How Sasol got Lake Charles so wrong

Sasol’s acknowledgment that its massive Lake Charles Chemical Project (LCCP) will require a further $1bn due to mistakes and cost overruns sparked a savage response from the market. It was to be expected, especially so late in the game, with 96% of the project completed.

In response to the dismal update, Sasol’s market value has fallen by R35bn — a brutal knock, given that Sasol warned of an escalation in costs of R14.75bn. Now, Sasol says its total investment in Lake Charles will be in the range of $12.6bn-$12.9bn — representing about 75% of Sasol’s market value.

The LCCP has been billed as the future for Sasol, which started life in 1950 as a state-owned oil company. Back in 2014, former CEO David Constable said Lake Charles "will enable future growth for decades to come". Constable also boasted of the team’s "strong track record in project management‚ engineering‚ fabrication and construction of similar large-scale petrochemical complexes‚ with deep expertise along the US Gulf Coast".

But the problem for Sasol is that last week’s cost hike is the third since the project was launched with an estimated price tag of $8.9bn. Two years after that, in 2016, the budget was revised to $11bn. It means the total cost of building the Louisiana plant, if we take the upper end of Sasol’s estimate ($12.9bn), could end up 45% higher than planned.

After last week’s revelations, virtually all analysts who cover Sasol slashed expectations. HSBC, Investec, JPMorgan, Renaissance Capital and Macquarie all downgraded it from a "buy" to a "hold". HSBC, for example, slashed its one-year target price from R525 to R400.

Partly, this is because higher investment implies lower returns. Sasol now expects, having updated its chemical pricing assumptions too, that its internal rate of return for Lake Charles will be between 6% and 6.5% — a mediocre result for a project from which so much was hoped.

Besides the lower returns, Sasol will incur greater finance costs owing to elevated debt required to complete the project, which should be a factor for a period of 18 to 24 months. At least the timeline remains intact, even if it’s costing more.

What concerns investors, however, is that Sasol doesn’t seem to entirely understand what happened. To establish this, it has asked "external experts" to conduct a review. "This review will cover the circumstances that may have delayed the prompt identification and reporting of the above-mentioned matters. Upon conclusion of the review, the board will take appropriate action to address the finding," it said.

So, was the market’s response justified? One shareholder particularly irked by the development is Visio Capital Management, which wrote to Sasol in February after the company issued an update to investors on the project.

In that update, Sasol pushed the price of Lake Charles up by $500m, citing changes to design, poor weather affecting construction, and productivity losses owing to absenteeism.

Visio asked whether the board and executive team really had a grip on the issues.

Sasol wrote back, assuring Visio all was under control. The board wrote: "We are satisfied that management has taken actions to ensure that the organisation learns from the lessons of recent months and completes the project within the revised guidance."

Patrice Moyal, Visio’s chief investment officer, says Sasol provided "firm assurances" that there was proper oversight of the project. "They were confident of the project timing and costs, but this has clearly not been the case."

Sasol’s update last week, however, suggested basic errors in calculation, which raises serious questions about just how much oversight the board and executive committee really exercised.

For example, the largest single line item given for the $1bn increase was a $230m adjustment for "duplication of investment allowances". This implies Sasol made a rookie error: mistakenly doubling the investment allowances it was to receive from federal and state grants.

Asked by the FM this week to explain these basic errors, Sasol spokesperson Alex Anderson appeared to suggest it was the project team on the ground at Lake Charles that messed up.

"They failed to engage the wider financial organisation to verify the accuracy of their underlying assumptions, and therefore, the forecast. The previous LCCP leadership was not transparent in these matters and the recently appointed LCCP leadership has been instrumental in identifying and remediating these issues," he says.

But Anderson is adamant that the lack of financial controls relates only to Lake Charles — and is not indicative of wider issues relating to the robustness of Sasol’s financial reporting.

Shareholders can be forgiven for wondering.

Visio, for one, thinks more needs to be done to align its project execution to executive remuneration. There should be some "shared pain".

Last year, Sasol’s joint CEOs, Steve Cornell and Bongani Nqwababa, between them took home R83.5m.

Moyal says: "Management and board remuneration has been inversely correlated to the delivery on shareholder value creation. We question the lack of controls and believe they have been more than generously remunerated for their efforts at value destruction."

Anderson says the project has only a 5% weighting in the scorecard used to determine executives’ short-term bonuses. But he says the negative impact of cost overruns at Lake Charles will be felt in items such as earnings and production volumes, which collectively carry a weighting of nearly 50%.

"In terms of the long-term incentives, in addition to the direct impact on the share price, [factors including] return on invested capital (25%), volumes (25%) and both total shareholder return measures are all directly impacted by the schedule delays and budget overruns," he says.

Feisty shareholders may not be accommodating when it comes to the AGM. The possibility of clawing back past bonuses may be raised, for example.

Asked about this, Anderson says Sasol does indeed have a clawback policy. "Should the circumstances that are specified in the policy be confirmed, the board will consider the triggering of the clawback conditions."

The other worry for investors is that while the finish line is near, the project isn’t done yet. Bringing the various units onstream is often tricky, for example. Ask any engineer if the "ramp-up" phase is risk-free and you might well hear an expletive.

The company will have to work hard to regain investors’ trust following this debacle — and Sasol will struggle to find any appetite to fund other big-ticket items in the near future.