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.
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.
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, 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.
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.
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.
Comments by oil services companies over many years have confirmed that Saudi Aramco is a significant client. For example, in its Q4, 2014 call Schlumberger commented that “activity reached a new record in Saudi Arabia led by growth from a number of key projects, and we expect to see continued strong levels of both rig related and rigless activity in the coming year”.
The big three oil services groups (Schlumberger, Halliburton and Baker Hughes) together generated $10.1bn of revenues in 2016 from the Middle East and Asia, down 15% from 2015. We estimate that US service companies generate some $4bn of revenues from Saudi Aramco and that the cost to Aramco is over $1/bbl, but it’s difficult to prove. In our calculations, we use a round figure of $10/barrel as the likely cost.
We have done a very simple calculation of the likely profitability of the core Aramco crude oil production business, using the published number of 3.7bn barrels of production, a cost of $10 per barrel, and a flat crude price of $50/bbl. We use a 20% royalty and 50% corporate tax, and assume overheads of c.$5bn and a (perhaps overly conservative) 2x dividend cover.
Aramco Financial Model
Revenue 185
Direct Costs -37
Royalties -37
Gross profit 111
Overheads -5
EBIT 106
Tax -53
Profit after tax 53
Dividend 26.5
If a $2tn market cap is used, this would equate to a P/E of 37.7x and a yield of 1.3%. Clearly with Shell and Exxon trading at a P/E of 15x and 21x and a yield of 7.1% and 3.7% respectively, such a valuation looks ambitious.
Our contention is that Exxon is overvalued because of its inclusion in multiple ETFs and that Shell is a better comparative to use; clearly this is arguable. Applying the Shell yield would give an Aramco valuation of $372bn and using its P/E would give $784bn. There is a plausible argument that Saudi Aramco should trade at a significant P/E discount and yield premium to Shell because of its geographical concentration, political risk and governance issues. Adding in say $50bn for its other businesses, it would be difficult to derive a valuation for Aramco of much over $500bn.
Alternatively, the $2tn valuation can be reverse engineered. On a generous 6% yield, it would require a $120bn dividend, which, based on a $10/bbl cost, would exceed the pre-tax profit. It is clearly an unrealistic aspiration, and would represent a valuation of over 10x sales; even the recently trailed lower internal valuation figure of $1.5tn equates to over 8x sales; such valuations have hitherto been the province of Silicon Valley technology start-ups.
The valuation of Aramco relative to its international oil company (IOC) peers is subject to some significant risk factors, including geographical, geological and earnings quality. In particular, country risk for this company is significant. The Saudi market is small (Tadawul Index has a $700bn market capitalisation) lowly rated, trading on a P/E of 13.8x forward earnings, a 50% premium to book, and offers a dividend yield of 3.6%, per Bloomberg. Aramco’s domicile will be perceived as risky, because
– it has a concentration of assets in a volatile region, with restricted maritime access
– the potential for a change of policy by the existing ruler, a voluntary change of ruler or an enforced change of system are clear political risks
– if oil prices remain low, there could be a reversal of its recent corporate tax cut in order to maintain budget stability
Reserves risk is perceived as high as the company/state has been secretive in the past and there has been suspicion that its reserves were over-stated. This risk could prove largely irrelevant as all the reserves are unlikely to be exploited (on flat volumes, they would last until 2090).
Governance is clearly a sensitive issue both for the seller and potential international investors; there has been no suggestion as yet that Aramco will appoint an internationally experienced businessman as non-executive Chairman, but if not, a significant governance discount will be required; and even if an appropriate suite of non-executives were to be appointed, some governance discount will certainly be necessary.
The IPO valuation will be capped by the company’s limited growth prospects. Aramco’s earnings from the production of crude oil will inevitably decline in a stable oil price environment as new production comes at a higher cost; hence the dividend growth potential will likely have to come from other sources; but replacing the core cash flow stream will be difficult and returns there will almost inevitably decline, unless oil prices rise.
Moreover, Aramco is less geared to higher oil prices than its peers, as its estimated cost of production is far lower and hence incremental rises in oil prices have a much higher geared effect on its peers. The chart illustrates the sensitivity of Aramco’s profitability at a $10 production cost vs a peer with a $35 production cost to changes in oil prices – Aramco derives much less benefit from higher oil prices. And although its downside is better protected than its peers, the downside risk for Aramco is greater than the upside because of likely lower output if oil prices are weaker.
Hence if Aramco’s earnings growth depends on higher oil prices, then an IOC would be a better investment, unless Aramco was priced at a significant discount. Equities in commodity sectors are generally considered higher quality if they have a lower cost of production. Aramco is unusual in being low cost and lower quality than peers.
There are upsides to the valuation, notably in that the downstream and other businesses could have a significant value. We assume a $50bn valuation, but clearly this could be significantly lower or possibly somewhat higher. Similarly, production costs could conceivably be lower than our $10/bbl estimate. Even if they were higher, that could reflect a significant investment already incurred, which could mean lower future investment and higher future free cash flow, boosting the valuation.
The most important upside to the valuation relative to the IOCs is reserves replacement. Oil majors reserves’ lives have been falling for several years, as reserves replacement has been below 100%, certainly organically (although Shell’s mega-acquisition of BG has boosted the overall ratio). Finding costs for the majors have fallen significantly as reserve replacement has declined. Reserve life for the majors is now estimated at around 13 years.
A comparison of Free Cash Flow should certainly favour Aramco, and it is conceivable that dividend policy will be set at a higher payout of earnings than the international players as less cash is required for investment, and notably reserve replacement. This could boost the valuation significantly, but we contend that earnings multiples will be constrained by the peer group average and by the geographical/political risk.
It may be impossible for an outsider to value Aramco accurately, but a $1.5-2.0tn valuation is stretching credibility beyond comprehension. We believe the IPO timetable is ambitious, and the valuation aspirations are totally unrealistic.
Aramco is unusual for a commodity producer in that it is both low cost and lower quality. Market consensus is that the Aramco IPO is a key support for the oil price over the next 12-18 months. A failure to IPO Aramco would undermine one bull argument for higher oil prices. It should not be a surprise if the Saudis cancel the IPO and resort to a combination of sovereign debt, Aramco debt issues, and other privatisations.
An alternative would be a private placement of equity with one or more Chinese state-owned enterprises; they might have a more strategic objective and value security of supply over financial return on investment.
Saudi Aramco was IPO’ed on 5 December, 2019 with a market capitalisation of $1.7 trillion. In spite of a COVID-19 induced collapse in the oil price, its shares have been resilient as can be seen in the chart of its market cap in doillars since IPO.
