Everything You Need to Know About the Saudi Aramco IPO

"The devil's excrement." 

That is how Juan Pablo P¿rez Alfonzo, former Venezuelan oil minister and co-founder of the Organization of the Petroleum Exporting Countries, referred to oil in 1975.

"Ten years from now, 20 years from now, you will see: oil will bring us ruin," he famously said.

In fact, a decade ago, Venezuela went from being a country with the highest per-capita income in South America, to a near civil-war state with per-capita income lower than the level in the 1960s.

This is what economists refer to as a "natural-resources curse," similar to a 16th-century Spain that was once rich in gold from the Americas, but which eventually went bankrupt when the ships stopped sailing.

Ever since its inception, OPEC has had oil prices under its control, with the Saudi Arabian oil company, Saudi Aramco, as its driving force. It isn't surprising that when the ruling family of Saudi Arabia that owns the oil giant lets out feelers about a likely Saudi Aramco initial public offering to perhaps reduce the country's economic dependency on oil, that the world's political, economic and investor classes pay attention.

Let's take a look at the sheer scale of the company and its impact on the industry, size up possibly one of the largest IPOs that the financial world has seen, and determine what political and economic ramifications such an event could have.

Saudi Aramco is one of the largest oil exploring and producing companies in the world. It is nearly as big as Venezuela's oil reserves as a whole, bigger than Canada's oil reserves and several times larger than its other global corporate competitors such as BP, ExxonMobil, PetroChina and Rosneft. 

Saudi Aramco boasts crude oil and condensate reserves of nearly 260 billion barrels and nearly 294 trillion standard cubic feet of natural-gas reserves. Reports suggest that Saudi Arabia was the world's second-largest producer of crude oil and natural-gas liquids in 2014, with a production of 11.6 million barrels per day.

The state-owned oil producer alone contributes to 45% of Saudi Arabia's gross domestic product, 90% of the country's export revenue and almost 80% of budget revenue. Saudi Aramco also has a significant influence on how the official selling price of crude oil is determined, calculated by adding a differential to a specific crude oil benchmark price depending on the location of a customer and quality of crude oil being considered.

Saudi Aramco is the world's largest exporter of petroleum and is responsible for supplying nearly one-tenth of global oil. The company's oil reserves are more than 10 times more than that of ExxonMobil, the world's largest public oil company with a market capitalization of $362 billion.

 

Production, Mn Barrels Per Day, 2014
Production, Mn Barrels Per Day, 2014
 
Reserves In Billion Barrels (2015)
Reserves In Billion Barrels (2015)

Aramco vs. Competitors (BoEpd, mn)
Aramco vs. Competitors (BoEpd, mn)
 
Company Facts And Figures
Company Facts And Figures


The company exports nearly 2.5 billion barrels of crude oil each year, though these levels have fallen in recent months due to weaker demand and a sharp decline in oil prices. However, its record low production costs and high cash reserves of more than $500 billion have cushioned the impact from the downward spiral of oil prices.

According to industry sources, the cost of production is around $25 to $80 per barrel in the United States, compared with about $10 per barrel at Saudi Arabia's Ghawar oilfield, giving the latter significant competitive advantage.

In addition, Saudi Arabia recently signed an agreement with Russia to freeze productions at the last recorded levels, which is likely to further affect competitors.

This year, Saudi Arabia's Deputy Crown Prince Muhammad bin Salman suggested that the company is evaluating the possibility of selling a percentage of shares for public ownership.

He expressed his enthusiasm about the prospects of Saudi Aramco going public mainly as a measure to "increase transparency" and "curb corruption."

Prince bin Salman reportedly thought that it would also be beneficial to the emerging Saudi Arabia Stock Exchange (Tadawul), particularly as it opened to foreign investors just last year.

Saudi Aramco has since come out with an official announcement saying that it is considering options to allow public participation in its equity through an IPO that could include its downstream businesses or the lucrative upstream business of exploration and production or a combination of assets from both segments.

Much of the inspiration to go public seems to be driven by the direction in which the oil industry is heading. The uncertain demand, low (read: volatile) oil prices and the increasing self sufficiency of major economies, such as the United States, is forcing the desert kingdom to explore ways to reduce its economic dependence on oil.

Some may suggest that it surely looks like Saudi Arabia finally took Alfonzo's prophetic rant against oil dependency to heart to unlock the value of its prized assets, making use of its dominant position and cashing out, while the world frantically searches for sustainable alternative energy.

In fact, Prince bin Salman has floated the idea of forming a $2 trillion mega-fund likely to be funded by the Saudi Aramco IPO proceeds. The aim of the fund would be to achieve a level of nearly 50% of the country's total investments in foreign assets and create a global conglomerate over a period of time, thereby aiming to shift the economy's dependency away from oil.

 

How The Saudi Public Investment Fund Would Stack Up?
How The Saudi Public Investment Fund Would Stack Up?

Only time will tell whether the oil giant will be able to cope with the scrutiny to which a public company is subjected. Considering that Saudi Aramco is known to be extremely secretive about its operational revenue and reserves, a decision to go public certainly invites skepticism from prospective investors as much as it raises interest among global financial markets.

In a recent interview with Bloomberg, Prince bin Salman said that less than 5% of the equity might be offered in the IPO, which could happen as early as next year.

Naturally, that has led analysts to try to gauge the size of the IPO.

Conservatively, using an industry standard of $10 per barrel would itself imply a valuation of $2.6 trillion for Saudi Aramco.

However, oil and gas companies rarely get valued purely on the basis of their reserves alone.

Saudi Aramco's closest rivals, Exxon Mobil, Petrobras, PetroChina and BP,  trade at an average enterprise value to reserve ratio of 23 times. Applying this to Saudi Aramco's reserves of about 260 billion barrels implies an enterprise value of a little more than $6 trillion.

In fact, media reports have quoted Mohammad al-Sabban, a former senior adviser to the Saudi oil ministry, as putting Saudi Aramco's valuation as high as $10 trillion.

Going by these unfathomable figures, listing a mere 5% of Aramco could raise anywhere between $130 billion and $500 billion. This would make some of the largest IPOs, such as those of Alibaba, which raised $25 billion in 2014, and Facebook, which raised $16 billion in 2012, look insignificant.

The one thing we know for sure is the amount of interest that these figures would generate among the largest investment banks, looking to grab a share of what could be sizable commissions.

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Top-10 Largest IPOs (In US$ Bn)
Top-10 Largest IPOs (In US$ Bn)
 
Top-10 Oil & Gas IPOs (In US$ Bn)
Top-10 Oil & Gas IPOs (In US$ Bn)

Saudi Arabia is undergoing socio-political reform under King Salman's regime. Prince bin Salman, who is also the country's defense minister, assumed office last April.

The country, which has heavily relied on oil revenue, hasn't been immune to the impact of falling oil prices. Saudi Arabia reported a deficit of $98 billion last year, 15% of its GDP.

The country has, since then, adopted stiff measures to curb the deficit, including reduction in subsidies for water, electrical power and fuel, something that Saudi Arabia has comfortably enjoyed over the years.

However, falling oil prices aren't the only reason for the economic impact. The kingdom has also spent heavily on military activity in the Middle East, including nearly 25% of its annual budget on military personnel and the purchase of sophisticated vehicles and armament last year.

There is, therefore, an emerging feeling of economic and policy-level reform in the kingdom, and the Saudi Aramco IPO could well be the beginning.

Prince Bin Salman, in an interview with The Economist, said that he plans to reduce the heavy reliance on oil revenue by levying value added taxes and privatizing certain sectors such as education and health care.

Other areas that are open for change include religious tourism and exploring mining opportunities in uranium, as Saudi Arabia claims to have 6% of the world's uranium reserves.

Selling shares of Saudi Aramco clearly appears to be part of Prince bin Salman's bigger plan to reform the country sociopolitically by increasing transparency and curbing corruption.

Additionally, Saudi Arabia is entering a phase of stiff competition from Iran and Russia, both from a market and social standpoint. A successful attempt at letting the global investor community get a glimpse of its assets and their valuation could help the country use the finances to maintain its dominance in the region and also plan for long-term economic growth.

The desert kingdom may not want to wait too long before both Iran and Russia shrug off the effects of global sanctions, many of which have already been lifted from the former via recent agreements with the United States.

Saudi Aramco holds enough influence to be able to sway OPEC's decisions, keeping competitors at bay and yet sustain operations supported by its high cash reserves. So why would an industry-dominating country such as Saudi Arabia want to let the world in on its most critical national asset?

One reason could be the so-called "shale revolution," which has had more effect psychologically than on the ground. Yet the oil-producing and exporting countries have started to weigh its impact on their longer-term sustainable competitiveness.

The Saudi Aramco IPO could be a major step for Saudi Arabia to ensure that it stays relevant, even as the influence of OPEC starts to wane.

Despite higher production costs, growth in the U.S, output has outshone that of Saudi Arabia, especially after an export prohibition on U.S. producers was lifted. It also looks like the recent Russia-Saudi Arabia pact to freeze production at last recorded levels is an attempt to curtail the shale upsurge.

However, Saudi Aramco's vulnerability to the growth of shale could be far-fetched, as there is still time for shale producers to ramp up to meaningful production levels. Iran and the United States are expected to become leading producers among OPEC and non-OPEC nations, respectively by 2021.

The United States has gained significant competitive advantage with its ability to adjust production as per market fluctuations.

For example, at current market prices, there are several shale oil wells with idled production that are waiting for oil prices to rise to be able to initiate production again.

Industry experts call this period the "fracklog." It is the ability of shale oil producers to be able to start and stop production and have a "quick reaction time" to fluctuations that will decide whether U.S. producers will be price takers or price makers in the future.

That being said, Saudi Arabia doesn't intend to fall too far behind in the race to get a hold in the shale market. So far, through Saudi Aramco, the country has spent more than $10 billion on shale-related investments, the most recent being the company's campaign to explore the unconventional gas in the kingdom's Jafurah gas basin.

 

Production Growth: United States vs. Saudi Arabia
Production Growth: United States vs. Saudi Arabia

Meanwhile, with nearly 20% of its imports coming from Saudi Arabia, China has been one of the country's largest crude oil importers. It is therefore no surprise that Chinese officials are also asking for a dual listing of Saudi Aramco on the Hong Kong stock exchange.

However, imports have also begun to fall in recent years as China has increasingly been importing crude oil from Rosneft, Russia's largest oil producer. The close proximity and the ease of transport due to the East Siberia Pacific Ocean Pipeline only strengthen ties between China and Russia.

In fact, China National Petroleum and Rosneft have a 25-year agreement worth $270 billion under which the Russian company is expected to supply nearly 360 million tons of crude to China.

Even though China's monthly oil imports from Saudi Arabia hit their second-highest level on record in February, Russia has proved to be a tough competitor. With Iran back in play after its United Sanctions sanctions were lifted, Saudi Aramco could face more than a few issues.

Contribution To China's Oil Imports: Saudi Arabia vs. Russia, Feb 2004 - Feb 2016
Contribution To China's Oil Imports: Saudi Arabia vs. Russia, Feb 2004 - Feb 2016

With weak oil prices and higher military expenditures led by the continuing regional crisis that is pushing Saudi Arabia into a deficit, exploring a public listing of one of its most prized assets is indicative of a changing political and economic stance. The royal family has clearly become more vocal in expressing its views in changing Saudi Arabia's economic and socio-political structure and the way forward.

As part of that, Prince bin Salman's long-term growth blueprint will require investments of nearly $4 trillion over the next 15 years, according to a McKinsey report from December.

A significant portion of that would need to be funded by private and foreign capital and partly by selling stakes in existing assets. In order to do that this, Saudi Arabia would need to present itself as a corruption-free destination for international investors with avenues for high-return potential.

The announcement of the $2 trillion Public Investment Fund ties up well with this strategy but would need careful execution.

A bigger flow of foreign capital into Saudi Arabia could play a crucial role in diversifying the country's revenue sources outside oil and into other industries and sectors. Also, these measures could have valuable long-term impact on the country's employable population, 70% of which is below 30.

So would the world be different if the IPO proceeds? That depends on whether and which part of the business the company decides to make available for public listing.

Clearly, the upstream business is where all eyes would be focused. But, it would also mean putting the most prized and highly valued asset up for scrutiny.

Global oil economics is, to a very large degree, dependent on OPEC's assets and its ability to control demand and supply. So far, OPEC's asset values have been determined internally by respective countries.

A public listing of Saudi Aramco's upstream assets would warrant a certain amount of external audit. Any level of negative assessment of Saudi Aramco's oil reserves could have a significant impact on global oil prices, not to mention the pressure it could put on other OPEC nations.

Selling or diluting a stake in the downstream business may not necessarily be as eventful. Saudi Aramco's downstream business is a cluster of joint ventures, and it wouldn't be too difficult to offload a stake in one or a group of such entities.

Saudi Aramco's downstream business ranks fourth in the world behind those at ExxonMobil, Royal Dutch Shell and China National Petroleum. The company processes more than 5.3 million barrels per day through the joint ventures.

Current plans call for that number to increase to 10 million barrels per day, and a downstream IPO could aid in achieving that target.

Is there a precedent in history for this IPO? The only one in the oil and gas industry that possibly generated similar buzz and bore reasonable similarities was that of Petrobras in 2010.

Brazil's state-owned oil producer raised $70 billion by selling 36% of the government's stake. Brazil's oil sector, back then, contributed nearly 10% of the country's GDP.

Brazil's government received $43 billion in shares in exchange for allowing Petrobras to drill for 5 billion barrels in reserves. The offer was also part of Petrobras' development targets in 2010, with capital worth $224 billion needed over five years for oil extraction from the "pre-salt layer" under about 4,000 meters of salt, which was another 2,500 meters below the Atlantic Ocean.

However, five years after ambitious production targets and raising a significant amount of money, the company's performance has fallen a bit short of expectations.

In addition, political and corporate irregularities started to surface, with reports of funds from construction companies being diverted for political purposes and large amounts of unaccounted expenses affecting investor confidence.

Takeaways from Petrobras include that a big government stake meant that there was always a mix of politics and business, which affected performance and ultimately the company's market valuation.

In addition, the size of the IPO and its subsequent weak performance meant that the Brazilian Stock Exchange bore the brunt of it. At one point, Petrobras accounted for nearly 10% of the country's total market cap.

A sell-off in a stock this big can easily trigger a risk-off trade and exacerbate the impact.

One thing we know for sure is that a Saudi Aramco IPO, upstream, downstream or a combination of both, would involve amounts of money that the global financial markets have rarely seen. Absorbing an IPO of this size itself would be demanding and could even have an impact on smaller, emerging markets as funds find their way to the offer.

But, that is just one elements. A company as big as Saudi Aramco and an industry as critical as oil can ill-afford an event such as this to miss its mark.

Given the impact of oil price volatility on economies, significant reserves at stake and the severe geo-political complexities, the repercussions could be significant. Therefore, all factors including timing the IPO, assets to include in the offer, size and listing exchanges would have to be carefully weighed before Saudi Arabia proceeds.

That said, the desert kingdom would eventually have to open up sooner rather than later to achieve a more lasting and political, economic and financially stable economy. A successful Saudi Aramco IPO could kick-start that.

This article is written by Rhea Sthalekar, analyst, investment research and analytics at Aranca.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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