Kinder’s Major Bet on a Boom in Fracking

Then there is Richard D. Kinder, chief executive of Kinder Morgan, who has personally made billions of dollars operating the industry’s equivalent of a toll road: pipelines.

Now, with Kinder Morgan’s $21 billion deal to buy a leading rival, the El Paso Corporation, he is doubling down.

Hydraulic fracturing techniques — despite causing a growing controversy — are creating a once-in-a-generation boom in oil and gas drilling in the United States, and the opportunity to build many more pipelines to carry new supplies to market.

Public concerns about the environmental risks posed by hydraulic fracturing, or fracking, raise the possibility of tough new restrictions, higher costs and even outright bans on new wells in some areas. But companies like Kinder Morgan and its competitors think the need for new energy sources means pipelines are a relatively low-risk way to play the boom.

If they are right, Kinder Morgan will collect new tolls for decades, along with the ones it is already pocketing.

The nation’s 450,000 miles of transport pipelines provide a steady flow of profits, and big players like Kinder Morgan are geographically diversified, diluting the impact of a drilling slowdown in any one region. Transmission rates are set by the Federal Energy Regulatory Commission and do not vary with fluctuating oil and gas prices. A special federal tax break unavailable to most industries bolsters investors’ returns. And before a single mile of a new pipeline is built, the operator typically lines up contracts with oil and gas companies that commit them to use it, guaranteeing revenue in advance.

Fed by such advantages, Kinder Morgan’s pipeline partnership yielded investors a 17.7 percent compound annual return from 2007 to 2010, compared with 3.5 percent for an index of large integrated oil companies, says IHS Herold, a consulting firm.

“Kinder has made a low-return, humdrum business into a river of money,” said Robin West, chief executive of the consulting firm PFC Energy. “The North American energy scene is being transformed, and this company reflects the colossal scale of the emerging industry.”

Kinder Morgan’s proposed purchase of El Paso, announced in October, is so big that it faces months of antitrust scrutiny. The deal would create the largest pipeline owner in the country, with 80,000 miles of pipelines crossing 35 states and linking new oil and gas fields from Texas to Pennsylvania to most major markets. Although regulators would still set transport prices, the company would have more power to direct what flows through its pipes and where.

“By restricting supplies or not expanding pipelines in the future, they are potentially going to keep natural gas from going to consumer markets where gas is needed, and that could impact prices indirectly,” said Ed Hirs, an economist at the University of Houston.

Analysts say antitrust regulators may require Kinder to divest itself of some pipelines, particularly in and around Colorado, though most expect the deal to be approved eventually.

Mr. Kinder and other Kinder officials declined interview requests. But Larry S. Pierce, a company vice president, denied in an e-mail that his company would restrict gas flows. “Pipelines make money by providing transportation service, not by deciding where the gas goes,” he said.

The increased scale would certainly put Kinder Morgan in a prime position to benefit from a coming wave of pipeline construction. Thousands of miles of new pipelines will be needed to serve wells in fast-growing shale fields like the Bakken in North Dakota, the Eagle Ford in south Texas and the Niobrara in Colorado. In some states, pipeline capacity is so scarce that much of the natural gas coming from wells is simply burned as waste.

All told, spending on new pipelines in the United States could reach more than $200 billion by 2035 (in 2010 dollars), according to the Interstate Natural Gas Association of America Foundation.

“Rich Kinder likes to identify tsunamis,” said Yves Siegel, a senior energy analyst at Credit Suisse, “and this is a tsunami that he believes in.”

If the El Paso deal was approved, analysts say, other big pipeline companies, like Williams Partners and Oneok, would need to scramble to keep up with the supersize Kinder Morgan, which would have easier access to capital and a far larger cash stream to buy or build the new networks.

In acquiring El Paso, Kinder Morgan gets pipelines that are likely to deliver growing cash flows. El Paso’s 14,000-mile Tennessee Gas Pipeline, which stretches from the Gulf of Mexico to Canada, cuts directly through the Marcellus shale field in Pennsylvania, where hundreds of gas wells have been drilled but not yet hooked up to a pipeline. Kinder would also acquire pipelines from West Texas to California that promise future growth as Southwestern states retire aging nuclear power plants in favor of gas-fired electrical generation.

Still, Kinder Morgan knows all too well that unexpected developments can upset the best of plans. When it began building the Rockies Express pipeline several years ago to connect isolated Colorado gas fields with eastern markets, it looked like a sure bet. But with the upsurge of gas production in the Marcellus shale field, demand for western gas had slipped by the time the pipeline was ready in 2009. (The El Paso deal would improve the value of that investment by allowing Kinder to synchronize pipelines owned by the two companies to redirect some Rocky Mountain gas to the Midwest, energy experts say.)

After a string of pipeline accidents in recent years, Congress is expected to pass a bill to tighten safety regulations and double the maximum fine for negligent behavior by pipeline operators to $2 million. Kinder Morgan talks up its safety record, but it has had its share of violations and accidents over the last decade. The company this year has been assessed $573,400 in proposed penalties from the federal Pipeline and Hazardous Materials Safety Administration for violations, although the company noted that the penalties were for terminal, not pipeline, infractions.

“As they get far bigger, how are they going to assure the public’s safety when they seem to have trouble handling the infrastructure they already have?” said Frank J. Gallagher, editor of NaturalGasWatch.org, who is a critic of the expansion of the natural gas industry.

Environmentalists and advocates of renewable energy also say the pipeline industry gets an unfair advantage because of the estimated $2 billion a year in federal tax breaks it receives through use of a corporate structure known as the master limited partnership.

Although Mr. Kinder didn’t invent the tax break, he has been a pioneer in using it. Mr. Kinder co-founded Kinder Morgan in 1997, after he had a falling out with Enron’s chairman, Kenneth L. Lay, and bought Enron’s small pipeline business for $40 million with another Enron colleague. From that perch, Mr. Kinder, a lawyer by background, used the partnership structure to assemble a pipeline network. He owns more than a third of the company.

Master limited partnerships trade on financial markets like stocks, but they are taxed as partnerships. That means the companies do not pay income taxes but instead pass through a share of profits and losses to the owners of the units, who then pay individual income taxes.

The structure has allowed Kinder Morgan and other pipeline companies to secure capital at a lower cost than normal corporations because they can offer investors higher after-tax returns.

In the late 1980s, Congress tightened regulations on such partnerships out of concern that many corporations would turn to them to avoid corporate income taxes. But it carved out an exception for the energy industry, which lobbied hard on the issue. The number of these partnerships in the energy industry has increased to 72 in 2010 from six in 1994, according to the Congressional Research Service.

Annual rates of return on pipelines are generally around 7 percent, hardly spectacular in the oil business. But pipelines often pay for themselves in 10 years or so, and they can produce revenue for decades after that.

“You can go to the movies and be making money,” said Mark Routt, a senior consultant at KBC Advanced Technologies. “You just sell the pipeline capacity over and over again.”

But Nathanael Greene, director of renewable energy policy at the Natural Resources Defense Council, said the industry was so profitable that Congress should either repeal the tax break or allow renewable projects like solar and wind to use the partnership structure, too.

Right now, he said, Congress is “picking winners in the worst sort of way because not only does it make things uneven now but locks in that advantage in a pipeline that lasts for decades.”

Mr. Pierce, the Kinder Morgan executive, defended the partnership structure as a useful policy tool to help build pipelines.

“Congress has made a conscious decision that the benefits of incremental energy infrastructure outweigh the slight decrease in federal revenue,” he wrote in an e-mail. He said that extending master limited partnership treatment to renewable energy sources would be “sound policy, in our opinion.”