20/03/2020
Coronavirus, Oil Price Wars and Sasol
For investors in the Allan Gray and Orbis equity funds, periods of short-term volatility are inevitable and shocks to local and global shares are not unusual. Nonetheless, the recent outbreak of coronavirus (COVID-19), as well as the crash in oil prices this week, has come at a time when our performance has been under pressure. Over the last five years, South African equity returns have been weak compared to cash, and the poor local economic backdrop only adds to the concern about what potentially lies ahead. We acknowledge that seeking comfort by switching or changing strategies may seem appealing, but there are opportunity costs to this decision. Below we hope to share some insights on these recent events.
Covid-19 Fears about the coronavirus have dominated both news headlines and markets over the past two months. The global economic impact of the coronavirus depends as much on reactions to the virus as it does on the spread of the virus itself. Questions about data quality abound, but as of 29 February, there have been 86,000 confirmed cases globally, over 90% of which have been in China. 2,900 people have died from the coronavirus, most of whom were elderly or had other health conditions. 2,700 of those who have died were in Hubei.
That is truly, truly awful, but it is important to keep the coronavirus in perspective. In the US alone, the ânormalâ seasonal flu infects 30 million people and results in 35,000 deaths in a typical year. As ever, our focus is on the relationship between market prices and company fundamentals, and on the long term rather than the next month or quarter.
A good example of how the virus can impact share prices, is Honda. The impact on automotive companies like Honda Motor, which Orbis owns on behalf of its clients, is negative. Half of Hondaâs Chinese production is in Wuhan (where the first outbreak of Corona was identified) and most auto dealers were forced to close, which hurts profits. The share price was down about 10% in the week to 28 February 2020.
As long-term investors, we need to consider whether the long-term value of the business is permanently impaired by 10%. We donât believe so, as car sales in China will resume eventually and production will recommence. In addition, Hondaâs auto business outside of China and its world-leading motorcycle business seem to have been forgotten in the noise of global markets.
For other companies, the financial impact may not be negative at all. Naspers, which has meaningful exposure to Tencent, and NetEase are two of the largest holdings in the Allan Gray and Orbis equity portfolios. These companies make and operate online games in China. Youdao, a NetEase subsidiary also offers online education services. For many in regions that are locked down by the contagion, leaving the house for entertainment or education is out of the question, and Tencent and NetEaseâs games and services provide a way for people to entertain themselves or study at home.
Locally, the market has also taken strain. Over the week to 28 February 2020, the FTSE/JSE All Share Index fell by 11%. The S&P 500 suffered its worst week since the 2008 financial crisis, its worst day since 2011 and its fastest 10% correction ever.
The above are just a few examples of how negative sentiment can create opportunities. As contrarian investors, we tend to find opportunities when the mood is depressed, and the coronavirus has only added to the prevailing pessimism for stock market returns. Many local shares are currently at multi-year lows and our investment team is finding more opportunities than we have in many years. As we have often said, the most important determinant of future returns is the price you pay for an asset.
Oil Price Wars The oil price crashed by as much as 30% intraday on the 9th of March 2020 after Saudi Arabia fired the first shots in a price war. This was crudeâs biggest one-day fall since 1991 (Gulf war) and the second largest since oil began trading on the NYMEX in 1983.
The cause: Saudi Arabia wanted to lead Opec and Russia in making deeper cuts to oil production to support crude prices in the face of reduced demand as the coronavirus outbreak disrupts global economic activity. Russia balked at the plan and Saudi ultimately responded by raising their production and offering it at steep discounts, this causing the significant price decline.
Ironically, the outlook for the oil price is the best it has been in a long time. US oil production growth has plateaued in recent months and at these oil prices, US production will slow sharply as the industry is cash flow negative at US$50, let alone US$35. US shale oil is not the only production source facing declines â the capital starvation of the past five years is beginning to bite in several jurisdictions. If oil prices remain low for a period of time, many US shale producers are likely to face bankruptcy, which should ultimately reduce supply further. The current Saudi/Russian strategy is perhaps the right one for a strong stable market in the long term.
Our Sasol holding and the impact of Corona and the Oil Price Wars We have owned Sasol on behalf of our clients for many years. It accounted for 2.5% of the Allan Gray Equity Fund, 1.9% of the Allan Gray Balanced Fund and 0.9% of the Allan Gray Stable Fund, just prior to the share falling 47% on 9 March on the back of the oil price plummeting.
Up until the end of February 2020, Sasol was the biggest absolute detractor over a 1-year period. However, in the latter half of 2018 and the first half of 2019 when the share was above R400, we sold 38% of our holding before news emerged of additional cost overruns and delays at LCCP. As a result, Sasol was only a marginal detractor (on an absolute and relative basis) over a 3- and 5-year period in our Equity Fund to the end of February 2020.
Why do we still hold the share today? And what are our views on Sasol going forward? Sasol management have made several mistakes over the past few years and ultimately destroyed value. Our estimate of their intrinsic value has subsequently decreased, largely driven by the significant cost overruns at the Lake Charles Chemicals Project.
The oil price crash places Sasolâs balance sheet in distress. If the oil price remains depressed for a prolonged period, we believe that Sasol would breach its debt covenants (3.5x net debt to EBITDA at June 2020; 3x net debt to EBITDA at December 2020). This significantly increases the probability of a rights issue. It is also worth noting that a low oil price may also negatively impact chemical prices. Despite chemical prices already being depressed, there is a risk that they could fall further.
At the current oil price, the company is cash flow negative. Whilst we donât believe the current oil price is sustainable, and that a higher than $40/barrel price will prevail in future, it is highly uncertain how long the current low price environment could persist. Whilst we still see significant value in the company, we are currently maintaining our position to keep capacity available to be able to follow our rights if needed.
A series of delays and cost overruns at Sasolâs massive Lake Charles Chemicals Project (LCCP) in 2019 were extremely disappointing. The LCCP cost estimates were revised upwards in February and in May (to $12.6-12.9bn) and EBITDA guidance revised downwards numerous times. The most recent decline was as a result of an explosion in one of the LCCP units in early January.
Furthermore, the financial results were disappointing and it became clear that future returns from the LCCP will be lower than initially expected. This is due to the current depressed chemical prices as well as higher than expected debt in order to build LCCP.
The delays, together with lower chemical prices affecting the profitability of LCCP, caused the share to fall to R300 by year-end from R425 in January 2019 despite the rand oil price rising 19% over the period. On 9 March 2020 the share price fell to R85.
What can Sasol do? Sasol could look to renegotiate covenants with its banks if the covenants are breached. The covenants are attached to their revolving credit facility. Management are also pressing ahead with their strategy of selling $2bn of non-core assets. They expect to have $500m of sales completed by June 2020.
More broadly, Sasolâs predicament is not unique in the oil industry. Many oil companies, especially US shale producers, cannot sustain production at spot oil prices. Supply should ultimately be curtailed in future leaving the industry in a more stable predicament and higher prevailing oil prices, which should be beneficial to those companies that can weather this storm.
*Spot prices: Brent crude $36.50 / Rand R15.85
Looking forward Looking across broader asset classes in our Balanced and Stable funds, South African bonds currently offer some of the most attractive real yields globally. The bond market appears to be pricing in a potential credit rating downgrade and we have taken advantage by increasing our duration over the past year.
In the local equity space, we are seeing good value across sectors. Prices have come down substantially since December and numerous companies are trading at free cash flow yields of over 10%. We have not seen expected total returns of this magnitude since the early 2000s, when South African shares were extremely out of favour, and the global financial crisis of 2007/08, both of which proved to be exceptional opportunities to invest in equities. We are excited about the prospects for real returns for our client portfolios. The price correction on Friday and Monday only amplified this view.
Abroad, the 10-year US Treasury yield fell to an all-time low, and now yields less than 1% as the US Federal Reserve has cut rates. In the offshore component of the funds, we are optimistic about the shares Orbis finds attractive and also hedge a portion which helps to protect our funds during a market downturn, but still benefit from Orbisâ stock-picking capability.
Being a long-term investor has its challenges. It can be really tough not to panic, but rather be patient and sit tight. At times when others are fearful, a long-term perspective is not just a bulwark against emotional decision making, but also a source of opportunity.
