Saudi Aramco’s over-ambitious valuation defies basic logic

An initial public offering of Saudi Arabia’s state-owned oil company, Saudi Aramco, is expected to value the firm at $2 trillion when it launches in 2018.

The valuation is over-ambitious and the flotation faces numerous challenges.

An IPO in the second half of 2018 is in itself a challenging deadline. It leaves scant time to restructure the conglomerate’s myriad public interest and non-commercial holdings (Aramco even builds schools and hospitals) and to produce financial accounts to international standards.

Aramco does not publish financial information, and assembling a full set of audited financial data that meets international accounting standards will be difficult.

Auditing the geological reserves is also a contentious issue. Apparently two consultancies have completed audits which have confirmed the Saudi figure of around 265bn barrels, an estimate questioned for decades by independent analysts. Reserves quoted by the Organisation of the Petroleum Exporting Countries (OPEC) have been almost constant, despite significant production over the last 30 years, a feat which no other oil major has achieved.

These audits seem unlikely to meet the exact requirements set out by the US Securities and Exchange Commission, which means a London listing is favoured, in addition to the local Saudi Exchange.

A London IPO (Singapore or Hong Kong would not be satisfactory from the perspective of US and European capital) would not meet the free float requirements for inclusion in the FTSE indices.

Aramco could be accommodated by creating a closed-end fund with 100 per cent free float on the London Exchange, which could own Aramco shares and flow through dividend payments to its own shareholders. Such solutions are being firmly resisted by institutional investors – a Royal London spokesman recently said listing rules should not be bent for Aramco.

Weakness in the oil price or Aramco volumes will reduce the valuation. This requires restraint from OPEC, Russia and US shale producers – an unlikely combination.

Aramco’s valuation will be dependent on markets’ assessment of long term oil prices, but current year profitability will determine the starting dividend, crucial to the IPO valuation. Hence markets are convinced that the Aramco IPO means the Saudis will have to support the oil price. Catch 22: achieving higher prices may force the Saudis to reduce production, which means lower volumes, revenue and profitability for Aramco.

Valuation is the real challenge. The Saudi ambition to sell 5 per cent of a $2 trillion business is unlikely to be achieved. I believe the valuation will be less than half this level, generating proceeds well short of $100bn, insufficient to make much difference to the Saudi budget. To boost the valuation, bankers are apparently urging Saudi officials to allow Aramco to sell locally at international market prices (which would require a government subsidy).

There is almost no financial data available for Aramco, but 3.7bn barrels of oil production at, say, $50 a barrel gives revenues of $185bn. With ancillary businesses, a $2 trillion valuation would imply a multiple of around 10 times those sales, more akin to a high flying tech company than a staid oil major.

My projections suggest a $2 trillion market cap would equate to a price-earnings ratio of over 35x and a yield of below two per cent. With Shell and Exxon trading at a price-earnings ratio of 15x and 21x and a yield of 7.1 per cent and 3.7 per cent respectively, that valuation looks over-ambitious.

I believe that Aramco should trade at a significant discount to Shell because of its geographical concentration, political risk and governance issues. Aramco has a concentration of assets in a volatile region, with restricted maritime access, and there are also clear political risks which include the potential for a change of policy by the existing ruler, a change of ruler, or introduction of a new system of government. Just yesterday, for example, the Saudi king appointed his 31-year-old son as crown prince, replacing his nephew as the country’s heir.

In addition, oil prices remain low, and a reversal of the recent corporate tax cut in order to maintain budget stability is possible. Reserves risk is perceived as high, and governance is clearly a sensitive issue both for the seller and potential international investors. A governance discount will be necessary.

Valuation will be capped by the company’s limited growth prospects. Aramco’s earnings from the production of crude oil will likely decline in a stable oil price environment as new production comes at a higher cost, and dividend growth will likely have to come from other sources.

Moreover, Aramco is less geared to higher oil prices than its peers, because of its already high profitability.

It is impossible for an outsider to value Aramco accurately, but a $2 trillion valuation is stretching credibility beyond comprehension.

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