Oil on the run

Is now the time to buy Sa­sol, or will in­vestors re­gret it?

Financial Mail - Investors Monthly - - Front Page -

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”.

The Sa­sol site in Se­cunda.

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