El Paso (EP)

Houston, Texas-based El Paso Corporation (EP) is a major player in both the natural gas transmission and exploration and production businesses within the energy space. The company has organized its operations around regulated and non-regulated businesses.

El Paso's regulated business primarily consists of 42,000 + miles of interstate natural gas pipeline system, the largest in the country. The pipeline assets have been organized into three groups: Southern Pipelines (includes a 93% interest in Southern Natural Gas, 50% interest in Florida Gas Transmission, and the Elba Island and 50% owned Gulf LNG terminals), Western Pipelines (includes El Paso Natural Gas, a 89% interest in Colorado Interstate Gas, a 73% interest in Wyoming Interstate, Cheyenne Plains Pipeline, and Mojave Pipeline), and the Eastern Pipelines (includes the Tennessee Gas Pipeline). In 2007 the company sold its ANR Pipeline, Great Lakes Gas Transmission stake and a few other related assets for approximately $3.7 billion. The pipeline segment's current backlog totals $8 billion dollars, the largest backlog in its industry.

El Paso's non-regulated businesses consist principally of its E&P segment. The marketing and power businesses generate little cash flow and are in the process of being sold (power segment assets) or operate for the sole purpose to hedge/mitigate commodity price volatility in relationship to the E&P segment. The 2.8 Tcfe of proved reserves makes El Paso E&P among the top 10 independent domestic producers (.2 Tcfe of proved reserves comes from its 49% interest in Four Star Oil & Gas Company). After adjusting for the People s Energy and Production company acquisition and the divested GOM and TGC assets, 86% of El Paso s productive assets are onshore U.S. and 69% of its proved reserves are classified as proved developed. Its E&P operations are organized into five geographic regions Texas Gulf Coast, Gulf of Mexico (includes South Louisiana), Onshore (includes North Louisiana, ArkLaTex and the Rockies), Brazil and Egypt. In order to high grade its productive portfolio, in Q1 '08 the company divested its GOM and Texas Gulf Coast mature assets for $752 MM. The company used the sale proceeds to pay down debt, which has been decreased by roughly 40% in the last four years.

Today's El Paso is not what it was a few years ago. Though the company is still a diversified natural gas player, with the most extensive set of natural gas pipelines owned by any player, it is not the merchant energy up and comer that it once was. A few years ago, just before the merchant energy crash, the company was an energy favorite. Aggressively building off of its extensive set of pipelines, it was vigorously constructing its E&P portfolio, merchant power portfolio, and a marketing and trading organization. While pursuing aggressive growth plans, the company increasingly took on debt. Fortunately for El Paso s management, its fate turned out to be different from some of the other more aggressive energy players of the time such as Enron, Mirant, and the old NRG. This is primarily due to the fact that El Paso had the good fortune of having a much more significant base of pipeline, field services, and E&P assets to fall back on.

However, the fall from grace has not been painless for management and equity holders. Since 2001, the stock price has dropped from almost $80 per share to the $13-$21 range. A new management team that came onboard in September 2003 shifted focus from growth to maximizing asset sales, debt retirement, improving liquidity, and restoring shareholder confidence. Significant progress has since been made. The number of businesses that the company operates in has been pared down from more than 10 in 2003 to the current level of essentially two, being pipelines and exploration and production. In the process, the company has divested a significant portion of its assets and reduced its net debt balance from $20.5 billion at the end of 2003 to $12.5 billion currently.

INVESTMENT THESIS

Our positive sentiment toward El Paso Corporation is based on:

Its industry leading pipeline infrastructure and $8 billion dollar multi-year project backlog

The high grading of its E&P assets and its large inventory of growth projects

Managements commitment to maximizing shareholder value

The pullback in EP's stock price

El Paso is the largest pipeline operator in the United States wholly owning or having a majority ownership interest in some of the largest, most active pipelines in the United States. Its pipeline network transports for more than 25% of daily U.S. throughput volume. After divesting its ANR pipeline in late 2006, the company used its proceeds to pay down debt and increased its pipeline operations to investment grade status. This allowed the company to grow its pipeline segment as project financing and commitments from utilities became easier to obtain.

The picture below depicts El Paso's pipeline infrastructure. These assets are located in close proximity to major consuming markets as well as regions where exploration and production of hydrocarbons is very active or increasing. This benefits the company on both the demand and supply front. The green circles represent areas in the continental U.S. where natural gas/electricity demand is the greatest. These areas are the most heavily populated regions in the United States as well. The northeast, southeast and western united states are all targets for continued growth in throughput capacity. El Paso has an industry leading $8 billion dollars of backlog projects, which will help it maintain steady long term throughput growth. The Ruby Pipeline, TGP Line 300, FGT Phase VIII and CIG High Plains projects will give EP 3.3 Bcf of additional throughput capacity. These and other projects in the company's backlog will help grow EBIT (earnings before interest and taxes) around 10% through 2013, a stellar performance for a pipeline operator. Although the company has a vast amount of projects planned, before capital is allocated for a pipeline expansion, nearly 100% of the throughput volumes are contracted out under long-term agreements, which basically guarantee consistent cash flow streams. We estimate that El Paso's backlog represents more than $1 billion of EBITDA.

On the supply side, the purple stars indicate areas where natural exploration and production is greatest or experiencing significant growth. From west to east, the Rockies region is filled with big name E&P players looking to tap the productive potential in the Powder River, Green River and Washakie Basins. In north, east and west Texas production and drilling activity has picked up significantly in recent years. The Permian Basin (west), Panhandle of Texas (north) and the eastern border between Arkansas and Louisiana (ArkLaTex) have become some of the hottest places to drill. The Haynesville and Barnett Shales are believed to have some of the largest gas deposits in the U.S. Heavy drilling and production in the Gulf of Mexico and in the northeast U.S. is also very prevalent.

Additionally in these regions, the use of unconventional (coalbed methane, tight gas, shale) drilling practices have become increasingly popular with the implementation of horizontal drilling. These advanced drilling techniques allow producers to recover more reserves in place than they were previously able to. Because more value is found in larger reserves and production rates, producers have accepted and use horizontal drilling rigs. This is evident by the picture below which depicts U.S. horizontal rig counts as a percentage of total drilling rigs. As more gas is produced at an increasing rate, this will allow El Paso to maximize its assets by not only increasing throughput capacity utilization but also by expanding existing infrastructure or building new pipelines.

Source: Schlumberger Ltd. Data

The exploration and production business segment of El Paso has improved its operations significantly since 2006 with its current business model of divesting assets which don't coincide with the company's core competencies or lack repeatability of drilling projects. The recent divestiture of 310 Bcfe of legacy assets in the higher risk Gulf of Mexico and Texas Gulf Coast and acquisition of Peoples Energy have helped solidify its operational strategy, focusing on lower risk, and more predictable onshore drilling these actions increased its onshore and low risk drilling as a percentage of total reserves from 65% to 86%. In addition to providing increased operational visibility, this strategy lowers El Paso's unit operating costs and increases profitability. Already a lower cost operator, this strategic move solidified the company's competitive edge.

El Paso's onshore future looks solid, with a large inventory of long-lived reserves as well as near term production growth and cash flow from plays in the ArkLaTex, south Texas and Texas Gulf Coast regions. The lower risk onshore unit of El Paso E&P focuses on conventional and unconventional gas in the western and south central United States, with an average production weighted reserve to production ratio of 10 years. In the medium risk south Texas and Texas Gulf Coast operating areas, production growth and near term cash flow generation will provide added upside to shareholders as these projects are repeatable and the wells drilled in these areas have historically high initial production rates. A significant value-add and likely source of proved reserves and increased production lies within its non-proved and unrisked projects. In particular, there are four onshore plays that look to contribute more than 4 Tcfe of reserve and production potential. In the Raton Basin, EP will likely begin downspace drilling from 160 to 80 acres between wells. This could add around 500 additional well locations which translate into roughly 250 Bcfe of additional low risk, low cost reserves. Slightly below the coalbed methane of the Raton is the Niobrara shale, which is another low risk exploration program that EP is currently undertaking. Three wells have been drilled with initial flow rates of roughly 1 MMcfe/d. Based on the 300,000 net acres of potential development the Niobrara could give EP around 2 Tcfe of reserves. Similar to the infill own downspace drilling that will be performed in the Raton Basin, the Altamont-Bluebell project will too likely begin infill drilling, reducing per well spacing from 320 to 160 acres. This could provide the company with approximately 200 additional gross well locations, potentially giving El Paso 180 Bcfe of reserves. Both the Altamont, Niobrara and Raton Basin CBM projects hold significant reserve potential with relatively no exploratory risk. Lastly, but probably holding the most significant resource potential is the Haynesville Shale, part of the ArkLaTex production region. While the potential from the Haynesville is not reflected in the company s 2P & 3P reserves, this shale could hold well over 2 Tcfe of reserve potential based on an approximate 400 well program. It is important to note that our estimates for reserve potential use conservative estimated ultimate recovery (EUR) figures as well as well spacing estimates. The exploration and production segment is forecasted to grow production between 8% - 12% over the next three to four years. This coupled with favorable pricing for its hedged production should lead to higher margins and earnings growth and will offer investors continued strength in the near term.

Other potential near term upside will come from El Paso's international exposure, specifically in Brazil. The company will invest $325 MM per year for three years exploring and developing acreage with working interests ranging from 20% - 100%. The company's 24% working interest with Petroleo Brasileiro's (NYSE: PBR) Bia/Camarupim project should see first production in Q1 2009. With four wells scheduled to be on production by Q1 '09, EP will enjoy more than 35 MMcf/d of net production. The company's other Brazilian project, which it has 100% working interest in, is the Pinauna developmental project. This oil producing area will give the company peak production rates of between 15-20 MBOE/d. These two plays combined give the company more than 500 Bcfe of reserve potential that will provide the company with an avenue for growth that the market has most likely not priced in.

Since new management took control of El Paso in 2003, the company has been actively pursuing ways to maximize shareholder value. El Paso management has been divesting assets and building a strong, more focused operation. Now essentially operating solely in the pipeline and E&P space, El Paso has managed to decrease total debt by nearly 40% and increase its share price by more than 100% since 2003. In both segments divesting more risky, less predictable assets and acquiring assets congruent with company strengths, management has regained investment grade status on its pipeline business and has created one of the top independent E&P operators in the industry. For example, on the E&P side, acquiring Peoples Energy helped not only decrease unit operating costs, but helped expand and complement El Paso's footprint into areas of high growth and historic company operating strengths. The company has also locked in favorable oil and gas prices for 2009, hedging approximately 50% of estimated yearly production. In the volatile commodities markets of today locking in gas production with floors of around $9.00 per Mmbtu and oil production close to $100 per barrel the company has ensured higher revenue and margins while mitigating the volatility of its cash flows. In late 2007, the company formed El Paso Pipeline Partners (NYSE: EPB), an MLP formed with drop down assets from existing EP pipeline infrastructure. This helped maximize pipeline assets as the MLP received a premium market valuation. Recently increasing its limited partner interest in EPB from 65% to 73%, EP will continue to benefit from not only a premium priced assets available for sale, but from the tax advantageous cash distributions from the MLP. Management's ability to maximize asset returns, strengthen its balance sheet and create internal liquidity offers investors security that should help its stock price trade at a premium relative to its peers.

Since its early July highs, crude oil has pulled back more than 30% on fears of a global slowdown. This has had the effect of hurting the entire energy sector as most E&P players and other producers of fossil fuels have seen their stock price lose 25% - 30% or more. However as the case for most companies in the energy space, fundamentals have not changed. Additionally the high prices of mid 2008 were not taken into consideration in our valuation model as we felt that those prices were unsustainable in the near term and oil and gas were due for a pullback. As a result our recommendation and price targets have remained relatively unchanged. El Paso is the leader in the pipeline transportation industry and a leading E&P player as well. It has a solid backlog of pipeline projects and an equally strong inventory of drilling to enable it to grow its operating income, cash flow and earnings through 2012. The more than 33% pullback in El Paso's stock price is unjustified and represents a buying opportunity at current levels.

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