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By Callum Turcan
Recent events have piqued our interest in the actions of Saudi Arabian Oil Company, better known as ARAMCO (ARMCO), the giant in charge of the Gulf nation’s hydrocarbon industry. Saudi Arabia is reportedly restarting ARAMCO’s IPO according to comments made by the Saudi Energy Minister, reviving a plan the country had previously put on ice primarily due to expectations that the company wouldn’t fetch a high enough valuation to suit the needs of the Kingdom. Many view ARAMCO as the most valuable company in the world, but whether this is a USD$2 trillion company or not is in the eye of the beholder (many see that target as overly ambitious, as do we). Please note that unless otherwise stated, the numbers cited in this piece are in US dollar terms.
Overview
Last year, ARAMCO produced 10.3 million barrels of crude oil along with a material amount of natural gas. Natural gas is sold to domestic markets, particularly as a fuel for electricity, as Saudi Arabia seeks to wean itself off oil-fired power generation to free up more crude for export. Most of its crude oil production is sold in overseas markets (roughly half goes to Asian markets ex-Saudi Arabia), but a considerable amount is also sold to domestic downstream operations (3.0 million barrels of crude per day on average last year). At the end of 2018, ARAMCO had 4.9 million barrels of gross crude throughput capacity across its petrochemical and refining operations, 3.1 million barrels per day net to the company (with 62% of that located in Saudi Arabia). ARAMCO’s downstream presence is expected to grow materially by the end of 2019 as new facilities become operational, and due to a significant acquisition which we will cover later on.
Upstream operations are supported by 256.9 billion barrels of oil equivalent in reserves at the end of 2018, roughly fourth-fifths of which is represented by crude oil and condensate (the remainder is split between natural gas liquids and natural gas). That was down by 3.3 billion barrels of oil equivalent from levels seen at the end of 2017, but still enough for ARAMCO to have a proved reserves life of 52 years.
Major Changes and Risks to be Aware of
We already got a look at ARAMCO’s inner workings when the company issued out its first US dollar denominated bonds earlier this year. Using that almost 500-page long prospectus as a guide, we can gauge how interesting a potential ARAMCO IPO might be for investors seeking either income or capital appreciation opportunities. Please note that the Kingdom of Saudi Arabia recently changed its fiscal regime, the accounting practices of ARAMCO, and other things that have PROFOUNDLY changed ARAMCO’s financials. Here is a brief note on that from its prospectus;
“The Company’s historical results of operations may not be easily compared from year to year.
The Government adopted the following changes to the fiscal regime under which the Company operates, effective as at 1 January 2017:
[1] the income tax rate applicable to Saudi Arabian Oil Company was reduced from 85% to 50% (the Company’s interests in in-Kingdom subsidiaries are generally subject to a 20% tax rate, unless such subsidiary is engaged in the production of oil and its associated hydrocarbon products…
[2] royalties payable by the Company are paid based on production rather than sales and are recorded as an expense rather than a reduction in revenue; and
[3] the Government implemented an equalisation mechanism to compensate the Company for the revenue it directly foregoes as a result of selling crude oil, kerosene, diesel, heavy fuel oil and gasoline in the Kingdom at regulated price
In addition, effective from 1 January 2018, a 20% rate applies to the Company’s taxable income related to the exploration and production of non-associated natural gas (including gas condensates), as well as the collection, treatment, processing, fractionation and transportation of associated and non-associated natural gas and their liquids, gas condensates and other associated elements.”
ARAMCO pays the Kingdom of Saudi Arabia a lot of money each year, a lot. The company paid $55.6 billion in ‘production royalties and excise and other taxes’ and $101.7 billion in income taxes last year, most or all of which went to the Kingdom. One of the biggest risks involved with ARAMCO is that the company is run for the good of the government, not for the good of shareholders, and there is no way getting around that. Production and income taxes represent the majority of the tax ARAMCO pays Saudi Arabia, on top of $58.0 billion in total dividend payments to the government in 2018.
Like all companies with large upstream operations, ARAMCO is exposed to fluctuations in raw energy resource prices. There are also potential foreign exchange risks to be aware of, however, that’s less of a downside risk for ARAMCO than pricing risk. Raw energy resources, such as oil, and refined petroleum product prices, such as gasoline, are almost always sold at prices based on US dollar denominated benchmarks. Most export sales are conducted via US dollars, and those that aren’t are usually done so at rates that reflect current USD-local currency exchange rates (barring geopolitical arrangements and the like that are outside the scope of this piece).
Diversification
ARAMCO is an integrated oil & gas major with substantial upstream (the production of raw energy resources, such as oil for export and natural gas for domestic use) and downstream (refining raw energy resources into petroleum, petrochemical, and other products) operations, supported by extensive midstream infrastructure (pipelines, storage facilities, processing plants, export terminals, and so forth). While the sale of crude oil represented over 56% of ARAMCO’s revenue in 2018 (with upstream activities generating 61% of ARAMCO’s consolidated revenue that year), note that the company generated 39% of its 2018 sales from its downstream operations.
Downstream operations produce far more consistent financial results than its upstream peers. More consistent financial performance allows for more certainty regarding future free cash flow generation. ARAMCO’s downstream presence just got a lot bigger due to its purchase of a 70% stake in SABIC, Saudi Arabia Basic Industries Corporation. The energy giant purchased a 70% equity stake in SABIC from the Public Investment Fund of Saudi Arabia through a deal announced in late-March 2019. That transaction had a value of $69.1 billion at the time (keeping exchange rates in mind), which was covered by cash and promissory notes. ARAMCO doesn’t intend to purchase the remaining 30% stake in SABIC and shares will continue to be listed on Saudi Arabia’s Tadawul stock exchange.
SABIC operates in over 50 countries with 34,000 employees worldwide working at its various petrochemical plants and related facilities. Last year, the company produced over 75 million metric tons of goods such as “ethylene, ethylene glycol, methanol, MTBE, polyethylene and engineering plastics and their derivatives.” Of that, 82% (almost 62 million metric tons) was represented by petrochemical and specialty products, with the remainder coming from “other products.” ARAMCO notes that SABIC generated $5.7 billion in net income on $45.0 billion in revenue in 2018 on a consolidated basis, with $85.0 billion in total assets.
We appreciate that SABIC was also free cash flow positive in 2018 (net operating cash flow of ~$44.7 billion Saudi Riyals exceeded capital expenditures of ~$14.2 billion Saudi Riyals plus investments in associates and joint ventures of ~$11.0 billion Saudi Riyals on a consolidated basis, according to ARAMCO’s bond prospectus).
Bond Offering Tests the Waters
In April 2019, ARAMCO announced it had raised $12.0 billion in US dollar denominated debt across several tranches, with its 2029 notes carrying a coupon of 3.5%. That debt issuance was largely to raise funds for the purchase of ARAMCO’s SABIC stake, but we also see this deal as the nation’s way of testing the waters for a potential IPO in the not so distant future.
Bloomberg noted that the bond offering had received ~$100.0 billion in orders, allowing ARAMCO to issue debt at rates below the sovereign. Fitch and Moody’s Corporation (MCO) each gave ARAMCO an investment grade credit rating of A+ and A1, respectively. Considering ARAMCO is very free cash flow positive and had a net cash position of $21.8 billion at the end of 2018 (gearing ratio was negative 8.6%), we see the expected debt that the firm will take on to acquire its equity stake in SABIC as very manageable. Not only is ARAMCO gaining additional cash flow generating assets, but the firm also stand to gain from the positive effects of diversifying further into the downstream space.
ARAMCO generated $85.85 billion in free cash flow in 2018 on $121.0 billion in net operating cash flow less $35.15 billion in capital expenditures. The energy giant has consistently been free cash flow positive since at least 2016 (if not longer, much longer). Keep in mind raw energy resource prices were aggressively subdued for a good portion of that period (from 2016 to 2018), highlighting both the resilient economics of its low-cost upstream operations (a product of scale at the Kingdom’s massive onshore oil fields) and the benefits of having a large downstream presence.
Good OPEC+ News
There is good news on the raw energy resource pricing front, at least in the short-term. At the beginning of July, the OPEC+ oil cartel agreed to extend their current production curtailment deal for nine months through the end of March 2020, which at 100% compliance would keep 1.2 million bpd of oil production off the market. Saudi Arabia has been over-complying in order to reduce worldwide inventories at a quicker pace and help revive crude pricing benchmarks over the medium-term.
Non-OPEC supply growth, particularly from America and Brazil, are offsetting those reductions. Global demand for petroleum products is at-risk from a weakening macroeconomic picture, but oil demand grew substantially in 2018, up 1.2 million bpd according to the International Energy Agency. Whether oil prices move significantly higher remains to be seen. Global demand has held up well so far in 2019 and the IEA sees strong 1+ million bpd growth ahead, but we will be monitoring the situation closely.
Concluding Thoughts
We don’t think ARAMCO could fetch the kind of valuation the Kingdom of Saudi Arabia wishes it could get (somewhere in the ~$2 trillion range), not unless oil prices shoot up significantly higher due to structural changes in the market (as a ridiculous example, if “fracking” were to become banned in America). Investors value equities based on expected future free cash flows, and a short-term upward movement in raw energy resource prices isn’t the same as a sustained increase.
While oil prices could increase in the short-term due to the OPEC+ news or a significant geopolitical event (i.e. additional supply disruptions out of Libya, Nigeria, Venezuela, or Iran), say Brent hits $80 per barrel by the Summer of 2020, if that were to simply be followed by Brent hitting $45 by the Summer of 2021 due to rising supply from American shale plays, then ARAMCO can’t expect the market to value its equity as if Brent were going to stay flat at $80. As of this writing, Brent trades at $62.50 per barrel for September 2019 deliveries.
Assuming a discount rate of 10%, a perpetual growth rate of 3%, and using ARAMCO’s 2018 free cash flow of ~$86 billion as a baseline, the entire company’s equity is worth ~$1.3 trillion before taking net cash/debt into account. The SABIC purchase changes things somewhat, but only somewhat, as ARAMCO is a very large corporation. We will be following this potential IPO as it progresses.
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Callum Turcan does not own shares in any of the securities mentioned above. Callum Turcan owns shares of BP plc (BP). Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.