Saudi Aramco’s natural gas
liquids plant and oil production base
in the Shaybah field. Some have
suggested the Aramco IPO value
would need global oil prices of
around US$70 per barrel.


Despite extreme fiscal stresses felt by OPEC’s members, an unlikely accord emerged from behind closed doors on November 30. Members set aside fractious geopolitical tensions to try and stem the bleeding, and Christmas came early for long-suffering oil markets.

The agreement leaves the output for Libya and Nigeria as unrestrained. Actual reductions in OPEC production weren’t fully in place until January. In the interim, OPEC gathered support from key non-OPEC members, with Russia signalling a willingness to participate meaningfully. Although the agreed-upon supply cut to 32.5 million barrels per day doesn’t immediately solve oversupply issues, it will likely move the global oil market toward a rebalancing as early as the first part of 2017.

Saudi Arabia suddenly agreed to what had previously been a non-starter: committing to steep cuts while arch-rival Iran does not. Saudi Arabia was seemingly positioned to weather a protracted market share war while sitting atop a staggeringly large war chest. Developed-market inventories had bloated to more than 300 million barrels of surplus. Then Saudi Arabia blinked. Why?

The simplest answer: Saudi Aramco

Saudi Arabia has embarked on an ambitious plan, called Vision 2030, to diversify away from oil. Launched by Deputy Crown Prince Mohammed bin Salman, Vision 2030’s apparent centrepiece is the sale of up to 5% of Saudi Aramco, the world’s largest oil company. The partial initial public offering (IPO), likely in early 2018, would be an unprecedented stock deal and create the globe’s biggest publicly traded energy company. The plan hinges on Saudi Arabia setting up the world’s largest sovereign wealth fund, the lynchpin of the Kingdom’s plan to reduce its reliance on hydrocarbons.

Chart 1: Saudi Aramco would be history’s biggest IPO

Chart 1: Saudi Aramco would be history’s biggest IPO

In November, Saudi Arabia agreed to cut almost 500,000 barrels per day with a goal of raising oil prices. Where prices go will depend on the extent to which OPEC and non-OPEC participants comply with their commitments. So why did OPEC’s most powerful player concede? To shore up the valuation of Saudi Aramco ahead of the world’s largest stock issuance.

Saudi Aramco’s worth might be difficult to determine, as it includes future price expectations, an estimate of the size of the company’s remaining oil and gas reserves, and other factors like the value of downstream refining and petrochemical assets. Saudi Arabia says a 5% stake in Aramco is worth US$100 billion. Some have suggested that to support this value, global oil prices would need to be US$70. Given the country’s influence, this may be the simplest prediction of where prices are headed in 2017.

Aramco: most valuable company

Explorers from Standard Oil first struck oil in 1938 with the establishment of the Arabian American Oil venture. They went on to discover the Ghawar field, still the world’s largest onshore deposit. In 1980, the Saudi government nationalized the world’s largest oil company. Aramco currently generates 90% of the government’s revenue, and its oil accounts for as much as one in eight barrels consumed on the planet. That’s why Aramco is known as the world’s swing producer: its production decisions are the dominant force in oil markets. If US$70 per barrel is what the Saudis want, it’s what they’ll get.

Aramco’s scale is mind-boggling. The company says it has discovered more than 800 billion barrels of oil. Of these, 141.5 billion barrels have been produced, and of the remaining barrels, more than 260 billion are reserves the company says it’ll likely recover. Aramco has said it employs about 65,000 and creates work either directly or indirectly for about 200,000 people (see Table 1).

Table 1: Aramco against top global peers

Source: Company reports; Bloomberg; Bernstein analysis, June 6, 2016.

Aramco Rosneft Exxon Mobil PetroChina Shell
Oil and condensate reserves (bn BbIs) 261.1 32.0 14.7 8.5 5.3
Gas reserves (TCF) 297.6 67.0 60.2 77.5 37.4
Total reserves (bn Boe) 310.7 43.8 24.8 21.4 11.5
Oil reserves 84% 73% 59% 40% 46%
Gas reserves 16% 27% 41% 60% 54%
Total liquids (MMBbls/d) 11.5 4.1 2.3 2.7 1.5
Gas sales (Bcf/d) 8.8 6.0 10.5 8.6 9.5
Total production (MMboe/d) 13.0 5.1 4.1 4.1 3.1
Refining throughout (MMBbls/d) 1.8 2.1 4.4 2.0 2.8
Number of employees 65,266 243,023 73,500 521,566 93,000

Easier said than done?

An Aramco IPO probably seems daunting. The company’s financials are a riddle, and its structure is unique. What will really be for sale to investors?

Aramco CEO Amin Nasser has acknowledged the firm must do a lot of work to prepare for an IPO. He’s also indicated the offering will include refining, marketing and distribution. Yet some experts have suggested that the upstream operations—those aging super-giant oilfields—may not actually be part of the IPO.

OPEC has traditionally allocated production quotas based in part on reserves, and in doing so created an incentive to misrepresent reserves. Chart 2 shows the gap up in Saudi reserves in the 1980s—when the cartel’s quota formula was determined—and there’s been virtually no change to the reserves since. After decades of production, few people now accept the legitimacy of these reserves. However, listing shares on the world’s main stock exchanges would require greater transparency. We don’t even know how much oil is really left in Saudi Arabia (see “Focus on oil facts,” AER December 2016).

Chart 2: Saudi Arabian oil reserves

Enlarge

Chart 2: Saudi Arabian oil reserves

There remain other risks to the IPO, with more questions than answers. The company does not disclose how much tax it pays, but some estimates say the rate is 93%, since the company hands nearly all revenue to the state. A tax rate this high could dissuade investors and raise concerns about shareholders receiving a fair share of profits. What’s more, tensions with the U.S. have risen. Legislation may now pave the way for victims of the September 11th attacks to sue the Kingdom, and recent moves to block arms sales to Saudi Arabia, as well as a Donald Trump presidency, seem to represent a significant sea change in U.S. relations with the Arab world. This may ultimately impact the stock exchanges where shares of Aramco will trade.

Energy investing in 2017

Regardless of Aramco, there is growing optimism about a more balanced market in the coming months, and investors have become increasingly constructive on energy for 2017. Coming out of the crash, the oil and gas sector has reinvented itself with a leaner, more competitive cost structure (see “Oil: $60 is the new $90,” AER September 2016). Investors should focus on stronger companies with access to capital and sustainable cost structures as we emerge from this downturn.

by D. Mason Granger, P.Eng., MBA, CFA, is a portfolio manager in Toronto.

Originally published in Advisor's Edge Report

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