HARD-TO-FORECAST OIL PRICES
Sasol has for years depended heavily on the rand price of oil, and last year was no different. OPEC production cuts, combined with strong global economic growth, led to oil prices starting to rise from mid-2017 to early 2018. The rally continued on the back of US President Donald Trump abandoning the Iranian nuclear deal in May 2018 and reimposing economic sanctions – which were expected to result in roughly two million barrels per day (around 2% of global supply) exiting the market. In anticipation of this, Saudi Arabia started to increase supply.
In November 2018, when sanctions against Iran were due to kick in, the US granted exemptions to certain buyers of Iranian oil, leading to only about one million barrels per day exiting the market. In addition, the US shale industry reported record production of 8.2 million barrels per day (around 8% of world supply) in November, a 23% increase from a year ago.
These supply factors, combined with fears of the global economy showing signs of a slowdown, led to oil prices falling from a peak of US$85 per barrel in early October to a low of US$50 per barrel on Christmas Day. At the start of 2019, oil prices recovered on the back of another production cut by OPEC member countries to settle within the US$60-70 per barrel range.
Oil prices have always been – and will continue to be – very difficult to forecast. What has become apparent is that OPEC isn’t willing to tolerate an oil price below US$60 per barrel and would rather cede market share to US producers in order to restore prices. In contrast, oil prices above U$70 per barrel incentivise too much new US shale oil to enter the market. In our view, it’s reasonable to assume that oil prices will remain within this range. For us, an investment in Sasol needs to make sense without assuming oil prices that are too aggressive.
NEAR-TERM HEADWINDS
On top of the recent oil price slide, Sasol released a disappointing operating update on 8 February this year, indicating that the company’s Lake Charles ethane cracker will be delayed by five months and that capital costs will increase by a further US$500-700 million (an increase of around 6%). Sasol attributed these developments to poor productivity, bad weather and late scope changes that needed to be made. In our view, most of these factors could have been controlled by better management. However, it’s of course not unheard of for major projects to run over time and over budget.
There are also a few other short-term negatives, including lower traded petrol-refining margins that impact the price at which Sasol sells its fuel to retail stations in South Africa, depressed global chemical prices and the implementation of a carbon tax on South African operations – resulting in around R1 billion (or R1.60 per share) in earnings.
Despite all the negative news, we remain constructive on the counter. We believe the negative news is either short term in nature or immaterial to the investment case, and that the market is underplaying the positive, longer-term story around Lake Charles.
LAKE CHARLES CHEMICAL PROJECT
In October 2014, Sasol announced that a final investment decision had been reached to build a world-scale ethane cracker in Lake Charles, Louisiana – essentially, a very large petrochemical plant that ‘cracks’ or breaks down ethane into ethylene – and six downstream units. The cracker, initially expected to reach a beneficial operation stage last year, is set to transform Sasol from a predominately South African energy company to a global chemicals company.
The main reason for building the cracker in Lake Charles is the abundant supply of ethane. This implies that Sasol can gain a cost advantage over competitors in other regions, and in fact the cracker is expected to be in the first quartile of the global ethylene cost curve.
Sasol’s chemical products are used to create various everyday items. The two biggest products (low density polyethylene (LDPE) and linear LDPE) are used to create various plastics products, including plastic bottles and sheets. In addition, other chemicals are used to make detergents and personal care products – even the anti-freeze used in motor vehicles. The prices of these products are to a large extent still linked to oil prices, albeit they’re much more stable compared to oil prices, since oil can also be used to create these products.
Sasol had initially planned to pay US$8.1 billion for the cracker. Over time, however, this estimate has increased to about US$11.8 billion, more than half of what Sasol is worth today. The project isn’t likely to generate a return on capital of more than its cost of capital, and in hindsight, shareholders can rightfully be critical of it. Economic value has been destroyed. However, from the perspective of a current shareholder, most of the capital for the project has now been spent and the market is not giving Sasol credit for the cash that the operation will generate.
Sasol’s management team has estimated that the project will generate around US$1.3 billion of earnings before interest, tax, depreciation and amortisation (EBITDA) by 2022, which is roughly a third of Sasol’s 2018 EBITDA. Given tax rebates under Trump’s new laws, and the fact that limited capital would be needed to sustain operations in the early years of the project, the result will likely be cash flow of more than US$1 billion per year. On a per-share basis, this translates to around R25 a share at an exchange rate of R14 to the US dollar.
The increased revenues from Lake Charles also mean that within the next few years, more than 50% of Sasol’s earnings will come from chemicals, which means the company will be less exposed to movements in the oil price. Over time, as dividends begin to increase again, the market could start rewarding the company with a higher multiple as a result of greater earnings stability.
In summary, we believe the short-term negative news around Sasol has provided us an opportunity to take advantage of what we believe to be a good long-term story playing out. It may take time for the market to acknowledge the value, but in our view, the risk-reward equation is skewed to the upside – over the long term, investors are likely to be rewarded for the risks of investing in this company.
