Like dreams, rumors sometimes come true-and more frequentlythese days when the gossip foretells of yet another energy industryconsolidation. Last week’s buzz became this week’s ballyhoo Mondaywhen El Paso Energy and Sonat Inc. said they will merge in a $6billion deal.

The transaction includes $2 billion in Sonat debt and isexpected to be completed in the second half of the year. Each Sonatshare is to be converted into one share of El Paso in a pooling ofinterests to create a combined company worth more than $14 billionbased on El Paso’s Friday closing price. Sonat shareholders wouldown 48% of the new company.

According to the companies, the joining of El Paso and Sonatwould unseat top players as measured by two industry yardsticks. ElPaso-Sonat’s 40,600 miles of interstate pipe would surpass Enron’s32,000 miles, and El Paso-Sonat’s 12.4 Bcf/d of interstatetransport volumes would better Williams and the stand-alone ElPaso, both of which transport 9.2 Bcf/d. The combined company wouldrank No. 3 in gas marketing, behind Enron and Duke Energy, and No.4 in power marketing, behind Enron, Duke, and Coastal.

“The merger between El Paso and Sonat will create the preeminentnatural gas company in North America,” said El Paso CEO William A.Wise. “The combined company will rank among the leaders in all keysectors of our industry including interstate transmission,intrastate transmission, gas gathering and processing, energymarketing and power development.”

Wise will head the combined company, which will retain the ElPaso name. One industry observer said he thinks it was Wise’sdesire to remain top dog that quashed a rumored El Paso pairingwith Southern Co. Still, the observer did not rule out thepotential for El Paso to pair with an electric company down theroad.

El Paso-Sonat’s interstate pipeline systems would stretch fromBakersfield to Birmingham and Brownsville to Boston. “They will tapthe most prolific supply basins in North America and access thelargest and fastest growing natural gas markets in the UnitedStates, including Florida and other key southeastern states,” Wisesaid. “New gas-fueled power generation development is particularlyactive in these areas. Our ability to access these new markets willfurther diversify our market base and allow us to employ ourcombined expertise in energy marketing and power generation.”

Wise also highlighted the Sonat E&P assets his company wouldacquire and the opportunities they would provide for El Paso FieldServices. In a conference call, Wise pledged to maintain E&Poperations as a “strategic asset,” not a “growth engine.” Sonat’sproduction is seen by El Paso as ripe for powering gas-firedelectric generation. The combined company would control about 4,000MW of generation, and there are plans in the next two to threeyears to develop 7,000 to 8,000 MW more. Some analysts scoffed atthe idea of merely maintaining an E&P business, saying it’seither a growth or depletion business. One noted Sonat produces farmore gas than a combined El Paso-Sonat would need to fire its powerplants.

“Sonat Exploration has a substantial oil and gas exploration andproduction base that spans the southern United States from Texas toAlabama, including an important presence in the Gulf of Mexico,”Wise said. “Our onshore gathering and processing facilities andLeviathan Gas Pipeline’s offshore gathering operations will provideSonat Exploration’s existing 1.6 Tcf of natural gas equivalentreserves access to burgeoning power generation markets and the bestinterstate pipeline network in the U.S.”

El Paso-Sonat would hedge a large portion of its production.”[El Paso] is acquiring the E&P program at near $1.00 per Mcfafter it has been fully restructured over the past year.Nevertheless, we would not rule out a divestment at some point,”PaineWebber said in a research note. As the merger would be apooling of interests, El Paso would be constrained by Securitiesand Exchange regulations affecting the amount of combined companyassets it could sell initially.

Analysts considering an El Paso-Sonat pairing generally didn’tsee a deal as being non-dilutive to earnings, one of El Paso’sstated criteria for acquisitions. That thinking has changed.PaineWebber analyst Ron Barone, in a research note, said threefactors cause him to believe the deal will be accretive in 2000.They are cost savings and synergies, a lower depreciation,depletion and amortization rate per unit of production at Sonatafter a ceiling test write-down, and lower benefits plan expensesat El Paso. PaineWebber raised its 2000 earnings per share estimatefor El Paso to $2.40 from $2.35 and retained its 1999 estimate of$2.10/share. El Paso said it expects earnings accretion of about 3%in 2000.

The combined company will be headquartered in Houston. Sonat iscurrently headquartered in Birmingham, AL, and the headquarters ofSonat’s interstate pipeline, Southern Natural Gas Co., will remainin Birmingham. Sonat CEO Ronald L. Kuehn Jr. will become thenon-executive chairman of the board for the combined company untilDec. 31, 2000. The board will consist of 15 directors-ninedesignated by El Paso and six by Sonat. The merger is subject tocustomary conditions, including approval by the stockholders ofSonat and receipt of certain required governmental approvals.

To assure Sonat stockholders the deal will be completed, El Pasoagreed that if El Paso stockholder approval for the common issuancewere not obtained, El Paso would issue 19.9% of its outstandingcommon stock as merger consideration, with the balance of theconsideration paid in non-convertible, long-term preferred stock.This arrangement, which is not expected to come to pass, is similarto a provision in El Paso’s acquisition of Tenneco Energy threeyears ago.

The merger agreement includes customary non-solicitation,termination fee and expense reimbursement provisions. In addition,each of the companies granted the other an option to buy up to19.9% of its outstanding common stock, exercisable if the merger isterminated under certain circumstances. Members of the Zilkhafamily, who own about 21% of the outstanding Sonat shares, agreedto vote for the merger. Donaldson, Lufkin and Jenrette Securitiesis El Paso’s financial advisor, and Merrill Lynch is advisingSonat.

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