The falling oil price and its impact on Sasol

The nearly 41% depreciation in the share price of Sasol last year, precipitated by a more dramatic drop in the market price of oil, has had investment professionals scratching their heads about the counter’s medium-term prospects. After a high of R645/share during the first half of the year, Sasol is now trading at just R382. Is it time to buy?

Brent crude oil prices dropped from a high of US$110,80/bbl in January 2014, to the current $48/bbl, a level last seen at the height of the global economic crisis in March 2009. The fuel came under pressure after the Organisation of the Petroleum Exporting Countries (Opec), a cartel of some of the commodity’s biggest producers, ruled out reducing production in order to artificially arrest the price decline at its biannual November meeting.

That sent the price tumbling down from $78/bbl to current levels on the day.

Chances of the cartel reversing that decision, which is hurting government revenues of some of its member countries the most, look remote. Opec’s next scheduled meeting is only in June.

Moreover, Saudi Arabia’s government, the most influential member with the most votes at Opec meetings, is against reducing oil output as it hopes a sustained oversupply and the resultant low price will kill off some of the high-cost shale oil producers that have transformed the US into the world’s biggest oil net exporter — albeit only to Canada — from the single largest importer less than a decade ago.

Saudi Arabia can survive low prices because, when oil was over $100/bbl, it saved more of the windfall than it spent.

The biggest losers are countries that didn’t. Notable among these are Opec members Venezuela, Nigeria and Iran and nonmembers the US and Russia.

The Saudis have huge foreign capital reserves and can therefore sustain lower prices longer, says Victor von Reiche, a senior investment analyst at Cannon Asset Managers.

It costs an estimated average $75/bbl to produce shale oil [as in the US], says Investec Asset Management in a January note to clients. “At [below] $50/bbl we are already well below the marginal supply cost, defined as the cost of pumping the last and most expensive barrel required to satisfy demand, for the industry,” say portfolio managers Tom Nelson and Charles Whall in the note.

Shale oil is extracted through a highly technical method called hydraulic fracturing, or fracking, by accessing oil trapped in rock formations deep in the earth.

Opec members, on the other hand, rely on low-cost and old production methods to get to their more accessible fuel resources.

Though lower oil revenues are definitely hurting governments’ budgets, some Middle Eastern state-owned companies can tolerate lower oil prices better than the private companies that dominate the US shale market.

At these levels, many producers are not making money, says Wayne McCurrie, portfolio manager at Momentum Asset Management. But oversupplies don’t last forever, he says. The medium-term effect of a sustained oil price depression will be a reduction in new exploration and drilling activity, which will lead to lower production.

Spending is being reduced, projects are being delayed, and investment in the sector is falling, says Investec. The firm estimates that investment spending by US shale oil producers will fall by 30% this year, which will then slow shale oil production growth to less than 0,5m b/d , from 1m b/d for each of the past three years.

While Investec expects a 40%-50% recovery in the current oil price to an average $70$75/bbl this year, Moody’s Investors Service is more pessimistic, with a $60/bbl forecast. Banking group HSBC, on the other hand, expects a $90/bbl price. “The recovery is likely to surprise investors in its speed and scale, just as the sell-off has, and we believe we are approaching the bottom in terms of sentiment, investor positioning and valuation,” says Investec. The average price of Brent oil in 2014 was $99/bbl.

Where does all this leave local chemicals company Sasol, which has most of its current earnings tied to the international oil price and is in the early stages of building an $8,1bn ethane cracker in the US?

Von Reiche points to the fiveyear oil futures contract price (currently $73/bbl) as a sign of where oil prices are going in the medium term. “That is significantly higher than the spot price, which means the market expects the market price to rise.”

Sasol estimates that every $1/bbl change in the annual average crude oil price will affect its operating profit by about $70m (about R806m) this year. Similarly, a 10c change in the average dollar exchange rate against the rand will affect its operating profit by about R857m. The rand has depreciated 10% against the dollar since last January.

If one uses the futures contract price to determine a fair price level for Sasol, says Von Reiche, then Sasol should be trading at around R400. “Still, I don’t think Sasol is a screaming buy at the moment,” he says.

Von Reiche estimates the company will earn about R30/share in the current financial year, down from R60/share last year. “The stock will become more attractive when the market uses the spot price of oil (which is lower than the futures contract) to value Sasol. Then you can buy Sasol knowing whatever price you pay, you’ll be in the money.”

The share price is also underpinned by a solid dividend yield of 3,4%.