributions of all of ourAvailable Cash, generally defined as consolidated cash receipts lessconsolidated cash disbursements and cash reserves established by the GeneralPartner in its sole discretion.  Pursuantto the Partnership Agreement, the Company receives incremental incentive cashdistributions when cash distributions exceed certain target thresholds asfollows:

 

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| ** **                                                           | ** ** | **Unitholders** | ** ** | **General  Partner** | ** ** |
|----------------------------------------------------------------------|------------|-----------------|------------|----------------------|------------|
| Quarterly Cash  Distribution per Unit:                               |       |            |       |                 |       |
| Up to Minimum  Quarterly Distribution ($0.275 per Unit)              |       | 98              | %          | 2                    | %          |
| First Target -  $0.276 per Unit up to $0.325 per Unit                |       | 85              | %          | 15                   | %          |
| Second Target -  $0.326 per Unit up to $0.45 per Unit                |       | 75              | %          | 25                   | %          |
| Over Second  Target - Cash distributions greater than $0.45 per Unit |       | 50              | %          | 50                   | %          |

 

The following table reflects the allocation of totaldistributions paid during the nine months ended September 30, 2004 and 2003 (inthousands, except per Unit amounts):

 
| ** **                                       | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                       | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| Limited Partner  Units                           |       | $                                    | 124,422    |   | $ | 104,478 |   |
| General Partner  Ownership Interest              |       | 2,539                                |       | 2,180 |   |
| General Partner  Incentive                       |       | 47,438                               |       | 36,410 |   |
| Total Partners’  Capital Cash Distributions |       | 174,399                              |       | 143,068 |   |
| Class B Units                                    |       | —                               |       | 2,347 |   |
| Total Cash  Distributions Paid                   |       | $                                    | 174,399    |   | $ | 145,415 |   |
| Total Cash  Distributions Paid Per Unit          |       | $                                    | 1.975      |   | $ | 1.85 |   |

 

OnNovember 5, 2004, we will pay a cash distribution of $0.6625 per Unit for thequarter ended September 30, 2004.  The thirdquarter 2004 cash distribution will total $58.7 million.

 

**General Partner’s Interest**

 

As of September 30, 2004, and December31, 2003, we had a deficit balance of $27.1 million and $7.2 million,respectively, in our General Partner’s equity account. This negative balancedoes not represent an asset to us and does not represent an obligation of theGeneral Partner to contribute cash or other property to us. The General Partner’sequity account generally consists of its cumulative share of our net incomeless cash distributions made to the General Partner plus capital contributionsthat it has made to us.  For the ninemonths ended September 30, 2004, the General Partner was allocated $30.0million (representing 28.85%) of our net income and received $50.0 million incash distributions.

 

Capital Accounts, as defined under ourPartnership Agreement, are maintained for our General Partner and our limitedpartners.  The Capital Account provisionsof our Partnership Agreement incorporate principles established for U.S.federal income tax purposes and are not comparable to the equity accountsreflected under accounting principles generally accepted in the United Statesin our financial statements.  Under ourPartnership Agreement, the General Partner is only required to make additionalcapital contributions to us upon the issuance of any additional Units ifnecessary to maintain a Capital Account balance equal to 1.999999% of the totalCapital Accounts of all partners.  At September30, 2004, and December 31, 2003, the General Partner’s Capital Account balancesubstantially exceeded this requirement.

 

Netincome is allocated between the General Partner and the limited partners in thesame proportion as aggregate cash distributions made to the General Partner andthe limited partners during the period. This is generally consistent with the manner of allocating net incomeunder our Partnership Agreement.  Netincome determined under our Partnership Agreement, however, incorporatesprinciples established for U.S. federal income tax purposes and is

 

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notcomparable to net income reflected under accounting principles generallyaccepted in the United States in our financial statements.

 

Cash distributions that we make duringa period may exceed our net income for the period.  We make quarterly cash distributions of allof our Available Cash, generally defined as consolidated cash receipts lessconsolidated cash disbursements and cash reserves established by the GeneralPartner in its sole discretion.  Cashdistributions in excess of net income allocations and capital contributionsduring the year ended December 31, 2003, and the nine months ended September 30,2004, resulted in a deficit in the General Partner’s equity account at December31, 2003, and September 30, 2004.  Futurecash distributions that exceed net income will result in an increase in thedeficit balance in the General Partner’s equity account.

 

Accordingto the Partnership Agreement, in the event of our dissolution, after satisfyingour liabilities, our remaining assets would be divided among our limitedpartners and the General Partner generally in the same proportion as AvailableCash but calculated on a cumulative basis over the life of the Partnership.  If a deficit balance still remains in theGeneral Partner’s equity account after all allocations are made between thepartners, the General Partner would not be required to make whole any suchdeficit.

 

**NOTE 10. EMPLOYEE BENEFIT PLANS**

 

## **Retirement Plans**

## ** **

We have adopted the TEPPCO Retirement Cash BalancePlan (“TEPPCO RCBP”), which is a non-contributory, trustee-administered pensionplan.  In addition, certain executiveofficers participate in the TEPPCO Supplemental Benefit Plan (“TEPPCO SBP”),which is a non-contributory, nonqualified, defined benefit retirement plan.  The TEPPCO SBP was established to restorebenefit reductions caused by the maximum benefit limitations that apply toqualified plans.  The benefit formula forall eligible employees is a cash balance formula.  Under a cash balance formula, a plan participantaccumulates a retirement benefit based upon pay credits and current interestcredits.  The pay credits are based on aparticipant’s salary, age and service. We use a December 31 measurement date for these plans.

 

The components of net pension benefits costs for theTEPPCO RCBP and the TEPPCO SBP for the three months and nine months ended September30, 2004 and 2003, were as follows (in thousands):

 
| ** **                                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                     | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Service cost  benefit earned during the period |       | $                                     | 936        |                                 | $          | 795 |   | $ | 2,808 |   | $ | 2,385 |   |
| Interest cost on  projected benefit obligation |       | 176                                   |       | 126                                  |       | 528 |   | 378 |   |
| Expected return  on plan assets                |       | (224                                  | )          | (151                                 | )          | (672 | ) | (453 | ) |
| Amortization of  prior service cost            |       | 2                                     |       | 2                                    |       | 6 |   | 6 |   |
| Recognized net  actuarial loss                 |       | 4                                     |       | 6                                    |       | 12 |   | 18 |   |
| Net pension  benefits costs                    |       | $                                     | 894        |                                 | $          | 778 |   | $ | 2,682 |   | $ | 2,334 |   |

## ** **

## **Other Postretirement Benefits**

## ** **

Effective January 1, 2001, we provide certain healthcare and life insurance benefits for retired employees on a contributory andnon-contributory basis (“TEPPCO OPB”). Employees become eligible for these benefits if they meet certain ageand service requirements at retirement, as defined in the plans.  We provide a fixed dollar

 

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contribution, which does not increase from year toyear, towards retired employee medical costs. The retiree pays all health care cost increases due to medicalinflation.  We use a December 31measurement date for this plan.

 

The components of net postretirement benefits costsfor the TEPPCO OPB for the three months and nine months ended September 30,2004 and 2003, were as follows (in thousands):

 
| ** **                                                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                      | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Service cost  benefit earned during the period                  |       | $                                     | 44         |                                 | $          | 34 |   | $ | 132 |   | $ | 102 |   |
| Interest cost on  accumulated postretirement benefit obligation |       | 39                                    |       | 34                                   |       | 117 |   | 102 |   |
| Amortization of  prior service cost                             |       | 32                                    |       | 32                                   |       | 96 |   | 96 |   |
| Net postretirement  benefits costs                              |       | $                                     | 115        |                                 | $          | 100 |   | $ | 345 |   | $ | 300 |   |

## ** **

## **Estimated Future BenefitContributions**

## ** **

We expect to contribute approximately $3.0 million toour retirement plans and other postretirement benefit plans in 2004.

 

**NOTE 11. SEGMENT INFORMATION**

 

We have three reporting segments:

 

•                  transportationand storage of refined products, LPGs and petrochemicals, which operates as theDownstream Segment;

 

•                  gathering,transportation, marketing and storage of crude oil and distribution oflubrication oils and specialty chemicals, which operates as the UpstreamSegment; and

 

•                  gathering ofnatural gas, fractionation of NGLs and transportation of NGLs, which operatesas the Midstream Segment.

 

The amounts indicated below as “Partnership and Other”relate primarily to intersegment eliminations and assets that we hold that havenot been allocated to any of our reporting segments.

 

Our Downstream Segment revenues are earned fromtransportation and storage of refined products and LPGs, intrastatetransportation of petrochemicals, sales of product inventory and otherancillary services. The two largest operating expense items of the DownstreamSegment are labor and electric power.  Wegenerally realize higher revenues during the first and fourth quarters of eachyear as our operations are somewhat seasonal. Refined products volumes aregenerally higher during the second and third quarters because of greater demandfor gasolines during the spring and summer driving seasons. LPGs volumes aregenerally higher from November through March due to higher demand in theNortheast for propane, a major fuel for residential heating.  Our Downstream Segment also includes theresults of operations of the northern portion of the Dean Pipeline, whichtransports refinery grade propylene from Mont Belvieu to Point Comfort,Texas.  Our Downstream Segment alsoincludes our equity investments in Centennial and MB Storage (see Note 7.  Equity Investments).

 

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Our Upstream Segment revenues are earned fromgathering, transportation, marketing and storage of crude oil and distributionof lubrication oils and specialty chemicals, principally in Oklahoma, Texas,New Mexico and the Rocky Mountain region. Marketing operations consist primarily of aggregating purchased crudeoil along our pipeline systems, or along third party pipeline systems, andarranging the necessary transportation logistics for the ultimate sale of thecrude oil to local refineries, marketers or other end users.  Our Upstream Segment also includes our equityinvestment in Seaway.  Seaway consists oflarge diameter pipelines that transport crude oil from Seaway’s marineterminals on the U.S. Gulf Coast to Cushing, Oklahoma, a crude oil distributionpoint for the central United States, and to refineries in the Texas City andHouston areas.

 

OurMidstream Segment revenues are earned from the fractionation of NGLs inColorado; transportation of NGLs from two trunkline NGL pipelines in SouthTexas, two NGL pipelines in East Texas and a pipeline system (“Chaparral”) fromWest Texas and New Mexico to Mont Belvieu; the gathering of natural gas in theGreen River Basin in southwestern Wyoming, through Jonah; and the gathering ofcoal bed methane (“CBM”) in the San Juan Basin in New Mexico and Colorado,through Val Verde.  DEFS manages andoperates the Val Verde, Jonah and Chaparral assets for us under contractualagreements.

 

Thefollowing tables include financial information by reporting segment for thethree months and nine months ended September 30, 2004 and 2003 (in thousands):

 
| ** **                             | ** ** | **Three Months Ended September 30, 2004** | ** ** |
|----------------------------------------|------------|-------------------------------------------|------------|
| ** **                             | ** ** | **Downstream  Segment**                   | ** ** | **Upstream  Segment** | ** ** | **Midstream  Segment** | ** ** | **Segments  Total** | ** ** | **Partnership  and Other** | ** ** | **Consolidated** | ** ** |
|                                   |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Sales of  petroleum products           |       | $                                         | —     |   | $ | 1,358,220 |   | $ | 1,734 |   | $ | 1,359,954 |   | $ | — |   | $ | 1,359,954 |   |
| Operating  revenues                    |       | 68,546                                    |       | 11,866 |   | 49,961 |   | 130,373 |   | (317 | ) | 130,056 |   |
| Purchases of  petroleum products       |       | —                                    |       | 1,344,613 |   | 1,381 |   | 1,345,994 |   | (317 | ) | 1,345,677 |   |
| Operating  expenses, including power   |       | 43,419                                    |       | 17,804 |   | 16,601 |   | 77,824 |   | — |   | 77,824 |   |
| Depreciation and  amortization expense |       | 12,818                                    |       | 3,268 |   | 14,191 |   | 30,277 |   | — |   | 30,277 |   |
| Gains on sales  of assets              |       | (472                                      | )          | (377 | ) | — |   | (849 | ) | — |   | (849 | ) |
| Operating income                       |       | 12,781                                    |       | 4,778 |   | 19,522 |   | 37,081 |   | — |   | 37,081 |   |
| Equity earnings  (losses)              |       | (322                                      | )          | 5,943 |   | — |   | 5,621 |   | — |   | 5,621 |   |
| Other income,  net                     |       | 203                                       |       | 60 |   | 21 |   | 284 |   | — |   | 284 |   |
| Earnings before  interest              |       | $                                         | 12,662     |   | $ | 10,781 |   | $ | 19,543 |   | $ | 42,986 |   | $ | — |   | $ | 42,986 |   |

 

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| ** **                             | ** ** | **Three Months Ended September 30, 2003** | ** ** |
|----------------------------------------|------------|-------------------------------------------|------------|
| ** **                             | ** ** | **Downstream  Segment**                   | ** ** | **Upstream  Segment** | ** ** | **Midstream  Segment** | ** ** | **Segments  Total** | ** ** | **Partnership  and Other** | ** ** | **Consolidated** | ** ** |
|                                   |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Sales of  petroleum products           |       | $                                         | —     |   | $ | 946,402 |   | $ | — |   | $ | 946,402 |   | $ | — |   | $ | 946,402 |   |
| Operating  revenues                    |       | 65,009                                    |       | 9,575 |   | 46,045 |   | 120,629 |   | (142 | ) | 120,487 |   |
| Purchases of  petroleum products       |       | —                                    |       | 932,688 |   | — |   | 932,688 |   | (142 | ) | 932,546 |   |
| Operating  expenses, including power   |       | 40,336                                    |       | 14,792 |   | 11,388 |   | 66,516 |   | — |   | 66,516 |   |
| Depreciation and  amortization expense |       | 7,127                                     |       | 2,594 |   | 12,841 |   | 22,562 |   | — |   | 22,562 |   |
| Operating income                       |       | 17,546                                    |       | 5,903 |   | 21,816 |   | 45,265 |   | — |   | 45,265 |   |
| Equity earnings  (losses)              |       | (1,437                                    | )          | 7,205 |   | — |   | 5,768 |   | — |   | 5,768 |   |
| Other income,  net                     |       | 70                                        |       | (183 | ) | 108 |   | (5 | ) | — |   | (5 | ) |
| Earnings before  interest              |       | $                                         | 16,179     |   | $ | 12,925 |   | $ | 21,924 |   | $ | 51,028 |   | $ | — |   | $ | 51,028 |   |

 
| ** **                             | ** ** | **Nine Months Ended September 30, 2004** | ** ** |
|----------------------------------------|------------|------------------------------------------|------------|
| ** **                             | ** ** | **Downstream  Segment**                  | ** ** | **Upstream  Segment** | ** ** | **Midstream  Segment** | ** ** | **Segments  Total** | ** ** | **Partnership  and Other** | ** ** | **Consolidated** | ** ** |
|                                   |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Sales of  petroleum products           |       | $                                        | —     |   | $ | 3,770,006 |   | $ | 4,868 |   | $ | 3,774,874 |   | $ | — |   | $ | 3,774,874 |   |
| Operating  revenues                    |       | 205,719                                  |       | 37,430 |   | 146,994 |   | 390,143 |   | (2,382 | ) | 387,761 |   |
| Purchases of  petroleum products       |       | —                                   |       | 3,728,345 |   | 4,367 |   | 3,732,712 |   | (2,382 | ) | 3,730,330 |   |
| Operating  expenses, including power   |       | 122,118                                  |       | 46,880 |   | 46,487 |   | 215,485 |   | — |   | 215,485 |   |
| Depreciation and  amortization expense |       | 31,106                                   |       | 9,381 |   | 44,021 |   | 84,508 |   | — |   | 84,508 |   |
| Gains on sales  of assets              |       | (587                                     | )          | (484 | ) | — |   | (1,071 | ) | — |   | (1,071 | ) |
| Operating income                       |       | 53,082                                   |       | 23,314 |   | 56,987 |   | 133,383 |   | — |   | 133,383 |   |
| Equity earnings  (losses)              |       | (2,069                                   | )          | 24,923 |   | — |   | 22,854 |   | — |   | 22,854 |   |
| Other income,  net                     |       | 648                                      |       | 257 |   | 95 |   | 1,000 |   | — |   | 1,000 |   |
| Earnings before  interest              |       | $                                        | 51,661     |   | $ | 48,494 |   | $ | 57,082 |   | $ | 157,237 |   | $ | — |   | $ | 157,237 |   |

 

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| ** **                             | ** ** | **Nine Months Ended September 30, 2003** | ** ** |
|----------------------------------------|------------|------------------------------------------|------------|
| ** **                             | ** ** | **Downstream  Segment**                  | ** ** | **Upstream  Segment** | ** ** | **Midstream  Segment** | ** ** | **Segments  Total** | ** ** | **Partnership  and Other** | ** ** | **Consolidated** | ** ** |
|                                   |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Sales of  petroleum products           |       | $                                        | —     |   | $ | 2,849,594 |   | $ | — |   | $ | 2,849,594 |   | $ | — |   | $ | 2,849,594 |   |
| Operating  revenues                    |       | 193,032                                  |       | 28,461 |   | 137,411 |   | 358,904 |   | (1,570 | ) | 357,334 |   |
| Purchases of  petroleum products       |       | —                                   |       | 2,809,304 |   | — |   | 2,809,304 |   | (1,570 | ) | 2,807,734 |   |
| Operating  expenses, including power   |       | 108,153                                  |       | 43,384 |   | 33,650 |   | 185,187 |   | — |   | 185,187 |   |
| Depreciation and  amortization expense |       | 21,341                                   |       | 8,125 |   | 43,896 |   | 73,362 |   | — |   | 73,362 |   |
| Gain on sale of  assets                |       | —                                   |       | (3,948 | ) | — |   | (3,948 | ) | — |   | (3,948 | ) |
| Operating income                       |       | 63,538                                   |       | 21,190 |   | 59,865 |   | 144,593 |   | — |   | 144,593 |   |
| Equity earnings  (losses)              |       | (2,632                                   | )          | 20,360 |   | — |   | 17,728 |   | — |   | 17,728 |   |
| Other income,  net                     |       | 119                                      |       | 219 |   | 172 |   | 510 |   | (73 | ) | 437 |   |
| Earnings before  interest              |       | $                                        | 61,025     |   | $ | 41,769 |   | $ | 60,037 |   | $ | 162,831 |   | $ | (73 | ) | $ | 162,758 |   |

 

Thefollowing table shows total assets, capital expenditures and significantnon-cash investing activities for each of our reporting segments as of September30, 2004, and December 31, 2003 (in thousands):

 
| ** **                     | ** ** | **Downstream  Segment** | ** ** | **Upstream  Segment** | ** ** | **Midstream  Segment** | ** ** | **Segments  Total** | ** ** | **Partnership  and Other** | ** ** | **Consolidated** | ** ** |
|--------------------------------|------------|-------------------------|------------|-----------------------|------------|------------------------|------------|---------------------|------------|----------------------------|------------|------------------|------------|
|                           |       |                    |       |                  |       |                   |       |                |       |                       |       |             |       |
| September 30,  2004:           |       |                    |       |                  |       |                   |       |                |       |                       |       |             |       |
| Total assets                   |       | $                       | 952,050    |                  | $          | 1,025,832              |       | $                   | 1,176,289  |                       | $          | 3,154,171        |       | $ | (21,208 | ) | $ | 3,132,963 |   |
| Capital  expenditures          |       | 50,893                  |       | 27,994                |       | 31,416                 |       | 110,303             |       | 597                        |       | 110,900          |       |
|                           |       |                    |       |                  |       |                   |       |                |       |                       |       |             |       |
| December 31,  2003:            |       |                    |       |                  |       |                   |       |                |       |                       |       |             |       |
| Total assets                   |       | $                       | 916,917    |                  | $          | 834,502                |       | $                   | 1,194,844  |                       | $          | 2,946,263        |       | $ | (5,271 | ) | $ | 2,940,992 |   |
| Capital  expenditures          |       | 59,061                  |       | 13,427                |       | 67,882                 |       | 140,370             |       | 147                        |       | 140,517          |       |
| Non-cash  investing activities |       | 61,042                  |       | —                |       | —                 |       | 61,042              |       | —                     |       | 61,042           |       |

 

Thefollowing table reconciles the segments’ total earnings before interest toconsolidated net income for the three months and nine months ended September30, 2004 and 2003 (in thousands):

 
| ** **                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                   | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Earnings before  interest    |       | $                                     | 42,986     |                                 | $          | 51,028 |   | $ | 157,237 |   | $ | 162,758 |   |
| Interest expense  – net |       | (17,131                               | )          | (20,537                              | )          | (53,190 | ) | (64,398 | ) |
| Net income                   |       | $                                     | 25,855     |                                 | $          | 30,491 |   | $ | 104,047 |   | $ | 98,360 |   |

 

**NOTE 12.  COMMITMENTSAND CONTINGENCIES**

** **

In the fall of 1999 and on December 1, 2000, theGeneral Partner and the Partnership were named as defendants in two separatelawsuits in Jackson County Circuit Court, Jackson County, Indiana, styled *Ryan E. McCleery*

 

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*and Marcia S. McCleery, et al. v. Texas EasternCorporation, et al.*(including the General Partner andPartnership) and*Gilbert Richards and Jean Richards v. TexasEastern Corporation, et al.*(including the General Partner andPartnership).* *Inboth cases, the plaintiffs contend, among other things, that we and otherdefendants stored and disposed of toxic and hazardous substances and hazardouswastes in a manner that caused the materials to be released into the air, soiland water.  They further contend that therelease caused damages to the plaintiffs. In their complaints, the plaintiffs allege strict liability for bothpersonal injury and property damage together with gross negligence, continuingnuisance, trespass, criminal mischief and loss of consortium. The plaintiffsare seeking compensatory, punitive and treble damages.  We have filed an answer to both complaints,denying the allegations, as well as various other motions.  In April 2004, the court granted a partialmotion for summary judgment in favor of the defendants, dismissing two of theplaintiffs’ personal injury claims in their entirety.  It is anticipated that the plaintiffs willappeal this ruling.  These cases are notcovered by insurance.  Discovery isongoing, and we are defending ourselves vigorously against the lawsuits.  The plaintiffs have not stipulated the amountof damages that they are seeking in the suits. We cannot estimate the loss, if any, associated with these pendinglawsuits.

 

On December 21, 2001, TE Products was named as adefendant in a lawsuit in the 10th Judicial District, Natchitoches Parish,Louisiana, styled *Rebecca L. Grisham et al. v.  TE Products Pipeline Company, LimitedPartnership*.  In this case,the plaintiffs contend that our pipeline, which crosses the plaintiffs’property, leaked toxic products onto their property and, consequently, causeddamages to them.  We have filed an answerto the plaintiffs’ petition denying the allegations and are defending ourselvesvigorously against the lawsuit.  Theplaintiffs have not stipulated the amount of damages they are seeking in thesuit; however, this case is covered by insurance.  We do not believe that the outcome of thislawsuit will have a material adverse effect on our financial position, resultsof operations or cash flows.

 

In May 2003, the General Partner was named as adefendant in a lawsuit styled *John R. James, et al. v. JGraves Insulation Company, et al*.,**asfiled in the first Judicial District Court, Caddo Parish, Louisiana.  There are numerous plaintiffs identified inthe action that are alleged to have suffered damages as the result of allegedexposure to asbestos-containing products and materials.  According to the petition and as a result ofa preliminary investigation, the General Partner believes that the only claimasserted against it results from one individual for the period from July 1971through September 1972, who is alleged to have worked on a facility owned bythe General Partner’s predecessor.  Thisperiod represents a small portion of the total alleged exposure period fromJanuary 1964 through December 2001 for this individual.  The individual’s claims involve numerousemployers and alleged job sites.  TheGeneral Partner has been unable to confirm involvement by the General Partneror its predecessors with the alleged location, and it is uncertain at this timewhether this case is covered by insurance. Discovery is planned, and theGeneral Partner intends to defend itself vigorously against this lawsuit.  The plaintiffs have not stipulated the amountof damages that they are seeking in this suit. We are obligated to reimburse the General Partner for any costs itincurs related to this lawsuit.  Wecannot estimate the loss, if any, associated with this pending lawsuit.  We do not believe that the outcome of thislawsuit will have a material adverse effect on our financial position, resultsof operations or cash flows.

 

On April 2, 2003, Centennial was served with apetition in a matter styled *Adams, et al. v.Centennial Pipeline Company LLC, et al*.  This matter involves approximately 2,000plaintiffs who allege that over 200 defendants, including Centennial,generated, transported, and/or disposed of hazardous and toxic waste at twosites in Bayou Sorrell, Louisiana, an underground injection well and alandfill.  The plaintiffs allege personalinjuries, allergies, birth defects, cancer and death.  The underground injection well has been inoperation since May 1976.  Based uponcurrent information, Centennial appears to be a *de minimis*contributor, having used the disposal site during the two month time period ofDecember 2001 to January 2002.  Marathonhas been handling this matter for Centennial under its operating agreement withCentennial.  TE Products has a 50%ownership interest in Centennial.  Basedupon Centennial’s limited involvement with the disposal site, we do not believethat the outcome of this matter will have a material adverse effect on ourfinancial position, results of operations or cash flows.

 

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On December 16, 2003, Centennial, the General Partner,the Partnership and other Partnership entities were named as defendants in alawsuit in the 128th District Court of Orange County, Texas, styled *Elwood Karr et al. v. Centennial Pipeline, LLC et al*.  In this case, the plaintiffs contend that ourpipeline leaked toxic substances on their property, causing them propertydamage.  We have filed an answer to theplaintiffs’ petition, denying the allegations and are defending ourselvesvigorously against this lawsuit.  Thiscase is covered by insurance.  We do notbelieve that the outcome of this lawsuit will have a material adverse effect onour financial position, results of operations or cash flows.

 

In addition to the litigation discussed above, we havebeen, in the ordinary course of business, a defendant in various lawsuits and aparty to various other legal proceedings, some of which are covered in whole orin part by insurance. We believe that the outcome of these lawsuits and otherproceedings will not individually or in the aggregate have a material adverseeffect on our consolidated financial position, results of operations or cashflows.

 

Our operations are subject to federal, state and locallaws and regulations governing the discharge of materials into the environment.Failure to comply with these laws and regulations may result in the assessmentof administrative, civil and criminal penalties, imposition of injunctionsdelaying or prohibiting certain activities and the need to performinvestigatory and remedial activities. Although we believe our operations are in material compliance withapplicable environmental laws and regulations, risks of significant costs andliabilities are inherent in pipeline operations, and we cannot assure you thatsignificant costs and liabilities will not be incurred. Moreover, it ispossible that other developments, such as increasingly strict environmentallaws and regulations and enforcement policies thereunder, and claims fordamages to property or persons resulting from our operations, could result insubstantial costs and liabilities to us. We believe that changes in environmental laws and regulations will nothave a material adverse effect on our financial position, results of operationsor cash flows in the near term.

 

On February 6, 2004, a lawsuit styled *San Juan Citizens Alliance et al. v. Norton et al*., wasfiled against the United States Department of Interior and the Bureau of LandManagement (“BLM”) in the U.S. District Court, District of Columbia,challenging a recent decision by the BLM. In that decision, the BLM adopted a Resource Management Plan thatauthorized the development of additional gas wells on public lands innorthwestern New Mexico.  A substantialportion of the development activity in the area that is the subject of the suitinvolves the infill drilling in the Basin-Fruitland Coal Gas Pool, which coversmost of the San Juan Basin.  The ValVerde system, in our Midstream Segment, gathers CBM from the Fruitland CoalFormation in the San Juan Basin in New Mexico and Colorado.  We believe the BLM followed the requirementsof the law and reached a balanced decision in adopting the Resource ManagementPlan.  However, an adverse decision couldimpact infill drilling activities in the San Juan Basin.

 

On March 26, 2004, an initial decision in *ARCO Products Co., et al. v. SFPP*, Docket OR96-2-000, et al.was issued by the FERC, which made several significant determinations withrespect to finding “changed circumstances” under the Energy Policy Act of 1992(“EP Act”).  The decision lists factorsthat will be considered by the FERC, which include showing a substantial changein economic circumstances, the time factor that will be reviewed, what will beconsidered the basis of the rate and a pipeline’s documentaryrequirements.  The decision largelyclarifies, but does not fully quantify, the standard required for a complainantto demonstrate that an oil pipeline’s rates are no longer subject to the rateprotection of the EP Act by demonstrating that a substantial change incircumstances has occurred since 1992 with respect to the basis of the ratesbeing challenged.  In the decision, theFERC found that a limited number of rate elements will significantly affect theeconomic basis for a pipeline company’s rates. The elements identified in the decision are volume changes, allowedtotal return and total cost of service (including major cost elements of ratebase such as tax rates and tax allowances, among others).  The FERC did reject, however, the use ofchanges in tax rate and income tax allowances as standalone factors.  The FERC further found that if a complainantcan show that a pipeline’s volumes and overall cost of service collectivelyreflect a significant increase in net earnings between the establishment of thechallenged rate pre-1992 and the time of the

 

23

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complaint, based primarily on the combined impact ofchanges in volumes and changes in overall cost of service, the complainant hasmet its burden relative to establishing “changed circumstances.”  It appears likely that the decision will beappealed.  We have not yet determined theimpact, if any, that the decision could have on our rates if they were reviewedunder the criteria of this decision.

 

On July 20, 2004, the United States Court of Appealsfor the District of Columbia Circuit issued a decision in *BP WestCoast Products, LLC v. Federal Energy Regulatory Commission and United Statesof America*, which reviewed the decisions that the FERC issued inOpinion Nos. 435, 435-A, 435-B and Clarification and Rehearing Order.  In these opinions, the FERC considered thetariffs of SFPP, L.P. (“SFPP”) and complaints and other filings by shippercustomers of SFPP.  The Court determined,in part, that SFPP, a publicly traded limited partnership, is not allowed toinclude income tax allowance in its cost-of-service analysis in thedetermination of just and reasonable rates that were not grandfathered underthe EP Act.  With respect to SFPP’sgrandfathered rates, the Court remanded to the FERC for further review, inlight of the Court’s holding on income tax allowance, of the FERC’sdetermination that changes in the FERC’s tax allowance policy do not constitute“substantially changed circumstances” under the EP Act.  The Court’s decision on income tax allowancedoes not affect our current rates and rate structure because our rates are notbased on the cost-of-service methodology. However, the Court’s decision might become relevant to us should we (i)elect in the future to use cost-of-service to support our rates or (ii) berequired to use such methodology to defend our indexed rates against a shippercomplaint.

 

In 1994, the Louisiana Department of EnvironmentalQuality (“LDEQ”) issued a compliance order for environmental contamination atour Arcadia, Louisiana, facility.  In1999, our Arcadia facility and adjacent terminals were directed by theRemediation Services Division of the LDEQ to pursue remediation of thiscontamination.  At September 30, 2004, wehave an accrued liability of $0.2 million for remediation costs at our Arcadiafacility.  Effective in March 2004, weexecuted an access agreement with an adjacent industrial landowner who islocated upgradient of the Arcadia facility. This agreement enables the landowner to proceed with remediation activitiesat our Arcadia facility for which it has accepted shared responsibility.  We do not expect that the completion of theremediation program proposed to the LDEQ will have a future material adverseeffect on our financial position, results of operations or cash flows.

 

On March 17, 2003, we experienced a release of 511barrels of jet fuel from a storage tank at our Blue Island terminal located inCook County, Illinois.  As a result ofthe release, we have entered into an Agreed Order with the State of Illinoiswhich required us to conduct an environmental investigation.  At this time, we have complied with the termsof the Agreed Order, and the results of the environmental investigationindicated there were no soil or groundwater impacts from the release.  We are in the process of negotiating a finalsettlement with the State of Illinois, and we do not expect that compliancewith the settlement will have a future material adverse effect on our financialposition, results of operations or cash flows.

 

On July 22, 2004, we experienced a release ofapproximately 12 barrels of jet fuel from a sump at our Lebanon, Ohio,terminal.  The released jet fuel wascontained within a stormwater retention pond located on the terminalproperty.  Six migratory waterfowl wereaffected by the jet fuel and were subsequently euthanized by or at the requestof the United States Fish and Wildlife Service (“USFWS”).  On October 1, 2004, the USFWS served us witha Notice of Violation, alleging that we violated 16 USC 703 of the MigratoryBird Treaty Act for the “take[ing] of migratory birds by illegal methods.”  Such a violation, if proven, would be amisdemeanor criminal offense; however, we deny that any such criminal violationoccurred, and we are vigorously defending our position in this matter.  We do not expect the results of this noticewill have a future material adverse effect on our financial position, resultsof operations or cash flows.

 

On July 27, 2004, we received notice from the UnitedStates Department of Justice (“DOJ”) of its intent to seek a civil penaltyagainst us related to our November 21, 2001, release of approximately 2,575barrels of jet fuel

 

24

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from our 14-inch diameter pipeline located in OrangeCounty, Texas.  The DOJ, at the request ofthe United States Environmental Protection Agency, is seeking a civil penaltyagainst us for alleged violations of the Clean Water Act (“CWA”) arising out ofthis release.  The maximum statutory penaltycalculated for this alleged violation of the CWA is $2.8 million.  We are in discussions with the DOJ regardingthis matter, and we do not expect a civil penalty, if any, to have a materialadverse effect on our financial position, results of operations or cash flows.

 

At September 30, 2004, we have an accrued liability of$7.0 million, related to various TCTM and TE Products sites requiringenvironmental remediation activities.  Wedo not expect that the completion of remediation programs associated with TCTMand TE Products activities will have a future material adverse effect on ourfinancial position, results of operations or cash flows.

 

We regularly review our long-lived assets forimpairment in accordance with SFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets*.  At September 30, 2004, we have identifiedcertain assets that we are assessing for recoverability resulting from recentoperational changes.  We are continuingto monitor these circumstances; however, we do not believe that the resolutionof the matter will have a material effect on our financial condition, resultsof operations or cash flows.

 

Centennial has entered into credit facilities totaling$150.0 million and, as of September 30, 2004, $150.0 million was outstandingunder those credit facilities.  Theproceeds were used to fund construction and conversion costs of Centennial’spipeline system.  TE Products andMarathon have each guaranteed one half of Centennial’s debt, up to a maximumamount of $75.0 million each.

 

**NOTE 13. COMPREHENSIVE INCOME**

 

SFAS No. 130, *Reporting ComprehensiveIncome* requires certain items such as foreign currency translationadjustments, minimum pension liability adjustments, and unrealized gains andlosses on certain investments to be reported in a financial statement.  As of September 30, 2004, and for the ninemonths ended September 30, 2004 and 2003, the components of comprehensiveincome were due to the interest rate swap related to our variable rate revolvingcredit facility, which was designated as a cash flow hedge.  This interest rate swap matured on April 6,2004.  While the interest rate swap wasin effect, changes in the fair value of the cash flow hedge, to the extent thehedge was effective, were recognized in other comprehensive income until thehedged interest costs were recognized in net income.  As of September 30, 2004, all othercomprehensive income has been recognized in net income.

 

The table below reconciles reported net income tototal comprehensive income for the three months and nine months ended September30, 2004 and 2003 (in thousands):

 
| ** **                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income                      |       | $                                     | 25,855     |                                 | $          | 30,491 |   | $ | 104,047 |   | $ | 98,360 |   |
| Net income on  cash flow hedges |       | —                                |       | 3,739                                |       | 2,902 |   | 12,443 |   |
| Total  comprehensive income     |       | $                                     | 25,855     |                                 | $          | 34,230 |   | $ | 106,949 |   | $ | 110,803 |   |

 

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Theaccumulated balance of other comprehensive loss related to our cash flow hedgeis as follows (in thousands):

 
| Balance  at December 31, 2002                                    |   | $      | (20,055 | )      |
|------------------------------------------------------------------|--------|--------|---------|--------|
| Reclassification  due to discontinued portion of cash flow hedge |   | 989    |    |
| Transferred to  earnings                                         |   | 14,417 |    |
| Change in fair  value of cash flow hedge                         |   | 1,747  |    |
| Balance at  December 31, 2003                                    |   | $      | (2,902  | )      |
| Transferred to  earnings                                         |   | 2,939  |    |
| Change in fair  value of cash flow hedge                         |   | (37    | )       |
| Balance at  September 30, 2004                                   |   | $      | —  |   |

** **

**NOTE 14.  SUPPLEMENTAL CONDENSED CONSOLIDATINGFINANCIAL INFORMATION**

 

Our significant operating subsidiaries, TE ProductsPipeline Company, Limited Partnership, TCTM, L.P., TEPPCO Midstream Companies,L.P., Jonah Gas Gathering Company and Val Verde Gas Gathering Company, L.P.,have issued unconditional guarantees of our debt securities.  The guarantees are full, unconditional, andjoint and several.  TE Products PipelineCompany, Limited Partnership, TCTM, L.P., TEPPCO Midstream Companies, L.P.,Jonah Gas Gathering Company and Val Verde Gas Gathering Company, L.P. arecollectively referred to as the “Guarantor Subsidiaries.”

 

The following supplemental condensed consolidatingfinancial information reflects our separate accounts, the combined accounts ofthe Guarantor Subsidiaries, the combined accounts of our other non-guarantorsubsidiaries, the combined consolidating adjustments and eliminations and ourconsolidated accounts for the dates and periods indicated.  For purposes of the following consolidatinginformation, our investments in our subsidiaries and the Guarantor Subsidiaries’investments in their subsidiaries are accounted for under the equity method ofaccounting.

 

26

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| ** **                                    | ** ** | **September 30, 2004**      | ** ** |
|-----------------------------------------------|------------|-----------------------------|------------|
| ** **                                    | ** ** | **TEPPCO  Partners, L .P.** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Consolidating   Adjustments** | ** ** | **TEPPCO  Partners, L.P.  Consolidated** | ** ** |
| ** **                                    | ** ** | **(in thousands)**          | ** ** |
| Assets                                        |       |                        |       |   |   |   |   |   |   |   |   |
| Current assets                                |       | $                           | 35,362     |   | $ | 88,957 |   | $ | 528,685 |   | $ | (49,115 | ) | $ | 603,889 |   |
| Property, plant  and equipment – net     |       | —                      |       | 1,181,242 |   | 487,755 |   | — |   | 1,668,997 |   |
| Equity  investments                           |       | 1,041,799                   |       | 430,003 |   | 205,051 |   | (1,301,665 | ) | 375,188 |   |
| Intercompany  notes receivable                |       | 1,057,192                   |       | — |   | — |   | (1,057,192 | ) | — |   |
| Intangible  assets                            |       | —                      |       | 378,944 |   | 35,576 |   | — |   | 414,520 |   |
| Other assets                                  |       | 5,309                       |       | 25,509 |   | 39,551 |   | — |   | 70,369 |   |
| Total assets                                  |       | $                           | 2,139,662  |   | $ | 2,104,655 |   | $ | 1,296,618 |   | $ | (2,407,972 | ) | $ | 3,132,963 |   |
| Liabilities and  partners’ capital       |       |                        |       |   |   |   |   |   |   |   |   |
| Current liabilities                           |       | $                           | 35,861     |   | $ | 122,821 |   | $ | 511,487 |   | $ | (49,115 | ) | $ | 621,054 |   |
| Long-term debt                                |       | 1,060,327                   |       | 393,793 |   | — |   | — |   | 1,454,120 |   |
| Intercompany  notes payable                   |       | —                      |       | 653,306 |   | 403,885 |   | (1,057,191 | ) | — |   |
| Other long term  liabilities                  |       | 1,702                       |       | 11,737 |   | 2,578 |   | — |   | 16,017 |   |
| Total partners’  capital                 |       | 1,041,772                   |       | 922,998 |   | 378,668 |   | (1,301,666 | ) | 1,041,772 |   |
| Total  liabilities and partners’ capital |       | $                           | 2,139,662  |   | $ | 2,104,655 |   | $ | 1,296,618 |   | $ | (2,407,972 | ) | $ | 3,132,963 |   |

 
| ** **                                    | ** ** | **December 31, 2003**      | ** ** |
|-----------------------------------------------|------------|----------------------------|------------|
| ** **                                    | ** ** | **TEPPCO  Partners, L.P.** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Consolidating  Adjustments** | ** ** | **TEPPCO  Partners, L.P.  Consolidated** | ** ** |
| ** **                                    | ** ** | **(in thousands)**         | ** ** |
| Assets                                        |       |                       |       |   |   |   |   |   |   |   |   |
| Current assets                                |       | $                          | 38,281     |   | $ | 92,817 |   | $ | 360,564 |   | $ | (38,844 | ) | $ | 452,818 |   |
| Property, plant  and equipment – net     |       | —                     |       | 1,146,455 |   | 472,708 |   | — |   | 1,619,163 |   |
| Equity  investments                           |       | 1,112,252                  |       | 404,886 |   | 209,438 |   | (1,361,290 | ) | 365,286 |   |
| Intercompany  notes receivable                |       | 943,447                    |       | — |   | — |   | (943,447 | ) | — |   |
| Intangible  assets                            |       | —                     |       | 401,404 |   | 37,161 |   | — |   | 438,565 |   |
| Other assets                                  |       | 6,157                      |       | 21,444 |   | 37,559 |   | — |   | 65,160 |   |
| Total assets                                  |       | $                          | 2,100,137  |   | $ | 2,067,006 |   | $ | 1,117,430 |   | $ | (2,343,581 | ) | $ | 2,940,992 |   |
| Liabilities and  partners’ capital       |       |                       |       |   |   |   |   |   |   |   |   |
| Current  liabilities                          |       | $                          | 41,895     |   | $ | 105,285 |   | $ | 367,260 |   | $ | (38,849 | ) | $ | 475,591 |   |
| Long-term debt                                |       | 947,486                    |       | 392,164 |   | — |   | — |   | 1,339,650 |   |
| Intercompany  notes payable                   |       | —                     |       | 557,842 |   | 385,604 |   | (943,446 | ) | — |   |
| Other long term  liabilities                  |       | 1,435                      |       | 14,995 |   | — |   | — |   | 16,430 |   |
| Total partners’  capital                 |       | 1,109,321                  |       | 996,720 |   | 364,566 |   | (1,361,286 | ) | 1,109,321 |   |
| Total  liabilities and partners’ capital |       | $                          | 2,100,137  |   | $ | 2,067,006 |   | $ | 1,117,430 |   | $ | (2,343,581 | ) | $ | 2,940,992 |   |

 

27

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| ** **                   | ** ** | **Three Months Ended September 30, 2004** | ** ** |
|------------------------------|------------|-------------------------------------------|------------|
| ** **                   | ** ** | **TEPPCO  Partners, L.P.**                | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Consolidating  Adjustments** | ** ** | **TEPPCO  Partners, L.P.  Consolidated** | ** ** |
| ** **                   | ** ** | **(in thousands)**                        | ** ** |
| Operating  revenues          |       | $                                         | —     |   | $ | 106,776 |   | $ | 1,383,551 |   | $ | (317 | ) | $ | 1,490,010 |   |
| Costs and  expenses          |       | —                                    |       | 81,291 |   | 1,372,804 |   | (317 | ) | 1,453,778 |   |
| Gains on sales  of assets    |       | —                                    |       | (472 | ) | (377 | ) | — |   | (849 | ) |
| Operating income             |       | —                                    |       | 25,957 |   | 11,124 |   | — |   | 37,081 |   |
| Interest expense  – net |       | —                                    |       | (11,625 | ) | (5,506 | ) | — |   | (17,131 | ) |
| Equity earnings              |       | 25,855                                    |       | 11,304 |   | 5,943 |   | (37,481 | ) | 5,621 |   |
| Other income –  net     |       | —                                    |       | 219 |   | 65 |   | — |   | 284 |   |
| Net income                   |       | $                                         | 25,855     |   | $ | 25,855 |   | $ | 11,626 |   | $ | (37,481 | ) | $ | 25,855 |   |

 
| ** **                   | ** ** | **Three Months Ended September 30, 2003** | ** ** |
|------------------------------|------------|-------------------------------------------|------------|
| ** **                   | ** ** | **TEPPCO  Partners, L.P.**                | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Consolidating  Adjustments** | ** ** | **TEPPCO  Partners, L.P.  Consolidated** | ** ** |
| ** **                   | ** ** | **(in thousands)**                        | ** ** |
| Operating  revenues          |       | $                                         | —     |   | $ | 98,013 |   | $ | 969,018 |   | $ | (142 | ) | $ | 1,066,889 |   |
| Costs and  expenses          |       | —                                    |       | 66,130 |   | 955,636 |   | (142 | ) | 1,021,624 |   |
| Operating income             |       | —                                    |       | 31,883 |   | 13,382 |   | — |   | 45,265 |   |
| Interest expense  – net |       | —                                    |       | (12,493 | ) | (8,044 | ) | — |   | (20,537 | ) |
| Equity earnings              |       | 30,491                                    |       | 10,871 |   | 7,205 |   | (42,799 | ) | 5,768 |   |
| Other income –  net     |       | —                                    |       | 230 |   | (235 | ) | — |   | (5 | ) |
| Net income                   |       | $                                         | 30,491     |   | $ | 30,491 |   | $ | 12,308 |   | $ | (42,799 | ) | $ | 30,491 |   |

 
| ** **                   | ** ** | **Nine Months Ended September 30, 2004** | ** ** |
|------------------------------|------------|------------------------------------------|------------|
| ** **                   | ** ** | **TEPPCO  Partners, L.P.**               | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Consolidating  Adjustments** | ** ** | **TEPPCO  Partners, L.P.  Consolidated** | ** ** |
| ** **                   | ** ** | **(in thousands)**                       | ** ** |
| Operating  revenues          |       | $                                        | —     |   | $ | 317,477 |   | $ | 3,847,540 |   | $ | (2,382 | ) | $ | 4,162,635 |   |
| Costs and  expenses          |       | —                                   |       | 226,236 |   | 3,806,469 |   | (2,382 | ) | 4,030,323 |   |
| Gains on sales  of assets    |       | —                                   |       | (587 | ) | (484 | ) | — |   | (1,071 | ) |
| Operating income             |       | —                                   |       | 91,828 |   | 41,555 |   | — |   | 133,383 |   |
| Interest expense  – net |       | —                                   |       | (35,636 | ) | (17,554 | ) | — |   | (53,190 | ) |
| Equity earnings              |       | 104,047                                  |       | 47,144 |   | 24,923 |   | (153,260 | ) | 22,854 |   |
| Other income –  net     |       | —                                   |       | 711 |   | 289 |   | — |   | 1,000 |   |
| Net income                   |       | $                                        | 104,047    |   | $ | 104,047 |   | $ | 49,213 |   | $ | (153,260 | ) | $ | 104,047 |   |

 

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| ** **                   | ** ** | **Nine Months Ended September 30, 2003** | ** ** |
|------------------------------|------------|------------------------------------------|------------|
| ** **                   | ** ** | **TEPPCO  Partners, L.P.**               | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Consolidating  Adjustments** | ** ** | **TEPPCO  Partners, L.P.  Consolidated** | ** ** |
| ** **                   | ** ** | **(in thousands)**                       | ** ** |
| Operating  revenues          |       | $                                        | —     |   | $ | 291,904 |   | $ | 2,916,594 |   | $ | (1,570 | ) | $ | 3,206,928 |   |
| Costs and  expenses          |       | —                                   |       | 189,370 |   | 2,878,483 |   | (1,570 | ) | 3,066,283 |   |
| Gain on sale of  assets      |       | —                                   |       | — |   | (3,948 | ) | — |   | (3,948 | ) |
| Operating income             |       | —                                   |       | 102,534 |   | 42,059 |   | — |   | 144,593 |   |
| Interest expense  – net |       | —                                   |       | (40,484 | ) | (23,987 | ) | 73 |   | (64,398 | ) |
| Equity earnings              |       | 98,360                                   |       | 36,042 |   | 20,360 |   | (137,034 | ) | 17,728 |   |
| Other income –  net     |       | —                                   |       | 268 |   | 242 |   | (73 | ) | 437 |   |
| Net income                   |       | $                                        | 98,360     |   | $ | 98,360 |   | $ | 38,674 |   | $ | (137,034 | ) | $ | 98,360 |   |

 
| ** **                                                                         | ** ** | **Nine Months Ended September 30, 2004** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                         | ** ** | **TEPPCO  Partners, L.P.**               | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Consolidating  Adjustments** | ** ** | **TEPPCO  Partners, L.P.  Consolidated** | ** ** |
|                                                                               |       |                                     |       |   |   | **(in thousands)** |   |   |   |   |   |
| Cash flows from  operating activities                                              |       |                                     |       |   |   |   |   |   |   |   |   |
| Net income                                                                         |       | $                                        | 104,047    |   | $ | 104,047 |   | $ | 49,213 |   | $ | (153,260 | ) | $ | 104,047 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                     |       |   |   |   |   |   |   |   |   |
| Depreciation and  amortization                                                     |       | —                                   |       | 67,784 |   | 16,724 |   | — |   | 84,508 |   |
| Earnings in  equity investments, net of distributions                              |       | 70,352                                   |       | (4,236 | ) | 5,977 |   | (56,319 | ) | 15,774 |   |
| Gains on sales  of assets                                                          |       | —                                   |       | (587 | ) | (484 | ) | — |   | (1,071 | ) |
| Changes in  assets and liabilities and other                                       |       | (133,125                                 | )          | 4,060 |   | (27,902 | ) | 126,747 |   | (30,220 | ) |
| Net cash  provided by operating activities                                         |       | 41,274                                   |       | 171,068 |   | 43,528 |   | (82,832 | ) | 173,038 |   |
| Cash flows from  investing activities                                              |       | 98                                       |       | (17,830 | ) | (29,888 | ) | (86,363 | ) | (133,983 | ) |
| Cash flows from  financing activities                                              |       | (58,899                                  | )          | (165,268 | ) | (16,898 | ) | 182,166 |   | (58,899 | ) |
| Net decrease in  cash and cash equivalents                                         |       | (17,527                                  | )          | (12,030 | ) | (3,258 | ) | 12,971 |   | (19,844 | ) |
| Cash and cash  equivalents at beginning of period                                  |       | 19,744                                   |       | 19,243 |   | 5,670 |   | (15,188 | ) | 29,469 |   |
| Cash and cash  equivalents at end of period                                        |       | $                                        | 2,217      |   | $ | 7,213 |   | $ | 2,412 |   | $ | (2,217 | ) | $ | 9,625 |   |

 

29

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| ** **                                                                         | ** ** | **Nine Months Ended September 30, 2003** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                         | ** ** | **TEPPCO  Partners, L.P.**               | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiaries** | ** ** | **Consolidating  Adjustments** | ** ** | **TEPPCO  Partners, L.P.  Consolidated** | ** ** |
|                                                                               |       |                                     |       |   |   | **(in  thousands)** |   |   |   |   |   |
| Cash flows from  operating activities                                              |       |                                     |       |   |   |   |   |   |   |   |   |
| Net income                                                                         |       | $                                        | 98,360     |   | $ | 98,360 |   | $ | 38,674 |   | $ | (137,034 | ) | $ | 98,360 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                     |       |   |   |   |   |   |   |   |   |
| Depreciation and  amortization                                                     |       | —                                   |       | 58,274 |   | 15,088 |   | — |   | 73,362 |   |
| Earnings in  equity investments, net of distributions                              |       | 47,055                                   |       | (7,583 | ) | (9,620 | ) | (36,840 | ) | (6,988 | ) |
| Gain on sale of  assets                                                            |       | —                                   |       | — |   | (3,948 | ) | — |   | (3,948 | ) |
| Changes in  assets and liabilities and other                                       |       | 103,806                                  |       | (19,471 | ) | (45,929 | ) | (22,533 | ) | 15,873 |   |
| Net cash  provided by (used in) operating activities                               |       | 249,221                                  |       | 129,580 |   | (5,735 | ) | (196,407 | ) | 176,659 |   |
| Cash flows from  investing activities                                              |       | (175,615                                 | )          | (164,221 | ) | (6,407 | ) | 222,162 |   | (124,081 | ) |
| Cash flows from  financing activities                                              |       | 16,815                                   |       | 40,987 |   | (6,949 | ) | (34,035 | ) | 16,818 |   |
| Net increase  (decrease) in cash and cash equivalents                              |       | 90,421                                   |       | 6,346 |   | (19,091 | ) | (8,280 | ) | 69,396 |   |
| Cash and cash  equivalents at beginning of period                                  |       | —                                   |       | 8,247 |   | 22,721 |   | — |   | 30,968 |   |
| Cash and cash  equivalents at end of period                                        |       | $                                        | 90,421     |   | $ | 14,593 |   | $ | 3,630 |   | $ | (8,280 | ) | $ | 100,364 |   |

 

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**Item 2.  Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

**General**

 

You should read the following review of our financialposition and results of operations in conjunction with our ConsolidatedFinancial Statements and the notes thereto. Material period-to-period variances in the consolidated statements ofincome are discussed under “Results of Operations.”  The “Financial Condition and Liquidity”section analyzes our cash flows and financial position.  “Other Considerations” addresses trends,future plans and contingencies that are reasonably likely to materially affectour future liquidity or earnings.  The ConsolidatedFinancial Statements should be read in conjunction with the financialstatements and related notes, together with our discussion and analysis offinancial position and results of operations included in our Annual Report onForm 10-K for the year ended December 31, 2003.

 

**Critical Accounting Policies and Estimates**

 

A summary of the significant accounting policies wehave adopted and followed in the preparation of our consolidated financialstatements is detailed in our consolidated financial statements for the yearended December 31, 2003, included in our Annual Report on Form 10-K. Certain ofthese accounting policies require the use of estimates.  The following estimates, in our opinion, aresubjective in nature, require the exercise of judgment and involve complexanalysis: revenue and expense accruals, including accruals for power costs,property taxes and crude oil margins; environmental costs; depreciation expenseand asset impairment analysis related to property, plant and equipment; and amortizationexpense and asset impairment analysis related to goodwill and other intangibleassets.  These estimates are based on ourknowledge and understanding of current conditions and actions we may take inthe future.  Changes in these estimateswill occur as a result of the passage of time and the occurrence of futureevents.  Subsequent changes in theseestimates may have a significant impact on our financial condition and resultsof operations.

 

## ****Management Overview of the ThreeMonths and Nine Months Ended September 30, 2004****

 

## ****We reported net income of $25.9 million, or$0.29 per Limited Partner and Class B Unit (collectively, “Unit” or “Units”),for the three months ended September 30, 2004, compared with net income of$30.5 million, or $0.36 per Unit, for the three months ended September 30,2003.  Net income for the nine monthsended September 30, 2004, was $104.1 million, or $1.18 per Unit, compared withnet income of $98.4 million, or $1.21 per Unit, for the nine months endedSeptember 30, 2003.  Our three month andnine month periods ended September 30, 2004, include a non-cash assetimpairment charge of $4.4 million (see Note 3. Property, Plant and Equipment) and increased pipeline integrity costs ofapproximately $3.5 million and $14.2 million, respectively, for the threemonths and nine months ended September 30, 2004, on all of our businesssegments.  These decreases in net incomewere partially offset by the recognition of $4.1 million of deferred revenue inour Downstream Segment.  The weighted averagenumber of Units outstanding was 63.0 million and 60.5 million for the threemonths ended September 30, 2004 and 2003, respectively, and 63.0 million and58.7 million for the nine months ended September 30, 2004 and 2003,respectively.****

 

## ****Our Upstream Segment had a strong ninemonths, with increased transportation volumes on Seaway Crude Pipeline Company(“Seaway”) and on our South Texas system, which benefited from our November2003 acquisition of assets from Genesis Crude Oil, L.P. and Genesis PipelineTexas, L.P. (“Genesis”), partially offset by increased pipeline integrityexpenses of $3.7 million.  We anticipatethat our 2004 pipeline integrity expenses for our Upstream Segment will beapproximately $5.4 million higher than our 2003 costs as we continue to performpipeline inspections and repairs under our integrity management program.****

 

## ****Our Downstream Segment results for thethree months and nine months ended September 30, 2004, were impacted by higherpipeline integrity expenses of $1.1 million and $9.1 million, respectively, andan asset impairment charge of $4.4 million related to a marine facility inBeaumont, Texas.  These decreases werepartially offset by increased revenues from our refined products business andthe recognition of $4.1 million of deferred****

**** ****

****31****

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**** ****

## ****revenue.  We anticipatethat our pipeline integrity expenses for our Downstream Segment for 2004 willbe approximately $3.0 million higher than our 2003 costs.****

## ** **

## ****Our Midstream Segment benefited fromincreased volumes on Jonah Gas Gathering Company (“Jonah”), resulting from ourrecent Phase III expansion, offsetting the impact of reduced volumes on ValVerde Gas Gathering Company (“Val Verde”) primarily due to the natural declineof coal bed methane (“CBM”) production and slower than anticipated completionand connection of infill wells.****

## ** **

## ****We increased our quarterly distributionfrom $0.65 per Unit to $0.6625 per Unit for the first quarter of 2004.  Our third quarter distribution will remain at$0.6625 per Unit and will be paid on November 5, 2004.****

 

We arefocused on opportunities, challenges and risks that are inherent in ourbusiness segments.  These include thesafe, reliable and efficient operation of the pipelines and facilities that weown or operate while meeting increased regulations that govern the operation ofour assets and the costs associated with such regulations.  We are also focused on our continued growththrough expansion of the assets that we own and through the acquisition of assetsthat complement our current operations.

 

We remain confident that our currentstrategy and focus will provide continued growth in earnings and cashdistributions.  These growthopportunities include:

 

•                   continueddevelopment of refined products and propane market opportunities, includingpipeline and terminal expansions;

•                   continueddevelopment of the Jonah gas gathering system which serves the Jonah andPinedale fields;

•                   integration ofthe Genesis crude oil assets and increased utilization of Seaway; and

•                   gathering ofvolumes from infill drilling of CBM by producers and new connections ofconventional gas in the San Juan Basin, where our Val Verde system is located.

 

****We have completed system changes toreverse the flow of the pipeline segment from Shreveport, Louisiana, to ElDorado, Arkansas.  This segment is nowconfigured to permit bi-directional flow of products.  We have completed feasibility studies and arein discussions with potential customers regarding the transportation of volumesthrough the pipeline system in this area.****

 

****We are currently constructing a newrefined products truck loading terminal in Bossier City, Louisiana.  The facility will include six storage tanksand a fully automated two-bay truck loading rack.  The terminal will expand delivery capacity ofrefined products to the Northwest Louisiana and East Texas markets by more than20,000 barrels per day.  The facilitywill increase the delivery of branded and unbranded premium and regular gasoline,as well as low-sulfur diesel fuels, which will meet the different productspecifications of both market areas.  Theproject is scheduled to be completed in the first quarter of 2005.****

 

****In 2003, we increased the deliverycapability between Todhunter, Ohio, and Coshocton, Ohio, by 8,000 to 10,000barrels per day and increased storage and improved loading capability atOneonta, New York.  We are nearingcompletion of a Phase II project to further expand our delivery capacity ofliquefied petroleum gases (“LPGs”) to the Northeast by 8,000 to 10,000 barrelsper day.  The Phase II expansion includesthe construction of three pump stations between Coshocton and Greensburg,Pennsylvania, and two stations from Greensburg to Watkins Glen, New York.  Additional work on the pipeline segmentbetween Greensburg and Philadelphia, Pennsylvania, to increase delivery ratesto the Philadelphia area has been completed. Improvements are also underway at our Dubois, Pennsylvania, and Eagle,Pennsylvania, terminals.  These projects willbe completed by year-end 2004.****

 

We have expanded both the pipeline capacity andprocessing capacity of the Jonah system. In 2003, the Phase III expansion was begun, which included an 80-mileexpansion and 3,700 horsepower of new compression on the system and thebuilding of a new 250 million cubic feet per day (“MMcf/day”) gas processingplant near Opal, Wyoming.  Phase III wassubstantially completed during the fourth quarter of 2003, with system capacityincreasing

 

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to 1,180 MMcf/day at a cost of approximately $59.0million.  Additional capacity of 100MMcf/day is expected to be completed in the fourth quarter of 2004, at a costof approximately $13.0 million.

 

We completed anacquisition in 2003 and expanded systems that have improved our results ofoperations as discussed in this Report. On November 1, 2003, we purchased crude supply and transportation assetsalong the upper Texas Gulf Coast for $21.0 million from Genesis Crude Oil, L.P.and Genesis Pipeline Texas, L.P.  The assetsacquired included approximately 150 miles of small diameter trunk lines, 26,000barrels per day of throughput and 12,000 barrels per day of lease marketing andsupply business.  We are integratingthese assets into our South Texas pipeline system (see Note 5.  Acquisitions and Dispositions).  The acquisition of Genesis was accounted forin accordance with the purchase method of accounting under Statement ofFinancial Accounting Standards (“SFAS”) No. 141, *BusinessCombinations*.  Additionally, during2004, the Basin system, which is a part of our Upstream Segment, was expandedbetween Midland, Texas, and Cushing, Oklahoma, resulting in an additionalcapacity of ten thousand barrels per day on the system.

## ** **

## **Consistent with our business strategy, we continuouslyevaluate possible acquisitions of assets that would complement our currentoperations.  Such acquisition effortsinvolve participation by us in processes that have been made public and involvea number of potential buyers, as well as situations in which we believe we arethe only party or one of a very limited number of potential buyers innegotiations with the potential seller. These acquisition efforts often involve assets which, if acquired, wouldhave a material effect on our financial position, results of operations or cashflows.**

## ** **

## ****Our Business****

 

TEPPCO Partners, L.P., a Delaware limited partnership,is a publicly traded master limited partnership formed in March 1990.  We operate through TE Products PipelineCompany, Limited Partnership (“TE Products”), TCTM, L.P. (“TCTM”) and TEPPCOMidstream Companies, L.P. (“TEPPCO Midstream”), which are collectively referredto as the “Operating Partnerships.” Texas Eastern Products Pipeline Company, LLC (the “Company” or “GeneralPartner”), a Delaware limited liability company, serves as our general partnerand owns a 2% general partner interest in us. The General Partner is a wholly owned subsidiary of Duke Energy FieldServices, LLC (“DEFS”), a joint venture between Duke Energy Corporation (“DukeEnergy”) and ConocoPhillips.  Duke Energyholds an interest of approximately 70% in DEFS, and ConocoPhillips holds theremaining interest of approximately 30%. The Company, as general partner, performs all management and operatingfunctions required for us, except for the management and operations of certainof our TEPPCO Midstream assets that are managed by DEFS on our behalf.  We reimburse the General Partner for allreasonable direct and indirect expenses incurred in managing us.  TEPPCO GP, Inc. (“TEPPCO GP”), oursubsidiary, is the general partner of our Operating Partnerships.  We hold a 99.999% limited partner interest inthe Operating Partnerships and TEPPCO GP holds a 0.001% general partnerinterest.

 

We operate and report in three business segments:

 

•                  DownstreamSegment – transportation and storage of refined products, LPGs andpetrochemicals;

 

•                  Upstream Segment– gathering, transportation, marketing and storage of crude oil anddistribution of lubrication oils and specialty chemicals; and

 

•                  Midstream Segment– gathering of natural gas, transportation of natural gas liquids (“NGLs”) andfractionation of NGLs.

 

Our reportable segments offer different products andservices and are managed separately because each requires a different businessstrategy. TEPPCO GP, our wholly owned subsidiary, acts as managing generalpartner of our Operating Partnerships, with a 0.001% general partner interestin each, and manages our subsidiaries.

 

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Our Downstream Segment revenues are earned fromtransportation and storage of refined products and LPGs, intrastatetransportation of petrochemicals, sales of product inventory and otherancillary services.  The two largestoperating expense items of the Downstream Segment are labor and electricpower.  We generally realize higherrevenues during the first and fourth quarters of each year as our operationsare somewhat seasonal. Refined products volumes are generally higher during thesecond and third quarters because of greater demand for gasolines during thespring and summer driving seasons. LPGs volumes are generally higher fromNovember through March due to higher demand in the Northeast for propane, amajor fuel for residential heating.  OurDownstream Segment also includes the results of operations of the northernportion of the Dean Pipeline, which transports refinery grade propylene fromMont Belvieu, Texas, to Point Comfort, Texas. Our Downstream Segment also includes our equity investments inCentennial and Mont Belvieu Storage Partners, L.P. (“MB Storage”) (see Note 7.  Equity Investments).

 

OurUpstream Segment revenues are earned from gathering, transportation, marketingand storage of crude oil and distribution of lubrication oils and specialtychemicals, principally in Oklahoma, Texas, New Mexico and the Rocky Mountainregion.  Marketing operations consistprimarily of aggregating purchased crude oil along our pipeline systems, oralong third party pipeline systems, and arranging the necessary transportationlogistics for the ultimate sale of the crude oil to local refineries, marketersor other end users.  Our Upstream Segmentalso includes our equity investment in Seaway (see Note 7.  Equity Investments).

 

OurMidstream Segment revenues are earned from the fractionation of NGLs inColorado; transportation of NGLs from two trunkline NGL pipelines in SouthTexas, two NGL pipelines in East Texas and a pipeline system (“Chaparral”) fromWest Texas and New Mexico to Mont Belvieu; the gathering of natural gas in theGreen River Basin in southwestern Wyoming, through Jonah; and the gathering ofCBM in the San Juan Basin in New Mexico and Colorado, through Val Verde.  DEFS manages and operates the Val Verde,Jonah and Chaparral assets for us under contractual agreements.

 

Weearn revenues and income and generate cash by charging our customers a fee forthe transportation, storage, gathering, terminaling, fractionation and otherservices we provide.  In our UpstreamSegment, we seek to maintain a balanced marketing position until we makephysical delivery of the crude oil, thereby minimizing or eliminating ourexposure to price fluctuations occurring after the initial purchase.  We are subject to economic and other factorsthat affect our industry.  The demand forcrude oil and petroleum products is dependent on the price of crude oil and theproducts produced from the refining of crude oil; the price of natural gas andlocations in which natural gas is drilled; and the demand for petrochemicals,which is dependent on prices for products produced from petrochemicals.  We are also subject to regulatory factorssuch as the amounts we are allowed to charge our customers for the services weprovide on our regulated pipeline systems.

 

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** **

**Results ofOperations**

 

The following table summarizesfinancial information by business segment for the three months and nine monthsended September 30, 2004 and 2003 (in thousands):

 
| ** **                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Operating  revenues:            |       |                                  |       |                                 |       |   |   |   |   |
| Downstream  Segment             |       | $                                     | 68,546     |                                 | $          | 65,009 |   | $ | 205,719 |   | $ | 193,032 |   |
| Upstream Segment                |       | 1,370,086                             |       | 955,977                              |       | 3,807,436 |   | 2,878,055 |   |
| Midstream  Segment              |       | 51,695                                |       | 46,045                               |       | 151,862 |   | 137,411 |   |
| Intersegment  eliminations      |       | (317                                  | )          | (142                                 | )          | (2,382 | ) | (1,570 | ) |
| Total operating  revenues       |       | 1,490,010                             |       | 1,066,889                            |       | 4,162,635 |   | 3,206,928 |   |
|                            |       |                                  |       |                                 |       |   |   |   |   |
| Operating  income:              |       |                                  |       |                                 |       |   |   |   |   |
| Downstream  Segment             |       | 12,781                                |       | 17,546                               |       | 53,082 |   | 63,538 |   |
| Upstream Segment                |       | 4,778                                 |       | 5,903                                |       | 23,314 |   | 21,190 |   |
| Midstream  Segment              |       | 19,522                                |       | 21,816                               |       | 56,987 |   | 59,865 |   |
| Total operating  income         |       | 37,081                                |       | 45,265                               |       | 133,383 |   | 144,593 |   |
|                            |       |                                  |       |                                 |       |   |   |   |   |
| Earnings before  interest:      |       |                                  |       |                                 |       |   |   |   |   |
| Downstream  Segment             |       | 12,662                                |       | 16,179                               |       | 51,661 |   | 61,025 |   |
| Upstream Segment                |       | 10,781                                |       | 12,925                               |       | 48,494 |   | 41,769 |   |
| Midstream  Segment              |       | 19,543                                |       | 21,924                               |       | 57,082 |   | 60,037 |   |
| Intersegment  eliminations      |       | —                                |       | —                               |       | — |   | (73 | ) |
| Total earnings  before interest |       | 42,986                                |       | 51,028                               |       | 157,237 |   | 162,758 |   |
|                            |       |                                  |       |                                 |       |   |   |   |   |
| Interest expense                |       | (18,495                               | )          | (22,352                              | )          | (57,002 | ) | (67,772 | ) |
| Interest  capitalized           |       | 1,364                                 |       | 1,815                                |       | 3,812 |   | 3,374 |   |
| Net income                      |       | $                                     | 25,855     |                                 | $          | 30,491 |   | $ | 104,047 |   | $ | 98,360 |   |

 

Thefollowing is a detailed analysis of the results of operations, includingreasons for changes in results, by each of our operating segments.

 

**Downstream Segment**

 

The following table presents volumes deliveredin barrels and average tariff per barrel for the three months and nine monthsended September 30, 2004 and 2003 (in thousands, except tariff information):

 
| ** **                        | ** ** | **Three Months Ended** | ** ** | **Percentage** | ** ** | **Nine Months Ended** | ** ** | **Percentage** | ** ** |
|-----------------------------------|------------|------------------------|------------|----------------|------------|-----------------------|------------|----------------|------------|
| ** **                        | ** ** | **September 30,**      | ** ** | **Increase**   | ** ** | **September 30,**     | ** ** | **Increase**   | ** ** |
| ** **                        | ** ** | **2004**               | ** ** | **2003**       | ** ** | **(Decrease)**        | ** ** | **2004**       | ** ** | **2003** | ** ** | **(Decrease)** | ** ** |
| **Volumes  Delivered**            |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| Refined products                  |       | 41,726                 |       | 42,476         |       | (2                    | )%         | 116,184        |       | 114,964 |   | 1 | % |
| LPGs                              |       | 9,107                  |       | 9,146          |       | —                |       | 31,109         |       | 29,678 |   | 5 | % |
| Total                             |       | 50,833                 |       | 51,622         |       | (2                    | )%         | 147,293        |       | 144,642 |   | 2 | % |
|                              |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| **Average  Tariff per Barrel**    |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| Refined products                  |       | $                      | 1.04       |           | $          | 0.89                  |       | 17             | %          | $ | 0.98 |   | $ | 0.89 |   | 10 | % |
| LPGs                              |       | 1.76                   |       | 2.02           |       | (13                   | )%         | 1.88           |       | 2.11 |   | (11 | )% |
| Average system  tariff per barrel |       | $                      | 1.17       |           | $          | 1.09                  |       | 7              | %          | $ | 1.17 |   | $ | 1.14 |   | 3 | % |

 

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*Three Months EndedSeptember 30, 2004 Compared with Three Months Ended September 30, 2003*

 

Our Downstream Segment reportedearnings before interest of $12.7 million for the three months ended September30, 2004, compared with earnings before interest of $16.2 million for the threemonths ended September 30, 2003. Earnings before interest decreased $3.5 million primarily due to anincrease of $8.3 million in costs and expenses, partially offset by an increaseof $3.6 million in operating revenues, a decrease of $1.1 million in lossesfrom equity investments and an increase of $0.1 million in other income –net.  We discuss the factors influencingour operating performance below.

 

Revenues from refined products transportation increased $5.4million for the three months ended September 30, 2004, compared with the threemonths ended September 30, 2003, primarily due to the recognition of $4.1million of deferred revenue related to the expiration of two customertransportation agreements.  Under some ofour transportation agreements with customers, the contracts specify minimummonthly payments for transportation services. If the transportation services for the month are not used, the unusedtransportation service is recorded as deferred revenue.  The contracts generally specify a subsequentperiod of time in which the customer can deliver excess products to us torecover the deferred revenue.  During thethird quarter of 2004, the time limit under two transportation agreements expiredwithout the customers recovering the deferred revenue.  As a result, we recognized the deferredrevenue as refined products revenues in the current period.  This additional revenue increased the refinedproducts average tariff by $0.10 per barrel, or 11%.

 

The remaining refined products average tariff increased 6%primarily as a result of higher market-based tariff rates which went intoeffect in May 2004 and decreased short-haul deliveries of product received intoour system from Centennial at Creal Springs, Illinois.  Prior to the construction of Centennial,deliveries on our pipeline system were limited by our pipeline capacity, andtransportation services for our customers were allocated in accordance with aproration policy.  With this incrementalpipeline capacity, our previously constrained system has expanded deliveries inmarkets both south and north of Creal Springs. In February 2003, we entered into a lease agreement with Centennial thatincreased our flexibility to deliver refined products to our market areas.  During the three months ended September 30,2004, overall refined product volumes transported decreased 2% primarily due tolower short-haul volumes received into our system from Centennial, partiallyoffset by increased demand and market share for products supplied from the U.S.Gulf Coast into Midwest markets.

 

Revenuesfrom LPGs transportation decreased $2.4 million for the three months ended September30, 2004, compared with the three months ended September 30, 2003, primarilydue to lower deliveries of propane in the upper Midwest and Northeast marketareas due to less favorable price differentials between Mont Belvieu and otherpropane storage centers combined with pipeline downtime associated with thecompletion of the Northeast capacity expansion project, partially offset by higherdeliveries of isobutane to Chicago area refineries and increased short-haulpropane deliveries to Gulf Coast petrochemical customers. The higher propaneprices in 2004 also reduced the fill of consumer storage of propane during2004.  The LPGs average rate per barreldecreased 13% from the prior year period primarily as a result of increasedshort-haul deliveries during the three months ended September 30, 2004.

 

Otheroperating revenues increased $0.6 million for the three months ended September30, 2004, compared with the three months ended September 30, 2003, primarilydue to higher refined products tender deduction and loading fees.  These increases were partially offset bylower revenues from product exchanges, which are used to position product inthe Midwest market area.

 

Costsand expenses increased $8.3 million for the three months ended September 30,2004, compared with the three months ended September 30, 2003. The increase wasmade up of a $5.7 million increase in depreciation and amortization expense, a $2.8million increase in operating, general and administrative expenses and a $0.8million increase in operating fuel and power, partially offset by a $0.5million decrease in taxes – other than income taxes and $0.5 million of net gainson the sales of assets.  Depreciationexpense increased from the prior year period because of a $4.4 million charge inthe third quarter of 2004, resulting from the impairment of marine assets inthe Beaumont, Texas, area (see Note 3. Property, Plant and Equipment). Depreciation expense also increased primarily as a result of assetsplaced in service during 2003 and 2004. This increase was partially offset by

 

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anincrease in the estimated remaining life of a section of our pipeline system inthe Northeast, resulting from pipeline capital improvements made as part of ourintegrity management program.  Operating,general and administrative expenses increased primarily due to a $1.1 million increasein pipeline inspection and repair costs associated with our integritymanagement program, a $0.7 million increase in labor and benefits expense primarilyrelated to incentive compensation plans, a $0.4 million increase in productlosses relating to settlements with a shipper regarding jet fuel and an increaseof $0.3 million in consulting and contract services primarily related tocompliance with the Sarbanes-Oxley Act of 2002. Operating fuel and power expense increased $0.8 million primarily as aresult of higher power rates during the 2004 period.  Taxes – other than income taxes decreased$0.5 million as a result of revisions to estimated property tax accruals.  In addition, we recognized net gains of $0.5million for the three months ended September 30, 2004, from the sales ofvarious assets in the Downstream Segment.

 

Netlosses from equity investments decreased $1.1 million for the three monthsended September 30, 2004, compared with the three months ended September 30,2003, as shown below (in thousands):

 
| ** **           | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** |
|----------------------|------------|------------------------|------------|--------------|------------|
| ** **           | ** ** | **September 30,**      | ** ** | **Increase** | ** ** |
| ** **           | ** ** | **2004**               | ** ** | **2003**     | ** ** | **(Decrease)** | ** ** |
|                 |       |                   |       |         |       |   |   |
| Centennial           |       | $                      | (1,839     | )            | $          | (2,964 | ) | $ | 1,125 |   |
| MB Storage           |       | 1,530                  |       | 1,556        |       | (26 | ) |
| Other                |       | (13                    | )          | (29          | )          | 16 |   |
| Total equity  losses |       | $                      | (322       | )            | $          | (1,437 | ) | $ | 1,115 |   |

 

Equitylosses in Centennial for the three months ended September 30, 2004, comparedwith the three months ended September 30, 2003, decreased $1.1 million primarilydue to lower operating expenses, partially offset by a decrease intransportation revenues and volumes. Included in the equity loss for the three months ended September 30,2004, is $1.7 million of equity income relating to the settlement of certain transmixmatters recognized in previous periods.

 

Equityearnings from our 50% ownership interest in MB Storage remained virtually unchangedfor the three months ended September 30, 2004, compared with the three monthsended September 30, 2003.  In April 2004,MB Storage acquired storage assets and contracts for $33.5 million, of which TEProducts contributed $16.5 million.  Decreasesin equity earnings were due to increased amortization and depreciation expenseon the acquired storage assets and contracts, offset by increased storagerevenue and rental revenue primarily from the acquired contracts and lowerpipeline rehabilitation expenses on the MB Storage system.

 

Otherincome – net increased $0.1 million for the three months ended September 30,2004, compared with the three months ended September 30, 2003, primarily due tohigher interest income earned on cash investments and other investing activities.

 

*Nine Months EndedSeptember 30, 2004 Compared with Nine Months Ended September 30, 2003*

 

Our Downstream Segment reportedearnings before interest of $51.7 million for the nine months ended September30, 2004, compared with earnings before interest of $61.0 million for the ninemonths ended September 30, 2003. Earnings before interest decreased $9.3 million primarily due to anincrease of $23.2 million in costs and expense, partially offset by an increaseof $12.7 million in operating revenues, a decrease of $0.6 million in lossesfrom equity investments and an increase of $0.5 million in other income –net.  We discuss the factors influencingour operating performance below.

** **

Revenues from refined products transportation increased $10.6million for the nine months ended September 30, 2004, compared with the ninemonths ended September 30, 2003, primarily due to the recognition of  $4.1 million of deferred revenue related tothe expiration of two customer transportation agreements, an overall increaseof 1% in the refined products volumes delivered, primarily due to increases inmotor fuel and distillate volumes transported as a result of a strong truckingmarket, and higher market-based tariff rates which went into effect in July

 

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2003and May 2004.  These volume increaseswere primarily due to deliveries of products received into our pipeline fromCentennial at Creal Springs, Illinois. Centennial has provided our system with additional pipeline capacity forproducts originating in the U.S. Gulf Coast area.  Prior to the construction of Centennial,deliveries on our pipeline system were limited by our pipeline capacity, andtransportation services for our customers were allocated in accordance with aproration policy.  With this incrementalpipeline capacity, our previously constrained system has expanded deliveries inmarkets both south and north of Creal Springs. In February 2003, we entered into a lease agreement with Centennial thatincreased our flexibility to deliver refined products to our market areas.  Volume increases were due to increased demandand market share for products supplied from the U.S. Gulf Coast into Midwestmarkets.  The refined products averagerate per barrel increased 10% from the prior year period primarily due tohigher market-based tariff rates which went into effect in July 2003 and May2004, partially offset by the impact of the Midwest origin point for barrelsreceived from Centennial, which resulted in decreased short-haul barrelstransported on our system.

 

Revenuesfrom LPGs transportation decreased $4.1 million for the nine months ended September30, 2004, compared with the nine months ended September 30, 2003, due to lowerdeliveries of propane in the upper Midwest and Northeast market areasattributable to warmer weather during the first three months of 2004.  Additionally, in late February 2004, the MontBelvieu propane price spiked, which resulted in our sourced propane being lesscompetitive than propane from other source points.  Also contributing to the decrease were lessfavorable price differentials between Mont Belvieu and other supply centersduring the second and third quarters of 2004.  The higher propane prices in 2004also reduced the fill of consumer storage of propane during 2004.  These decreases were partially offset byincreased deliveries of isobutane to Chicago area refineries and increasedshort-haul propane deliveries to Gulf Coast petrochemical customers.  The LPGs average rate per barrel decreased 11%from the prior year period primarily as a result of increased short-haul deliveriesduring the nine months ended September 30, 2004.

 

Otheroperating revenues increased $6.2 million for the nine months ended September30, 2004, compared with the nine months ended September 30, 2003, primarily dueto higher propane inventory fees, higher refined products tender deduction andloading fees, higher revenues from product exchanges, which are used toposition product in the Midwest market area, higher margins on productinventory sales and higher propane deliveries at our Providence, Rhode Islandimport facility.

 

Costsand expenses increased $23.2 million for the nine months ended September 30,2004, compared with the nine months ended September 30, 2003. The increase wasmade up of a $14.2 million increase in operating, general and administrativeexpenses, a $9.8 million increase in depreciation and amortization expense anda $0.1 million increase in operating fuel and power, partially offset by a $0.3million decrease in taxes – other than income taxes and $0.6 million of net gainson the sales of assets.  Operating,general and administrative expenses increased primarily due to a $9.1 million increasein pipeline inspection and repair costs associated with our integritymanagement program, a $1.4 million increase in consulting and contractservices, of which $0.8 million was related to compliance with theSarbanes-Oxley Act of 2002, a $1.1 million increase in potential acquisitionevaluation activities, a $0.9 million increase in rental expense from theCentennial pipeline capacity lease agreement that we entered into in February2003, a $0.9 million increase in rental expense primarily related to a capacitylease on another pipeline and a $0.2 million increase in environmentalassessment and remediation activities.  Theseincreases were partially offset by lower expenses in the 2004 period associatedwith the write-off of receivables related to customer bankruptcies andnon-payments in 2003.  Depreciationexpense increased from the prior year period because of a $4.4 million chargeresulting from the impairment of marine assets in the Beaumont area (see Note3.  Property, Plant and Equipment).  Depreciation expense also increased as aresult of assets placed in service during 2003, partially offset by an increasein the estimated remaining life of a section of our pipeline system in theNortheast, resulting from pipeline capital improvements made as part of ourintegrity management program.  Taxes –other than income taxes decreased $0.3 million as a result of adjustments inthe property tax accruals.  In addition,we recognized net gains of $0.6 million for the nine months ended September 30,2004, from the sales of various assets in the Downstream Segment.

 

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Netlosses from equity investments decreased $0.6 million for the nine months endedSeptember 30, 2004, compared with the nine months ended September 30, 2003, asshown below (in thousands):

 
| ** **           | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** |
|----------------------|------------|-----------------------|------------|--------------|------------|
| ** **           | ** ** | **September 30,**     | ** ** | **Increase** | ** ** |
| ** **           | ** ** | **2004**              | ** ** | **2003**     | ** ** | **(Decrease)** | ** ** |
|                 |       |                  |       |         |       |   |   |
| Centennial           |       | $                     | (7,982     | )            | $          | (7,969 | ) | $ | (13 | ) |
| MB Storage           |       | 5,944                 |       | 5,400        |       | 544 |   |
| Other                |       | (31                   | )          | (63          | )          | 32 |   |
| Total equity  losses |       | $                     | (2,069     | )            | $          | (2,632 | ) | $ | 563 |   |

 

Equitylosses in Centennial for the nine months ended September 30, 2004, comparedwith the nine months ended September 30, 2003, remained virtually unchanged,with increases primarily due to the acquisition of an additional 16.7% interestin Centennial on February 10, 2003, bringing TE Products’ ownership interest to50%, and an increase in operating expenses, offset by increased transportationrevenues and volumes.  Included in theequity loss for the nine months ended September 30, 2004, is $1.7 million ofequity income relating to the settlement of certain transmix matters recognizedin previous periods.

 

Equityearnings from our 50% ownership interest in MB Storage increased $0.5 millionfor the nine months ended September 30, 2004, compared with the nine monthsended September 30, 2003.  In April 2004,MB Storage acquired storage assets and contracts for $33.5 million, of which TEProducts contributed $16.5 million.  Theincrease in equity earnings is due to increased storage revenue, shuttlerevenue and rental revenue primarily from the acquired contracts and lowerpipeline rehabilitation expenses on the MB Storage system, partially offset byincreased amortization and depreciation expense on storage assets and contractsacquired.

 

Otherincome – net increased $0.5 million for the nine months ended September 30,2004, compared with the nine months ended September 30, 2003, primarily due tohigher interest income earned on cash investments and other investingactivities.

 

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**Upstream Segment**

 

Informationpresented in the following table includes the margin of the Upstream Segment,which may be viewed as a non-GAAP (Generally Accepted Accounting Principles)financial measure under the rules of the Securities and Exchange Commission.  We calculate the margin of the UpstreamSegment as revenues generated from the sale of crude oil and lubrication oil,and transportation of crude oil, less the costs of purchases of crude oil andlubrication oil.  We believe that marginis a more meaningful measure of financial performance than operating revenuesand operating expenses due to the significant fluctuations in revenues andexpenses caused by variations in the level of marketing activity and prices forproducts marketed.  Margin and volumeinformation for the three months and nine months ended September 30, 2004 and2003, is presented below (in thousands, except per barrel and per gallonamounts):

 
| ** **                              | ** ** | **Three Months Ended** | ** ** | **Percentage** | ** ** | **Nine Months Ended** | ** ** | **Percentage** | ** ** |
|-----------------------------------------|------------|------------------------|------------|----------------|------------|-----------------------|------------|----------------|------------|
| ** **                              | ** ** | **September 30,**      | ** ** | **Increase**   | ** ** | **September 30,**     | ** ** | **Increase**   | ** ** |
| ** **                              | ** ** | **2004**               | ** ** | **2003**       | ** ** | **(Decrease)**        | ** ** | **2004**       | ** ** | **2003** | ** ** | **(Decrease)** | ** ** |
|                                    |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| Margins:                                |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| Crude oil  transportation               |       | $                      | 14,485     |           | $          | 11,182                |       | 30             | %          | $ | 40,860 |   | $ | 33,278 |   | 23 | % |
| Crude oil  marketing                    |       | 4,327                  |       | 5,732          |       | (25                   | )%         | 16,920         |       | 16,936 |   | — |   |
| Crude oil  terminaling                  |       | 2,426                  |       | 2,294          |       | 6                     | %          | 7,392          |       | 6,843 |   | 8 | % |
| Lubrication oil  sales                  |       | 1,657                  |       | 1,319          |       | 26                    | %          | 4,653          |       | 4,010 |   | 16 | % |
| Total margin                            |       | $                      | 22,895     |           | $          | 20,527                |       | 12             | %          | $ | 69,825 |   | $ | 61,067 |   | 14 | % |
|                                    |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| Total barrels:                          |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| Crude oil  transportation               |       | 25,093                 |       | 22,114         |       | 13                    | %          | 75,941         |       | 70,670 |   | 7 | % |
| Crude oil  marketing                    |       | 43,284                 |       | 43,694         |       | (1                    | )%         | 131,208        |       | 118,269 |   | 11 | % |
| Crude oil  terminaling                  |       | 28,889                 |       | 28,004         |       | 3                     | %          | 89,777         |       | 83,566 |   | 7 | % |
|                                    |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| Lubrication oil  volume (total gallons) |       | 3,346                  |       | 2,420          |       | 38                    | %          | 9,765          |       | 7,573 |   | 29 | % |
|                                    |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| Margin per  barrel:                     |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| Crude oil  transportation               |       | $                      | 0.577      |           | $          | 0.506                 |       | 14             | %          | $ | 0.538 |   | $ | 0.471 |   | 14 | % |
| Crude oil  marketing                    |       | 0.100                  |       | 0.131          |       | (24                   | )%         | 0.129          |       | 0.143 |   | (10 | )% |
| Crude oil  terminaling                  |       | 0.084                  |       | 0.082          |       | 3                     | %          | 0.082          |       | 0.082 |   | — |   |
| Lubrication oil  margin (per gallon)    |       | 0.495                  |       | 0.545          |       | (9                    | )%         | 0.476          |       | 0.530 |   | (10 | )% |

 

The following table reconciles theUpstream Segment margin to the consolidated statements of income using theinformation included in the consolidated statements of income and thestatements of income in Note 11.  SegmentInformation (in thousands):

 
| ** **                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| ** **                             | ** ** | **2004**               | ** ** | **2003**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Sales of  petroleum products           |       | $                      | 1,358,220  |                  | $          | 946,402 |   | $ | 3,770,006 |   | $ | 2,849,594 |   |
| Transportation –  Crude oil       |       | 9,288                  |       | 6,813                 |       | 28,164 |   | 20,777 |   |
| Less: Purchases  of petroleum products |       | (1,344,613             | )          | (932,688              | )          | (3,728,345 | ) | (2,809,304 | ) |
| Total margin                           |       | $                      | 22,895     |                  | $          | 20,527 |   | $ | 69,825 |   | $ | 61,067 |   |

 

*Three MonthsEnded September 30, 2004 Compared with Three Months Ended September 30, 2003*

 

Our Upstream Segment reported earningsbefore interest of $10.8 million for the three months ended September 30, 2004,compared with earnings before interest of $12.9 million for the three monthsended September 30, 2003.  Earningsbefore interest decreased $2.1 million primarily due to an increase of $3.3million in costs and

 

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expenses(excluding purchases of crude oil and lubrication oil), a decrease of $1.3million in equity earnings from Seaway and a decrease of $0.2 million in otheroperating revenues, partially offset by an increase of $2.4 million in marginand an increase of $0.3 million in other income – net.  We discuss factors influencing our operatingperformance below.

 

Ourmargin increased $2.4 million for the three months ended September 30, 2004,compared with the three months ended September 30, 2003. Crude oiltransportation margin increased $3.3 million primarily due to an increase intransportation volumes and an increase in transportation revenues on our SouthTexas system, our Basin system and our Red River system.  During the fourth quarter of 2003, wecompleted the purchase of crude supply and transportation assets (Genesis),which are being integrated into our South Texas system (see Note 5.  Acquisitions and Dispositions), resulting in anincrease in transportation volumes and revenues.  These increases were partially offset bylower transportation volumes on our West Texas and other gathering systems.  Lubrication oil sales margin increased $0.4million due to increased sales of chemical volumes and increased volumesrelated to the acquisitions of lubrication oil distributors in Abilene, Texas,in December 2003 and Casper, Wyoming, in August 2004.  Crude oil terminaling margin increased $0.1million as a result of higher pumpover volumes at Cushing, Oklahoma, partiallyoffset by lower pumpover volumes at Midland, Texas.  Crude oil marketing margin decreased $1.4million primarily due to increased transportation costs and a $0.3 million pricingsettlement with a customer.

 

Otheroperating revenue of the Upstream Segment decreased $0.2 million for the threemonths ended September 30, 2004, compared with the three months ended September30, 2003, primarily due to lower revenues from documentation and other servicesto support customers’ trading activity at Midland and Cushing.

 

Costsand expenses, excluding expenses associated with purchases of crude oil andlubrication oil, increased $3.3 million for the three months ended September30, 2004, compared with the three months ended September 30, 2003.  The increase was comprised of a $2.1 millionincrease in operating, general and administrative expenses, a $0.7 millionincrease in depreciation and amortization expense, a $0.6 million increase intaxes – other than income taxes and a $0.3 million increase in operating fueland power, partially offset by a $0.4 million gain on the sale of assets.  Operating, general and administrativeexpenses increased $2.1 million from the prior year period primarily due to a$2.2 million increase in pipeline inspection and repair costs associated withour integrity management program, $0.5 million of additional expenses due tothe acquisition of Genesis, including increased labor costs due to an increasein the number of employees between periods and increased operating costs and a$0.2 million increase in consulting and contract services primarily related tocompliance with the Sarbanes-Oxley Act of 2002. These increases were partially offset by $0.9 million of lowerenvironmental assessment and remediation costs in the 2004 period compared withthe 2003 period.  Depreciation andamortization expense increased $0.7 million primarily due to the assets acquiredfrom Genesis.  Taxes – other than incometaxes increased $0.6 million due to increases in property tax accruals.  Operating fuel and power increased $0.3million primarily as a result of the acquisition of the Genesis assets andhigher volumes in the 2004 period.  Inaddition, we recognized a gain of $0.4 million for the three months endedSeptember 30, 2004, from the sale of our remaining interest in the originalRancho Pipeline system (see Note 5. Acquisitions and Dispositions).

 

Equityearnings in Seaway decreased $1.3 million for the three months ended September30, 2004, compared with the three months ended September 30, 2003, due to higher operating and general andadministrative expenses, partially offset by higher third-party transportationvolumes and gains on crude oil inventory sales.

 

Other income – net increased $0.3million for the three months ended September 30, 2004, compared with the three monthsended September 30, 2003, due to higher interest income earned on cashinvestments.

 

*Nine Months EndedSeptember 30, 2004 Compared with Nine Months Ended September 30, 2003*

 

Our Upstream Segment reported earningsbefore interest of $48.5 million for the nine months ended September 30, 2004,compared with earnings before interest of $41.8 million for the nine monthsended September 30, 2003.  Earningsbefore interest increased $6.7 million primarily due to an increase of $8.8million in margin, an increase of $4.6 million in equity earnings from Seawayand an increase of $1.6 million in other operating revenues,

 

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partiallyoffset by an increase of $4.8 million in costs and expenses (excluding purchasesof crude oil and lubrication oil). Additionally, for the nine months ended September 30, 2004 and 2003, werecognized gains of $0.5 million and $3.9 million, respectively, on the salesof assets.  We discuss factorsinfluencing our operating performance below.

 

Ourmargin increased $8.8 million for the nine months ended September 30, 2004,compared with the nine months ended September 30, 2003.  Crude oil transportation margin increased $7.6million primarily due to an increase in transportation volumes and increasedtransportation revenues on our South Texas system and increased revenues on ourBasin system from movements of barrels on higher tariff segments.  During the fourth quarter of 2003, wecompleted the purchase of crude supply and transportation assets (Genesis),which are being integrated into our South Texas system (see Note 5.  Acquisitions and Dispositions).  These increases are partially offset by lowertransportation volumes on our West Texas and other gathering systems.  Crude oil terminaling margin increased $0.6million as a result of higher pumpover volumes at Cushing, Oklahoma, partiallyoffset by lower pumpover volumes at Midland, Texas.  Lubrication oil sales margin increased $0.6million due to increased sales of chemical volumes and increased volumesrelated to the acquisitions of lubrication oil distributors in Abilene, Texas,in December 2003 and in Casper, Wyoming, in August 2004.  Crude oil marketing margin remained unchangedwith increased volumes marketed, offset by an unfavorable invoicing settlementon a marketing contract in the first quarter of 2003, which reduced themarketing margin in 2003, and increased transportation costs.

 

Otheroperating revenue of the Upstream Segment increased $1.6 million for the ninemonths ended September 30, 2004, compared with the nine months ended September30, 2003, primarily due to a $1.4 million favorable settlement with the formerowner of some of our crude oil assets for inventory imbalances with customerson assets that were not acquired by us, and higher revenues from documentationand other services to support customers’ trading activity at Midland andCushing.

 

Costsand expenses, excluding expenses associated with purchases of crude oil andlubrication oil, increased $4.8 million for the nine months ended September 30,2004, compared with the nine months ended September 30, 2003.  The increase was made up of a $1.8 millionincrease in operating fuel and power, a $1.3 million increase in depreciationand amortization expense, a $1.0 million increase in operating, general andadministrative expenses and a $0.7 million increase in taxes – other thanincome taxes.  Operating fuel and powerincreased $1.8 million primarily as a result of the acquisition of the Genesisassets and higher volumes in the 2004 period. Depreciation and amortization expense increased $1.3 million primarily dueto the assets acquired from Genesis. Operating, general and administrative expenses increased $1.0 millionfrom the prior year period primarily due to a $3.7 million increase in pipelineinspection and repair costs associated with our integrity management program, a$1.9 million increase in labor and benefits expense related to incentivecompensation plans and an increase in the number of employees between periods,a $1.7 million increase in expenses related to the Genesis acquisition, a $0.6million increase in rental expense due to our pipeline lease at Freeport withSeaway and a $0.4 million increase in consulting and contract servicesprimarily related to compliance with the Sarbanes-Oxley Act of 2002.  These increases were partially offset by $4.1million of higher environmental assessment and remediation costs in 2003, $1.7million of expense in 2003 from the net settlement of crude oil imbalances withcustomers and $1.5 million of higher legal costs in 2003 related to thelitigation and settlement with D.R.D. Environmental Services, Inc.  Taxes – other than income taxes increased$0.7 million due to increases in property tax accruals.

 

InJune 2003, we recorded a net gain of $3.9 million, included in the gain on saleof assets in our consolidated statements of income, on the sale of certain ofthe assets of the Rancho Pipeline. During the nine months ended September 30, 2004, we recorded net gainsof $0.5 million, included in the gains on sales of assets in our consolidatedstatements of income, primarily related to the sale of our remaining interestin the original Rancho Pipeline system (see Note 5.  Acquisitions and Dispositions).

 

Equity earnings in Seaway increased $4.6million for the nine months ended September 30, 2004, compared with the ninemonths ended September 30, 2003, due tohigher transportation volumes, gains on crude oil inventory sales and asettlement with a former owner of Seaway’s crude oil assets regarding inventoryimbalances with

 

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customerson assets that were not acquired by us, partially offset by higher operating and general and administrativeexpenses.

 

**Midstream Segment**

 

Thefollowing table presents volume and average rate information for the threemonths and nine months ended September 30, 2004 and 2003 (in thousands, exceptaverage fee and average rate amounts):

 
| ** **                                         | ** ** | **Three Months Ended** | ** ** | **Percentage** | ** ** | **Nine Months Ended** | ** ** | **Percentage** | ** ** |
|----------------------------------------------------|------------|------------------------|------------|----------------|------------|-----------------------|------------|----------------|------------|
| ** **                                         | ** ** | **September 30,**      | ** ** | **Increase**   | ** ** | **September 30,**     | ** ** | **Increase**   | ** ** |
| ** **                                         | ** ** | **2004**               | ** ** | **2003**       | ** ** | **(Decrease)**        | ** ** | **2004**       | ** ** | **2003** | ** ** | **(Decrease)** | ** ** |
| Gathering –  Natural Gas – Jonah :       |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| Million cubic  feet                                |       | 90,005                 |       | 75,807         |       | 19                    | %          | 257,402        |       | 220,600 |   | 17 | % |
| Million British  thermal units (“MMBtu”) |       | 99,531                 |       | 84,182         |       | 18                    | %          | 284,858        |       | 244,636 |   | 16 | % |
| Average fee per  MMBtu                             |       | $                      | 0.191      |           | $          | 0.193                 |       | (1             | )%         | $ | 0.195 |   | $ | 0.192 |   | 2 | % |
|                                               |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| Gathering –  Natural Gas – Val Verde:    |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| Million cubic  feet                                |       | 36,733                 |       | 39,312         |       | (7                    | )%         | 108,213        |       | 120,948 |   | (11 | )% |
| MMBtu                                              |       | 31,294                 |       | 32,981         |       | (5                    | )%         | 91,459         |       | 101,740 |   | (10 | )% |
| Average fee per  MMBtu                             |       | $                      | 0.527      |           | $          | 0.540                 |       | (2             | )%         | $ | 0.533 |   | $ | 0.528 |   | 1 | % |
|                                               |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| Transportation –  NGLs:                       |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| Thousand barrels                                   |       | 15,064                 |       | 14,929         |       | 1                     | %          | 45,209         |       | 43,150 |   | 5 | % |
| Average rate per  barrel                           |       | $                      | 0.692      |           | $          | 0.670                 |       | 3              | %          | $ | 0.686 |   | $ | 0.680 |   | 1 | % |
|                                               |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| Fractionation –  NGLs:                        |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| Thousand barrels                                   |       | 994                    |       | 956            |       | 4                     | %          | 3,064          |       | 3,034 |   | 1 | % |
| Average rate per  barrel                           |       | $                      | 1.866      |           | $          | 1.873                 |       | —         |       | $ | 1.802 |   | $ | 1.815 |   | (1 | )% |
|                                               |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| Sales –  Condensate:                          |       |                   |       |           |       |                  |       |           |       |   |   |   |   |
| Thousand barrels                                   |       | 7.3                    |       | 6.0            |       | 22                    | %          | 67.0           |       | 52.0 |   | 29 | % |
| Average rate per  barrel                           |       | $                      | 43.54      |           | $          | 23.89                 |       | 82             | %          | $ | 35.58 |   | $ | 30.22 |   | 18 | % |

 

*Three MonthsEnded September 30, 2004 Compared with Three Months Ended September 30, 2003*

 

Our Midstream Segment reportedearnings before interest of $19.5 million for the three months ended September30, 2004, compared with earnings before interest of $21.9 million for the threemonths ended September 30, 2003. Earnings before interest decreased $2.4 million due to an increase of $6.5million in costs and expenses (excluding purchases of petroleum products) and adecrease of $0.1 million in other income – net, partially offset by an increaseof $4.2 million in operating revenues and margin.  We discuss factors influencing our operatingperformance below.

 

Revenuesfrom the gathering of natural gas increased $1.4 million for the three monthsended September 30, 2004, compared with the three months ended September 30,2003.  Natural gas gathering revenuesfrom the Jonah system increased $2.7 million and volumes delivered increased 14.2Bcf for the three months ended September 30, 2004, due to the Phase IIIexpansion of the Jonah system during 2003. The Phase III expansion was substantially completed during the fourthquarter of 2003 and increased system capacity from 880 MMcf/day to 1,180MMcf/day.  Natural gas gathering revenuesfrom the Val Verde system decreased $1.3 million and volumes delivereddecreased 2.6 Bcf for the three months ended September 30, 2004, primarily dueto the natural decline of

 

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CBMproduction and slower than anticipated completion and connection of infillwells, partially offset by increased volumes from new well connections to theVal Verde system in late May 2004.  ValVerde’s average gas gathering rate decreased 2% for the three months endedSeptember 30, 2004, compared with the three months ended September 30, 2003,due to new well connections of conventional natural gas, which have a lowergathering rate than the existing Val Verde system average rates, made on theVal Verde system in late May 2004, partially offset by an increase in the averagenatural gas gathering rate due to annual fee escalations in gatheringagreements and higher carbon dioxide treating fees as a result of increasingcarbon dioxide content in the natural gas.

 

Jonah’sPioneer gas processing plant was completed during the first quarter of 2004, asa part of the Phase III expansion to increase the processing capacity insouthwestern Wyoming.  Pioneer’sprocessing agreements allow the producers to elect annually whether to becharged under a fee-based arrangement or a fee plus keep-wholearrangement.  Under the fee-basedelection, Jonah receives a fee for its processing services.  Under the fee plus keep-whole election, Jonahreceives a lower fee for its processing services, retains and sells the NGLsextracted during the process and delivers to the producers residue gasequivalent in energy to the natural gas received from the producers.  Jonah purchases gas from a DEFS affiliate toreplace the equivalent energy removed in the liquids.  Jonah sells the NGLs it retains to a DEFSaffiliate.  These transactions resultedin a net sales and purchases margin in the three months ended September 30, 2004,of $0.3 million*.*

 

Revenuesfrom the transportation of NGLs increased $0.4 million for the three monthsended September 30, 2004, compared with the three months ended September 30,2003, primarily due to increased volumes transported on the Chaparral andPanola pipelines, partially offset by decreased volumes transported on the Deanand Wilcox pipelines.  The increase inthe NGL transportation average rate per barrel resulted primarily from higheraverage rates per barrel on volumes transported on the Panola and Wilcox pipelines.

 

Otheroperating revenues increased $2.1 million for the three months ended September30, 2004, compared with the three months ended September 30, 2003.  Processing fee revenues increased $0.7million as a result of Jonah’s Pioneer processing plant, which was constructedas part of the Phase III expansion and placed in service in January 2004.  Jonah’s other operating revenues also increased$0.2 million due to higher condensate sales. Other operating revenues on Val Verde increased primarily due to $0.4million in revenues generated as a result of contractual producer minimum fuellevels exceeding actual operating fuel usage for the three months endedSeptember 30, 2004.  Val Verde retains aportion of its producers’ gas to compensate for fuel used in operations.  The actual usage of gas can differ from theamount contractually retained from producers. Value retained from producers or sales generated as a result ofefficient fuel usage are recognized as other operating revenues.  The remaining increase in other revenues wasdue to other miscellaneous revenue items.

 

Costsand expenses (excluding purchases of petroleum products) increased $6.5 millionfor the three months ended September 30, 2004, compared with the three monthsended September 30, 2003, due to a $4.1 million increase in operating, generaland administrative expense, a $1.4 million increase in depreciation andamortization expense and a $1.2 million increase in operating fuel and power, partiallyoffset by a $0.2 million decrease in taxes – other than income taxes.  Operating, general and administrative expenseincreased due to a $1.6 million increase in pipeline maintenance and repairexpenses, of which $0.2 million was associated with our integrity managementprogram, a $0.9 million increase in general and administrative labor andbenefits expense, a $0.9 million increase in gas settlement expenses, a $0.4million increase in consulting and contract services related to compliance withthe Sarbanes-Oxley Act of 2002 and a $0.3 million increase in other expenses.  Depreciation expense increased primarily as aresult of assets placed in service in 2003 related to the expansion of theJonah system.  Amortization expenseincreased $0.2 million, due to a $0.5 million increase in amortization expenseon Jonah as a result of higher volumes in the 2004 period, partially offset bya $0.3 million decrease on Val Verde as a result of lower volumes in the 2004period.  Operating fuel and powerincreased $1.2 million primarily due to increased NGL volumes transported onChaparral, higher power costs and adjustments to fuel and power accruals.  Taxes – other than income taxes decreased $0.1million as a result of adjustments to property tax accruals.

 

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Otherincome – net decreased $0.1 million for the three months ended September 30,2004, compared with the three months ended September 30, 2003, due to lowerinterest income earned on cash investments.

 

*Nine Months EndedSeptember 30, 2004 Compared with Nine Months Ended September 30, 2003*

 

Our Midstream Segment reportedearnings before interest of $57.1 million for the nine months ended September30, 2004, compared with earnings before interest of $60.0 million for the ninemonths ended September 30, 2003. Earnings before interest decreased $2.9 million due to an increase of $12.9million in costs and expenses (excluding purchases of petroleum products) and adecrease of $0.1 million in other income – net, partially offset by an increaseof $10.1 million in operating revenues and margin.  We discuss factors influencing our operatingperformance below.

 

Revenuesfrom the gathering of natural gas increased $3.8 million for the nine monthsended September 30, 2004, compared with the nine months ended September 30,2003.  Natural gas gathering revenuesfrom the Jonah system increased $8.7 million and volumes delivered increased 36.8Bcf for the nine months ended September 30, 2004, due to the expansion of theJonah system during 2003.  The Phase IIIexpansion was substantially completed during the fourth quarter of 2003 andincreased system capacity from 880 MMcf/day to 1,180 MMcf/day.  The increase in Jonah’s revenues was alsopartially due to higher gathering rates realized due to lower system pressuresresulting from the increased capacity provided by the Phase III expansion.  Natural gas gathering revenues from the ValVerde system decreased $4.9 million and volumes delivered decreased 12.7 Bcffor the nine months ended September 30, 2004, primarily due to the naturaldecline of CBM production and slower than anticipated completion and connectionof infill wells, partially offset by increased volumes from new well connectionsmade to the Val Verde system in late May 2004. Val Verde’s average natural gas gathering rate increased due to annualfee escalations in gathering agreements and higher carbon dioxide treating feesas a result of increasing carbon dioxide content in the natural gas, partiallyoffset by a lower gathering rate on some of the new well connections.

 

Jonah’sPioneer gas processing plant was completed during the first quarter of 2004, asa part of the Phase III expansion to increase the processing capacity insouthwestern Wyoming.  For the ninemonths ended September 30, 2004, the sales and purchases under the feearrangements at the Pioneer plant resulted in a margin of $0.5 million.

 

Revenuesfrom the transportation of NGLs increased $1.7 million for the nine monthsended September 30, 2004, compared with the nine months ended September 30,2003, primarily due to increases in volumes transported on the Chaparral andPanola pipelines, partially offset by decreased volumes on the Dean and Wilcoxpipelines.  Higher average rates perbarrel on volumes transported on the Panola and Wilcox pipelines were offset bylower average rates per barrel on volumes transported on the Chaparral and Deanpipelines.

 

Otheroperating revenues increased $4.1 million for the nine months ended September30, 2004, compared with the nine months ended September 30, 2003.  Processing fee revenues increased $2.2million as a result of Jonah’s Pioneer processing plant, which was constructedas part of the Phase III expansion and placed in service in January 2004.  Jonah’s other operating revenues alsoincreased $0.8 million due to higher condensate sales.  Other operating revenues on Val Verdeincreased $1.1 million due to revenues generated as a result of contractualproducer minimum fuel levels exceeding actual operating fuel usage during thenine months ended September 30, 2004.  ValVerde retains a portion of its producers’ gas to compensate for fuel used inoperations.  The actual usage of gas candiffer from the amount contractually retained from producers.  Value retained from producers or salesgenerated as a result of efficient fuel usage are recognized as other operatingrevenues.

 

Costsand expenses (excluding purchases of petroleum products) increased $12.9million for the nine months ended September 30, 2004, compared with the ninemonths ended September 30, 2003, due to a $10.7 million increase in operating,general and administrative expense, a $1.9 million increase in operating fueland power, a $0.2 million increase in taxes – other than income taxes and a$0.1 million increase in depreciation and amortization expense.  Operating, general and administrative expenseincreased due to a $4.3 million increase in gas settlement expenses, a $3.1million increase in contract services for pipeline maintenance and repair costs,of which

 

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$1.4million was associated with our integrity management program and $0.8 millionwas related to accelerated maintenance expenditures at Val Verde to accommodateexpected incremental volumes from an adjacent gathering system, a $2.4 millionincrease in general and administrative labor expense and an increase of $1.3million in consulting and contract services, of which $0.8 million related tocompliance with the Sarbanes-Oxley Act of 2002. These increases are partially offset by a $0.6 million decrease inexpense related to the sale of our Enron Corp. receivable, which had been fullyreserved in 2001.  In December 2001, weexpensed approximately $4.3 million of uncollected transportation deficiencyrevenues due to the bankruptcy of Enron Corp. and certain of its subsidiariesin December 2001.  Operating fuel andpower increased $1.9 million primarily due to increased NGL volumes transportedand higher power costs.  Taxes – otherthan income taxes increased $0.2 million as a result of higher propertybalances.  Amortization expense decreased$3.6 million primarily due to a $3.4 million decrease on Jonah’s intangibleassets under the units-of-production method resulting from an extension of theexpected amortization period from approximately 16 years to approximately 25years (see Note 2.  Goodwill and OtherIntangible Assets), partially offset by a $1.3 million increase as a result ofhigher volumes in the 2004 period. Amortization expense on the Val Verde system decreased $1.5 millionprimarily due to lower volumes in the 2004 period, resulting from the naturaldecline in CBM production.  These decreaseswere partially offset by increased depreciation expense of $3.6 million,primarily as a result of assets placed in service in 2003 related to theexpansion of the Jonah system and additional well connections on the Val Verdesystem in 2004.

 

Otherincome – net decreased $0.1 million for the nine months ended September 30,2004, compared with the nine months ended September 30, 2003, due to lowerinterest income earned on cash investments.

 

**Interest Expense and Capitalized Interest**

 

*Three Months EndedSeptember 30, 2004 Compared with Three Months Ended September 30, 2003*

 

Interestexpense decreased $3.9 million for the three months ended September 30, 2004,compared with the three months ended September 30, 2003, primarily due to ahigher percentage of variable interest rate debt during the three months ended September30, 2004, that carried a lower rate of interest as compared to fixed interestrate debt.  The higher percentage ofvariable interest rate debt resulted from the expiration of an interest rateswap in April 2004 (see Note 4. Interest Rate Swaps).

 

Capitalizedinterest decreased $0.5 million for the three months ended September 30, 2004,compared with the three months ended September 30, 2003, due to interestcapitalized on lower construction work-in-progress balances in 2004.

 

*Nine Months EndedSeptember 30, 2004 Compared with Nine Months Ended September 30, 2003*

 

Interestexpense decreased $10.8 million for the nine months ended September 30, 2004,compared with the nine months ended September 30, 2003, due to a higherpercentage of variable interest rate debt during the nine months ended September30, 2004, that carried a lower rate of interest as compared to fixed interestrate debt.  The higher percentage ofvariable interest rate debt resulted from the expiration of an interest rateswap in April 2004 (see Note 4. Interest Rate Swaps).

 

Capitalizedinterest increased $0.4 million for the nine months ended September 30, 2004,compared with the nine months ended September 30, 2003, due to interestcapitalized on higher construction work-in-progress balances in 2004.

 

**Financial Condition and Liquidity**

 

Cash generated from operations, credit facilities anddebt and equity offerings is our primary source of liquidity.  At September 30, 2004, and December 31, 2003,we had working capital deficits of $17.2 million and

 

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$22.8 million,respectively.  At September 30, 2004, wehad approximately $115.0 million in available borrowing capacity under our revolvingcredit facility to cover any working capital needs.  Cash flows for the nine months ended September30, 2004 and 2003 were as follows (in millions): 

 
| ** **                   | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------|------------|--------------------------------------|------------|
| ** **                   | ** ** | **2004**                             | ** ** | **2003** | ** ** |
|                         |       |                                 |       |   |   |
| Cash provided by  (used in): |       |                                 |       |   |   |
| Operating  activities        |       | $                                    | 173.0      |   | $ | 176.7 |   |
| Investing  activities        |       | (134.0                               | )          | (124.1 | ) |
| Financing  activities        |       | (58.9                                | )          | 16.8 |   |
|                              |            |                                      |            |  |  |  |  |

 

*        Operating Activities*

Net cash from operating activities for the nine monthsended September 30, 2004 and 2003, was comprised of the following (inmillions): 
| ** **                                            | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                            | ** ** | **2004**                             | ** ** | **2003** | ** ** |
|                                                  |       |                                 |       |   |   |
| Net income                                            |       | $                                    | 104.1      |   | $ | 98.4 |   |
| Depreciation and  amortization                        |       | 84.5                                 |       | 73.4 |   |
| Earnings in  equity investments                       |       | (22.8                                | )          | (17.8 | ) |
| Distributions  from equity investments                |       | 38.6                                 |       | 10.8 |   |
| Gains on sales  of assets                             |       | (1.1                                 | )          | (3.9 | ) |
| Non-cash portion  of interest expense                 |       | 0.2                                  |       | 4.2 |   |
| Cash provided by  (used in) working capital and other |       | (30.5                                | )          | 11.6 |   |
| Net cash from operating activities                    |       | $                                    | 173.0      |   | $ | 176.7 |   |

 

Cash provided by operating activities decreased $3.7million for the nine months ended September 30, 2004, compared with the ninemonths ended September 30, 2003, primarily due to the timing of payments forworking capital components, partially offset by an increase of $27.8 million indistributions received from our equity investments in Seaway and MB Storageduring the nine months ended September 30, 2004, and higher net income in the2004 period.

 

We believe that we will continue to have adequateliquidity to fund future recurring operating and investing activities.  Our primary cash requirements consist ofnormal operating expenses, capital expenditures to sustain existing operationsand revenue generating expenditures, interest payments on our Senior Notes andrevolving credit facility, distributions to our General Partner and unitholdersand acquisitions of new assets or businesses. Short-term cash requirements, such as operating expenses, capitalexpenditures to sustain existing operations and quarterly distributions to ourGeneral Partner and unitholders, are expected to be funded through operatingcash flows.  Long-term cash requirements for expansion projects andacquisitions are expected to be funded by several sources, including cash flowsfrom operating activities, borrowings under credit facilities, and the issuanceof additional equity and debt securities. Our ability to complete future debt and equity offerings and the timingof any such offerings will depend on various factors, including prevailingmarket conditions, interest rates, our financial condition and our creditrating at the time.

 

Net cash from operating activities for the nine monthsended September 30, 2004 and 2003, included interest payments, net of amountscapitalized, of $75.5 million and $76.5 million, respectively.  Excluding the effects of hedging activitiesand interest capitalized, during the year ended December 31, 2004, we expectinterest payments

 

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on our fixed rate Senior Notes to be approximately $78.0million.  We expect to pay our interestpayments with cash flows from operating activities.

 

*Investing Activities*

 

Cash flows used in investing activities totaled $134.0million for the nine months ended September 30, 2004, and were comprised of$110.9 million of capital expenditures, $1.5 million of cash contributions forTE Products’ ownership interest in Centennial, $19.4 million of cashcontributions for TE Products’ ownership interest in MB Storage and $3.4million for the acquisition of assets acquired during the nine months endedSeptember 30, 2004, partially offset by $1.2 million in net cash proceeds fromthe sales of various assets in our Upstream and Downstream Segments.   Cash flows used in investing activitiestotaled $124.1 million for the nine months ended September 30, 2003, and werecomprised of $103.9 million of capital expenditures, $20.0 million for TEProducts’ acquisition of an additional 16.7% interest in Centennial, $3.0million of cash contributions for TE Products’ ownership interest in Centennialand $0.2 million of cash contributions for TE Products’ ownership interest inMB Storage, partially offset by $3.0 million in net cash proceeds from theRancho Pipeline transactions.

* *

*Financing Activities*

 

Cash flows used in financing activities totaled $58.9million for the nine months ended September 30, 2004, and were comprised of $174.4million of distributions paid to unitholders, partially offset by $115.5million in borrowings, net of repayments from our revolving credit facility.  Cash flows provided by financing activitiestotaled $16.8 million for the nine months ended September 30, 2003, and werecomprised of $382.0 million in proceeds from revolving credit facilities;$198.6 million from the issuance in January 2003 of our 6.125% Senior Notes due2013, partially offset by debt issuance costs of $3.1 million; and $287.5million from the issuance of 9.2 million Units in April and August 2003.  These sources of cash for the nine monthsended September 30, 2003, were partially offset by $589.0 million of repaymentson our revolving credit facilities, $113.8 million to repurchase and retire allof the 3.9 million outstanding Class B Units and $145.4 million ofdistributions paid to unitholders.

** **

**Centennial has entered into credit facilities totaling $150.0million and, as of September 30, 2004, $150.0 million was outstanding underthose credit facilities.  The proceedswere used to fund construction and conversion costs of Centennial’s pipelinesystem.  TE Products and Marathon AshlandPetroleum LLC have each guaranteed one half of Centennial’s debt, up to amaximum of $75.0 million each.**

** **

***Universal Shelf***

** **

**We have filed with the Securities and Exchange Commission auniversal shelf registration statement that, subject to agreement on terms atthe time of use and appropriate supplementation, allows us to issue, in one ormore offerings, up to an aggregate of $2.0 billion of equity securities, debtsecurities or a combination thereof.  At September30, 2004, we have $2.0 billion available under this shelf registration.**

** **

*Credit Facilitiesand Interest Rate Swap Agreements*

 

OnApril 6, 2001, we entered into a $500.0 million revolving credit facilityincluding the issuance of letters of credit of up to $20.0 million (“Three YearFacility”).  The interest rate was based,at our option, on either the lender’s base rate plus a spread, or LIBOR plus aspread in effect at the time of the borrowings. The credit agreement for the Three Year Facility contained certainrestrictive financial covenant ratios. During the first quarter of 2003, we repaid $182.0 million of theoutstanding balance of the Three Year Facility with proceeds from the issuanceof our 6.125% Senior Notes on January 30, 2003. On June 27, 2003, we repaid the outstanding balance under the Three YearFacility with borrowings under a new credit facility, and canceled the ThreeYear Facility.

 

OnJune 27, 2003, we entered into a $550.0 million revolving credit facility witha three year term, including the issuance of letters of credit of up to $20.0million (“Revolving Credit Facility”). The interest rate is based, at our option, on either the lender’s baserate plus a spread, or LIBOR plus a spread in effect at the time of the

 

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borrowings.  The credit agreement for the Revolving CreditFacility contains certain restrictive financial covenant ratios.  We borrowed $263.0 million under theRevolving Credit Facility and repaid the outstanding balance of the Three YearFacility.  On September 30, 2004, $325.5million was outstanding under the Revolving Credit Facility at a weighted averageinterest rate of 2.5%.  At September 30,2004, we were in compliance with the covenants in this credit agreement.  On October 21, 2004, we amended our RevolvingCredit Facility to (i) increase the facility size to $600.0 million, (ii)extend the term to October 21, 2009, (iii) remove certain restrictivecovenants, (iv) increase the available amount for the issuance of letters ofcredit up to $100.0 million and (v) decrease the LIBOR rate spread charged atthe time of each borrowing.

 

OnJanuary 30, 2003, we completed the issuance of $200.0 million principal amountof 6.125% Senior Notes due 2013.  The6.125% Senior Notes were issued at a discount of $1.4 million and are beingaccreted to their face value over the term of the notes.  We used $182.0 million of the proceeds fromthe offering to reduce the outstanding principal on the Three Year Facility to$250.0 million.  The balance of the netproceeds received was used for general partnership purposes.  The Senior Notes may be redeemed at any timeat our option with the payment of accrued interest and a make-whole premiumdetermined by discounting remaining interest and principal payments using adiscount rate equal to the rate of the United States Treasury securities ofcomparable remaining maturity plus 35 basis points.  The indenture governing our 6.125% SeniorNotes contains covenants, including, but not limited to, covenants limiting thecreation of liens securing indebtedness and sale and leasebacktransactions.  However, the indenturedoes not limit our ability to incur additional indebtedness.  As of September 30, 2004, we were incompliance with the covenants of these Senior Notes.

 

We haveentered into interest rate swap agreements to hedge our exposure to cash flowsand fair value changes.  These agreementsare more fully described in Item 3. Quantitative and Qualitative Disclosures About Market Risk.

 

Thefollowing table summarizes our credit facilities as of September 30, 2004 (inmillions):

 
| ** **                     | ** ** | **As of September 30, 2004** | ** ** |
|--------------------------------|------------|------------------------------|------------|
| ** **                     | ** ** | ** **                   | ** ** | **Available** | ** ** | ** ** | ** ** |
| ** **                     | ** ** | **Outstanding**              | ** ** | **Borrowing** | ** ** | **Maturity** | ** ** |
| **Description:**               | ** ** | **Principal**                | ** ** | **Capacity** | ** ** | **Date** | ** ** |
| Revolving Credit  Facility (1) |       | $                            | 325.5      |   | $ | 224.5 |   | June 2006 |   |
| 6.45% Senior  Notes (2)        |       | 180.0                        |       | — |   | January 2008 |   |
| 7.625% Senior  Notes (2)       |       | 500.0                        |       | — |   | February 2012 |   |
| 6.125% Senior  Notes (2)       |       | 200.0                        |       | — |   | February 2013 |   |
| 7.51% Senior  Notes (2)        |       | 210.0                        |       | — |   | January 2028 |   |
| Total                          |       | $                            | 1,415.5    |   | $ | 224.5 |   |   |   |

 

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(1)          Our Revolving Credit Facility contains restrictivecovenants that require us to maintain certain financial ratios.  Under the most restrictive financialcovenant, approximately $115.0 million was available to be borrowed atSeptember 30, 2004.  Certain of theserestrictive covenants are adjusted in the event of an acquisition by us, whichwould permit additional borrowings under the facility.  On October 21, 2004, the Revolving CreditFacility was amended.  Total borrowingcapacity was increased to $600.0 million, and the maturity date was extended to October 2009.  

 

(2)          Our TE Products subsidiary entered into an interestrate swap agreement to hedge its exposure to changes in the fair value of its7.51% Senior Notes due 2028.  AtSeptember 30, 2004, the 7.51% Senior Notes include an adjustment to increasethe fair value of the debt by $3.9 million related to this interest rate swapagreement.  We also entered into interestrate swap agreements to hedge our exposure to changes in the fair value of our7.625% Senior Notes due 2012.  AtSeptember 30, 2004, the 7.625% Senior Notes include a deferred gain, net ofamortization, from previous interest rate swap terminations of $37.6million.  At September 30, 2004, our6.45% Senior Notes, our 7.625% Senior Notes 

 

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andour 6.125% Senior Notes include $2.9 million of unamortized debtdiscounts.  The fair value adjustments,the deferred gain adjustment and the unamortized debt discounts are excludedfrom this table.

 

### ***Distributions and Issuance of Additional LimitedPartner Units***

### ** **

We paid cash distributions of $174.4 million ($1.975per Unit) and $145.4 million ($1.85 per Unit) during the nine months ended September30, 2004 and 2003, respectively. Additionally, we declared a cash distribution of $0.6625 per Unit forthe quarter ended September 30, 2004. We will pay the quarterly distribution of$58.7 million on November 5, 2004, to unitholders of record on October 29,2004.

 

OnApril 2, 2003, we sold in an underwritten public offering 3.9 million Units at$30.35 per Unit.  The proceeds from theoffering, net of underwriting discount, totaled approximately $114.5 million,of which approximately $113.8 million was used to repurchase and retire all ofthe 3.9 million previously outstanding Class B Units held by Duke EnergyTransport and Trading Company, LLC.  Wereceived approximately $0.7 million in proceeds from the offering in excess ofthe amount needed to repurchase and retire the Class B Units.

 

OnAugust 7, 2003, we sold in an underwritten public offering 5.0 million Units at$34.68 per Unit.  The proceeds from theoffering, net of underwriting discount, totaled approximately $166.0million.  On August 19, 2003, 162,900Units were sold upon exercise of the underwriters’ over-allotment optiongranted in connection with the offering on August 7, 2003.  Proceeds from the over-allotment sale, net ofunderwriting discount, totaled $5.4 million. Approximately $53.0 million of the proceeds was used to repayindebtedness under our revolving credit facility and $21.0 million was used tofund the acquisition of the Genesis assets (see Note 5.  Acquisitions and Dispositions).  The remaining amount was used primarily tofund revenue generating and system upgrade capital expenditures and for generalpartnership purposes.

 

*General Partner Interest*

 

Asof September 30, 2004, and December 31, 2003, we had a deficit balance of $27.1million and $7.2 million, respectively, in our General Partner’s equityaccount. This negative balance does not represent an asset to us and does notrepresent an obligation of the General Partner to contribute cash or otherproperty to us. The General Partner’s equity account generally consists of itscumulative share of our net income less cash distributions made to the GeneralPartner plus capital contributions that it has made to us.  For the nine months ended September 30, 2004,the General Partner was allocated $30.0 million (representing 28.85%) of ournet income and received $50.0 million in cash distributions.

 

CapitalAccounts, as defined under our Partnership Agreement, are maintained for ourGeneral Partner and our limited partners. The Capital Account provisions of our Partnership Agreement incorporateprinciples established for U.S. federal income tax purposes and are notcomparable to the equity accounts reflected under accounting principlesgenerally accepted in the United States in our financial statements.  Under our Partnership Agreement, the GeneralPartner is only required to make additional capital contributions to us uponthe issuance of any additional Units if necessary to maintain a Capital Accountbalance equal to 1.999999% of the total Capital Accounts of all partners.  At September 30, 2004, and December 31, 2003,the General Partner’s Capital Account balance substantially exceeded thisrequirement.

 

Netincome is allocated between the General Partner and the limited partners in thesame proportion as aggregate cash distributions made to the General Partner andthe limited partners during the period. This is generally consistent with the manner of allocating net incomeunder our Partnership Agreement.  Netincome determined under our Partnership Agreement, however, incorporatesprinciples established for U.S. federal income tax purposes and is not comparableto net income reflected under accounting principles generally accepted in theUnited States in our financial statements.

 

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Cashdistributions that we make during a period may exceed our net income for theperiod.  We make quarterly cashdistributions of all of our Available Cash, generally defined as consolidatedcash receipts less consolidated cash disbursements and cash reservesestablished by the General Partner in its sole discretion.  Cash distributions in excess of net incomeallocations and capital contributions during the year ended December 31, 2003,and the nine months ended September 30, 2004, resulted in a deficit in theGeneral Partner’s equity account at December 31, 2003, and September 30, 2004.  Future cash distributions that exceed netincome will result in an increase in the deficit balance in the General Partner’sequity account.

 

Accordingto the Partnership Agreement, in the event of our dissolution, after satisfyingour liabilities, our remaining assets would be divided among our limitedpartners and the General Partner generally in the same proportion as AvailableCash but calculated on a cumulative basis over the life of the Partnership.  If a deficit balance still remains in theGeneral Partner’s equity account after all allocations are made between thepartners, the General Partner would not be required to make whole any suchdeficit.

 

*Future Capital Needs andCommitments*

 

We estimate that capital expenditures, excluding acquisitions,for 2004 will be approximately $156.0 million (which includes $4.0 million ofcapitalized interest).  We expect tospend approximately $116.3 million for revenue generating projects and facilityimprovements.  Capital spending onrevenue generating projects and facility improvements will includeapproximately $42.9 million for the expansion of our Downstream Segmentfacilities including pipelines extending from Seymour to Indianapolis, Indiana,further expansions of our Northeast pipeline system and construction of a newtruck loading terminal in Bossier City, Louisiana.  We expect to spend $25.9 million to expandour Upstream Segment pipelines and facilities in South Texas and Oklahoma andapproximately $47.5 million to expand our Midstream Segment assets.  We expect to spend approximately $35.7million to sustain existing operations, including life-cycle replacements forequipment at various facilities and pipeline and tank replacements among all ofour business segments.  We continuallyreview and evaluate potential capital improvements and expansions that would becomplementary to our present business segments. These expenditures can varygreatly depending on the magnitude of our transactions.  We may finance capital expenditures throughinternally generated funds, debt or the issuance of additional equity.

 

Our debt repayment obligations consist of payments forprincipal and interest on (i) outstanding principal amounts under the RevolvingCredit Facility due in June 2006 ($325.5 million outstanding at September 30, 2004),(ii) the TE Products $180.0 million 6.45% Senior Notes due January 15, 2008,(iii) our $500.0 million 7.625% Senior Notes due February 15, 2012, (iv) our$200.0 million 6.125% Senior Notes due February 1, 2013, and (v) the TE Products$210.0 million 7.51% Senior Notes due January 15, 2028.

 

TE Products is contingently liable as guarantor forthe lesser of one half or $75.0 million principal amount (plus interest) ofCentennial’s borrowings.  In January2003, TE Products entered into a pipeline capacity lease agreement withCentennial for a period of five years that contains a minimum throughputrequirement.  For the year ended December31, 2003, and for the nine months ended September 30, 2004, TE Productsexceeded the minimum throughput requirements on the lease agreement.

 

During the nine months ended September 30, 2004, TEProducts contributed $1.5 million to Centennial to cover operating needs andcapital expenditures.  During the ninemonths ended September 30, 2004, TE Products contributed $19.4 million to MBStorage, of which $16.5 million was used for its acquisition of storage assetsin April 2004.  TE Products may berequired to contribute cash to Centennial during the remainder of 2004, tocover capital expenditures, acquisitions or other operating needs and to MBStorage to cover significant capital expenditures or additional acquisitions.

 

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*Off-Balance Sheet Arrangements*

 

We do not rely on off-balance sheet borrowings to fundour acquisitions.  We have no off-balancesheet commitments for indebtedness other than the limited guaranty ofCentennial debt and leases covering assets utilized in several areas of ouroperations.

 

*Contractual Obligations*

 

The following table summarizes our debt repaymentobligations and material contractual commitments as of September 30, 2004 (inmillions):  

 
| ** **                           | ** ** | **Amount of Commitment Expiration Per Period** | ** ** |
|--------------------------------------|------------|------------------------------------------------|------------|
| ** **                           | ** ** | **Total**                                      | ** ** | **Less than  1 Year** | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **After 5  Years** | ** ** |
|                                 |       |                                           |       |   |   |   |   |   |   |   |   |
| Revolving Credit  Facility (1)       |       | $                                              | 325.5      |   | $ | — |   | $ | 325.5 |   | $ | — |   | $ | — |   |
| 6.45% Senior  Notes due 2008 (2) (3) |       | 180.0                                          |       | — |   | — |   | 180.0 |   | — |   |
| 7.625% Senior  Notes due 2012 (3)    |       | 500.0                                          |       | — |   | — |   | — |   | 500.0 |   |
| 6.125% Senior  Notes due 2013 (3)    |       | 200.0                                          |       | — |   | — |   | — |   | 200.0 |   |
| 7.51% Senior  Notes due 2028 (2) (3) |       | 210.0                                          |       | — |   | — |   | — |   | 210.0 |   |
| Debt subtotal                        |       | 1,415.5                                        |       | — |   | 325.5 |   | 180.0 |   | 910.0 |   |
|                                 |       |                                           |       |   |   |   |   |   |   |   |   |
| Operating leases                     |       | 84.2                                           |       | 18.0 |   | 28.3 |   | 14.4 |   | 23.5 |   |
|                                 |       |                                           |       |   |   |   |   |   |   |   |   |
| Total                                |       | $                                              | 1,499.7    |   | $ | 18.0 |   | $ | 353.8 |   | $ | 194.4 |   | $ | 933.5 |   |

 

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(1)          On October 21, 2004, theRevolving Credit Facility was amended. Total borrowing capacity was increased to $600.0 million, subject tocompliance with prescribed financial covenants, and the maturity date wasextended to October 2009.

 

(2)          Obligations of TEProducts.

 

(3)          Our TE Products subsidiary entered into an interestrate swap agreement to hedge its exposure to changes in the fair value of its7.51% Senior Notes due 2028.  At September30, 2004, the 7.51% Senior Notes include an adjustment to increase the fairvalue of the debt by $3.9 million related to this interest rate swapagreement.  We also entered into interestrate swap agreements to hedge our exposure to changes in the fair value of our7.625% Senior Notes due 2012.  At September30, 2004, the 7.625% Senior Notes include a deferred gain, net of amortization,from previous interest rate swap terminations of $37.6 million.  At September 30, 2004, our 6.45% SeniorNotes, our 7.625% Senior Notes and our 6.125% Senior Notes include $2.9 millionof unamortized debt discounts.  The fairvalue adjustments, the deferred gain adjustments and the unamortized debtdiscounts are excluded from this table.

 

We expect to repay the long-term, senior unsecuredobligations and bank debt through the issuance of additional long-term seniorunsecured debt at the time the 2008, 2012, 2013 and 2028 debt matures, issuanceof additional equity, proceeds from dispositions of assets, cash flow fromoperations or any combination of the above items.

 

### ***Sources of Future Capital***

 

Historically, we have funded our capital commitmentsfrom operating cash flow and borrowings under bank credit facilities or bridgeloans.  We repaid these loans in part bythe issuance of long term debt in capital markets and the public offering ofUnits.  We expect future capital needswould be similarly funded to the extent not otherwise available from cash flowfrom operations.

 

As of September 30, 2004, we had $224.5 million inavailable borrowing capacity under the Revolving Credit Facility, subject tocompliance with prescribed financial covenants. We expect that cash flows from operating activities will be adequate tofund cash distributions and

 

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capital additions necessary to sustain existingoperations.  However, future expansionarycapital projects and acquisitions may require funding through proceeds from thesale of additional debt or equity offerings.

 

Our senior unsecured debt is rated BBBby Standard and Poors (“S&P”) and Baa3 by Moody’s Investors Service (“Moody’s”).  Both ratings are stable.  A rating reflects only the view of a ratingagency and is not a recommendation to buy, sell or hold any indebtedness.  Any rating can be revised upward or downwardor withdrawn at any time by a rating agency if it determines that thecircumstances warrant such a change.  Thesenior unsecured debt of our subsidiary, TE Products, is also rated BBB byS&P and Baa3 by Moody’s.  Bothratings are stable.

 

****Other Considerations****

** **

Our operations are subject to federal, state and locallaws and regulations governing the discharge of materials into the environment.Failure to comply with these laws and regulations may result in the assessmentof administrative, civil and criminal penalties, imposition of injunctionsdelaying or prohibiting certain activities and the need to performinvestigatory and remedial activities. Although we believe our operations are in material compliance withapplicable environmental laws and regulations, risks of significant costs andliabilities are inherent in pipeline operations, and we cannot assure you thatsignificant costs and liabilities will not be incurred. Moreover, it ispossible that other developments, such as increasingly strict environmentallaws and regulations and enforcement policies thereunder, and claims fordamages to property or persons resulting from our operations, could result insubstantial costs and liabilities to us. We believe that changes in environmental laws and regulations will nothave a material adverse effect on our financial position, results of operationsor cash flows in the near term.

 

In 1994, the Louisiana Department of EnvironmentalQuality (“LDEQ”) issued a compliance order for environmental contamination atour Arcadia, Louisiana, facility.  In1999, our Arcadia facility and adjacent terminals were directed by theRemediation Services Division of the LDEQ to pursue remediation of thiscontamination.  At September 30, 2004, wehave an accrued liability of $0.2 million for remediation costs at our Arcadiafacility.  Effective in March 2004, weexecuted an access agreement with an adjacent industrial landowner who islocated upgradient of the Arcadia facility. This agreement enables the landowner to proceed with remediation activitiesat our Arcadia facility for which it has accepted shared responsibility.  We do not expect that the completion of theremediation program proposed to the LDEQ will have a future material adverseeffect on our financial position, results of operations or cash flows.

 

On March 17, 2003, we experienced a release of 511barrels of jet fuel from a storage tank at our Blue Island terminal located inCook County, Illinois.  As a result ofthe release, we have entered into an Agreed Order with the State of Illinoiswhich required us to conduct an environmental investigation.  At this time, we have complied with the termsof the Agreed Order, and the results of the environmental investigationindicated there were no soil or groundwater impacts from the release.  We are in the process of negotiating a finalsettlement with the State of Illinois, and we do not expect that compliancewith the settlement will have a future material adverse effect on our financialposition, results of operations or cash flows.

 

On July 22, 2004, we experienced a release ofapproximately 12 barrels of jet fuel from a sump at our Lebanon, Ohio,terminal.  The released jet fuel wascontained within a stormwater retention pond located on the terminalproperty.  Six migratory waterfowl wereaffected by the jet fuel and were subsequently euthanized by or at the requestof the United States Fish and Wildlife Service (“USFWS”).  On October 1, 2004, the USFWS served us witha Notice of Violation, alleging that we violated 16 USC 703 of the MigratoryBird Treaty Act for the “take[ing] of migratory birds by illegal methods.”  Such a violation, if proven, would be amisdemeanor criminal offense; however, we deny that any such criminal violationoccurred, and we are vigorously defending our position in this matter.  We do not expect the results of this noticewill have a future material adverse effect on our financial position, resultsof operations or cash flows.

 

On July 27, 2004, we received notice from the UnitedStates Department of Justice (“DOJ”) of its intent to seek a civil penaltyagainst us related to our November 21, 2001, release of approximately 2,575barrels of jet fuel

 

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from our 14-inch diameter pipeline located in OrangeCounty, Texas.  The DOJ, at the requestof the United States Environmental Protection Agency, is seeking a civilpenalty against us for alleged violations of the Clean Water Act (“CWA”)arising out of this release.  The maximumstatutory penalty calculated for this alleged violation of the CWA is $2.8million.  We are in discussions with theDOJ regarding this matter, and we do not expect a civil penalty, if any, tohave a material adverse effect on our financial position, results of operationsor cash flows.

 

At September 30, 2004, we have an accrued liability of$7.0 million, related to various TCTM and TE Products sites requiringenvironmental remediation activities.  We do not expect that the completion of remediation programs associatedwith TCTM and TE Products activities will have a future material adverse effecton our financial position, results of operations or cash flows.

 

On February 6, 2004, a lawsuit styled *San Juan Citizens Alliance et al. v. Norton et al*., wasfiled against the United States Department of Interior and the Bureau of LandManagement (“BLM”) in the U.S. District Court, District of Columbia,challenging a recent decision by the BLM. In that decision, the BLM adopted a Resource Management Plan thatauthorized the development of additional gas wells on public lands innorthwestern New Mexico.  A substantialportion of the development activity in the area that is the subject of the suitinvolves the infill drilling in the Basin-Fruitland Coal Gas Pool, which coversmost of the San Juan Basin.  The ValVerde system, in our Midstream segment, gathers CBM from the Fruitland CoalFormation in the San Juan Basin in New Mexico and Colorado.  We believe the BLM followed the requirementsof the law and reached a balanced decision in adopting the Resource ManagementPlan.  However, an adverse decision couldimpact infill drilling activities in the San Juan Basin.

 

We regularly review our long-lived assets forimpairment in accordance with SFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets*.  At September 30, 2004, we have identifiedcertain assets that we are assessing for recoverability resulting from recentoperational changes.  We are continuingto monitor these circumstances; however, we do not believe that the resolutionof the matter will have a material effect on our financial condition, resultsof operations or cash flows.

* *

*Recent Accounting Pronouncements*

* *

**See discussion of new accounting pronouncements in Note1.  Organization and Basis ofPresentation - New Accounting Pronouncements in the accompanying consolidatedfinancial statements.**

 

**Forward****-Looking Statements**

 

Thematters discussed in this Report include “forward-looking statements” withinthe meaning of various provisions of the Securities Act of 1933 and the SecuritiesExchange Act of 1934.  All statements,other than statements of historical facts, included in this document thataddress activities, events or developments that we expect or anticipate will ormay occur in the future, including such things as estimated future capitalexpenditures (including the amount and nature thereof), business strategy andmeasures to implement strategy, competitive strengths, goals, expansion andgrowth of our business and operations, plans, references to future success,references to intentions as to future matters and other such matters areforward-looking statements.  Thesestatements are based on certain assumptions and analyses made by us in light ofour experience and our perception of historical trends, current conditions andexpected future developments as well as other factors we believe areappropriate under the circumstances. However, whether actual results and developments will conform with ourexpectations and predictions is subject to a number of risks and uncertainties,including general economic, market or business conditions, the opportunities(or lack thereof) that may be presented to and pursued by us, competitiveactions by other pipeline companies, changes in laws or regulations and otherfactors, many of which are beyond our control. Consequently, all of the forward-looking statements made in thisdocument are qualified by these cautionary statements and we cannot assure youthat actual results or developments that we anticipate will be realized or,even if substantially realized, will have the expected consequences to oreffect on us or our business or operations. For

 

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additionaldiscussion of such risks and uncertainties, see our Annual Report on Form 10-Kfor the year ended December 31, 2003, and other filings we have made with theSecurities and Exchange Commission.

 

OurCorporate Governance Guidelines are available on our website at www.teppco.com.

** **

**Item 3. Quantitative**and Qualitative Disclosures About Market Risk

 

We may be exposed to market risk through changes incrude oil commodity prices and interest rates. We do not have foreign exchange risks. Our Risk Management Committee has established policies to monitor andcontrol these market risks.  The RiskManagement Committee is comprised, in part, of senior executives of theCompany.

 

At September 30, 2004, we had $325.5 millionoutstanding under our variable interest rate revolving credit agreement.  The interest rate is based, at our option, oneither the lender’s base rate plus a spread or LIBOR plus a spread in effect atthe time of the borrowings and is adjusted monthly, bimonthly, quarterly orsemiannually.  Utilizing the balances ofour variable interest rate debt outstanding at September 30, 2004, and assumingmarket interest rates increase 100 basis points, the potential annual increasein interest expense would be $3.3 million.

 

We have utilized and expect to continue to utilizeinterest rate swap agreements to hedge a portion of our cash flow and fairvalue risks.  Interest rate swapagreements are used to manage the fixed and floating interest rate mix of ourtotal debt portfolio and overall cost of borrowing.  The interest rate swap related to our cashflow risk is intended to reduce our exposure to increases in the benchmarkinterest rates underlying our variable rate revolving credit facility.  The interest rate swaps related to our fairvalue risks are intended to reduce our exposure to changes in the fair value ofthe fixed rate Senior Notes.  Theinterest rate swap agreements involve the periodic exchange of payments withoutthe exchange of the notional amount upon which the payments are based.  The related amount payable to or receivablefrom counterparties is included as an adjustment to accrued interest.

 

At September 30, 2004, TE Products had outstanding$180.0 million principal amount of 6.45% Senior Notes due 2008 and $210.0million principal amount of 7.51% Senior Notes due 2028 (collectively, the “TEProducts Senior Notes”).  At September 30,2004, the estimated fair value of the TE Products Senior Notes wasapproximately $412.0 million.  At September30, 2004, we had outstanding $500.0 million principal amount of 7.625% SeniorNotes due 2012 and $200.0 million principal amount of 6.125% Senior Notes due2013.  At September 30, 2004, theestimated fair value of the $500.0 million 7.625% Senior Notes and the $200.0million 6.125% Senior Notes was approximately $577.0 million and $210.7 million,respectively.

 

On October 4, 2001, TE Products entered into aninterest rate swap agreement to hedge its exposure to changes in the fair valueof its fixed rate 7.51% Senior Notes due 2028. We designated this swapagreement as a fair value hedge.  Theswap agreement has a notional amount of $210.0 million and matures in January2028 to match the principal and maturity of the TE Products Senior Notes.  Under the swap agreement, TE Products pays afloating rate of interest based on a three-month U.S. Dollar LIBOR rate, plus aspread, and receives a fixed rate of interest of 7.51%. During the nine monthsended September 30, 2004 and 2003, we recognized reductions in interest expenseof $7.5 million and $7.4 million, respectively, related to the differencebetween the fixed rate and the floating rate of interest on the interest rateswap.  During the quarter ended September30, 2004, we measured the hedge effectiveness of this interest rate swap andnoted that no gain or loss from ineffectiveness was required to berecognized.  The fair value of this interestrate swap was a gain of approximately $3.9 million at September 30, 2004, and again of approximately $2.3 million at December 31, 2003.  Utilizing the balance of the 7.51% TEProducts Senior Notes outstanding at September 30, 2004, and including the effectsof hedging activities, assuming market interest rates increase 100 basispoints, the potential annual increase in interest expense is $2.1 million.

 

We entered into an interest rate swap agreement tohedge our exposure to increases in the benchmark interest rate underlying ourvariable rate revolving credit facility. This interest rate swap matured onApril 6, 2004.   We designated this swapagreement, which hedged exposure to variability in expected future cash flowsattributed to

 

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changes in interest rates, as a cash flow hedge. Theswap agreement was based on a notional amount of $250.0 million.  Under the swap agreement, we paid a fixedrate of interest of 6.955% and received a floating rate based on a three-monthU.S. Dollar LIBOR rate.  Because thisswap was designated as a cash flow hedge, the changes in fair value, to theextent the swap was effective, were recognized in other comprehensive incomeuntil the hedged interest costs were recognized in earnings.  On June 27, 2003, we repaid the amountsoutstanding under our revolving credit facility with borrowings under a newthree year revolving credit facility and canceled the old facility (see Note 8.  Debt). We redesignated this interest rate swap as a hedge of our exposure toincreases in the benchmark interest rate underlying the new variable raterevolving credit facility.  During the ninemonths ended September 30, 2004 and 2003, we recognized increases in interestexpense of $2.9 million and $10.7 million, respectively, related to thedifference between the fixed rate and the floating rate of interest on theinterest rate swap.

 

During2003, we determined that we would repay a portion of the amount outstandingunder the revolving credit facility with proceeds from our Unit offering inAugust 2003 (see Note 9.  Partners’Capital and Distributions) resulting in a reduction of probable future interestpayments under the credit facility.  Wereduced the outstanding balance of the revolving credit facility at December31, 2003, to $210.0 million.  During theyear ended December 31, 2003, we recognized a loss of $1.0 million for theportion of the discontinued hedge.  Thetotal fair value of the interest rate swap was a loss of approximately $3.9 millionat December 31, 2003.  The remaining $2.9million of other comprehensive income was transferred to earnings during theperiod from January 1, 2004, through the maturity of the interest rate swap onApril 6, 2004.

 

OnFebruary 20, 2002, we entered into interest rate swap agreements, designated asfair value hedges, to hedge our exposure to changes in the fair value of ourfixed rate 7.625% Senior Notes due 2012. The swap agreements had a combined notional amount of $500.0 million andmatured in 2012 to match the principal and maturity of the Senior Notes.  Under the swap agreements, we paid a floatingrate of interest based on a U.S. Dollar LIBOR rate, plus a spread, and receiveda fixed rate of interest of 7.625%.  OnJuly 16, 2002, the swap agreements were terminated resulting in a gain ofapproximately $18.0 million.  Concurrentwith the swap terminations, we entered into new interest rate swap agreements,with identical terms as the previous swap agreements; however, the floatingrate of interest was based upon a spread of an additional 50 basis points.  In December 2002, the swap agreements enteredinto on July 16, 2002, were terminated, resulting in a gain of approximately$26.9 million.  The gains realized fromthe July 2002 and December 2002 swap terminations have been deferred asadjustments to the carrying value of the Senior Notes and are being amortizedusing the effective interest method as reductions to future interest expenseover the remaining term of the Senior Notes. At September 30, 2004, the unamortized balance of the deferred gains was$37.6 million.  In the event of earlyextinguishment of the Senior Notes, any remaining unamortized gains would berecognized in the consolidated statement of income at the time ofextinguishment.

** **

**Item4.  Controlsand Procedures**

 

Theprincipal executive officer and principal financial officer of our GeneralPartner, after evaluating the effectiveness of our disclosure controls andprocedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of September30, 2004, have concluded that, as of such date, our disclosure controls andprocedures are adequate and effective to ensure that material informationrelating to us and our consolidated subsidiaries would be made known to them byothers within those entities.

 

Duringthe third quarter of 2004, there have been no changes in our internal controlover financial reporting that have materially affected, or are reasonablylikely to materially affect, those internal controls subsequent to the date ofthe evaluation.   As a result, nocorrective actions were required or undertaken.

 

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**PART II****.  OTHERINFORMATION**

 

**Item 1.  Legal Proceedings**

 

Wehave been, in the ordinary course of business, a defendant in various lawsuitsand a party to various other legal proceedings, some of which are covered inwhole or in part by insurance.  Webelieve that the outcome of these lawsuits and other proceedings will notindividually or in the aggregate have a material adverse effect on ourconsolidated financial position, results of operations or cash flows.  See discussion of legal proceedings in Note 12.  Commitments and Contingencies in theaccompanying consolidated financial statements.

 

**Item 6.  Exhibitsand Reports on Form 8-K.**

 

(a)           Exhibits:

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 3.1                 |       | Certificate of Limited Partnership of TEPPCO  Partners, L.P. (Filed as Exhibit 3.2 to the Registration Statement of TEPPCO  Partners, L.P. (Commission File No. 33-32203) and incorporated herein by  reference).                                                                                                                                                                                                                                                                                                |
| 3.2                 |       | Third Amended and Restated Agreement of Limited  Partnership of TEPPCO Partners, L.P., dated September 21, 2001 (Filed as  Exhibit 3.7 to Form 10-Q of TEPPCO Partners, L.P. (Commission File No.  1-10403) for the quarter ended September 30, 2001 and incorporated herein by  reference).                                                                                                                                                                                                                     |
| 4.1                 |       | Form of Certificate representing Limited Partner  Units (Filed as Exhibit 4.1 to the Registration Statement of TEPPCO Partners,  L.P. (Commission File No. 33-32203) and incorporated herein by reference).                                                                                                                                                                                                                                                                                                      |
| 4.2                 |       | Form of Indenture between TE Products Pipeline  Company, Limited Partnership and The Bank of New York, as Trustee, dated as  of January 27, 1998 (Filed as Exhibit 4.3 to TE Products Pipeline Company,  Limited Partnership’s Registration Statement on Form S-3 (Commission File No.  333-38473) and incorporated herein by reference).                                                                                                                                                                   |
| 4.3                 |       | Form of Certificate representing Class B Units (Filed  as Exhibit 4.3 to Form 10-K of TEPPCO Partners, L.P. (Commission File No.  1-10403) for the year ended December 31, 1998 and incorporated herein by  reference).                                                                                                                                                                                                                                                                                          |
| 4.4                 |       | Form of Indenture between TEPPCO Partners, L.P., as  issuer, TE Products Pipeline Company, Limited Partnership, TCTM, L.P., TEPPCO  Midstream Companies, L.P. and Jonah Gas Gathering Company, as subsidiary  guarantors, and First Union National Bank, NA, as trustee, dated as of  February 20, 2002 (Filed as Exhibit 99.2 to Form 8-K of TEPPCO Partners, L.P.  (Commission File No. 1-10403) dated as of February 20, 2002 and incorporated  herein by reference).                                         |
| 4.5                 |       | First Supplemental Indenture between TEPPCO Partners,  L.P., as issuer, TE Products Pipeline Company, Limited Partnership, TCTM,  L.P., TEPPCO Midstream Companies, L.P. and Jonah Gas Gathering Company, as  subsidiary guarantors, and First Union National Bank, NA, as trustee, dated  as of February 20, 2002 (Filed as Exhibit 99.3 to Form 8-K of TEPPCO  Partners, L.P. (Commission File No. 1-10403) dated as of February 20, 2002  and incorporated herein by reference).                              |
| 4.6                 |       | Second Supplemental Indenture, dated as of June 27,  2002, among TEPPCO Partners, L.P., as issuer, TE Products Pipeline Company,  Limited Partnership, TCTM, L.P., TEPPCO Midstream Companies, L.P., and Jonah  Gas Gathering Company, as Initial Subsidiary Guarantors, and Val Verde Gas  Gathering Company, L.P., as New Subsidiary Guarantor, and Wachovia Bank,  National Association, formerly known as First Union National Bank, as trustee  (Filed as Exhibit 4.6 to Form 10-Q of TEPPCO Partners, L.P. |

 

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|   |   | (Commission File No. 1-10403) for the quarter ended  June 30, 2002 and incorporated herein by reference).                                                                                                                                                                                                                                                                                                                                                                                                                           |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.7    |   | Third Supplemental Indenture among TEPPCO Partners,  L.P. as issuer, TE Products Pipeline Company, Limited Partnership, TCTM,  L.P., TEPPCO Midstream Companies, L.P., Jonah Gas Gathering Company and Val  Verde Gas Gathering Company, L.P. as Subsidiary Guarantors, and Wachovia  Bank, National Association, as trustee, dated as of January 30, 2003 (Filed  as Exhibit 4.7 to Form 10-K of TEPPCO Partners, L.P. (Commission File No.  1-10403) for the year ended December 31, 2002 and incorporated herein by  reference). |
| 10.1   |   | Amended and Restated Credit Agreement among TEPPCO  Partners, L.P., as Borrower, SunTrust Bank, as Administrative Agent and LC  Issuing Bank and The Lenders Party Hereto, as Lenders dated as of October 21,  2004 ($600,000,000 Revolving Facility) (Filed as Exhibit 99.1 to Form 8-K of  TEPPCO Partners, L.P. (Commission File No. 1-10403) dated as of October 21,  2004 and incorporated herein by reference).                                                                                                               |
| 12.1*  |   | Statement of Computation of Ratio of Earnings to  Fixed Charges.                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 31.1*  |   | Certification of Chief Executive Officer Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 31.2*  |   | Certification of Chief Financial Officer Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 32.1** |   | Certification of Chief Executive Officer Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 32.2** |   | Certification of Chief Financial Officer Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                |

 

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* Filed herewith.

** Furnished herewith pursuant to Item601(b)-(32) of Regulation S-K.

 

 

**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                   |                                    | TEPPCO Partners, L.P.                 |   |
|------------------------|-----------------------------------------|---------------------------------------|--------|
|                   |                                    | (Registrant)                          |   |
|                   |                                    | (A Delaware Limited Partnership)      |   |
|                   |                                    |                                  |   |
|                   | By:                                     | Texas Eastern Products Pipeline       |   |
|                   |  Company, LLC,  as General Partner |                                  |
|                   |                                    |                                  |   |
|                   | By:                                     | /s/ BARRY R. PEARL                    |   |   |
|                   |                                    | Barry R. Pearl,                       |   |
|                   |                                    | President and Chief Executive Officer |   |
|                   |                                    |                                  |   |
|                   | By:                                     | /s/ CHARLES H. LEONARD                |   |   |
|                   |                                    | Charles H. Leonard,                   |   |
|                   |                                    | Senior Vice President and Chief       |   |
|                   |                                    | Financial Officer                     |   |
| Date: November 1, 2004 |                                    |                                  |   |
|                        |                                         |                                       |        |  |  |

 

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