Commodity Strategy, April 10, 2018 21:20 Saudi Aramco...

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Commodity Strategy, April 10, 2018 21:20

Saudi Aramco IPO

Can the crown prince deliver?

McKinsey report laid the foundations

Aramco is too big to value

Too many “ifs” and “buts”

Contents

Saudi Aramco IPO: Summary 3

Can the crown prince deliver? 4

Selling the crown jewel 8

Structural shift in oil market 13

Disclaimers 15

Martin Jansson

+46 8 701 2343

[email protected]

Kiran Sakaria

46 8 701 4614

[email protected]

The potential IPO of Aramco offers investors the chance of

gaining exposure to an oil giant sitting on vast reserves.

However, exposure to Aramco means exposure to the

Saudi state, with which the company is tightly entwined.

The IPO is the cornerstone of Saudi Crown Prince

Mohammed bin Salman’s plan to ‘rewire’ the country, so

a bet on Aramco is a bet on his ability to deliver McKinsey-

inspired economic reforms in a country that faces many

challenges. Conditions for a listing look near perfect, with

stock markets close to record highs, the oil price at a

cyclical high and the electric vehicle revolution perhaps

hinting that peak demand could be close. The IPO has

been delayed, but we argue that reflects a desire to find the

right investors rather than the right price.

mailto:[email protected]

Commodity Strategy, April 11, 2018

3

Saudi Aramco IPO: Summary

The potential IPO of Aramco offers investors the chance of gaining exposure to an oil giant sitting on vast reserves.

However, exposure to Aramco means exposure to the Saudi state, with which the company is tightly entwined.

The IPO is the cornerstone of Saudi Crown Prince Mohammed bin Salman’s plan to ‘rewire’ the country, so a bet

on Aramco is a bet on his ability to deliver McKinsey-inspired economic reforms in a country that faces many

challenges. Conditions for a listing look near perfect, with stock markets close to record highs, the oil price at a

cyclical high and the electric vehicle revolution perhaps hinting that peak demand could be close. The IPO has

been delayed, but we argue that reflects a desire to find the right investors rather than the right price.

It’s now or never

From our point of view, now is the time to finalise the last steps of the Aramco IPO.

The global economy is in the midst of synchronised economic growth, boosted by

quantitative easing from central banks. Asset markets are high and interest rates are

low from a historical perspective, while the oil price has recovered from its lows of

2016. In a nutshell, the stars are aligned.

Not to everyone’s taste

Recent talk about delaying the listing until 2019 signals to us that MBS has not found

the investors he so dearly needs. Investing in oil is already restricted by many

financial institutions on environmental grounds, but investing in an oil company

based in a country ranked lowest in Freedom House’s democracy survey narrows

the pool of potential investors even further.

Events in Russia couldn’t have occurred at a worse time

Investors demand a political risk premium when buying a share of a state-owned

company. The recent share price falls for Russia companies Rusal and EN+ as the

US announced fresh sanctions came at a bad time for MBS and reminded investors

just how quickly things can unravel. Even if MBS is able to find investors in the west,

the two sides are unlikely to settle on a valuation that suits both parties. Investors

will argue that heightened risk justifies a substantial risk premium, while MBS cannot

accept any price.

China might buy, but it’s not a long-term solution

From that perspective, China looks to be the only natural investor, although that

would not provide the Saudis with the acceptance from the west that MBS needs to

secure additional investment in the future. We believe MBS will run out of time, either

through diminished global risk appetite, a falling oil price or some other problem

causing the IPO to be delayed further or even cancelled. If that scenario materialises,

MBS’s days in power look to be numbered.


4

Can the crown prince deliver?

The approaching IPO of Aramco offers the chance of exposure to an oil giant sitting on vast reserves. However,

exposure to Aramco means exposure to the Saudi state, with which the company is tightly entwined. The IPO is

a cornerstone of Saudi Crown Prince Mohammed bin Salman’s plan to redirect the country and a bet on Aramco

is a bet on and his ability to deliver his McKinsey-inspired economic reforms in a country facing a long list of

challenges. Conditions for a listing look near perfect with stock markets at record levels, the oil price at a cycle

high and an electric vehicle revolution suggesting peak demand could be close. Still, the IPO has been delayed,

and we argue that this reflects a desire to find the right investors rather than the right price.

McKinsey’s plan

In December 2015, the consultancy McKinsey published a report on how Saudi could

become less dependent on oil. The report listed ways to inject new dynamism into

the Saudi economy through a productivity and investment-led transformation which

could ensure future growth. The report stated that Saudi Arabia could no longer rely

on oil revenue and public spending for growth. It highlighted how the global energy

market is changing at the same time as a demographic transition means the number

of working-age Saudis is rising, creating opportunities and a need for structural

change in the Saudi economy. The report’s proposed productivity-led economic

transformation suggested a doubling of GDP and the creation of six million new jobs

by 2030 could be possible. This would need four trillion USD in investment. Eight

sectors, mining and metals, petrochemicals, manufacturing, retail and wholesale

trade, tourism and hospitality, healthcare, and finance and construction, have the

potential to generate more than 60 percent of this growth opportunity, the report said.

In order for this transition to take place, the government would need to shift toward

a more market-based economy, according to the report. The labour force

participation rate in Saudi Arabia is currently at around 41 percent, and the creation

of more jobs would lead to a rapid increase in household income. In order to achieve

faster productivity growth, the government requires better business regulation, and

greater openness to competition, trade and investment, the report said. Improved

spending efficiency and new revenue sources, possibly including taxes and higher

domestic energy prices, would help ensure fiscal sustainability, it said.

In 2015 McKinsey

produced a report on

how Saudi Arabia

could become less

dependent on oil


5

Vision 2030

In the first decade of the twenty-first century, Saudi Arabia’s economy flourished. A

high oil price led to a large budget surplus and the rapid amortisation of Saudi debt.

When the oil price fell in 2014, the large surplus turned into deficit and debts started

to rise again, illustrating Saudi Arabia’s sensitivity to fluctuations in the oil price. In

2016, Crown Prince Mohammad bin Salman (MBS) presented Vision 2030. Vision

2030 is a strategic plan to make the country less dependent on oil by diversifying

government revenues. There are many similarities with the McKinsey plan.

The vision is an ambitious blueprint built on three pillars:

The first pillar is to make Saudi the heart of the Arab and Islamic worlds. The two holy

mosques, Mecca and Medina, are located in the country.

The second pillar focuses on attracting foreign investors. MBS wants to make the country

into a better investment opportunity for foreign investors.

The third pillar focuses on making Saudi a hub between Asia, Europe and Africa. Because

of its geographical location on water and land routes, the country meets some of the

necessary conditions to become a regional hub for global trade.

Aramco IPO is part of Vision 2030

In order to deliver Vision 2030, MBS has laid out a plan that includes the government

becoming more transparent, efficient, accountable, enabling and high performing. In

the west, the element of Vision 2030 most commonly known is the selling off of a

part of the national “crown jewel”, the huge state-owned oil company Saudi Aramco.

The initial public offering (IPO) of Aramco would be the world’s largest IPO at

approximately USD 2 trillion, according to national valuations. Saudi officials say

they hope to raise a record of USD 100bn for a five percent stake in the company.

The flow of funds that the IPO would bring would be large. According to Vision 2030,

it is to be invested in a state sovereign fund. The government is also working to

increase revenue from non-oil sectors.

Vision 2030 is an

ambitious plan to

make Saudi Arabia

less dependent on oil

revenue


6

State sovereign fund

Vision 2030 is all about diversifying Saudi Arabia’s income streams, expanding the

economic base and creating jobs. In order to finance this, the Saudis need resources

and foreign investment. One way to achieve this is to sell a stake in Saudi Aramco.

The plan is to invest the funds in the Public Investment Fund, a Saudi sovereign

wealth fund. However, neighbouring countries have shown that sovereign wealth

funds do not necessarily lead to more domestic investment in employment-creating

sectors. Instead, their wealth funds have predominately invested assets in foreign

markets. Looking at the Saudi Public Investment Fund’s top holdings now, you find

Saudi companies, but they also hold stakes in Uber, Softbank and Blackstone

Infrastructure Fund. For long-term economic growth, it is important that the

resources from the Aramco listing finance domestic investments and not foreign

investments.

What has happened so far?

There is some scepticism about investing in Saudi Arabia. There is a widely held

view that a lack of political institutions, transparency, democracy and checks on

power make Saudi Arabia unstable, even with big oil reserves. For example, Saudi

Arabia scores lowest in Freedom House’s annual survey of political and civil rights.

Large subsidies and high government spending have also weakened the economy.

In order to dampen scepticism, MBS has launched several campaigns to improve

foreign investment conditions.

Things have been moving fast in Saudi Arabia lately. Women have been given the

right to drive cars, starting in June 2018. Movie theatres and other types of

entertainment are reopening. However, MBS must be careful not to bite the hand

that feeds him. The changes mean a distancing from the ultra-conservative

Wahhabism that is part of the establishment. In order to modernise, MBS has to both

be firm and generous to avoid too much conflict in a country with 15,000 princes.

Anti-corruption campaign

In November, MBS locked up dozens of princes and other officials in what was called

an anti-corruption campaign. The campaign was a way of removing opponents, in

our view, but at the same time made an equal number of enemies. These actions

show MBS’s commitment to Vision 2030, we believe, but it comes at a cost: MBS is

the most dominant Arab leader in a generation, but also one of the most heavily-

guarded men in the world.

Saudi Arabia will sell

a part of Aramco and

put the money in a

fund to invest in

Saudi holdings

Several signs of a

pick-up in the pace

of reform


7

In 2014, when the oil price fell from over USD 100 to USD 27 the budget deficit sky

rocketed. The government started cutting subsidies while trying to increase tax

revenue and invest in new industries. In 2016, it cancelled bonuses for state

employees, which had been taken for granted for a long time. MBS had to go back

on that decision after huge public complaints. Also, women have been encouraged

to work outside the home. These radical campaigns have consequences, and there

is little room for failure. There are likely to be some who disagree with MBS’s vision

and who are waiting for a chance to force him out of the picture.

Radical campaigns

have consequences


8

Selling the crown jewel

Saudi state-owned oil company Aramco is likely to launch its IPO in late 2018 or early 2019. It is still uncertain

where Aramco will be listed. The latest speculation concerns a listing for Aramco on the domestic stock

exchange. We argue that a more strategic choice would be a dual listing, domestic and foreign. In order to

attract investors, a listing on a more widely-used stock exchange, such as Hong Kong, London or Frankfurt

would ease potential risks. Privatisation is an important component of Saudi Arabia’s modernisation effort,

and should not been seen as a desperate attempt to raise money, in our view. This will not be a purely market-

driven IPO, although conditions are close to a perfect with stock markets at record levels, the oil price at a cycle

high and an EV revolution suggesting peak demand is close. The concentration of power in MBS’s hands may

also be at a peak . In many ways, it is now or never for him.

Corporate history

The House of Saud has held a leading position on the Arabian peninsula since at

least 1720. Previously, Saudi Arabia relied heavily on the many foreign pilgrims who

came annually to the Muslim holy cities of Mecca and Medina.

In the spring of 1933, the Standard Oil of Californian was granted a concession to

explore for oil across Saudi Arabia. The subsidiary it formed was the seed from which

today’s mighty Saudi Aramco grew. At the time, the British did not see a lot of

potential in Saudi Arabia, and they focused on Iraq and Kuwait.

Striking oil

In 1938 oil was finally struck, and in 1940 what turned out to be the world’s largest

oil field ever, Ghawar, was found. It is still producing.

In the late 1930s, the Saudi King opened the valve that sent the first shipment of

Saudi oil to a tanker and opened the underdeveloped kingdom’s first commercial

connection to the outside world.

WWII slowed the progress of the Saudi oil industry dramatically, but as it became

clear that the tide of the war had turned in the Allies’ favour, the Saudis positioned

their oil business closer to the US. This was echoed in the name of the oil company,

changed to Arabian American Oil Company, Aramco, in 1944.

The nationalisation of Aramco did not follow the typical playbook, with the

government kicking the foreign management out and taking over; rather, it was a

gradual process and American shareholders were compensated, despite having no

other choice. The process took a few decades and ended with complete Saudi

ownership in the early 1980s. This was a true Saudi success.

Too big to value

The Saudi state-owned oil giant is unique. Our simple peer valuation based on oil

majors gives an indication of its value at USD 733bn. What such an analysis misses

are the extraordinary reserves Aramco controls in the ground. Oil reserves alone,

roughly 260 billion barrels, are nearly ten times those of Exxon Mobile. Applying a

moderate value of USD 10 per barrel of oil in the ground, Aramco could be worth

more than USD 2.5 trillion. Those are the levels MBS refers to, but of all the major

state-owned oil groups, only Chinese companies, such as Petro China, have large

market capitalisations. Real or perceived risks reduce investor appetite for Russian

and Brazilian oil companies. If Aramco were treated like those state-owned groups,

it might fetch as little as USD 100bn.

Ghawar was found in

1940…and is still

producing

Aramco controls

extraordinary

reserves in the

ground


9

Figure 6: Peer valuation

Climbing the Great Wall

As early as 1989, former Oil Minister and Aramco CEO, Ali Al-Naimi sent two

representatives to explore Aramco’s options in China, which was at the time an

unknown quantity. Al-Naimi’s Marco Polos returned describing a country filled with

hundreds of thousands of bicycles burning coal; the team did not think there was

much future for cars there.

Al Naimi still believed the twenty-first century would belong to China, just as the

nineteenth had belonged to Europe and twentieth to America. He met a lot of

resistance within Aramco, but China and Asia remained vital to the strategy for

Aramco’s long-term success.

Build refineries and they will need your oil

Saudi Arabia started off in Korea, setting up refineries in 1990; it was a successful

story and Saudi Arabia is still the largest crude exporter to Korea. After a failure in

Japan, Aramco turned back to China in 1992; now there were more cars and

indications of accelerating growth everywhere. Aramco started to invest in China’s

refining sector and established a joint venture in Qingdao, ensuring continuity of oil

supply.

Main supplier to Asia

Since these early days, Saudi Arabia has been the largest exporter to each of the

major Asian economies most years. Aramco’s strategic investments in south-west

China work as a guarantee for a long-lasting footprint. Most refineries and the

infrastructure for supplying oil from China to the Indian Ocean are built for Saudi

crude oil qualities.

China is the obvious buyer

It is not only Saudi Arabia investing in China; in 2015, Chinese Sinopec

commissioned the world’s most advanced refining complex on the Red Sea. It would

not be too surprising to see China take the opportunity to buy a stake in Aramco. If

it was only about finding a buyer, we think it would be a done deal with China, but

for MBS, it is also important to bring in Western buyers.

When will the IPO take place?

For almost two years, Saudi officials have been saying that the IPO is on track and

the company will go public in the second half of 2018. Recently, there have been

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Aramco started to

invest in China’s

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Important to bring in

Western buyers


10

mixed signals from top officials regarding the timeline of the IPO. MBS has shifted

from the second half of 2018 to the first half of 2019, while the CEO of Aramco

defended the existing plans and said that the IPO is ready to take place in 2018, but

he noted that the government has the final say.

MBS has invested a lot in Vision 2030, and in order for the Vision to materialise, the

IPO needs to be successful. It could be argued that MBS’s future as crown prince

relies on Vision 2030, and by extension the IPO. MBS is probably waiting for the

stars to align before he announces the IPO, but time is not on his side. Saudi Arabia

has invested a lot in keeping the oil price high and maintaining OPEC’s production

cap. MBS made many enemies when he locked up Saudi princes and froze their

accounts. They are likely waiting for a chance to bite back.

Taking a chance on Saudi Arabia

So why the delay? We argue that the IPO is more than just the selling off of a part

of the state-owned company. It is so intertwined with the Saudi economy that you

cannot look at the company in isolation. Saudi Aramco is a part of Saudi Arabia and

Saudi Arabia is a part of Saudi Aramco. By investing in Aramco, you are not only

getting a part of an oil company but also a part of Saudi Arabia. By investing in

Aramco, you thereby take a chance on Saudi Arabia. This explains MBS’s eagerness

for new economic reforms. The second pillar of Vision 2030 is to attract foreign

investors and the IPO is a way of doing this. By getting a broad-based ownership

structure from all over the world, MBS hopes to be able to attract other investors to

the country.

Listing and investors

From a media perspective, MBS’s primary focus has been on finding investors in the

US and UK. At first, he did this by flirting with a listing for Aramco on a US stock

exchange, which he later decided not to do. Recently, he went on a roadshow in the

US to promote the company and Saudi Arabia as an investment opportunity.

Surprisingly, there has not been as much focus on China, which is the more obvious

buyer because of the close relationship when it comes to oil, among other things.

We believe this is because the Chinese deal is already set in place. Now MBS wants

to get US investors, as he hopes it would signal US acceptance that Saudi Arabia is

taking its social responsibility and by extension signal acceptance of Saudi Arabia

as a legitimate target of investment. Acceptance by US investors could mean other

countries follow. We believe that the listing will take place when MBS is satisfied with

the investors. The right investors are likely more important than the price in the big

picture, in our view.

USDSAR peg: Not an alternative solution

In 1986, the riyal was firmly pegged to the US dollar at a value that has not changed

for almost three decades; so, Saudi Arabia has a long history with a fixed currency.

The dollar peg has served Saudi Arabia well, in our view, and is likely to do so until

it becomes a meaningfully diversified economy, with exports denominated in a mix

of currencies. Over the period between 1986 and the current oil price collapse in

2014 Saudi Arabia has been doing well, with GDP growth of 4% and low and stable

inflation averaging 1.4%. Much of this is, of course, explained by the low engagement

of the local labour force, breaking the usual link between salaries and inflation.

The IPO needs to be

successful

Intertwined with the

Saudi economy

Acceptance by US

investors could mean

that other countries

follow

Long history of a

fixed currency


11

The country’s central bank is not statutorily committed to maintaining the peg at 3.75;

the peg can be raised or lowered when misalignment becomes a problem. The central

bank can defend the peg, either through direct intervention in the spot and forward

markets, or indirectly, through monetary policy and domestic interest rates. Most

central bank functions are possible, but are limited, given free capital movements.

Advantages of a fixed peg regime for Saudi Arabia:

Stability, as the peg is credible

Lower interest rates

A clear and easy-to-understand nominal anchor

Moderation of inflationary expectations, especially when oil price is high

Disadvantages of a fixed peg regime for Saudi Arabia:

Susceptibility to currency crises

Requirement of a high level of international reserves

Low ability to absorb shocks, which are instead passed on to the real sector of the

economy. This is what has happened since 2014.

If the depressed oil prices were to last for much longer, there are concerns that Saudi

FX reserves could become exhausted, unless government spending is curbed and

new sources of revenue are established. This explains why Saudi Arabia was so

keen to start raising money from bond markets instead of depleting FX reserves

further. The Saudi government has borrowed this money from both domestic and

international sources, but it comes at a cost, with the country paying twice as much

for its international bond as Qatar did. A combination of targeted cuts in government

spending, particularly on imported goods, combined with the issuance of government

bonds to domestic borrowers, including citizens, and the spending from reserve

accounts, particularly from those funds earmarked for specific capital projects,

should enable the government to maintain a sufficient level of deposits. In this

equation, the Saudi-led change to OPEC’s strategy from flooding the market in 2014

to production cut in 2017 makes sense. Oil has rebounded from USD 45 to USD 65.

Advantages of a peg

Disadvantages of a

fixed peg regime for

Saudi Arabia


12

There has been much speculation about the desirability of a devaluation of the riyal

against the dollar as a way to balance the budget “painlessly” by boosting

government oil revenues, which are denominated in riyals. However, such a move

would be far from painless, as it would raise import costs for both the general public

and the government. The current plan was to restrain government spending, raise

non-oil revenue, and borrow the funds necessary to close the revenue-expenditure

gap. As the bond issuance has been too expensive, the modified plan includes

raising money from the IPO instead.


13

Structural shift in oil market

Today, the US, Canada and Mexico produce more oil than the three largest OPEC members, namely Saudi

Arabia, Iraq and Iran. The cartel’s position of power finally came under pressure when production started to

grow rapidly outside the cartel in 2010 and US shale became a commercial source of new supply. Supply growth

broke all records and production disruptions decreased; oil fell by 50% in 2014 as a consequence and the fall

marked the end of that cycle.

EV revolution: tipping point for oil demand

The automotive industry is on the verge of major change as manufacturers race to

meet new fuel economy regulations. The IEA predicts that electric vehicle sales will

reach 25 million units by 2030. Using a consensus growth estimate for the global car

fleet of 3 percent annually, but assuming a rising penetration of EVs, results in a

scenario of 5 percent of the global installed car fleet being EVs in 2027.

That is a critical point. From 2027 onward, oil demand growth for personal cars will

be flat, and during the 2030s, we expect it to begin to decline. From 2025, we believe

battery costs will be low enough to incentivise consumers to choose EVs over fossil

fuel cars, and governmental subsidies could be phased out. OPEC expects a similar

scenario, but over a longer period. It expects oil demand to peak in the early 2030s

instead of in 2027 as it does in our scenario.

History repeats itself

The EV scenario might sound too futuristic, but it echoes almost perfectly what

happened in the 1980s.

OPEC makes its presence felt in 1973

OPEC’s first effective action was the embargo against the US and the Netherlands

in conjunction with their assistance to Israel in 1973. In parallel with the embargo,

OPEC reduced production as a reaction to the US having implemented import

quotas in 1959, which rewarded the import of oil from Canada and Mexico. This

discriminated against oil from the Middle East and forced it to be sold at a discount.

It was the reduction in production, rather than the embargo, that was responsible for

the price increase associated with the first oil crisis.

In parallel with the

embargo in 1973,

OPEC reduced

production


14

As a reaction to the high oil prices of the 1970s, the major oil-consuming countries

started to reduce their consumption. Substitutes, such as coal, natural gas and

nuclear power, started to emerge alongside new oil production outside OPEC.

Norway, UK, Colombia and Angola all developed into significant oil producers during

this period. As a result of rising supply and lower demand, oil prices collapsed and

stayed low for 20 years, until the next cycle started in 2001. Needless to say, there

were limited options for OPEC during this period; a cartel does not function when oil

prices are low, due to rising supply outside the cartel, it only functions during shorter

periods of slower demand (i.e. economic crises).

The second oil boom: the self-playing piano

The end of the dot.com bubble in 2001 coupled with the 9/11 terror attacks in the

same year saw the next upswing, this time with China surging ahead as a central

player. China’s economic progress contributed to increased demand for almost all

commodities, including oil. At the same time, the US started to retaliate for 9/11, with

the invasion of Iraq in 2003 as a central factor. There then followed more than a

decade of production disruptions and destabilisation in the Middle East. This process

culminated with the toppling of Libya’s Gaddafi in 2011 after the progress of the Arab

Spring. At the same time, President Obama imposed sanctions preventing Iran from

exporting oil to the US, which Europe sympathised with. With the exception of the

financial crisis, OPEC has therefore needed to do very little to support the oil price.

Will MBS change the economic rules?

There is a clear link between OPEC’s current strategy of cutting production and

MBS’s time in office. There is also a clear link between the Saudis’ current financial

situation, the IPO and the need for higher oil prices. Saudi Arabia’s challenges are

vast, and the IPO will not provide a quick fix to those issues; rather it should be seen

as a small part of a long-lasting campaign of structural change.

In this context, we do not think Saudi Arabia and OPEC will be able to change the

established way of things; if supply is growing outside the cartel, marginal costs will

determine oil prices. If demand simultaneously slows for structural reasons, that

might accelerate the shift. Right now, we think US shale has the capacity to fill the

supply/demand gap.

China’s progress

contributed to

increased demand

for almost all

commodities

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Commodity Strategy, April 10, 2018 21:20 Saudi Aramco...

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