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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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Why The Saudi Aramco IPO Will Not Be Enough

Why The Saudi Aramco IPO Will Not Be Enough

The Saudi Arabian sale of Saudi Aramco is already starting to attract widespread attention after Mohammad bin Salman, deputy crown prince of the Kingdom, indicated that an IPO for the state owned giant will proceed next year. That IPO, likely to be for less than 5 percent of the company, is being talked about as a way for Saudi Arabia to raise funds in a time of continued low oil prices. While the additional funding would be a welcome boon – Saudi Aramco would likely be valued at over $2 trillion dollars – the reality is that the IPO only distracts from the Kingdom’s deep well of future challenges.

Saudi Arabia has run its own state-owned oil company for decades now, which should lead prudent investors to question why the country would be interested in giving up even a piece of the firm now. There are only two possible answers. Either Saudi Arabia needs the funding and sees profits from Saudi Aramco being depressed for years to come, or the Kingdom is looking to diversify its holdings. Related: The Real Reason Saudi Arabia Killed Doha

The timing of the IPO certainly suggests that the Kingdom expects persistent low oil prices for years to come, which should make buyers of the IPO wary. In addition, while the company is highly profitable and controls vast swaths of lucrative resources, only a portion of those assets will be up for sale. Specifically, its oil reserves are unlikely to be included in the IPO. Instead the IPO will probably be for a subsidiary, which includes downstream assets of Saudi Aramco.

Given that Saudi Arabia is not looking to sell its unproven reserves and the fact that it is selling less than 5 percent of the biggest national assets, the view that the Kingdom is trying to exit oil before a long period of depressed profits doesn’t seem to hold much water.

Instead Saudi Arabia is probably looking to diversify its holdings and sees the success of the Norwegian national Public Investment Fund as a model. Related: The Worst Is Yet To Come For Oilfield Services

Countries with large amounts of natural resources relative to their size have always struggled with growing their economies in a consistent manner and ensuring the prosperity of their citizens. That’s particularly true with oil rich economies. Only Norway has managed to avoid this issue. The problem is so endemic it even has its own name; the paradox of plenty.

Despite having vast wealth in the form of oil, Saudi Arabia is still economically far behind developed economies, and its economy is essentially focused only on oil – a situation that is proving challenging at present. To get beyond this reality, the Kingdom needs to diversify its assets.

That won’t be easy. While Saudi Arabia is gearing up to hire investment professionals around the world to help with asset evaluation and investment, the reality is that diversification will prove very difficult. Significant diversification would also require selling a lot more than 5 percent of Saudi Aramco as well. Related: Oil Crash Creates Glut Of Petroleum Engineers – More Layoffs Coming

To truly support its economy in the absence of oil revenues, Saudi Arabia would need trillions of dollars of ownership in international businesses outside its borders. To get that much exposure to overseas firms will require deep capital markets capable of absorbing significant Saudi investments and an extraordinarily efficient oversight process. Investing even $500 billion into most capital markets around the world simply has too much of a distortionary effect on asset prices to ever lead to profitable investments.

Perhaps the only exception to this rule is the U.S. The U.S. stock market value fluctuates routinely, but is worth roughly $20 trillion these days. Thus to invest $1 trillion would require that the Saudis buy 5 percent of all stocks. That’s a difficult hurdle to meet in an efficient way, especially given the Kingdom’s lack of experience in large-scale investments across potentially hundreds of firms. In summary then, the Saudi Aramco IPO may make headlines, but don’t expect it to solve the Kingdom’s future economic challenges any time soon.

By Michael McDonald of Oilprice.com

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  • JHM on April 25 2016 said:
    My theory is that Saudi Arabia will progressively sell off about 5% of each year for 20 years and progressively sell off proven reserves all, about 500 million barrels per week over the course of the next 10 years. This will draw in foreign oil interest to develop the oilfields, raising production to 24 to 36 mb/d. This increased production will improve the utilization of downstream Aramco assets. Thus, Aramco will become increasingly valuable, and the Saudis suffer no loss from selling it.

    So yes, selling 5% of Aramco is not nearly enough. Increased utilization is key to driving up the market value of Aramco, and selling the reserves is essential to that. All this needs to be carefully coordinated so that the Kingdom can exit oil without destroying the value of its oil assets in the process.
  • John Scior on April 26 2016 said:
    It may just be that by having outside investors, streamlining can occur and better efficiencies may be achieved as employment within the company may tend to gravitate toward more professionals and less nepotism and "who you know" hiring. Even selling 49.9999 % would still leave controlling interest in the Saudi hands while allowing better employment practices and giving the scapegoat of firing "inefficient" employees as succumbing to outside investors.
    Offhand, I'd say most of their investments are in US Treasuries. I say this because they easily convertible with a big market base and have low risk. I'm doubtful they will sell their reserves.
    One factor against the IPO is the fear ( on behalf of investors ) of nationalization that might make any investment fruitless.
  • Bill Simpson on April 26 2016 said:
    I don't know about the results inside Saudi Arabia, but it sounds like it could put a floor under stock prices in the US, Europe, and possibly Japan, for quite some time.
    You would be foolish to invest the future of your country into places without the rule of law. You wouldn't want to wake up one morning, and discover that a new government somewhere just pulled a Venezuela on you. Political stability must be a major consideration when making huge investments for decades to come.
    The big multi-nationals are going to love this fund. The Saudis might need a thousand experts to determine where to invest that kind of money. I would start out by contacting the best venture capital people in California. People with proven records of successful investing. Big thinkers. And, as much as I dislike admitting it, the big Wall Street banks, like JPM, Citi, and Goldman. I wonder where Norway put their oil money? They need to talk to them.
    You've got to figure that batteries and solar power will only grow, as oil runs out and gets more expensive. I see most new cars sold being electric within 20 years. Governments will mandate it in developed countries. Of course, many other machines will still be powered by oil products. Despite what Elon Musk says, we won't by flying electric aircraft in this century. Trucks, trains, tractors, ships, lawnmowers, and chainsaws, will be oil powered for as long as oil is still available to run them. Oil is too energy dense to replace with batteries in those applications. Nuclear could make a comeback, especially as global warming becomes evident to nearly everyone. They need to talk to Bill Gates and his friends who are researching the 'new nuclear'. The Internet of Things will be big, as will robots. Tourism could boost demand for planes, ships and hotels, especially if China can successfully reconfigure their economy. Space industries might increase the demand for rare earth elements, and some metals which aren't used much today. Mining will always be needed, and mostly profitable. Try not using copper, iron, or aluminum. There are no substitutes for metals like platinum, palladium and rhodium as catalyst for some chemical reactions. Gold will always be valuable. And silver is quite useful. Imagine how much lithium will be needed during this century. Where will it all come from? They might need to consult with the USGS geologists, and talk to CIA experts. I'm sure the next President can arrange some meetings after he/she hears the word 'trillions'. Rubber tires aren't going anywhere anytime soon. Chemicals will only be in greater demand. You don't want to run out of fertilizer. People will always need that. A supersonic airliner which was more fuel efficient than existing designs could change the world as much as the 747 did, by reducing the transit time across oceans. I doubt if the sonic boom problem could ever be solved to allow supersonic flight over land. I don't see them running on hydrogen. It is too dangerous and expensive. So kerosene will be needed for a long time.
    And the oil price will be going up a lot sooner than many people think. It could easily be $100 a barrel by 2020, unless we go into a global depression. So I doubt the Saudis will be going broke anytime soon. Oh, and offshore drilling will make a big comeback within 10 years. Hydrocarbons will mostly run the world for next 50 years.
  • Phil Collins on October 24 2016 said:
    But I 100% agree with analyst Raymond James who considers that 'oil prices will reach over $60 a barrel even if the very OPEC does nothing to curb production or there is no coordinated production cut' by other world oil producers http://finance.yahoo.com/news/oil-prices-rising-165500287.html
    The matter is that current Chinese oil demand is poised to keep growing now, although at a slower pace than in previous years, and will boost global demand. So, the underlying balance of supply and demand continues to tighten, driven by solid growth in demand and by weakening supply, as non-member countries' dramatic cuts in exploration and production are starting to take effect.

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