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Saudi Aramco IPO: Will investors buy into the promise?

Appetite for investment will depend on production cuts being enforced

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An engineer shows visitors a model of Saudi Aramco’s maritime yard in Ras al-Khair, Saudi Arabia, on Nov. 29.   © Reuters

The impending initial public offering of the world's largest oil-producing and exporting company, Saudi Aramco, dubbed the "sale of the century," has the oil and financial markets abuzz. But even as extensive preparations get underway for the historic listing expected in the second half of 2018, some institutional investors wonder if the stock will be a compelling purchase.

A year on from Deputy Crown Prince Mohammad bin Salman's declaration in January 2016 that the kingdom was considering floating shares in Aramco, vital details of the plan are yet to be made public. Media reports that earlier billed the Saudi crown jewel as being worth "trillions of dollars" now refer to an estimated $2 trillion enterprise valuation, suggesting that an expected float of a 5% stake will be worth $100 billion. The locations being speculated for the listing are New York, London, Hong Kong and the national Saudi exchange, Tadawul.

What is clear in the picture, though, is the spectacular 75% jump in oil prices -- from a $32 a barrel Brent average in January 2016 to $56 a barrel in the first half of this month. That was engineered by the Saudis through the historic agreements by OPEC and a host of non-OPEC producers to cut production by a combined 1.8 million barrels a day, effective January 2017.

While crude vaulting above $50 undoubtedly improves the attractiveness of Aramco equity, investors have some reservations, principal among them being the decades of opacity around Saudi oil and gas reserves, and Saudi Aramco's financials. Questions also linger around the company's governance standards and a "secretive" way of doing things -- what some describe as a culture of sharing information strictly on a need-to-know basis.

Oil underpins the Saudi economy, and expectations of the Saudi government retaining strong control over Aramco even after taking it public means minority shareholders would not have much say in the management of the company, which does not sit well with some investors.

The company is based in a geopolitically unstable region, and unlike its multinational peers, has to cut production under any OPEC deals to rein in output.

Aramco's assets are predominantly upstream, and the evolving uncertainty over oil's share in the energy mix of a "decarbonizing" world makes it a questionable long-term play for some in the investment community.

On the flip side, investors argue, everything has a price and demand would depend on the IPO valuation. Saudi Arabia has about 266.5 billion barrels of proven crude and condensate reserves, enough to last 70 years at current production rates. About 98% of these are Saudi Aramco's reserves under a concession agreement, which it will maintain.

Aramco accounted for 10.16 million of Saudi Arabia's average 10.19 million barrel a day crude production in 2015, according to official figures. That represents nearly 11% of global oil consumption. The kingdom is among the world's lowest-cost oil producers, with an estimated breakeven of just around $10 a barrel.

Meanwhile, most equity investors typically operate on a one- to three-year time frame, so the prospect of oil eventually losing its crown in the global energy complex may not be an issue.

The market is watching carefully how the company is being primed. Efforts to streamline the business by setting aside the schools, hospitals and other social enterprises Aramco operates, from the entity to be listed, are moves in the right direction. So are reported plans to slash the 85% tax on its profits to 50%.

The company is also said to be readying for scrutiny of its finances and oil and gas reserve estimates, through independent audits. The Saudi reserves figure has remained puzzlingly constant since 1980, when the government completed its takeover of what was then the Arabian American Oil Company.

Saudi Aramco's refining footprint is relatively small, despite its domestic monopoly, but the company is rapidly expanding downstream in a bid to capture margins in the oil refining and petrochemicals business.

It set up two joint-venture greenfield refineries with a capacity of 400,000 barrels a day each at Jubail and Yanbu in 2013 and 2014, respectively, which are optimized for diesel production, with an eye on export markets in Europe. A third greenfield refinery complex of a similar capacity is under construction at Jazan on the Red Sea coast, though its completion date has slipped from the end of 2016 as previously planned.

Aramco's wholly owned and equity refinery projects had an aggregate global capacity of 5.4 million barrels a day at the end of 2015, with the company's share at 3.1 million barrels a day. Its refining ventures in China, Japan, South Korea and the United States give Aramco a stake in some of the biggest markets for Saudi crude.

The giant Sadara project coming up in Jubail, a joint venture between Aramco and Dow Chemical, is the world's largest petrochemical complex ever to be built in a single phase and will produce "specialty chemicals," which are usually at the higher end of the chemical value chain.

Some investors are of the opinion that a listing of Aramco's downstream business might fetch better value.

Upstream, crude has settled in a sweet spot of around $50 to $60 a barrel since the OPEC and non-OPEC production-cut agreements were forged. But it has been a sentiment-driven boost so far, uncertain of being sustained if the producers start slipping on their quota compliance, or U.S. oil production flips back into major growth territory on the back of a resurgent shale sector, or a combination of the two.

Saudi Oil Minister Khalid al-Falih's remarks on Jan. 16 that OPEC may not need to extend its cuts beyond June suggests the cartel might try to fine-tune its production levels in such a way that prices remain elevated but just short of triggering a big boost in U.S. tight oil output -- an uncharted territory for OPEC.

The U.S. Energy Information Administration's latest forecast calls for 2017 domestic oil production to grow by 100,000 barrels a day, instead of a decline by the same amount predicted in December, to an average of 9 million. It has also raised 2018 projected output to 9.3 million barrels a day, citing expectations of higher crude prices.

The Saudi Aramco IPO makes it imperative for Saudi Arabia to lead by example in adhering to its pledged output cut and ensuring that other OPEC producers as well as its major non-OPEC "ally" Russia do the same.

Vandana Hari is founder of Vanda Insights, which provides research and analysis on the energy markets.

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