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Tallgrass' play for more of REX pipeline is a bet on Utica, Marcellus

Privately owned TallgrassDevelopment LP is putting more chips on Appalachian shale gasflowing west while at the same time increasing its exposure to unused capacityand struggling shippers.

On March 29, Tallgrass announced that it struck a to buy anadditional 25% of Rockies ExpressPipeline LLC from SempraU.S. Gas & Power LLC. Tallgrassalready owned 50% of REX.

The purchase solves several problems for the SouthernCalifornia energy holding company SempraEnergy but could add some difficulties to Tallgrass' plate,analysts said.

While Sempra is taking a one-time $27 million loss on thecapacity contracts it is giving up, it will no longer have to spend millionsfor unused west-to-east capacity it signed up for in 2009 when REX was firstconstructed.

Tallgrass President and CEO David Dehaemers downplayed anyrisk built into his company's stake in REX and said he looks forward to the daywhen the gas markets stabilize and REX can be dropped into a Tallgrass MLP.

"I wonder who would have thought that three years agoheadlines like 'Ding dong, REX is dead' would be out there when today it'smoved 3.1 Bcf a day," Dehaemers said on Tallgrass Energy Partners LP's Feb. 17 earningsconference call. "I guess the point here is, I assure you REX is alive andwell. We continue be focused on the third phase of transformation at REX, whichis the 800 million cubic feet a day of Zone 3 capacity enhancement project."

Dehaemers said 98% of the east-to-west capacity on REX Zone3 is contracted with a weighted average contract life of 17 years.

But in addition to the unused west-to-east capacityTallgrass is buying from Sempra, it is increasing its exposure to Appalachianshale producers at a time when money is getting tight in the Northeast shaleplays.

Many Appalachian gas independents are solvent, having cuttheir CapEx to match their cash flows even at $2/Mcf gas. One major Appalachianplayer has had a bank redetermination so far this season, and survived thatwith its $4 billion credit facility untouched. Butredeterminations maylead to solvency problems for other producers.

"The more obvious issue for the sale is that [Sempra]is concerned about counterparty risk," analysts at Tudor Pickering Holt& Co. said March 30. "In its 10-K, [Sempra] noted that "severalcustomers are facing liquidity issues which may result in bankruptcy." Withthe majority of earnings still coming from the California utilities, [Sempra]does not have the same risk threshold as pure play midstream companies."

One of the biggest shipper question marks for REX isAscent Resources - Utica LLC,with contracts for 600,000 Dth/d. Ascent had been funded principally byEnergy & Minerals Group,but that funding was already reported to be in jeopardy at the time of Ascentfounder Aubrey McClendon's deathMarch 2.

Smaller shippers such as Vanguard Natural Resources LLC, with 25,000 Dth/d ofcapacity out of Appalachia, could especially be in a cash crunch when the banksredetermine credit lines this spring. Vanguard had only $107 million left onits $1.69 billion line of credit at the beginning of the year, according toS&P Capital IQ data.

According to SNL Energy pipeline contract data, the bulk ofREX's west-to-east shippers are majors such as and or majorindependents such as Encana Corp.

Tallgrass, convinced that east-to-west is the future forREX, got a fair deal that will get better when the original west-to-eastcontracts roll off the board in 2019, the Tudor Pickering Holt analysts said."Deal comes at a decent value for [Tallgrass Development] and expands[Tallgrass Energy Partners/TallgrassEnergy GP LP's] available dropdown inventory, but does little todiversify counterparty risk on both legacy and reversal capacity."

When that MLP dropdown will happen is still an unknown,Dehaemers said.

"We're not going to drop it in anytime soon, and infact we will reconsider dropping it, depending on the market," Dehaemerssaid on the February earnings call. "If you think the market ispermanently down here, then I don't know, maybe it never gets dropped in. It'skind of hard to speculate what the market may or may not be giving us at anytime."

"Are we undervalued today? Unequivocally,"Dehaemers added. "Has the market overcooked itself on the downside? In myhumble opinion, absolutely. So, asking me to speculate whether or not we'regoing to drop it in at 9 or 10 times [EBITDA], or at 5 or 6 a year from now, islittle hard for me to answer."

The additional 25% stake Tallgrass is buying could bereduced to 16.66% if a third REX partner, Phillips 66 Co., exercises its right to buy aproportional share.