//The $2tn Saudi Aramco question

The $2tn Saudi Aramco question

Its backers expect a valuation of $2tn. Even a partial slice of its business is likely to add up to the biggest ever initial public offering. And as a byproduct, it offers the prospect of a glimpse into the inner workings of one of the world’s most closed societies.

The part privatisation of Saudi Aramco, Saudi Arabia’s national oil company, is causing a huge stir well beyond the energy market and the offices of bankers and lawyers vying for contracts. A $2tn valuation would be equivalent to two-thirds the size of the London Stock Exchange, one of the markets on which Aramco may list. And it would make Aramco more than twice the size of Apple, the world’s biggest company.

But that $2tn figure is hard to believe. The company has disclosed very few financial details and its annual report lacks figures such as group sales or profits.

Instead an FT analysis points to a valuation roughly half that size, reflecting the difficulties faced by the Saudi authorities in selling even a sliver of Aramco on international markets, given the company’s complex structure, its unique and sensitive role in the country and the legal issues that will surround its planned listing. That is even without looking at the question of how much oil actually lies beneath the desert kingdom’s sands.

Riyadh looks to diversify

Mohammed bin Salman, the kingdom’s deputy crown prince and the power behind the throne of his father, King Salman, revealed the IPO idea in January 2016. It was initially proposed as a sale of just 5 per cent of Aramco, with perhaps more to follow, and came as a response to falling crude prices which have damaged the oil-dependent Saudi finances and accelerated the drive to diversify the economy.

The kingdom needs to shrink its enormous fiscal deficit of $75bn, well over a tenth of gross domestic product last year. In the five years to 2015, the government exceeded its budgeted expenditures by a quarter on average. Even with a recovery in oil prices to about $50 a barrel this year, the country will struggle to close that gap.

Subsidies have been slashed and public salaries cut as part of government efforts to improve efficiency throughout the state-run economy and diversify revenue streams by 2030. “Their plans are very ambitious. Even only partial completion would boost their [credit standing — now at A1] and offer a route to a higher credit rating over time,” says Steffen Dyck at Moody’s.

Privatising Aramco is the first step in rebalancing the economy. By disentangling the company, which accounts for more than two-thirds of government revenues, from the state, Prince Mohammed hopes to make Riyadh less oil-reliant, while providing capital for investment in new industries, ranging from technology, where it is pumping $45bn into the SoftBank Vision Fund, to mining. The privatisation of its national champion is crucial to this process.

Loosening state ties

The separation of the oil enterprise from the state threatens to be painful. From operating hospitals to building sports stadiums, Aramco has grown into a conglomerate way beyond its energy interests. Splitting off peripheral activities will be complicated but necessary for potential investors to be able to focus on Aramco’s hydrocarbons.

Another issue is how much oil Aramco can actually claim control over. In other privatisations, such as Norway’s Statoil, the state had allowed foreign competitors to operate fields in the country. “International oil companies even had ownership in the Norwegian continental shelf,” notes Hans Aasmund Frisak, Statoil’s head of government relations. This gave Norway a clearer sense of how efficient Statoil was compared with its international peers, and helped to verify its oil reserves.

In contrast foreign oil companies have had only limited access to Saudi oil via joint ventures since completing its nationalisation of the industry in 1980.

Aramco will have to control all of the state’s 261bn barrels of reserves to achieve the highest valuation. The kingdom’s repeated assertions that Saudi Aramco deserves a valuation of $2tn hint that all of these oil reserves will be on its balance sheet. Presumably the country’s 298tn cubic feet of natural gas, equivalent to 49bn barrels of oil, will also be included.

Analysts have suggested that Saudi Arabia might spin off just a component of the group, its refinery business for instance, so as to keep the bulk of the company out of public view. That probably would not do the trick for investors, as Aramco executives have acknowledged. An IPO will probably be of the whole company, including oil production and any downstream refining plus chemicals. Refining assets, the FT estimates, are not likely to be worth much more than $40bn.

No matter how much oil and gas Aramco actually oversees, the cash earnings rather than the assets will matter more to the market. The size of those earnings will depend heavily on two things, the oil price and lower taxes. Last week a royal order slashed the income tax rate for the hydrocarbons industry after it was suggested the high rates would deter investors. For Aramco, that meant a cut from 85 per cent to 50 per cent.

So how much is it worth?

For all the scepticism over the attempt to detach a national champion from state ownership, this is a well-worn path. The UK was an early adopter of using share placements, beginning with British Petroleum (BP) in 1977. Other countries such as Brazil with Petrobras and Norway with Statoil have since sold off large stakes in their oil companies.

Aswath Damodaran, a finance professor at New York University, highlights some myths about valuation. A common one is that the more quantitative or complicated a model, the more accurate the valuation.

Instead, Mr Damodaran argues for keeping things simple. With Aramco, he is for the moment getting his wish: there are few reliable numbers. Nevertheless, a reasonable estimate of Aramco’s total value is possible by working through assumptions about its costs.

The starting point is to look at the $2tn figure and try to work out how Saudi officials arrived at it. Dividing it by the stated reserves (261bn barrels) plus its natural gas assets arrives at a figure equivalent to $6.47 a barrel as the approximate discounted present value of the company per barrel of oil it holds. Compared with other international oil majors from ExxonMobil to intermediate explorers such as Anadarko, this figure looks high though not crazy.

That is very much a back-of-the-envelope calculation. To get a more durable estimate, the Financial Times calculated its own discounted cash flow valuation. This required some leaps of faith. We made an oil price assumption starting at $50 a barrel for the years ahead and multiplied it by the expected upstream production to generate a simplistic top line. This central case assumes long-term production of 10m barrels a day. We then deducted royalties, operating and financial costs and tax to arrive at a net profit figure.

Operating expenses and capital spending were together estimated at $40bn annually for the next decade by Khalid al-Falih, Aramco’s former chief executive and now energy minister, in 2014.

Given that oil service costs have come down since then, probably these expenses have fallen. Using lower numbers on a per barrel of production basis, and making the big assumption that the Saudi oil reserves are as stated, we can take a stab at valuing Aramco (see interactive calculator).

Calculating an annual cash flow and then subtracting capital expenditure leaves a free cash flow figure, which when discounted and added up over time leads to a valuation. “A stable cash flow is key if Aramco is to deliver a dividend to potential investors,” says Espen Erlingsen at Rystad Energy.

If we then tack on something for Aramco’s not insignificant refining and chemicals business, the total comes to several hundred billions. But not $2tn.

Start with a $50-a-barrel oil price and factor in a steady lift from inflation over the first five years. Then, as well as adopting the new 50 per cent tax rate, the FT has also halved the royalties from 20 per cent to 10 per cent. We believe this change is being discussed with advisers. On these assumptions Aramco would be worth nearly $900bn. Any lost tax revenues would mostly be replaced by a dividend to the state. Sell 5 per cent of Aramco and on this valuation it should raise $45bn.

That may not be as much as the kingdom expects, but it would still dwarf the $25bn Alibaba raised in 2014, the largest IPO ever.

Alternatively some might consider Aramco as a low-growth, income stock. Even though it is the most powerful member of Opec, the oil producers’ cartel, Saudi Arabia is restricted in being able to raise production. Thus earnings growth would mostly have to come via oil and gas prices.

If all of the free cash flow goes to the dividend, that would mean a high payout but not an unrealistic one for a cash cow. On a 5 per cent required yield, similar to the largest oil groups, Aramco looks to be worth at least $1.1tn. With the dividend expected to grow steadily, the valuation would rise higher still.

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Where Aramco floats matters

The location of the float could also affect the valuation. New York and London are the main contestants to lead the foreign part of the offering. Of the other exchanges, Tokyo and Toronto reportedly remain in the running.

The US has the deepest capital market but the UK is seen as more international in flavour. The LSE already hosts many multinational resources companies. But occasionally listings have gone awry, prompting tighter rules some of which may be impractical or unappealing to Aramco. These include protections for independent shareholders and a requirement for 25 per cent of shares to be floated. An exception to this rule would be needed.

Yet a US listing has its own problems. The Saudi state has exposure to lawsuits in the US. In September, the US Congress overrode a presidential veto to pass the Justice Against Sponsors of Terrorism Act. This allows US citizens to file lawsuits against individual nations if they believe themselves harmed by terrorists from a specific country. Claims have already been entered into court against the kingdom because of the involvement of Saudi Arabian attackers in the 9/11 terror attacks.

“I do wonder why the Saudis are not more worried about JASTA, really,” says Robin Mills of Dubai-based energy consultants Qamar Energy. Given the sovereign risk on a US listing, investors will probably put some discount on Aramco’s valuation if it chooses New York.

While a discounted cash flow valuation captures long-term potential earnings, the notion of Aramco as a yield play appeals. It fits with the keep-it-simple doctrine. Of course, any sovereign risk worries in the market could depress all of these valuations.

While the Saudi Aramco deal may appear daunting in scale, to financiers and investors it is plainly do-able. The biggest test could be openness. Mr Falih told the FT last year that the Aramco IPO would be “the most transparent national oil company listing of all time”. But doubts remain about the Saudi authorities’ willingness to share their national oil business with an inquisitive and sometimes critical outside world.

Email the Lex team at lex@ft.com

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