Financial Mail - Investors Monthly
Lake of Fire
Another cost overrun at the Sasol project has hammered the share price and management’s credibility,
Ever since Sasol’s ambitious Lake Charles Chemicals Project (LCCP) was first mooted, investors were concerned about potential cost overruns and delays.
Their fears were realised when, on May 20 this year, the oil and chemicals giant alerted the market to a third cost overrun at the Louisiana plant.
The project, which was expected to cost $8.9bn at the time of the final investment decision in 2014, has since become about 45% over budget, to reach an estimated $12.9bn.
And instead of starting up in 2018, the ethane cracker — the heart of the project — is aimed to start up in July this year.
Even more concerning is that the latest and sizable $1bn overrun came as a surprise, as the project is supposedly 96% complete.
The share price has been hammered, management’s credibility is in tatters and shareholders are fuming.
Sasol is desperately trying to make amends. It’s accelerating its programme of disposal of noncore assets and doubled it to $2bn, with an aim to use the proceeds to deleverage its balance sheet.
Meanwhile, the first two units of the mammoth chemicals plant have started up.
The LCCP is a large petrochemical plant that “cracks” or breaks down ethane, a compo
nent of natural gas, into ethylene. This is then supplied to six downstream units at the plant, which will make products that can be used in the manufacture of a range of everyday items that include plastics and detergents.
The project, for which the company is highly geared, is expected to not only help Sasol de-lever its balance sheet but also to transform it from a predominantly local energy company to a global chemicals player.
The first cost overrun and delay was already announced in 2016, but there was a great deal of optimism among shareholders and Sasol alike at the start of this year that this would be the period in which the LCCP would start generating cash for the company and paying investors. So the market was understandably alarmed to hear of further budget overruns at this stage.
“It’s unnerving to suddenly, so late in the day, find out you need to spend more than $1bn,” says Abdul Davids, portfolio manager at Kagiso Asset Management.
What’s also unsettled shareholders is that Sasol’s management has now established a pattern of reassuring investors that the project is in hand just a few months before each cost overrun is made known. Patrice Moyal of Visio Capital says: “The implication is that Sasol has invested about 75% of its market capitalisation in its largest offshore investment with a clear lack of controls.”
Shaun le Roux, portfolio manager at PSG Asset Management, says the company has been underweight on Sasol because there was always a high risk attached to the Lake Charles project.
“It was a very sizable bet,” he says. “We thought people underestimated the risk associated with execution.”
Indeed, it looks as if megaprojects like these almost always run over budget and deadline.
As noted in a 2014 study by Bent Flyvbjerg, a professor of Major Project Management at Oxford University, performance data for megaprojects shows nine out of 10 them commonly have cost overruns of up to 50% in real terms — often higher. The Empire State Building cost double what it was meant to, and the cost of the international space station had ballooned by 186% at the time of completion. The cost of Brazil’s world cup stadiums escalated 227%, and the Sydney Opera House cost 1,357% more than originally budgeted.
According to Flyvbjerg, megaprojects are also at high risk of not performing, or not delivering on benefits, as intended.
If, as the evidence indicates, approximately one out of 10 megaprojects is on budget, one out of 10 is on schedule and one out of 10 delivers on its intended benefits, then about one in a thousand projects is a success, he finds.
Le Roux says PSG had for long thought people were potentially overoptimistic on the economics of the LCCP.
And now, Sasol has warned that, because of capital costs and the latest market pricing
The International Energy Agency expects the growth of global demand for petrochemicals to surge over the next three decades
outlook, the forecast internal rate of return for the project has declined from 7.5% to between 6% and 6.5%.
Global financial services company IHS Markit is of the view that the prices of ethane — the feedstock for the LCCP — will spike as a new round of ethane-based crackers in the US start up this year.
It notes that when it comes on line, Sasol’s LCCP may be the one to tip the ethane market into tight supply.
At the same time, it appears that petrochemicals (chemicals obtained from oil or natural gas) are entering a down cycle.
While JP Morgan analysts say in a note they share the bearish outlook for the petrochemicals cycle, a recovery that comes sooner than expected could drive meaningful upside for the LCCP.
The International Energy Agency expects the growth of global demand for petrochemicals to surge over the next three decades.
The JP Morgan analysts say they believe that both the cost overrun and a reduction in chemical price forecasts can already be seen in the share price, which dropped off a cliff on May 20 and has since recovered only modestly to about R370 a share.
Christiaan Bothma, member of the Sanlam Private Wealth investment team, emphasises the positive longer-term story of the LCCP ventures and notes that the risk-reward ratio for investors is skewed to the upside.
“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,” Bothma says in a note. “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 about $1.3bn of earnings before interest, tax, depreciation and amortisation (Ebitda) by 2022, roughly a third of Sasol’s 2018 Ebitda. “Given tax rebates under [US President Donald] 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 $1bn per year. On a pershare basis, this translates to about R25 a share at an exchange rate of R14 to the US dollar,” Bothma says.
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, he says.
“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. It may take time for the market to acknowledge the value but, in our view, over the long term investors are likely to be rewarded for the risks of investing in this company.”
Making a success of the LCCP and deleveraging the balance sheet will likely be Sasol’s focus for the foreseeable future but, in the longer term, its track record at Lake Charles is likely to haunt the group.
Given the cost overruns, JP Morgan analysts believe the market’s trust in Sasol to make major investments successfully has been eroded. That’s a big problem for a company that can expect its core domestic business to suffer costs associated with its carbon emissions to sooner or later as a carbon tax regime in SA finds its feet.
“Without the backing of the market to use capital to diversify, we believe that Sasol is going to be in a bind, as the value and prospects of the domestic business evaporate,” the analysts say. A changing of the guards may help, and seems likely, they say:. “Given the unprecedented hostility to management we have experienced in our conversations with shareholders … we would not be surprised to see senior management changes at Sasol, which could well boost investor confidence.”