SaudiAramco:JustHowBigshouldtheWorld’sLargestIPObe?

AuthoredbytheInvestmentResearchDivisionoftheGoizuetaInvestmentManagementGroup,May29th2017

HeadofResearch

Co-Authors:AagamVakil,AndrewPorat,JasonLee,andNamanGupta

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IntroductionTheoilcrisisof1973markedaturningpointinMiddleEastrelationswiththerestoftheworld.AngeredbyAmericansupportforIsraelduringtheYomKippurWar,SaudiArabiaanditsalliesinOPECdecidedtodramaticallycurtailproductionofoilaswellasraisepricesontheglobalmarket.Nearlyovernight,thisdecisioncausedeconomichavocamongthedevelopedworldandbroughttheUnitedStatestothenegotiatingtable.Tothisday,oildiplomacyremainsapotenttoolinthearsenalofSaudidiplomacy.However,thepowerofSaudiAramco,thenationaloilcompany,hasnotagedwelloverthedecades.Althoughanunthinkableprospectevenfiveyearsago,aconfluenceofeconomicandpoliticalfactorshavebroughttolifethepossibilityofanInitialPublicOffering(IPO)toglobalcapitalmarkets.Ifcarriedthrough,suchanoccurrencecouldverywellbecomethelargestfinancialtransactioninthehistoryoftheworld.Whateventshaveledtothismonumentaldecision,andwhatvaluationshouldbeassignedtothissecretivecompany?Thispaperwillbeginwithabriefdiscussionofthegeopoliticalandeconomicfactorsatplay,followedbyananalysisonwhereweseetheoilmarketheadedandfinishwithaninitialvaluationforSaudiAramco.PoliticalFactorsHistorically,SaudiArabiahasalwaysrelieduponitsstrongalliancewiththeUnitedStatesforprotectionandinfluence.However,recenteventssuchastheIrandeal,AsiaPivotbytheObamaadministrationanddiminishingforeignoildependencyhavefosteredtheperceptionthatAmerica’scommitmentstoitsMiddleEastalliesareweakening.Consequently,somehavearguedthataSaudiAramcoIPOwouldprovidetheU.Sandothersignificantfinancialcountrieswithvestedinterestsinthepreservationofthemonarchy/politicalstability.Additionally,SaudiArabiahastakenanunusuallyassertiveroleinregionalgeopolitics.DuetoitsongoinginvolvementintheYemencivilwar,thecountryhasdramaticallysteppedupitspurchasingofmilitaryhardware,requiringfundsthatanIPOcouldprovide.However,theseactionsmustalsobeunderstoodamongthewidercontextoftheongoingroyalsuccession.Asthecurrentmonarch,KingSalmanbinAbdulaziz,growsolder,jockeyinghasbegunamongtheimmenseroyalfamilyforhissuccessor.Thepresumptivenextmonarch,theDeputyCrownPrinceMohammadbinSalmanalSaud,hasattemptedtocultivateapublicimageofhimselfasadaringandinnovativepublicleader.HeiswidelyseenastheprimaryarchitectbehindSaudiArabia’sinvolvementinYemen.

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Inaddition,Salmanhasalsopushedfordiversifyingtheeconomyawayfromoilinaplanhedubbed‘Vision2030’andcouldusetheproceedsfromtheIPOtoaccomplishthisgoal.ThefinancialwindfallfromofferingastakeinSaudiAramcowoulddovetailwithapoliticalwindfallfortheDeputyCrownPrince.EconomicContextTheoilmarketitselfhasfundamentallychangedinrecentyears.Advancesinhydraulicfracturing(fracking)methodshaveballoonedtheamountofrecoverableoilinNorthAmerica,causingashiftingdynamicforthesupplysideofoil–withtheUSasthenewmarginalproducer.ThisistheresultofseveralcompetitiveadvantagesforU.S.rigsinreactingtopricechangesintheoilmarkets.

1) GovernmentRegulation:Manyofthetraditionaltitansofoilproductionweregovernment-controlledentities,whoseoutputlevelsweredictatedbyawidevarietyoffactors.Instarkcontrasttothis,individualUSdrillersaregenerallyprivateeconomicactorsandcanthereforestartorstopproductionwithmuchmoresensitivitytothepriceofoil.

2) Versatility:Theserigscanbesetup,takendown,andassembledmuchmoreeasily.Someareevenmovedonthebacksof18wheelerstoquicklyrelocate,conferringaportabilityadvantageincomparisontotheirrivals.

3) DirectionalDrilling:Theassetsdon’thavetobemovedtoextractdifferentpocketsofoilifthatoilisreachablefromitsinitiallocation.

Akeydistinctiontonote,however,isthatnotallstrainsofoilarethesame:differencesexistintherefinerytechnologyneededandderivableendproducts.TheoilextractedintheU.S.contributestoWTICrude,thatfromtheNorthSeaisBrentCrudeandfromtheMiddleEastistheOPECreferencebasket.Whilethesepricestendtomovetogether,thespreadscanchangequitesignificantly.TheOPECreferencebasketpriceisusuallydiscountedafewdollarsastheoildrilledinthatregiontendstorequirethemostrefiningasitisheavierandlesssweetthaneitherBrentorWTIcrude.

Tocombatshale,SaudiArabiafloodedthemarketinlate2014–collapsingoilpricesfromover$100/barreltojustunder$30/barrelbyearly2016.Thisbankruptedmanyshaleoildrillers,whosebreakevenprice(i.e.thepriceatwhichitisprofitableforthemtodrill)forproductionatthetimewassubstantiallyhigherthanSaudiAramco,Iraq,andIran’s(~$55vs.~$10perbarrel).However,asoilprices(bothWTIandBrent)climbedbackabove$50perbarrelandtechnologicaladvancessubstantiallycutthebreakevenproductionpriceforshaledrillers(whichisnowaveraging$35perbarrel)–USproductionmadeasubstantialcomebackasseeninFigure1:

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Figure1:ChartsofUSproductiongrowth,2014-2016duetodeclineinbreak-evencosts.

CurrentStateofOilMarkets

NowthatSaudiArabiaislookingtomoveawayfromtheiroildependencythroughthisIPO,thecountryhasavestedinterestinproppingupthepriceofoiltogetthehighestvaluationpossible.AsthecountrycontinuestolosetheabilitytopushU.S.shaleproducersoutofthemarket,itisforcedtopushOPECmemberstatesandcertainalliestocurbtheircrudeoutputs.

ThisresultedinaNovember30th,2016dealtocurboiloutput.Ostensibly,duetothedeal,OPECcountrieswouldreduceoilby1.2millionbpdandnon-OPECmemberswouldcurboutputby600,000bpdwithRussiamakingup50%ofthis.This1.8millionbpdcutrepresents~2%ofthetotaloutputofoilintheworld.Sincethedealwasstruckhowever,SaudiArabiahashadtobearmostofthecutstokeepitontrack,asseeninFigure2.

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Figure2:OilproductionlevelsofdealsignatoriesinthousandsofbarrelssinceJanuary2017.NotethatonlySaudiArabiaandAngolasuccessfullymetproductiontargets.

SincetheNovember30thdeal,however,theUShasalreadyrampedupproductionlevelsbyaround500,000bpd,offsettingmuchoftheOPECcuts.Thissituationisuntenable,asitisonlyamatteroftimebeforeOPECnationsdecidetostopallowingAmericancompaniestoreapthebenefitoftheircuts.Additionally,whileSaudiArabiahadcutfarmorethanithadpledgedinJanuary,itsFebruaryoutputlevelstickedbackupto10.011millionbpd–anumberthat,whilebelowtheirpledgedamount(10.058bpd),doesnotsignalthesamecommitmenttocutsthatithadputforthbefore.Update:Sincethisarticlewaswritten,OPECextendedproductioncutsatthecurrentlevelforanother9months.This,interestingly,resultedinasharpdeclineinoilpricesastheannouncementwasweakerthanexpected.Ifpricesdonotstarttorise,alliedcountriesmaybegancheatingonthedealastheyseetheUSdrillersstealingeconomicprofitastheytakeoncontinuedrevenuelosseswithnoincreasesinmargins.AnalyzingtheFuturesCurve

Thecutsthemselvesalsohadanunintendedeffectthatcreateddownwardpressureonoilprices.Withanycommodity,therearetworelevanttypesofprices–thespotandthefutureprice.Thespotpriceisthepricethatyoucanbuyorsellthatgoodtoday,whilethefuturepriceisapricethatyoucanlockintodaytobuyorsellthatsamegoodatsomepointinthefuture.

Onegraphthatpeopleoftenlookattounderstandtheexpectationsforacommodity’spriceisthefuturescurve,whichshowsthepriceoffuturescontractsforthatcommodityovervarioustimehorizons.Whenspotpricesofoilwereextremelylowbutfuturespriceswereveryhigh,thiscurvewasextremelysteep.Asaresult,manypeoplestoredoilincargoshipsoffshorenear

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Singapore,evengoingsofarastodebt-fundtheirstoragecosts.Theydidthisontheexpectationsthatoil’spriceappreciationwouldbegreaterthanthecostofdebt(interestrateswerequitelow).Consequently,bybuyingoiltodayatthespotpricewhilesellingfuturescontractsofoilatasubstantiallyhigherprice,theycouldholdthatoiltoexpirationofthecontractandreaptheprofitsminustheirstoragecosts.Thiswasadirectresultofthesteepnessofthefuturescurve–calledacontangocurve.

TheOPECproductioncutsappliedupwardpressureonthespotpriceofoil,andUSdrillerssawanopportunitytolockinprofitableoilsalestoprofitevenafterdebtpayments.Asaresult,Americanproducersbegansellingfuturescontracts,whichplaceddownwardpressureonlaterdatedfuturescontracts,thusflatteningthefuturescurve.Thisdiminishedtheprofitabilityofholdingoiloffshore,resultinginafloodofoilsupplycomingbackonlinewhichhelpedtooffsetmuchoftheproductioncut.Figure3showstheimmenseflatteningofboththeWTIandBrentfuturescurvesandnowoilistradingwithinarelativelytightwindowfortheforeseeablefuture.

Figure3:FuturescurveforbothWTIandBrent,January2015-March2016.

Update:Sincethisarticlewasinitiallywritten,thespotpricesofbothWTIandBrenthavefallen~8%.Westillbelievethereisroomtofall.Interestingly,however,thisfalldidnotshiftthecurvedowninparallel,butonlyseemstobereflectedinthenearerdatedfutures–thussteepeningthefuturescurve.

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Figure4:WTIFuturescurve,March2017-April2017.

Becauseofthesefactors,wearebearishonoilpricesandseethefairvalueofoilinthelow$40sperbarrel.ThismatterssignificantlyforSaudiAramco,asitverydirectlyimpactstheirprofitability.

SaudiAramcoValuation

SaudiAramco’sIPOishistoricforavarietyofreasons.InadditiontothechangesthatitrepresentsforSaudiArabia’sfuture,itwillprobablybethelargestIPOever.ThecurrentholderofthatrecordisAlibabawhichraised$25billionin2014.Incomparison,SaudiAramco’sIPOisexpectedtobeintherangeof$50-$200billionUSD.Giventhis,therehasbeenalotofscrutinyintohowmuchthecompanyisactuallyworth.Onthelowend,WoodMackenzievaluedSaudiAramcoat$400billionandonthehighend,thecrownprincevaluedthecompanyat$2trillion.

ThetraditionalwaytovalueanoilcompanylikeExxonisbasedonmultiplesofreserves(theamountofoiltheycouldpotentiallydrill).However,whileSaudiAramcowasinitiallyapartofExxon,normalvaluationmethodsbreakdownquicklyduetoAramco’sstructureasanationaloilcompany.Forexample,thecompanypays20%ofallitsrevenueinroyaltiestotheSaudiArabiangovernment,itscorporatetaxratewillbe50%andithasbothsizeableupstreamanddownstream(drillingandrefining)businesses.

Givenallofthis,wedecidedtouseafreecashflowvaluation,whichshouldallowustobreakdownthevariousfactorsatplayinthevalueofthiscompany.Additionally,insteadofcomingupwithanindividualvaluationwelookedatthesensitivityofourvaluationestimateto2factors:oilpricesandourestimatedWAACasseeninFigure5.Whilewehaveadirectionalviewonoilprices,thistypeofavaluationprovidesamoreholisticwayoftryingtodeterminewhethertheIPOisatafairvaluationandusingsomeprobabilityanalysiswecandetermineifthatvaluefallswithinacertainconfidencelevelfortherangeinwhichweassumepriceswillbe.

OilPricethatAramcosellsat

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$40 $45 $50 $55 $60 $65

7% $709 $813 $916 $1,020 $1,124 $1,228

8% 621 712 803 894 984 1,0759% 552 633 714 795 875 956

10% 497 570 642 715 788 861

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Figure5:DollarValuesinmillionsUSD.SensitivitytableofpossibleAramcovaluationsbasedonestimatesfortheweightedaveragecostofcapital(shownintheleftcolumn)aswellasoilpricesdenominatedindollars(shownalongthetoprow).Notethatalmostnovaluationreachesthe$2trillion-marksetbytheCrownPrince.ListoffinancialandSaudispecificassumptionsintheappendix(page10).

However,thisanalysisissomewhatincomplete,asitispossibletoweighpotentialoilpricesbasedontheirlikelihood.Duetoouranalysisabove,weconcludedthatitwasratherunlikelythatpriceswouldriseabove$55inthenearfuture,andsoderivedaprobabilitydistributionbasedonourresearch,showninFigure6.Fromtheseestimates,wederivedconfidenceintervalsforSaudiAramcovaluationsusingdifferentestimatedWACClevels,whichcanbeseeninFigure7.

OilPrices EstimatedLikelihood

$40 15%$45 30%$50 25%$55 15%$60 10%$65 5%

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7% $194 $9068% $170 $7939% $151 $70610% $136 $635

Figure6:Probabilityestimatesforfutureoilprices-noteweightingtowardslowerendofthedistribution,and95%confidenceinterval(df=5).Numbersinmillions.

SaudiAramcoUpstreamvs.Downstream

LargeoilcompaniessuchasExxon-MobilandSaudiArabiausuallydividetheiroperationsintotwokeycomponents:upstreamanddownstream.Upstreamreferstotheactualprocessinvolvedinfindingandextractinghydrocarbonresources:thisincludesstepssuchasprospectingandconstructingactualoilwells.Incontrast,downstreamreferstotherefinement

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processbywhichcrudehydrocarbonsareconvertedintorefinedpetroleumproductsforexportorsaletodomesticconsumers.

Theupstreambusinessismuchmoreprofitableascomparedthedownstream.Thisisduetoreducedprofitmarginsassociatedwiththerefiningprocess.Whilethedetailsarenotconfirmed,CEOAminNasserstatedthatSaudiAramcoplansonselling5%oftheentirecompany,includingbothupstreamanddownstream.Tillnowasaprivatecompany,secrecyonreservesandprofitabilitynumbershavebeenbeneficialforbusiness.AlthoughtheIPOwillforcethecompanytoreleasecertaininformation,companytransparencywilllikelybecomparativelylow.

Conclusion

AstheIPOapproachesitsstatedQ22018estimate,SaudiAramcowilltryvariousmeanstopropupoilpricestoincreaseitsvaluation.Usingoilpriceestimatesbetween$40-$60,ourvaluationestimatesrarelybreakthe$1trillionmark,farfromthe$2trilliontargetedestimatesbyDeputyCrownPrincebinSalman.Alowvaluationwillpossiblystraintheprince’s“Vision2030”diversificationeffortsalongwithfundingfortheYemencivilwarintervention.Lookingforward,theIPOvaluationislargelycontingentuponnotonlyOPECandRussia’sproduction,butalsolargelyU.S.production,which,despiteOPECpleasforlimits,showssignsofcontinuedproductionhikesinto2017.Beyondthis,analysisofthefuturescurvesindicatesthattherearemuchhigherexpectationsforforwardoilprices,whichencouragestoringsupplyforlaterrelease.Suchacontangomarketsituationcreatesexcesssupplyfloodingmarkets,loweringtheprice.Ourestimatedoiloutlookofmid-$40sislargelyduetothesefactors.

GivenavaluationofSaudiAramcothatrestsaroundlessthan$1trillion,wemustnowconsiderhowmuchofthecompanymightinitiallybesoldoff.Asmentionedabove,theCrownPrince’sgoaltogainmorefundsforhisplannedreformsoftheSaudieconomymightrequireahighervaluationthaniscurrentlyfeasible.Mostanalystsforecastaninitialofferingofaround5%ofthedownstreamoperations,whichgivenouranalysis,wouldlikelybeagoodgaugeofoverallmarketreactiontowardsSaudiAramco.However,asmentionedpreviously,CEOAminNasserhasnonethelessstatedhisintentionsofsellingbothupstreamanddownstream.

Whilecertaininformationdoessuggestthatoildemandwilloutpacesupplysoon,ouranalysisconsistedofasupply-basedanalysisduetoafewkeypresumptions.First,U.S.productioncontinuestoincreaseandshowsnosignofdecline.ThelackofagoverningpactsuchasOPECintheU.S.preventsanypossibilityofaunifiedproductioncut.Second,whileOPEChasimplementedproductioncuts,manynon-OPECcountriessuchasRussiaarestillproducingatmuchhigherthanstatednumbers.HighproductionvolumeandeconomicprofitabilityseenbyU.S.producerscompelsthesecountriestoproducemorethanexpected.Thesesupply-sideconcernsmotivatedourdecisiontofocusonsupplyoverdemandandserveasthebasisforourargumentthatsupplywilloutpacedemand.

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RystadEnergyNasWellCube.RystadEnergyNasWellCube.N.p.,n.d.Web.1May2017.USOilShaleReserves

LiannaBrinded,WillMartinandElenaHolodny."OPEChasfinallyagreedtoaproductioncut-andoilisupalmost9%."BusinessInsider.BusinessInsider,30Nov.2016.Web.16May2017.

Wingfield,Brian,SamuelDodge,andHayleyWarren."OilProducersDeliverCuts.OilMarketDeliversNothing."Bloomberg.com.Bloomberg,20Apr.2017.Web.16May2017.

Cunningham,Nick."OilMarketsNotConvincedOPECDealCanKillTheGlut."OilPrice.com.N.p.,08Dec.2016.Web.16May2017.

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Sthalekar,Rhea."EverythingyouneedtoknowabouttheSaudiAramcoIPO."TheStreet.TheStreet,27Apr.2016.Web.16May2017.

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Cammack,Perry,DavidLivingston,DanielR.DePetris,DaveMajumdar,andTedGalenCarpenter."ThePrinceandPoliticsBehindaSaudiAramcoIPO."TheNationalInterest.TheCenterfortheNationalInterest,n.d.Web.1May2017.

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Appendix

Assumptionsinourvaluationmodel–oilpricewasvariableasexplainedinthemodelitself.

FinancialAssumptions S.A.Reserves OilPrice $50.00 Crudeoil 261,000,000,000Reserves 2.60E+11 Gasreserves 297,600,000,000,000TaxRate 50.00% NGL 474,400,000Royalties 20.00% Refinedproductexports 232,000,000Barrelsperyear 10011000 Refinedproductsproduced 641,000,000NatGasPrices $5.60 Refinedproductsdomesticallyused 409,000,000BTUperbarrelofNGL 4,200,000 Refiningcapacity 1,131,500,000AveragecostperBarrel(ExxonComp) $18.99 BarrelsperOilProduced 10640000CrackSpread*(asofApril2,2017) $19.76 BreakevenCostperBarrel 10

DemandperYear 331,200,000

Nextpageshowsanexamplevaluation

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Examplevaluationbasedon8%WAACand$50OPECreferencebasketprice:

Downstream Summary

TotalSales $169,510,496,000LNG Royalties $33,902,099,200NaturalGasPrice(MMBtu) $5.60 SG&A $8,475,524,800

BTUperbarrelofNGL 4,200,000 Peryearprofitbeforetax $127,132,872,000

Revenueperbarrel $23.52 Profitaftertax $63,566,436,000CostperBarrel $18.99 Cashflow ProfitperBarrel $4.53 Discountrate(WACC) 8.0%

TotalProfit $1,500,336,000 Timetotermination 96 PVMultiplier 12.49226911

RefinedProducts PV $794,089,024,884TotalProduced 641,000,000

CrackSpread* $19.76

TotalAnnualSales $12,666,160,000.00

TotalDownstream $14,166,496,000

Upstream

TotalBarrelsProducedperyr 3883600000

Breakeven $10

OilPriceperBarrel $50

TotalProfit $155,344,000,000

TotalUpstream $155,344,000,000