Tallgrass Focuses on Rockies for Growth

After a complete reversal of natural gas flows in the Northern United States over the past few years thanks to the emergence of Marcellus/Utica gas production,

Still, REX and Tallgrass must continue to be nimble. According to RBN Energy, there are about 20 pipelines under consideration, with the potential to add nearly 20 bcf/d of takeaway capacity for the Marcellus/Utica region over the next few years compared with existing gas production of about 27 bcf/d out of the Marcellus and Utica. Not all of these pipelines are likely to be built, but it’s clear that the region will be amply supplied with takeaway capacity within a few years. The key advantage that REX still holds is its 15 interstate pipeline connects along its recent Zone 3 addition across Missouri, Illinois, Indiana, and Ohio, offering access to these Western markets versus competing pipelines that are largely heading south and southeast. As a result, we believe REX will maintain its relevance.

Tallgrass’ other major asset is the Pony Express, moving oil from the Powder River, Bakken, and DJ basins, with major outlets in the Williston and Niobrara basins to Cushing, Oklahoma, among other markets. We harbor concerns about the production and differential outlook as well here, given the middling cost-competitiveness of the producing basins and the expiration of virtually all of Pony’s contracts in 2019 and 2020. Still, we think there’s ample opportunity for Tallgrass to expand along the value chain with the pipeline, offering up a healthy level of incremental fees. Tallgrass has invested over $200 million recently in storage and pipeline assets to support Pony Express flows, which we think is excellent progress.

Efficient Scale Results in Narrow Moat Tallgrass' two major pipeline assets are REX and Pony Express, while it also owns storage and gathering and processing assets that provide it with additional control over the hydrocarbons that feed into its pipelines. Ninety-seven percent of Tallgrass' revenue is subject to firm fee contracts, with only 1% exposed to commodity prices. Tallgrass' anticipated returns on invested capital in the mid- to high teens easily exceed our cost of capital, further supporting a narrow economic moat. If the company obtains another 25% of REX from Phillips 66 (acquiring 25% from Tallgrass Development would not result in REX being consolidated due to Phillips 66's voting interest) and has to consolidate the pipeline on its balance sheet, we believe returns would decline, as we estimate REX's ROICs are around the high single digits, but overall still above our cost of capital.

New pipelines are typically constructed to allow shippers or producers to take advantage of large price differentials (basis differentials) between two market hubs because supply and demand is out of balance in both markets. Pipeline operators will enter into long-term contracts with shippers to recover the project’s construction and development costs in exchange for a reasonable tariff that allows a shipper to capture a profitable differential, and capacity will be added until it is no longer profitable to do so. Pipelines are approved by regulators only when there is an economic need, and pipeline development takes about three years, according to the U.S. Energy Information Administration. Regulatory oversight is provided by the Federal Energy Regulatory Commission and at the state and local levels, and new pipelines under consideration have to contend with onerous environmental and other permitting issues. Further, project economics are locked in through long-term contracts with producers before even breaking ground on the project. If contracts cannot be secured, the pipeline will not be built. A network of pipelines serving multiple end markets and supplied by multiple regions is typically more valuable than a scattered collection of assets. A pipeline network allows the midstream company to optimize the flow of hydrocarbons across the system and capture geographic differentials; use storage facilities to capture price differentials over time; and direct more hydrocarbons through its system via storage and gathering and processing assets, ensuring security of flows and higher fees. Finally, it is typically cheaper for an incumbent pipeline to add capacity via compression, pumps, or a parallel line than it would be for a competitor to build a competing line.

To assess the strength of a midstream company’s moat, we consider two factors: the location and quality of the assets and the strength of the contract coverage. On both of these criteria, we believe Tallgrass only earns a narrow moat.

From an asset quality and location perspective, we think REX and Pony Express have attractive elements, but not enough to earn a wide moat rating. We have concerns about the location of the assets, as Pony Express obtains its oil from the DJ Basin, the Bakken, Powder River, and Niobrara, which are not some of the lowest-cost basins, raising concerns about the long-term production outlook. However, the diversity of supply and the fact that the pipeline is the cheapest transportation option for producers in these regions is a considerable benefit. Given that the pipeline is only a small portion of the combined basins’ overall production, even in a weak to declining production environment, we would still expect Pony Express to obtain solid volumes. REX is a critical cog for the giant Marcellus, Utica, and Rockies markets, providing ample flows of gas, but as both regions are self-sufficient in terms of gas, differentials have collapsed, meaning Tallgrass’ future contract terms will probably be weaker than recent contracts for east-to-west transportation in the 15- to 20-year range. We’re wary of new competition for flows out of the Marcellus/Utica region from Enterprise Transfer’s ETP 3.25 bcf/d Rover pipeline as well as Spectra Energy’s SEP 1.5 bcf/d Nexus Gas Transmission project and other pipelines also on deck, raising the prospect of fierce pipe-on-pipe competition. We would expect new pipelines to be canceled if they cannot secure contracts for capacity. However, with slowing or negative production growth, this would put substantial pressure on new contract pricing for existing pipelines and raise the risk of flows shifting to pipelines where shippers can earn the highest netbacks, leaving poorly positioned pipelines to suffer from lower pricing and volumes.

The middling location quality also shows in the contract terms for the most part. REX’s west-to-east contracts largely expire in 2019-20, as do Pony Express’ contracts. We believe that new contract pricing will decline around 30% for Pony Express and around 50% for new REX contracts from the original agreements signed in the late 2000s, based on where differentials are today. The strongest contracts are the REX agreements to ship gas east to west, which are 15-20 years; we estimate these contracts contribute about 30% of Tallgrass EBITDA, though we expect these flows to make up an increasing portion of Tallgrass EBITDA over time, particularly as Tallgrass may acquire an additional 25% ownership stake. Processing and logistics contract terms average about two years, and revenue is typically earned on volumes processed, with recent capacity levels in the 50s. Freshwater transportation and water gathering and disposal contracts average four- and eight-year terms, respectively. None of these supporting assets are moatworthy on a stand-alone basis, in our view.

Risks Include Capital Access, Contracts The major risks for Tallgrass are continued access to growth capital from the markets at a reasonable price and recontracting risks, given the short-term nature of many of Tallgrass' contracts and the related volume sensitivities, particularly for its gathering and processing operations. Additional risks include the specter of pipeline overbuilding and overcapacity in the Rockies and Marcellus regions, putting pressure on differentials and the prices Tallgrass can charge for transporting hydrocarbons. In fact, Tallgrass' anchor contract with Encana could be at risk if Tallgrass signs a contract with another producer at lower rates, as the Encana contract contains a "most favored nation" clause ensuring that Encana pays a rate equal to the lowest rate charged to peers. Finally, a rising interest-rate environment could put pressure on distribution yields as a steeper yield curve could make lower-risk assets look more attractive.

Tallgrass remains in solid financial health and has ample capacity to acquire and develop incremental assets as opportunities arise. Distribution coverage has historically been above 1.2 times, and we expect it to be similarly high going forward, reducing the need for equity issuances and providing incremental capital flexibility. The high coverage ratio also provides management with options when considering an elimination of incentive distribution rights, as it could lower the coverage ratio instead of cutting the distribution. Tallgrass Equity, a subsidiary of its parent general partner, Tallgrass Energy, owns the GP interest and incentive distribution rights, which are currently in the high splits, meaning about half of incremental distributions are paid to the GP. Tallgrass has indicated it plans to announce a simplification transaction in 2018, which we consider a positive step. The transaction appears well timed ahead of contracts expiring in the next few years, providing the partnership with a lower cost of capital (assuming IDRs are eliminated) to acquire new assets to mitigate any declines in volumes or tariffs.