THE HEDGEYE EDGE
Tallgrass Energy (TGE) is a midstream energy company, transporting crude oil and natural gas from the Rocky Mountains, Upper Midwest and Appalachian regions. Below are the core tenets of the TGE short thesis.
The Worst Has Already Happened? On 3/26/18 TEGP announced it would acquire TEP at a ~10% premium. Given TEP’s high total cost of equity, the collapse was not unexpected. The transaction, coupled with the CLR contract amendment, led many to believe early-2018 was as bad as it would get for Tallgrass. The simplification merely solved TEP’s MLP-related financial issues. The contract amendment is just the first in a series of lower tariffs. The key issues facing its businesses have not drastically changed.
Pony Express’ Window of Opportunity Is Closing: Pony Express is reliant on significant Bakken and PRB volume growth in order to stave off a meaningful EBITDA decline. Production growth, likely via higher oil prices, is Pony’s only salvation from falling throughput and tariff rates. But TGE’s window of opportunity is closing. The majority of contracts out of the Bakken and DJ expire between 4Q19 – 2Q20. Current growth rates out of the Bakken and PRB are unlikely to force producers to act with a sense of urgency.
Growth Project EBITDA Is Significantly Overstated: Tallgrass contends that growth projects and acquisitions will add an incremental ~$110MM of EBITDA by 2020. Rather than take management at its word, we analyzed each standalone projects’ available financial and operating data. In reality, we estimate that TGE’s EBITDA projection is overstated by ~$75MM.
Distribution Reset Still Necessary: We are modeling a 30% – 40% distribution cut in 1Q20 based on our outlook for growth project EBITDA deficiencies, Pony Express contract renegotiations, and REX contract renegotiations.
Meanwhile, pipe-on-pipe competition is moving from the DJ to the Bakken. Energy Transfer officially announced the expansion of DAPL from ~500 Mb/d to ~570 Mb/d, PSX and True Companies announced an open season for the 350 Mb/d Liberty Pipeline to Cushing, Saddlehorn announced a joint tariff from Guernsey to Cushing, and not to be outgunned, TGE announced an open season for a 300 Mb/d expansion on Pony Express.
Consistent with the history of midstream, wherever there is a dislocation in differentials, even if it’s clearly transitory, there is always someone looking to take advantage. DAPL will likely contract the initial marginal barrel out of the Bakken, but after that, assuming there is actually demand for additional capacity, it will be a dog fight on rate. And demand for long term contracts is not guaranteed as evidenced by the recent slowdown in the rig count as well as the price collapse. The drop off in WTI could not have come at worse time for TGE.
With 2019 E&P budgeting processes underway, discussions in the board rooms have become more complicated. Imagine a Bakken E&P announcing to its investors that, in the face of a 30% drop in crude, they will be significantly increasing their capital budget to pursue production growth… Now imagine being approached by a midstream company for a 5 year FT commitment… Not exactly a no-brainer.
BOTTOM LINE
Despite improvements in the operating environment and simplified corporate structure, we value TGE between $12.00 – $17.00 per share, 30% - 50% lower than current market prices. We’ve increased our valuation marginally from our last update, largely reflecting new project contributions and a more constructive crude oil price environment. However, at this juncture, we see no evidence to support walking away from the short.
ONE-YEAR TRAILING CHART
