July 2012, Vol. 239 No. 7

Features

Kinder Morgan, Energy Transfer Become Dominant Players

In recent months the biggest news in the hyperactive midstream energy sector involves the acquisitions of three companies destined to make their buyers kings of the pipeline business for years to come.

We’re talking about Houston-based Kinder Morgan, Inc., led by former Enron chief operating officer Richard Kinder, and Energy Transfer Partners of Dallas, led by Kelcy Warren. Both have spent their careers in the pipeline industry and long ago learned an incontrovertible fact: pipelines make money when they are operated efficiently and safely. And the more that you own and operate, the more money you can make.

Now, Kinder and Warren are in a position to shape much of the U.S. energy industry for years to come, based on their pipelines. Both men are billionaires, thanks to profits they’ve made from pipeline operations. Both of their companies have successfully used a tax-friendly device known as master limited partnerships to encourage investors known as unit holders. The key to keeping those unit holders happy is through continued growth, albeit new construction or buying another’s assets.

On May 25, Kinder Morgan, formed in 1997, completed its $21.1 billion takeover of El Paso Corp. in what has been described as one of the most complex transactions of its type ever attempted. Announced in October 2011, the combination of the two companies makes Kinder Morgan the largest midstream and the fourth-largest energy company (based on combined enterprise value) in North America. The company now controls more than 80,000 miles of pipeline in North America including the 44,000 miles of natural gas pipelines operated by El Paso.

Meanwhile, Energy Transfer Products, formed in 1995, has spent more than $10 billion buying pipeline operators Southern Union Group owned by investor George Lindemann, and Philadelphia-based Sunoco, better known for its refineries and other downstream assets. The Southern Union sale ($5.1 billion) was finalized in April while the final settlement with Sunoco ($5.3 billion) is still pending. Once finalized, Energy Transfer was hold one of the most diverse array of energy assets in the U.S.

Like their buyers, El Paso and Southern Union were also companies that had grown into major players in the natural gas pipeline industry during the past decade.

Today, with regulators keeping a close eye on any new infrastructure projects, i.e. Keystone XL pipeline, savvy cash-rich companies such as Kinder Morgan and Energy Transfer Partners are deciding that – legal and consulting fees aside – it can be a lot quicker to build your company through acquisition rather than new construction.

That’s the thought of Barbara Shirley, managing director in the enterprise risk advisory services group, of EHY Advisors, one of the nation’s largest independent auditing firms that includes a significant energy practice.

Shirley has closely observed the merger activity in the midstream sector and suggests that it the result of several factors, including regulatory issues that have been highlighted with the controversies surrounding TransCanada’s proposed Keystone XL pipeline project.

“These deals are a vehicle for growth as these companies look to expand their existing service areas. It’s a way to expand your business within the current regulatory environment which plays a huge role in the activities that energy companies choose to pursue,” she told P&GJ in an interview.

Companies that are focused on transportation assets have identified an opportunity with natural gas, which despite its extremely low price today, is assuming a role as the fuel of the future.

“So any service that would be related to natural gas such as pipelines would definitely be in high demand in the future as the country looks to phase out coal-fired plants and perhaps some nuclear as well in favor of gas-fueled electricity,” Shirley said.

With an eye on Keystone XL – where a final decision on a required Presidential Permit is expected to be made early next year – Shirley suggested that the federal government seems to have more interest in allowing these types of transactions to go forward as opposed to new construction of these facilities.

“Keystone XL was over three years of planning, preparing, doing due diligence, dotting all the ‘I’s and crossing all the ‘t’s as far as the regulatory environment went and it was still denied. So at least for right now, this is an easier way to grow your business,” she said. “Acquisition is a much faster process and you can recognize almost immediate results as opposed to a three-year period of approval process and then you still have to construct the facilities,” she said.

Expect more such deals in the future unless regulatory conditions change, Shirley added, as cash-rich companies may decide that it’s in their own best interests to do the acquiring and grow their companies that way, or risk being taking over themselves.

Today’s new energy environment is being driven by the midstream sector, which in past years would have essentially been a crude oil, natural gas or liquids pipeline. Out of necessity that definition of what a midstream company really is has expanded to the point where no two companies are exactly alike. That is being driven by the so-called shale revolution and other technological advances, but the Federal Energy Regulatory Commission also provides a specific overarching reason as to what can and cannot be done as a midstream company, Shirley said.

“The fact is that anything new has to go through this approval process. The competition therefore is somewhat limited. If you want to build a pipeline that served some of the same markets that Kinder Morgan/El Paso now does, the way the regulations are set up it restricts that unless you can prove the that there is demand for your service and there would be a reason to construct an additional pipeline. Again, the regulatory environment has an impact on what’s happening in the midstream business. With Keystone XL they proved there was a market and it was still denied.”

For Kinder Morgan and Energy Transfer, their latest acquisitions makes them much bigger players and enables them to assume more of a leadership role within the industry. As a vehicle for growth, it also lends itself to increased earnings and distributions for unit holders.

“Unit holders obviously expect a certain return on their investment and in order to continue to grow that return you would have to expand. That is a very important factor in influencing these deals,” Shirley added.

Both companies in the short term will have to iron out various operational challenges resulting from a melding of disparate systems, practices and processes.

“In the long term, it serves to be more efficient because there are obviously economies of scale. Once you get through the initial melding together of the cultures there are a lot of synergies to be gained,” she said.

Energy Transfer’s deal for Southern Union marks an effort to gain access to new markets in Florida and the U.S. Midwest. The Sunoco bid was a surprise to some because its Northeast geographic position doesn’t seem to fit Energy Transfer’s profile; however, with natural gas prices near historic lows, Energy Transfer is moving to diversify its holdings by adding more liquids to its portfolio. Growing your business within a set strategy can always create a good fit, Shirley said.

Kinder Morgan is now moving into the El Paso building at 1001 Louisiana which was once the headquarters of Tenneco Energy, an El Paso acquisition in 1997 that was followed by purchases of Southern Natural Gas (SONAT) and Coastal Corp. Some of the space will be subleased to EP Energy and a yet-to-be-named tenant. A Kinder Morgan spokesman said they will have about 1,700 employees in the building when the move is completed, likely in the first quarter of 2013.

On the first day the combined company, there were more than 11,250 full time employees, which represents approximately 95% of the total employees that EP and KM had when the deal was announced last October.  

“I’m very pleased with the herculean effort that has occurred over the past several months to combine Kinder Morgan and El Paso,” Kinder, 66, who is chairman and CEO of the combined company, said in a news release.

“The integration planning effort was managed and fully staffed by personnel from the two organizations, ensuring that the people who understand best how to operate these assets are establishing how they will be managed moving forward. This has required a tremendous amount of work by a large number of people who are still responsible for their normal jobs. The value of their contributions will be realized by the combined organization for many years to come.”

Kinder Morgan anticipates cost savings in excess of $400 million per year, significantly higher than the previously announced projection of approximately $350 million per year. These cost savings will benefit KMI, Kinder Morgan Energy Partners, L.P. and El Paso Pipeline Partners, L.P.

As previously announced, KMI will divest certain KMP assets needed to obtain Federal Trade Commission approval for the El Paso transaction. KMI has agreed to sell Kinder Morgan Interstate Gas Transmission, Trailblazer Pipeline Company, its Casper-Douglas natural gas processing and West Frenchie Draw treating facilities in Wyoming, and the company’s 50% interest in the Rockies Express Pipeline. The company has six months from the commission’s May 1 order to sell the assets.

In conjunction with the takeover, EP Energy, a leading North American oil and gas producer, announced the completion of its sale to investment funds affiliated with Apollo Global Management, LLC. along with Riverstone Holdings LLC, Access Industries, Inc., Korea National Oil Corporation and other investors, for approximately $7.15 billion. Almost the entire proceeds from the sale will be go to reduce substantially the debt incurred by KMI to fund the cash portion of its purchase of El Paso.

EP Energy has a diverse asset base, a significant reserve base, and large positions in four key development programs. The company’s operations include programs in the Eagle Ford Shale, an Altamont multipay oil program in the Uintah basin in Utah, a Wolfcamp shale oil program, and a natural gas program in the Haynesville Shale. During the first quarter, the company’s production volumes rose 11% and its oil and condensate production rose 66% from the same period last year.

EP Energy has more than 1,100 employees on and across its operating areas, which are primarily focused on onshore unconventional oil and gas plays in the southern and western United States. Other than its pipelines, the E&P unit was the only division of El Paso Corporation left after it was forced to divest many of its non-essential holdings following the corporation’s financial meltdown that led to a complete reorganization under CEO Doug Foshee several years ago.