Kinder Morgan Inc. (KMI) and El Paso Corp. have agreed to a friendly, $38 billion buyout of the latter to create North America's largest pipeline company worth about $94 billion. The purchase price is $21.1 billion before the assumption of debt. The combined company would have 80,000 miles of pipelines and its feet firmly planted in both oil and natural gas.

El Paso shares closed up nearly 25% Monday at $24.45 on trading volume that was more than eight times the norm. KMI shares closed up more than 5% at $28.24 on volume that was about nine times the norm.

When including master limited partnerships (MLP) Kinder Morgan Energy Partners LP (KMP) and El Paso Pipeline Partners LP (EPB), the combined KMI and El Paso would be the:

But the spotlight of the deal's rationale is on natural gas, particularly that from shale plays.

"We believe that natural gas is going to play an increasingly integral role in North America," said KMI CEO Richard D. Kinder. "With the recent development of shale resources, there are now abundant domestic supplies of natural gas, which are being used increasingly to generate electricity and are environmentally friendly. If America is serious about reducing carbon emissions to benefit the environment, and reducing its dependence on foreign oil, natural gas is absolutely the best readily available option."

Action in the shale patch has been heating up for years, and more recently the heat has been on in the midstream sector. Research by Bentek Energy LLC shows that the industry is in the midst of a shale-driven natural gas liquids investment cycle with an oil infrastructure investment cycle expected to follow (see Daily GPI, Sept. 29).

Becca Followill of U.S. Capital Advisors nodded to the recent bidding war for Southern Union Co. (see Daily GPI, Oct. 13), citing an estimated price of 10.5 times earnings before interest, taxes, depreciation and amortization (EBITDA) and the same 10.5 multiple for El Paso. "Midstream infrastructure is hot," she wrote Monday. The merger "goes to what is now almost complete consensus that gas is going to be cheap for a while, so find a way to play beneficiaries."

Analysts said it seemed unlikely that another company could step in and top KMI's offer. Kinder told financial analysts Monday he went to El Paso CEO Doug Foshee "on bended knee" with his proposal to acquire the company. "We believe that the deal has a high probability of being consummated..." wrote analysts at Tudor, Pickering Holt & Co. (TPH).

Kinder said he did not think the El Paso acquisition would run into antitrust trouble but the company would work with the Federal Trade Commission (FTC) to address any asset redundancies between the two companies. Followill said antitrust concerns were minimal and the most likely asset to raise antitrust concerns is Kinder Morgan Interstate Gas Transmission (KMIGT) in the Rockies.

The merged colossus would control major pipelines into most U.S. regions, more than any one company since Enron after it acquired systems running from coast to coast and border to border. Kinder started out as a partner of Enron CEO Ken Lay before splitting off and forming his own company. He is ranked as the 46th richest person in America by Forbes magazine.

El Paso assets include Tennessee Gas Pipeline, Elba Express Pipeline, Elba Island LNG, Florida Gas Transmission (50%), Gulf LNG (50%), Southern Natural Gas, Cheyenne Plains Pipeline, Wyoming Interstate, Colorado Interstate Gas, Mojave Pipeline, El Paso Natural Gas, and Ruby Pipeline (50%). El Paso and EPB have 43,100 miles of gas pipelines; combined with KMI and KMP's 23,600 miles the combined company would have 66,702 miles of gas pipelines.

Tennessee Gas Pipeline, traditionally a supply line from the Gulf Coast to the Northeast, has been given new life as a supply area pipeline in the Marcellus Shale. Tennessee's Line 300 has been overrun this year as Marcellus producers crowd the line trying to get to market (see Daily GPI, Sept. 7). The company's recently completed Ruby Pipeline is the third of five major pipeline projects El Paso said it expect to complete this year (see Daily GPI, Aug. 5).

Gas nominated for delivery Monday on El Paso pipelines at 31,480,101 Dth was slightly more than double the 14,273,621 Dth scheduled for delivery on Kinder Morgan pipes, according to NGI's reading of pipeline electronic bulletin boards. The largest spaghetti tangle of pipelines controlled by the two companies covers the Rockies and the Midcontinent and includes KMIGT, Trailblazer, TransColorado and Rockies Express.

El Paso had struggled for years to improve its share price. It was burdened by the weight of staggering debt in the wake of the industry meltdown precipitated by the collapse of Enron, according to Natural Gas Intelligence analyst Pat Rau.

But things recently had been looking up for the company following a substantial restructuring effort, said analysts at TPH in light of El Paso's planned spinoff of its exploration and production (E&P) assets. This year "was shaping up to be a good year," they wrote Monday. "We believe that a volatile market always reduces the size of the 'bid-ask spread,' and here, management was willing to hit the bid."

Kinder, who said he would stick with El Paso's plan to jettison its E&P assets, would be chairman and CEO of the combined entity, to be named Kinder Morgan Inc. with headquarters remaining in Houston. Two members of El Paso's board would join the KMI board.

In a presentation to financial analysts Monday to discuss the deal, KMI executives pointed out that this latest deal is "not our first rodeo."

In 1999 KMI acquired KN Energy in what one analyst called the deal of the decade. At the time Lakewood, CO-based KN was the nation's sixth largest integrated gas company with more than $8 billion in assets and one of the largest pipeline operators with more than 25,000 miles of pipe (see Daily GPI, July 12, 1999).

Then in 2005 KMI bought British Columbia gas utility Terasen for $3.1 billion in cash with $2.5 billion in assumed debt (see Daily GPI, Aug. 2, 2005).

And in May 2007 KMI went private in a $15 billion management buyout (see Daily GPI, May 31, 2007) after selling its U.S. natural gas retail distribution and related operations to GE Energy Financial Services and Alinda Investments LLC for $710 million plus working capital (see Daily GPI, Aug. 15, 2006).

But then last February KMI was a public company again in a move that raised well over $2 billion and gave it the deep pockets to pursue a quarry such as El Paso (see Daily GPI, Feb. 4). By bolting on the El Paso assets, KMI would gain a host of pipelines to drop down to KMP, which has grown so large that it has become hard to move the needle on unitholder distributions. Followill told NGI KMI would wind up with about four years' worth of drop-downs by acquiring the El Paso assets.

In the deal El Paso shareholders would get $26.87/share based on KMI's closing price last Friday. This is a 47% premium to the 20-day average of El Paso shares and a 37% premium to Friday's closing price. The offer is composed of $14.65 in cash, 0.4187 KMI shares (valued at $11.26 per El Paso share) and 0.640 KMI warrants (valued at $0.96 per El Paso share).

"This once in a lifetime transaction is a win-win opportunity for both companies," said Kinder. "The El Paso assets are primarily regulated interstate natural gas pipelines that produce substantial, stable cash flow and have access to key supply regions and major consuming markets. The natural gas pipeline systems of the two companies are very complementary as they primarily serve different supply sources and markets in the United States."

Because of this, shareholders would begin making money from the union upon closing, Kinder said. The transaction is expected to close in the second quarter subject to regulatory approvals. Cost savings from the tie-up are expected to be about $350 million per year, or about 5% of the combined systems' EBITDA.

"...[W]e believe that our agreement with Kinder Morgan will provide even greater value for our shareholders than we expected through the planned spinoff of our exploration and production business," said Foshee. "We are very pleased to become a significant part of this combined enterprise and offer our shareholders the opportunity to participate in what we believe will be North America's preeminent infrastructure company."

In May El Paso said it would spin off its E&P business by the end of this year to leave it with its pipeline group, midstream group and its general and limited partner interests in EPB (see Daily GPI, May 25). On Sunday KMI said once El Paso is acquired to become a KMI subsidiary, the parent would sell the El Paso E&P assets.

"...El Paso owns high-quality Eagle Ford, Haynesville, Altamont and Wolfcamp acreage that many players in each basin would covet," TPH said. TPH gave the E&P assets a gross value of $9.2 billion. Morningstar analyst Jason Stevens said the assets are worth about $10 billion.

El Paso's "net operating loss carry forwards will offset taxes associated with this sale and the resulting cash raised will substantially reduce the debt borrowed to fund the cash portion of the transaction," the company said. "KMI also intends to sell (drop down) all of [El Paso's] natural gas pipeline assets to KMP and EPB over the next few years."

This plan is expected by TPH to get a pass from credit ratings agencies, which it said have become familiar with drop-down plays. Ratings agencies "understand that KMI is not the intended long-term home for El Paso's assets and that the short-term increases in leverage will give way to lower, longer-term ratios at KMI."

If the deal closes at the beginning of next year and factoring in expected growth, KMI would expect to pay a dividend of about $1.45/share in 2012, up from its current annual rate of $1.20/share, the company said. KMI said with the deal it expects to grow its dividend at an average annual rate of about 12.5% from its budgeted 2011 dividend per share of $1.16 through 2015, which is higher than KMI's previously announced 10% average annual dividend growth rate expectation.

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