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SASOL:
A perfect storm

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Christiaan Bothma

Member of SPW Investment Team

Over the past month, market conditions aligned in such a way as to generate a perfect storm for petrochemicals giant Sasol. Just as its embattled Lake Charles project reached a cash flow turning point, with the balance sheet at peak gearing, the OPEC+ alliance broke down in the wake of a demand shock resulting from COVID-19, causing oil prices to collapse to below US$30 per barrel. Prices this low are not sustainable. The question is – how long will they remain this low, and what are the implications for Sasol? We think it’s likely that the company will survive the storm, but the cost to equity holders may be enormous.

Since Sasol’s 2014 decision to invest in the Lake Charles petrochemical plant in Louisiana in the US – at an original cost of US$8.9 billion – the project’s cost has increased by around 45% to US$13 billion, and ramp-up has been delayed by two to three years. This has led to the company’s debt increasing to uncomfortable levels of 2.9 times its earnings before interest, tax, depreciation and amortisation (EBITDA) by December 2019. This was still within renegotiated covenants of 3.5 times for both December and the June year-end and was expected to decrease to around 1.5 times by 2022 as the plant ramps up.

Despite a further setback after an explosion at one of their six downstream units, which led to a delay of at least six months in that unit, the project reached a cash flow turning point in January 2020. This means it was now generating cash and no longer needed external cash injections, and could start reducing its debt levels. However, the planned debt reduction process certainly didn’t assume an oil price as low as US$30 per barrel.

WHY DID THE OIL PRICE COLLAPSE?

The most obvious reason for the oil price coming under pressure was the spread of the COVID-19 novel coronavirus, which of course led to reduced travel and industrial activity, and therefore less fuel usage.

From a supply side perspective, almost everyone expected the OPEC+ alliance to step up and stabilise the market, as they’ve done many times before during market shocks (the cartel has after all been in existence for almost 50 years). However, after a falling-out between the two largest members, Russia and Saudi Arabia (roughly 10% of world supply each), precisely the opposite happened. OPEC+ started to aggressively push supply and apply price discounts in order to gain market share and force higher-cost American shale oil out of the market (a strategy also attempted – unsuccessfully – in 2015).

These two factors combined led to oil prices falling to levels not seen since 2003. Prices this low aren’t sustainable over the longer term, for a number of reasons. Most importantly, an oil price of US$30 per barrel doesn’t incentivise enough new production to meet future demand, with a significant part of the industry not making money at these levels. In addition, large OPEC members such as Saudi Arabia, despite being able to produce oil at only around US$20 per barrel, have a budget break-even of around US$80 per barrel, and it will therefore be very difficult for them to sustain these prices for too long.

Even if the price remains below US$40 per barrel for only two years, Sasol can’t simply sit on the sidelines and hope for oil to recover. Their high levels of debt simply won’t allow it.

SASOL’S PLANNED RESPONSE

On 17 March, Sasol provided a response on how it plans to mitigate this crisis. The company reiterated that it does have liquidity of around US$2.5 billion available and would be able to survive over the next 12 to 18 months, even with oil prices as low as US$25 per barrel and with no major debt repayments due until May next year. Sasol is also in discussions with its lenders to temporarily lift covenants for December 2020 and June 2021 (the company is still confident that it’ll be able to meet covenants in June 2020, even at spot oil prices).

However, with US$10 billion of gross debt on the balance sheet, Sasol believes it would need to reduce this by US$6 billion to be sustainable in a low oil price environment (US$30 to US$40 per barrel). US$2 billion will come from cost savings, capex deferrals and working capital releases from lower feedstock prices over the next few years – Sasol believes US$1 billion of this cost decrease to be sustainable into the future (if prices remain low).

At least another US$2 billion is to come from both planned asset sales (these aren’t new, but have been part of an ongoing asset review – assets of around US$400 million have been sold to date) and new asset sales. With regard to the latter, Sasol is also considering selling part of the Lake Charles project which, even though the company overpaid for it, is a good asset. We’re very sceptical that Sasol would be able to realise the desired value on these sales. Selling assets in these depressed circumstances will be difficult and, even if it is able to sell some, this is likely to be value-destructive.

The last US$2 billion will potentially have to come from a rights issue of new shares. Sasol was very clear that this remains a last resort, as it will be by far the most value-destructive option at this share price level. This remains dependent on the progress of asset sales and will only be considered after the company’s financial year-end in June.

PORTFOLIO IMPLICATIONS

In our view, Sasol will be able to survive this downturn. The question is: at what cost to equity holders? If commodity prices stay where they are, we believe Sasol will struggle to sell enough assets and would have to come to the market for around US$1–2 billion in August, leading to enormous value destruction. However, a fast uptick in oil prices after COVID-19 recedes will mean the company is easily worth 5 to 10 times more.

Fundamentally, we believe oil prices should be higher at around US$60 to US$70 per barrel. If we value Sasol on these assumptions, there’s a lot of upside. However, it’s very difficult to say with certainty how long oil prices will remain at these levels. If it’s too long, it could lead to serious value destruction (asset sales at suboptimal levels and a rights issue at a very low share price). For this reason, we’re refraining from adding to Sasol at the moment. In our view, there are companies offering more certainty elsewhere in the market – see our recent article.

If it comes down to it and the company needs to do a rights issue, however, we’re likely to follow our rights, as at this point the balance sheet should be in a better state after the issue and there’s likely to still be substantial upside from the rights issue price level.

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