/ 8 January 2015

Sasol takes stock of oil price crash

The oil price has hit a five-year low of $50 a barrel.
The oil price has hit a five-year low of $50 a barrel.

Many oil producers started feeling the pinch when oil dropped below the $80 mark in November. But, after oil hit a five-year low of $50 a barrel this week, it is the producers of natural gas in the United States that are reaching their break-even price. If the price goes any lower, they will be driven out of the market.

The oil price has been tumbling as supply exceeds demand, largely driven by new energy produced by the hydraulic fracturing (or fracking) industry in the US. This has led to the Organisation of Oil Exporting Countries (Opec) no longer being able to manage supplies.

With Opec in disarray, analysts say that low-cost producer Saudi Arabia is happy to see the oil price fall on the basis that relatively high-cost producers, including frackers, are likely to leave the market, allowing low-cost producers to re-establish their hegemony. For Sasol, whose earnings are significantly affected by the rand/oil price, the lower oil price means its share price has followed suit, dropping 36% in value in the past three months. The lower oil price, if sustained, could also mean Sasol will have to hold off on investments, such as the $14-billion gas-to-liquids plant in Louisiana.

Sasol produces synthetic fuel from coal and its earnings, largely domestic, are materially affected by the rand/oil price, which has dropped 50% since June last year. Its share price is known to follow this closely and has dropped from nearly R650 a share in mid-2014 to R400 this week.

“The Sasol share price is linked to what the spot rand/oil price is doing. And the spot rand/oil has crashed, fallen off a cliff, over the last six months,” an oil and gas analyst at Nedbank Capital, Mohamed Kharva, said.

Analysts say that, at these prices, at least one of Sasol’s two mega-projects in the US will be affected.

Independent projects
Sasol has two independent projects, an ethane cracker and the gas-to-liquids plant, at its site in Lake Charles in Louisiana. In October last year, Sasol made the final investment decision (FID) on the world-scale ethane cracker and secured a $4-billion credit facility in December. The cracker will convert ethane, a constituent of natural gas, into ethylene, which can be used to produce a wide range of chemical feedstocks for products such as cooldrink cans and detergents.

But the riskier of the two investments, the gas-to-liquids plant, is unlikely to go ahead under current conditions, analysts say – despite a special incentive offered by the state of Louisiana, which includes $257-million in grants, a $20-million worker training facility and a $115-million payment to the company for land and infrastructure.

The gas-to-liquids plant would create fuel from natural gas, taking advantage of the shale gas boom in the US, and will be the energy giant’s largest investment to date.

“The gas-to-liquids plant is not going to happen, not at these prices,” said an analyst who asked not to be named. “You need about $100 per barrel for it to work. Sasol will say they need $80, but at $50 it doesn’t make any sense at all. It’s not necessarily a bad thing”, the analyst said. “Shareholders were worried about it going ahead anyway … even with the subsidies.”

Terence Craig, the chief investment officer of Element Investment Managers, agreed. “What is likely is that future plans for gas-to-liquid plants will be put on the back burner in the current low oil price environment.”

Price differential
Speaking to the Mail & Guardian in 2013, Sasol chief executive David Constable said the price differential between the oil and gas price could go as low as 1:16. With oil dropping below $50, that ratio was hit this week.

Responding to questions, Sasol said the gas-to-liquids project was still in the front-end engineering and design phase, and a final investment decision on it would be made 24 months after that about the ethane cracker.

“In order to take an FID, the project must also meet our hurdle rate, which requires that a range of factors, including the macroeconomic climate, must be within limits to achieve that hurdle rate,” said Sasol’s spokesperson, Elton Fortuin. “Short-term forecasts are not a determining factor in the development of our project assumptions, as our project life cycles are in excess of 20 years.”

Sasol said lower gas prices improved the economics of the ethane cracker project, as feedstock costs would be reduced.

“Ethane is a by-product from natural gas production, and it is the increased natural gas being produced in North America that has driven the price of ethane lower, resulting in investment in new petrochemical projects, such as our project,” Fortuin said.

“The pricing of ethane in North America is driven by the dynamics of the natural gas market there, not the oil price … The market prices of the chemicals we produce are not directly correlated to oil and hence the current lower oil price impact on these chemical prices is negligible.”

US megaprojects
Kharva said: “When Sasol embarked on these megaprojects in the US, the assumptions it used to proceed with them may be out of kilter with what is happening at present in the oil market.”

According to his calculations, when the oil price is below $55 a barrel, Sasol is just breaking even at its synthetic fuels division at Secunda.

Craig said: “We expect material downgrades to Sasol future earnings forecasts over the next few weeks as analysts return to work.”

Sasol said the rand/dollar exchange rate also had a significant effect on Sasol’s earnings and the weakening of the rand against the US dollar was a factor that mitigated against lower oil prices.

“As reported in our 2014 annual financial statements, it is estimated that a 10c change in the annual average rand/US dollar exchange rate will impact our operating profit by approximately R857-million in 2015, depending on various economic factors.”

But the market isn’t buying into that as yet and, although consumers might delight in the lower oil price, investors are running scared. Fears that Greece might leave the eurozone have weighed on markets this week, but oil remains the biggest factor, and Sasol, usually the eighth-largest listing by market capitalisation, and the likes of BHP Billiton, have helped the JSE to dip to 47 000 points compared with an all-time high of more than 52 000 in 2014.

Economic realities
David Shapiro of Sasfin said the Sasol share price reflected economic realities. “The market is trying to build in what this [the oil price] could do to future profits,” he said. “I think it might have been overdone, but one is not quite sure how long it’s going to be at these levels. Markets tend to overshoot and people invested in this kind of industry tend to build in the worst-case scenario.”

Shapiro said it was hard to say what could happen as there has been no indication that demand for oil was picking up.

“Until we get signs of that, we can’t call the bottom.”

Nerves fray in the global battle for market share

Sasol is caught up in a much bigger game initiated by oil-rich Saudi Arabia, which has taken a decision not to cut oil production despite the oversupply.

“What Opec [Organisation of Oil Exporting Countries] have always done, they have cut production, bringing back the supply-and-demand balance, which pulls the oil price back up,” said Chris Bredenhann, PwC Africa’s oil and gas advisory leader. “But the reality has changed and, if they do that, they do it at their own cost of market share.”

With the boom in natural gas from shale oil, or tight oil, Americans could largely supply their own energy needs, he said, and, if the Saudis did cut production then Americans would take market share. “The reality is, marginal producers in the US need around $50 a barrel to break even. If the oil price goes below that, they will be pushed out. That will have a knock-on effect.”

It was a game of chicken, Bredenhann said.

The plan, if it is a plan, appears to be working. According to a December post on Oil-price.net, “applications for new US well permits dropped by nearly half last month”. But some industry watchers aren’t buying it. “I can’t see how Opec can push out American oil producers. Some of them produce at $50 per barrel,” said an analyst who did not want to be named. “Even if it goes to $40, as soon as it goes up again, they will just switch it [operations] back on. I think it could partly be a political agenda to put pressure on the Russian economy, although there is no proof of that.”

Economists.co.za director Mike Schüssler said it would not make much sense for the Saudis simply to target US energy producers when Opec members such as Venezuela had higher break-even points of $100 a barrel.

The end of the oversupply is not in sight as panic sets in and oil production soars.

Robert Besseling, the Africa analyst at IHS, said: “It will have an impact on the US, but not as much as most people are saying at the moment. Price around $50 per barrel will constrain US oil production. Most of the tight oil investment will dry up in the first quarter of the year.” This could mean “potentially a slight slowdown in the current pace of recovery, but it would not stymie recovery”.

Besseling said some oil experts expected the lack of investment in the first quarter to cause a correction in the second quarter and stabilise oil prices.

“In the longer run, there could be an opportunity for companies like Sasol, especially where they have access to expertise and technical know-how.”