El Paso Corp. last week said it is taking its rebuilt exploration and production (E&P) business for a spin as a publicly traded company by the end of the year.

Once the proposed spinoff is completed, El Paso Corp. would be composed of El Paso’s Pipeline Group, its Midstream Group and its general and limited partner interests in El Paso Pipeline Partners LP.

The news last Tuesday set the corporation’s share price jumping almost 7%, and the gains held through the week. Friday morning the stock price was hovering at around $20.80. Energy analysts also gave a collective thumb’s up to the news, noting the company’s successful turnaround after nearly flaming out in the aftermath of Enron Corp.’s demise 10 years ago.

“This is a big deal for us,” Foshee told analysts during a conference call. He told analysts that jettisoning the E&P operations would give the corporation running room to focus exclusively on its domestic natural gas pipeline business, which is the largest interstate system in the country, as well as midstream operations and the limited partner stakes it holds in El Paso Pipeline Partners LP.

With the balance sheet improving at a faster clip than expected and an $8 billion pipeline construction backlog scheduled to be completed this year, now seemed to be the right time to announce the plan, he added.

The spinoff didn’t come as a complete surprise, but its timing was perhaps six months ahead of most analysts’ expectations. Foshee has talked publicly of restructuring El Paso for the past three years and has hinted previously that splitting off the E&P business would increase shareholder value (see NGI, Jan. 31). However, the company had been expected to wait until at least 2012, when it was thought it would be able to regain an investment-grade rating.

The corporation should be able to achieve an “investment-grade balance sheet” by the time of the spinoff, Foshee said. Shareholders also have been restless about El Paso’s inability to build value; earlier this month Jana Partners LLC, a hedge fund that has been instrumental in breaking up companies, confirmed that it had purchased more than 4% of El Paso stock.

Regardless of the timing, the news is a positive, said energy analysts. The announcement by El Paso [EP] is “an exclamation to its post-Enron comeback,” said BMO Capital Markets analysts.

“While this is an announcement that comes six months earlier than we were expecting, strategically it’s square on target, and it’s why we’ve fundamentally viewed this name on a sum-of-the-parts basis,” said BMO Capital Markets analyst Carl Kirst and his team. “Importantly, EP is opening a new chapter in its history, and this one should usher in an investment-grade infrastructure name that will be the purest-play natural gas pipeline company (read high-quality assets and cash flow stability) with a 60 cent dividend (2012) and a targeted dividend [compounded average growth rate] over 10%, arguably the highest in the group.”

El Paso’s E&P business today is concentrated in four core programs in the United States that lean toward oil; it also has leaseholds in Egypt and Brazil. The domestic operations fall into one of three divisions, said E&P chief Brent Smolik, who will become CEO of the new company.

Smolik, formerly president of ConocoPhillips Canada, took over as president of El Paso’s E&P business in November 2006 (see NGI, Oct. 23, 2006).

The stand-alone E&P likely would compare in size to Newfield Exploration Co. or Petrohawk Energy Corp., both onshore shale players, Foshee told analysts. However, the “most visible indicators” of the company’s E&P business is the current drilling inventory, Smolik said. “We have well over 10 years of drilling inventory in just four core programs.”

The core domestic plays and estimated number of future drilling locations are:

“We’re only spending in one gas play,” Smolik said of the Haynesville. “We achieve returns even at current natural gas prices,” or even if they fall below $4/Mcf. In addition, the company still has drilling rights in several small onshore unconventional gas fields that include two coalbed methane (CBM) plays: the Pierre Field in the Raton Basin and the Black Warrior Basin of Alabama.

The gas plays won’t be developed until prices are higher, Smolik explained.

“We’re not investing much today [in the CBM plays], but the acreage is largely held by production. We can keep the options available as gas prices recover.”

Oil prices dictated a move to the unconventional oil holdings, which El Paso was able to obtain over the past few years at pre-hoopla prices. The company first picked up about 40,000 net acres in the gassy Haynesville Shale in 2007, and then took that know-how to the Eagle Ford in late 2009 (see NGI, Nov. 9, 2009).

Less than two months later the Altamont oil field in Utah was added to the portfolio after El Paso snapped up Rockies-based Flying J. Inc. for $103.5 million (see Daily GPI, Dec. 24, 2009). Leasing in the Wolfcamp began in 2010.

Oil will represent about two-thirds of the E&P company’s future value, a plan that has been in place for more than a year, Smolik said. He noted that El Paso ended 2007 weighted about 38% to oil; by the end of 2010 it was 48% oil-weighted.

The E&P business ended 2010 with 8 Tcfe in net risked resources, a huge jump from the end of 2007, when it had about 3.7 Tcfe. About 4.3 Tcfe of the reserves are unconventional, with 2.2 Tcfe considered “conventional, high-risk” reserves, and 1.3 Tcfe classified as proved undeveloped.

As to whether acquisitions are planned, Smolik said the company will “invest in places where we have competency and sell those that don’t work. We’re always looking for new opportunities to add.” But it has to fit within the company’s “culture,” he said, and efficiency is job No. 1. “The new additions must compete with the current inventory.”

To ensure that the E&P business splits from the parent in good fashion, El Paso announced a $300 million increase to its capital spending plan for 2011, which now will total $1.6 billion. Most of the new funds will target onshore shales, and of the shale assets it currently holds, the Eagle Ford will take the bulk of the spending, said Smolik.

The separation is to be completed through a tax-free spinoff, which can be completed in a shorter amount of time — and with a higher benefit to shareholders — than an initial public offering (IPO), Foshee told analysts.

“We analyzed a whole host of transactions,” he said. “We didn’t go with the partial IPO because we didn’t see burdening the company with more debt. We’re highly confident what El Paso Corp.’s cash flow will be going forward.” Still the separation isn’t set in stone; the company noted that the planned separation is subject to “market, regulatory, tax, final approval by the company’s board of directors and other customary conditions.”

Foshee would remain as chairman and CEO of El Paso Corp. and would become the nonexecutive chairman of the E&P company. Dane Whitehead was named CFO of the proposed E&P company.

The proposed spinoff follows one that is under way by Williams, which is similarly structured with U.S. gas pipelines and a domestic E&P business. Later this year Williams plans to launch a partial IPO (see NGI, May 23; Feb. 21). Last year Questar Corp. spun off its E&P unit (see NGI, May 24, 2010). And early this year the board of directors of integrated producer Marathon Oil Corp. voted to separate the upstream and downstream operations into two independent companies (see NGI, Jan. 17).

El Paso’s ability to recreate a successful E&P unit has been an uphill climb. After the gas marketing sector went into meltdown after Enron’s bankruptcy in late 2001, El Paso had to sell off some of its most prized assets to remain viable (see NGI, Aug. 18, 2003.

Foshee, who had been Halliburton’s COO, came aboard in November 2003 and set the company on a path to pay off debt and restructure; the E&P chief resigned shortly thereafter (see NGI, Nov. 17, 2003). In February 2004 the company had to revise its proved reserves downward by 41%, and many analysts thought it was only a matter of time as to when El Paso would dump the exploration business to focus on its substantial gas pipeline and midstream businesses (see NGI, Feb. 23, 2004).

However, the corporation persevered, as did the E&P unit, and by late 2005, with some small but significant acquisitions the makeover was considered nearly complete (see NGI, Sept. 26, 2005).

BMO Capital analysts put a value on the E&P operations at $8/share based on $8.4 billion in enterprise value.

Even though El Paso “has made tremendous strides in high-grading the asset base, inventory and overall execution, we believe it will still take time for pure-play energy investors to get comfortable enough such that the E&P-spin company trades at a notable premium out of the gate,” said the BMO team.

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