I've had no end of trouble with Compaq computers installing operating systems. From what I remember 98SE is looking for additional drivers that are specific to Compaq and they have got to be installed before the operating system is installed. What are the files its looking for?
It might be worth checking the HP web site and download the drivers. click here
One other thought, you are formatting in FAT32 and not FAT16? Probably a silly question, but it has happened.