Financial Mail - Investors Monthly
Oil on the run
Is now the time to buy Sasol, or will investors regret it?
Forecasting is not an exact science. This is true for the rand, which in 2015 made a mockery of most economists’ forecasts
Just 18 months ago Sasol was riding high on an oil price hovering around US$100/bbl. All was set for Sasol’s ambitious expansion plan, not least an $8.9bn oil-based ethane cracker project at its Lake Charles site in Louisiana, USA, due to come on stream in 2018.
A confident Sasol stated in its 2014 annual report: “Our view is that in the next five years crude oil prices will settle around $109/bbl.”
Then the wheels came off. Buckling under the strain of excess supply, the oil price collapsed and Sasol’s share price followed, falling more than 40%.
The share price has finally lifted, rising 20% from its January 2016 low in the wake of a $15/bbl (50%) jump in the Brent crude oil price from a 13-year low.
There could be more strength to come from Sasol. But before rushing in to buy, the question to ask is: is this the start of a sustained recovery or a relief rally waiting to ensnare the unwary?
Sasol is a forecasting challenge of note. At play is the oil price in rands, driven by two volatile fundamental inputs: the US dollar oil price and the US dollar/rand exchange rate.
Adding complexity is Sasol’s massive capital expenditure (capex) programme. The firm projects capex will jump from R45bn in its year to June 2015 to R74bn in 2016 and R73bn in 2017. This is despite postponing completion of smaller units of its Lake Charles project until 2019.
Outgoing CE and president David Constable warned at a presentation of interim results to December 2015 that the Lake Charles project’s “end-of-job” cost estimate would “remain under pressure”.
Huge capex comes at a time when falling profits have done big damage to Sasol’s cash flow. Reflecting this, cash flow after dividends and tax came in at R14.8bn in the six months to December, R19.2bn (56%) less than cash flow generated in the corresponding 2015 period.
With its cash flow constrained, Sasol is turning increasingly to debt, which is not ideal in an uncertain environment. Sasol’s guidance is that its net debt-to-equity ratio, now at 6.2%, will rise as high as 44% compared with its previous debt ceiling estimate of 15%-30%.
Sasol’s move to debt has earned it a downgrade of its long-term issuer rating from Moody’s, from Baa1 to Baa2 with a negative outlook. Baa2 is one notch above Moody’s minimum Baa3 investment grade rating.
Sasol will also soon embark on a new top management approach. At the end of June Constable will hand over to joint CEs Bongani Nqwababa, now Sasol CFO, and Steve Cornell, now executive vice-president of international operations. The experiment will be watched closely by the market.
But getting the rand oil price correct remains key. Over the past decade Sasol’s share price displayed a 73% correlation with the rand oil price. Put another
way, almost three-quarters of historical movements in its share price can be explained by movements in the rand oil price.
This is hardly surprising. In its six months to December 2015, 46% of Sasol’s net profit was generated by its synthetic liquid fuels and natural gas operations. A further 37% came from its chemicals operations, where pricing is strongly influenced by developments in the oil market.
In Sasol’s six months to December, the weak rand played the key role in limiting the damage of an oil price averaging $46.97/bbl, 47% down on the $89/bbl average in the six months to December 2014. At the closing exchange rate of R15.48/$, Sasol’s headline earnings per share (HEPS) in its latest reporting period came in at R24.28. Had the rand held steady at the R11.57/$ of a year earlier, HEPS would have fallen by 43%.
Unfortunately, forecasting is not an exact science. This is true for the rand, which in 2015 made a mockery of most economists’ forecasts. Confronted by factors which could have a profound influence on its trend, this year may be no different for the rand.
Potential negatives include SA’s political uncertainty and the danger of its sovereign rating being downgraded to junk status.
On the positive side is a clear signal from the US Federal Reserve that its rate hiking cycle will be far less aggressive than originally feared. The signal that halted the dollar’s rampant rise came from the Federal Open Market Committee’s (FOMC) meeting on March 16 when a decision was taken to leave the key federal funds rate unchanged.
The FOMC left no doubt that global economic uncertainty, recent extreme stock market volatility and a slump in US fourth-quarter 2015 GDP growth were behind its decision. In a statement the FOMC, which now promises to hold rates lower for longer, noted: “Global economic and financial developments continue to pose risks.”
Forecasting the oil price is no lesser challenge than the rand. At play is an imbalance between oil supply and demand. On paper it may not seem much.
According to the International Energy Agency (IEA), world oil demand ran at 96.74m barrels a day in the fourth quarter of 2015 and supply at 97.74m b/d. It was an imbalance of only 490,000 b/d. But in a market where oil stocks are at a record high and year-on-year supply grew by 1.8m b/d in the fourth quarter compared with a 1.2m b/d rise in demand, it was enough to hammer Brent oil to a low of $27/bbl in January.
But the oil price is prone to springing surprises. It did, rebounding to more than $41/bbl.
At work is the hope that major oil-producing countries will curb supply. Qatar, which holds the Organisation of the Petroleum Exporting Countries (Opec) presidency, is taking the lead.
The move was set in motion at a February meeting between Opec members Saudi Arabia, Qatar and Venezuela, and non-Opec member Russia. The four states, which between them produce a third of the world’s oil, proposed an accord that would freeze output at January 2016 levels. They called on other producers to follow their lead.
Their call has had a potentially positive response. According to Qatar’s energy ministry, 15 countries representing 73% of the world’s oil output will meet on April 17 in Qatar’s capital, Doha, to discuss the proposal.
An agreement would likely further strengthen the oil price. Failure to agree will leave the oil price facing at least another year before supply and demand come into balance.
Reflecting this, the US Energy Information Administration (EIA) forecast in its March 2016 market assessment that the Brent crude price will average $34/bbl in 2016 and $40/bbl in 2017.
The EIA cautions that a high level of uncertainty exists in the market. It points to West Texas intermediate (WTI) crude oil futures and options contracts that indicate the market expects the WTI price to range from $24/bbl to $58/bbl for June 2016 delivery.
The IEA presents a somewhat more upbeat picture. In its March analysis, the agency says: “There are clear signs that market forces — ahead of any production restraint initiative — are working their magic and higher-cost producers are cutting output.”
It will take time. The IEA predicts daily supply will exceed demand by between 1.5m bbl and 1.9m bbl in the first half of 2016 before falling to a surplus of 0.2m b/d in the second half. At some stage in 2017 supply and demand will come into balance. It could come sooner if an agreement is reached in Doha.
However, Sasol is not out of the woods yet. The rand oil price averaged R547/bbl between January and mid-March, well below the average R650/bbl in the six months to December. With oil now at R625/bbl it will require a strong rise in the three months to June to prevent Sasol’s HEPS taking another hit.
To its credit Sasol has weighed into its costs, achieving savings of R3.1bn in the six months to December and targeting R5bn/year by the end of its 2017 financial year. However, this represents a drop in the ocean compared with the group’s total annual costs of some R225bn.
At present Sasol is priced for an improving HEPS outlook, reflected in its 11.3 PE compared with a 15-year mean 10.3 PE. On balance, the oil price outlook appears to be in Sasol’s favour — assuming the rand does not strengthen to a significant degree.
Investors will have to weigh up the probabilities and feel certain they are not ignoring Warren Buffett’s warning to “never invest in a business you cannot understand”.