The audit of the geological reserves is also a potentially contentious issue. Apparently both Gaffney, Cline and Associates (a subsidiary of oil services major Baker Hughes which has a technology centre in Saudi Arabia) and Dallas-based DeGolyer and MacNaughton have completed audits which have confirmed the Saudi figure of c.265bn barrels. This estimate has been questioned over many years by a number of independent analysts – the chart shows that the reserves quoted by OPEC have flatlined in the last 25+ years, in spite of production which might have been expected to reduce reserves significantly; amazingly, new discoveries and technological advances have almost exactly matched production, a feat which no other oil major has achieved.
Whether these audits will meet exacting SEC requirements or whether the company takes the option of a venue outside New York (which will permit less onerous international standards to be applied) is a question occupying observers’ attention.
The timescale for an organisational restructuring, construction of audited financials, and resolution of reserves audit issues is extremely tight; senior management, unaccustomed to outsiders’ interference in internal affairs, will be under pressure.
Listing Location
Clearly, Aramco will be listed on the local Saudi Exchange, but a sole listing is impractical given the size of the flotation and the issue of where else to list the shares is apparently a vexing question. New York may have to be ruled out because of the reserves accounting question. London would be the obvious choice, but the IPO would not meet the free float requirements for inclusion in the FTSE Indices. The Sunday Times last week reported that the Investment Association has written to the regulator to say they would not tolerate any listing that did not adhere to the market’s rules and standards; it is thought this is a reference to the Aramco IPO.
We suspect that a way to accommodate Aramco in London will be found, as the alternative, a listing in Singapore or Hong Kong, would not be satisfactory from the perspective of US and European capital. One route would be to create a new investment trust or closed-end fund, with 100% free float on the London Exchange. It could own say 4% of Saudi Aramco, and it would flow through Aramco’s dividend payments direct to its own shareholders.
By placing the majority of this fund with Chinese SOE investors, and by setting it up to meet index inclusion requirements, a real shortage could potentially be created. The FTSE 100 Index is currently capitalised at c. $3.1tn. A fund owning 4% of Aramco will therefore be 0.6% of the index if Aramco is valued at $500bn or 2.6% at the desired upper-end $2tn valuation range. We discuss the valuation ranges below.
Oil Prices and Production Volatility
Weakness in the oil price or Aramco volumes will reduce the valuation, potentially significantly. It’s possible that restraint from the Russians, Iranians and other OPEC members will be maintained; it’s even possible that shale producers will not gear up production, but it seems an unlikely combination. Clearly the valuation of Aramco will be dependent on the market’s assessment of long term oil prices, but current year profitability will determine the starting dividend and this is crucial to the IPO valuation. Hence the market is convinced that the Aramco IPO means that the Saudis will have to support the oil price.
Catch 22: achieving higher prices may force the Saudis and OPEC to reduce production, but lower volumes means lower revenues and profitability for Aramco. Meanwhile, Aramco is expected to see production ramp from developments at the Shaybah and Khurais fields which will boost costs. The crude oil market backdrop is therefore also a serious potential risk to the timing of the flotation.
Valuation
Valuation, however, is the real challenge. The Saudi ambition to sell 5% of a $2tn business is unlikely to be achieved. We believe the valuation will be less than half this level, and the proceeds will fall well short of $100bn, insufficient to make much difference to the Saudi budget, and potentially a very limited net gain when the reduction in the corporate tax rate paid by Aramco is factored in.
Background
On January 4th, the Kingdom of Saudi Arabia’s Deputy Crown Prince, Muhammad bin Salman, told The Economist that Saudi Arabia was considering the possibility of floating shares in Saudi Aramco, adding that he personally was “enthusiastic” about the idea. The Economist article suggested that officials thought the company was worth trillions of dollars and subsequent press speculation has settled on a valuation of $2 trillion.
Financials
There are almost no financial data available for Aramco, but we know enough to make a rough calculation of likely revenues; given that crude production is by far the largest income source, we ignore the other business areas, including gas and downstream, for the moment. Our missing element is costs, and while we understand that its largest asset once had a lifting cost of c.$2/barrel, it is likely that it has risen to at least $5-8/bbl and more likely $10/bbl or more in more recent times, given that the rig count has increased by a multiple in the last 20 years. As reported in the Financial Times, Saudi Aramco CEO Amin Nasser commented in New York in mid-April that the company was investing heavily in future crude production and it is clear that the company’s cost of production will inevitably rise from here, as the easy oil has been extracted.