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Saudi Aramco’s $2 Trillion Valuation Has Too Many Assumptions


Changing a tax system that has endured since the 1970s is no small matter, especially when it concerns what could be the world’s most valuable company. Saudi Arabia’s announcement on Monday that it was cutting the tax rate on large oil companies to 50 percent from 85 percent is crucial for the fate of the initial public offering of state oil giant Aramco. But is it enough to bridge the gap between a $2 trillion aspiration and independent estimates of $400 billion?

When the IPO was first publicly suggested in January 2016, a notional value of $2 trillion was given, and it has become important to justify a figure around this level. The problem is that this number, based on a simplistic multiple of the company’s reserves, overlooked two factors: Aramco’s high tax rate, and the long period over which reserves are expected to be produced.

The original tax rate of 85 percent was set back in the 1970s, when Aramco was still a consortium of U.S. majors: Exxon, Mobil, Chevron and Texaco. Nationalisation was completed in 1982. The company also pays a royalty on gross revenues of 20 percent, which has apparently not been affected by the latest reform.

In a sense, the tax change is largely an accounting trick. With more than 80 percent of government revenues coming from Aramco’s production, the amount of money flowing from Aramco has to be maintained. Instead of paying most of its profits to the state via tax, Aramco will instead pay them as dividends. This has the welcome effect of better aligning the interests of state and the future private investors.

Instead of a multiple of reserves, private investors will look instead to value Aramco based on the free cashflow it generates. On this basis, the consulting firm Wood Mackenzie was said to value Aramco’s core production business at $400 billion, using a standard 10 percent annual discount rate. Our estimates come to a similar range, allowing for a moderate increase in oil prices over current levels.

This assumes, though, that all Aramco’s barrels are sold at world market prices. Of its 12 million barrels per day of crude oil and natural gas liquid production, almost 4 million is consumed at home where, despite 2015’s subsidy reforms, gasoline still sells at around $32 per barrel. Even though natural gas prices doubled to $1.50 per million British thermal units, they remain well below the U.S.’s $2.84, and even further below prices in Europe or Japan.

So how does Saudi Arabia bridge the valuation gap? It’s simple enough to see that cutting the tax rate to 50 percent from 85 percent would increase an initial value of $400 billion to $1.333 trillion. A moderate increase in domestic natural gas prices could add another $100 billion or so. Refining, petrochemical and shipping assets, net of debt, may be worth around $60 billion, but their operating performance has not been very impressive.

This may get Aramco close enough to its original figure to declare victory, but it assumes that investors do not discount heavily for factors such as high political influence, lack of transparency, and possible misalignment between the objectives of government and investors. Other listed national champions, such as Russia’s Gazprom and Rosneft, and Brazil’s Petrobras, trade at multiples far below those of their non-state peers.

Aramco may shed its non-core activities, but it will still carry the national mission, including enforcing the Kingdom’s OPEC policy. On the other hand, strategic investors, such as the Chinese state entities being wooed by Beijing, might pay a premium for access.

Beyond that, there are not many levers to pull. Cost cuts, the usual panacea, do not affect valuation much. While there is no doubt room for more efficiency, Saudi Arabia’s favorable geology and huge economies of scale already give it the industry’s lowest costs per barrel.

The company’s growth is constrained, in that its dilemma is essentially that of Saudi Arabia itself. It cannot expand production rapidly, despite its giant reserves, since this would crash oil prices. Conversely, as the current OPEC deal is demonstrating, cutting production boosts prices only modestly while giving up market share to OPEC colleagues, Russia and U.S. shale producers.

Much is made of the company’s 261 billion barrels of claimed oil reserves, the audits it is carrying out, and the requirements for disclosure on different stock exchanges. As noted, a multiple of its reserves was the basis for the original $2 trillion estimate of the company’s value. So what impact do the reserves have on its valuation? The answer may be surprising: absolutely nothing.

This is because, unless Aramco’s reserves are far below the claimed number, it can sustain current levels of production for decades. Even if its reserves were half the official figure, its notional reserves life — reserves divided by annual production — would be 34 years. That compares with 14.1 for the five largest international oil companies.

Of course, these figures should not be interpreted simplistically, but with improved recovery and new discoveries, Aramco should be able to maintain steady production growth for decades. Revenues that far out will be discounted to negligible levels.

This is even more so given the doubts over long-term demand, and the impact of growing efficiency, climate policies and electric vehicles. There may be reasonable skepticism over their impact within a decade or two, but it will surely be significant by the 2040s. In most projections, oil will remain a valuable fuel for aviation and feedstock for petrochemicals. The last barrel in the world will probably come from under Saudi sands — but it may not be worth very much.


7 Comments on "Saudi Aramco’s $2 Trillion Valuation Has Too Many Assumptions"

  1. rockman on Wed, 29th Mar 2017 12:22 pm 

    “…based on a simplistic multiple of the company’s reserves”. And thus an even more critical assumption that no one has brought up: Aramco may actually own NO OIL RESERVES. IOW as long as the oil remains in the reservoir it belongs 100% to the Saudi govt.

    Don’t laugh: that is exactly the situation in Mexico: PEMEX, the state oil company (same status as Aramco), does not own a single bbl of oil in those reservoirs. That is not just a policy but actually in the Mexican constitution. Ownership is only assigned as the oil is produced. This is not a minor technicality: this law has been a major deal killer for US public companies that wanted to provide capex thru a JV with PENEX. Even if that US pubco earned 50% of the revenue from oil sales it could not book $1 of of value on its books: the SEC only allows that for unproduced reserves that have had title assigned to the pubco. And that doesn’t happen in Mexico until the oil is actually produced. Thus ZERO booked proven reserves.

    And guess what: the Rockman has seen that same situation in countless JV’s even in the US. Often the title to those unproduced reserves isn’t INITIALLY assigned to a partner. Certain conditions must be met before that partner “earns its assignment”. That is a very specific and detailed legal condition. One of the purposes of this arrangement is to avoid a situation when a JV partner files bankruptcy before they earned its assignment: in bankruptcy that partner might not be able to pay its share going forward but the rest of the partnership cannot complete the project with a potential lean as a possibility. By not assigning those in ground reserves they are not the property (and thus a targetable asset) of the bankrupt company.

    So again the basic question: if the unproduced Saudi oil doesn’t belong to Aramco then the value of it WHILE STILL IN THE GROUND is not relevant. In that case Aramco’s worth would be based upon the value of its future revenue stream. Which is why the KSA govt reduced the tax rate: presumably because the future NET REVENUE of Aramco wasn’t sufficient to attract potential IPO buyers.

    But that’s still leaves a big question: if Aramco’s future revenue stream is worth $X how much is it worth to shareholders? Remember no public company is legally obligated to share (IOW dividends) any of its income with its shareholders. Even US pubcos: there are many US oil pubcos that have suspended dividends since oil prices collapsed. IOW regardless of what dividends Aramco says it might pay it can always suspend them if the majority of those shareholders agree. And since 95% of the stock will belong to the Saudi govt you can guess the outcome of any vote: that which benefits the Saudi govt. LOL.

    And one last point that hasn’t been confirmed but I’m pretty sure how it works: Aramco pays 100% of all development and production costs…not the Saudi govt. And it uses its revenue to pay for those expenses. So what may be available to pay dividends with is NET of operations costs as well of NET of taxes. And the Rockman has seen many shareholders of US oil pubcos f*cked over by a company’s management using GROSS revenue to pay big salaries and fund very nice expense accounts. All of which reduced the NET revenue. And those MINORITY shareholders had no legal recourse to address the situation.

    The Rockman has worked for a number of oil pubcos and has seen first hand how the system has been LEGALLY GAMED to the detriment of the shareholders. The caution the Rockman offers about the Aramco IPO is not theoretical: it’s exactly what he’s seen in the past. And also why he chose to finish his career with a privately owned company and not a pubco.

  2. BobInget on Wed, 29th Mar 2017 2:31 pm 

    Written by Bob Adelmann

    Fitch Knocks Saudi Arabia’s Credit Rating Down Another Notch
    Fitch Ratings downgraded Saudi Arabia’s credit rating again on Wednesday, bringing it perilously close to “speculative,” from “investment grade.” It dropped the country’s long-term credit rating from A+ to AA-, but with a “stable” outlook, noting that the reduction was due to the country’s “continued deterioration of public and external balance sheets.”

    Fitch sees what both Moody’s and Standard and Poor’s, the other two global credit rating agencies, see: declining oil prices hurting a country that once enjoyed the highest investment grade ratings thanks to high oil prices that not only paid for extravagant welfare programs and subsidies to its citizens but allowed it to accumulate three-quarters of a trillion dollars in foreign reserves — more than ample to ride out any conceivable storm.

    The rating agencies have seen that an inconceivable storm arrived in 2014 when the world price of crude dropped from more than $120 a barrel to $27 a barrel in February 2016, touching off a series of moves the sheiks likely never imagined would be necessary: cutting welfare state benefits, raising taxes, reducing subsidies for its citizens, liquidating massive portions of its foreign currency reserves, and — horror of horrors! — going to the international debt markets to raise some $17.5 billion to help shore up its weakening balance sheet. Its annual deficit hit $100 billion in 2015 and, according to all three credit rating agencies, will continue at that level, if not higher, for the foreseeable future, possibly reaching 10 percent of the country’s gross economic output every year through 2020.

  3. BobInget on Wed, 29th Mar 2017 2:43 pm 

    Instead of calling off War on Yemen, the word on the street is saying KSA might double down and invade.
    (As most of the Saudi Army is indeed Yemeni, invading might be an even bigger blunder).

    In any case, opting into that Aramco IPO might prove to be both the biggest IPO and con job in history.

    I see Rockman beat me to a detailed explanation.

    I’ll only add KSA is spending really big bucks. Not on E&P or buying foreign reserves but war material and 100 Billion in weapons.

  4. Anonymouse on Wed, 29th Mar 2017 5:17 pm 

    Come on rocker, there is no such thing as a ‘public’ uS oil corporation, a fact you are well aware of. The uS ‘public’ has about as much input and say over uS oil cartel activities as say, the, the uS ‘president’ does. At least put things in their proper context.

    As the subject matter, the more important question is how much net energy the sauds have left under the desert that the uS and its allies can extract in exchange for weapons and toilet paper of dubious quality. Of secondary importance, is how that energy is valued, currently by uS toilet paper conjured from thin air as well all know. Of course, if the ‘sauds’ manage to convince enough people that oil is worth 2 trillion in paper from air equivalent, well, we have a saying to describe them as well.

    There is a sucker born every minute.

    One quantity, the actual energy, has real measurable value and can be quantified, the other one, the uS dollar one, is basically imaginary.

  5. rockman on Wed, 29th Mar 2017 5:25 pm 

    We’re going to eventually cover a lot of details about IPO’s so we might as well start now. First, the common erroneous assumption made by many: none of the IPO stock is initially sold to the public. You already see different companies competing to be the IPO “underwriter”. It is the underwriter that will negotiate and SETS THE INITIAL PRICE OF THE ARAMCO STOCK. And typically they layoff much of that commitment (# of shares at $X/share) to other commercial investors.

    Thus Aramco nows exactly how much it will receive. So what does the underwriter and its partners make? That’s called the “gross spread” = the difference between the “underwritten price” and the “secondary price. And the difference between the UP and SP is not always positive: there have been IPO where the actual public market quickly decides it won’t pay the UP. But usually it makes the underwriter et al a huge profit especially when you consider it might only takes weeks or a few months to recover the investment.

    So OTOH it pushes the underwriter to negotiate a lower UP with the Saudi govt. But remember the underwriter is also going to play stock broker (collecting a sales commission) and not just stock owner looking to sell for a higher price(the SP) then it paid (the UP). IOW they make their money by negotiating the UP down and then hyping the SP up to the public.

    This makes which stock exchange the IPO is offered. The regs vary greatly especially when it comes to full disclosure and independent audits. So we need to see if it’s offered in a exchange governed by US SEC regs or someone else’s. IOW we’ll have a lot more to talk about later.

  6. BobInget on Wed, 29th Mar 2017 7:02 pm 

    How many underwriters do ya suppose it will take to sell ARAMCO’s government owned 5% of of the company?

    If the Saudis need funding so badly, they could make peace with Yemen, sell off a tiny percentage of European and US real-estate, that yacht just bought from a Russian ketchup magnet for 800 million on pure whim, mortgage a dozen of those private aircraft that have actual value, best of all, cancel at least 800 Billion$ in defense contracts.

    Will Saudi do any of these things? They will not.

  7. rockman on Wed, 29th Mar 2017 11:02 pm 

    Bob – Let’s say the KSA sells 5% of Aramco for $100 billion…5% of the $2 trillion that some say it’s worth. What exactly have they given up if Aramco ultimately pays little or no dividends? Aramco collects $X billion in revenue each year, pays 50% of those monies to the Saudi govt in taxes and then uses the remaining revenue for operations, capital projects and perhaps buying foreign oil reserves…or refineries…or LNG facilities…or anything else. IOW there’s no remaining net revenue to even consider paying dividends with. Or let’s say they end up with $200 billion in revenue the first year it’s public and they don’t spend on anything. They can keep that cash reserves and not distribute any dividends. Which any US pubco can legally do. Or guess what else it can do: the same thing ExxonMobil has done with tens of $billions of its revenue: buy its own stock. Which could be done very cheaply by Aramco when the market learns there will be very little to no dividends paid and the Aramco stock tanks.

    IOW the KSA might not be giving up anything in return for those $billions. This is very basic stock market dynamics. There are many US pubcos that have not paid dividends because they have never had a positive cash flow. But folks have made profits buying the stock low and selling it higher. Just look at all the Internet companies that have followed that model. Works great…until folks stop expecting the price of a stock in a company not making a profit or paying dividends to eventually sell for a higher price.

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