In a move that will make it the largest natural gas pipeline transporter in the U.S., Kinder Morgan Inc., Houston, (NYSE: KMI) plans to acquire Houston-based El Paso Corp. (NYSE: EP) for approximately $38 billion and subsequently spin out and sell El Paso’s upstream holdings.

Kinder Morgan chairman and chief executive Richard Kinder called the deal a once-in-a-lifetime transaction. “We believe natural gas is going to play an increasingly integral role in North America,” he says.

Pointing to abundant supplies of natural gas from developing shale resources and anticipated gas-fired power generation, he says, “We are delighted to be able to significantly expand our natural-gas transportation footprint at a time when it seems likely that domestic natural gas supply and demand will grow at attractive rates for years to come.”

Kinder Morgan will pay consideration equal to $26.87 per El Paso share, consisting of $14.65 per share in cash and KMI shares and warrants. The price represents a 37% premium to the closing price on Oct. 14, and a 47% premium to the 20-day average closing price. KMI shareholders will own approximately 68% of the combined companies. Kinder Morgan will assume some $16.7 billion of El Paso debt.

El Paso’s portfolio consists of 43,000 miles of pipeline in the Northeast, Southeast, Rockies and Southwest. Current throughput is 17 billion cubic feet per day, representing 26% of gas delivered to U.S. consumers. Total capacity is 28 Bcf per day.

“The El Paso assets are primarily regulated interstate natural gas pipelines that produce substantial, stable cash flow and have access to key regions and major consuming markets,” says Kinder. The combined systems are complementary, he says, as they primarily serve different supply sources and markets in the U.S.

Together, the companies will have an enterprise value of $94 billion with 80,000 miles of pipeline, making it the fourth-largest U.S. energy company.

El Paso will become a subsidiary to Kinder Morgan, at which time the company plans to sell El Paso’s E&P assets. In May, El Paso announced it planned to spin out the E&P assets into a separate company. The E&P sale proceeds instead will be used to offset assumed debt in the acquisition.

“As far as the game plan is concerned, our intention would be to sell the E&P assets of El Paso as soon as practical. We would anticipate and hope we'll be able to do most of that or maybe all of it contemporaneous with the closing of this merger transaction…We will proceed very expeditiously to drop down all the pipeline assets to the two MLPs -- KMP and EPB,” Kinder said during a conference call to discuss the merger.

He added that such dropdowns are one of the key components of the agreement as Kinder Morgan will have two large MLPs that it can drop assets to, with such dropdowns occurring faster than with one MLP. Kinder said during the conference call that the company may combine these two MLPs in the future should that prove to be beneficial to both companies, but such a move is not in the cards for now.

Raymond James & Associates analyst Darren Horowitz calculates El Paso’s E&P assets will attract $7.5- to $9 billion based on a multiple of 6-7x EBITDA. “Only a handful of companies are able to ante up that kind of capital, primarily large multinational E&P companies.”

Doug Foshee, El Paso chairman, president and chief executive, says, “Our agreement with Kinder Morgan will provide even greater value for our shareholders than we expected through the planned spin-off of our exploration and production business.”

El Paso holds E&P assets in the Eagle Ford and Haynesville shales, the Wolfcamp trend of the Permian Basin, the Altamont region of the Uinta Basin, the South Louisiana Wilcox, as well as international holdings in Egypt and Brazil. Total net risked resource potential is 8 trillion cubic feet equivalent with 3,260 total drilling locations in core operations (48% oil). Production at the end of the third quarter was 823 million cubic feet equivalent per day.

“Our preference [for selling the E&P assets] would be to sell them as a whole. If that’s not the case, if we can realize more by breaking it into pieces, it readily lends itself to that. It has some very good positions in various shale plays, for example, that could be separated out,” Kinder said during the conference call.

The present deal is expected to close in second-quarter 2012 and is subject to a $650-million termination fee. El Paso has agreed to not solicit competing bids.

Evercore Partners and Barclays Capital are financial advisors to Kinder Morgan and provided a fairness opinion. Weil Gotshal & Manges LLP and Bracewell & Guiliani LLP are legal counsel. Morgan Stanley is financial advisor to El Paso and provided a fairness opinion. Goldman Sachs also is financial advisor to El Paso in this transaction and in relation to its previously announced spin-off. Wachtell, Lipton, Rosen & Katz is legal advisor to El Paso.

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