In the first week of 2016, Saudi deputy crown prince Mohammed bin Salman, in an interview with the Economist, revealed that the Saudi government is considering selling shares in government-owned Saudi Aramco and/or its downstream assets through an IPO. He indicated that a decision on the IPO and its details (e.g., what share, what price, what assets) would be forthcoming within a few months.
Observers have focused on the financial value of Saudi Aramco—~$1.5 trillion at the low end of the spectrum and as much as $20 trillion at its high end.
While these are awe-inspiring valuations, the IPO’s strategic value—in terms of the Saudi economy and its conflict with Iran and Russia—equals, perhaps even exceeds the IPO’s financial value to Saudi Arabia and its government.
Strategic Objective: The Saudi Economy
As important as the cash this initial share sale in Saudi Aramco (hereafter referring both to Saudi Aramco itself and its downstream subsidiaries) could generate will be the market response to the offer—the price foreign and domestic investors are willing to pay. With this information, the Saudi government will gain a sense of Saudi Aramco’s market value and therefore how much revenue in incremental sales of share in Saudi Aramco could contribute to the Saudi government coffers (adjusted, of course, for expectations for future crude prices).
This information will also signal how much the government could have for priority investments over the next decade or so (after covering operating budget expenditures). In turn, this it will help the Saudi government estimate how much private capital it could attract—assuming various private fund/public fund leverage ratios.
Why is estimating the potential volume of private capital important? Internationally, Saudi Arabia, along with its Gulf Arab allies, is engaged in an existential struggle with Iran (and its ally Russia). Domestically, the Saudi government faces a number of difficult challenges: demographic (a bulging and potentially restive (male) youth cohort); political (a restive Shiite population concentrated in its oil-producing region); and financial in today’s lower for longer crude-price environment (e.g., a 2015 budget deficit at 15 percent of GDP, the likelihood of significant future budget deficits, and a ~$120 billion drop in foreign currency reserves since mid-year 2014).
The government’s capability to meet these challenges will depend on Saudi economic performance in the long run as much as or more than it does on day-to-day diplomacy and military operations. Yet is economy itself faces daunting challenges. In December 2015, the McKinsey Global Institute published a lengthy study on the prospects for the Saudi economy, Saudi Arabia Beyond Oil: The Investment and Productivity Transformation. McKinsey argues that Saudi Arabia, were it to stick to its current government-centric economic model—growth through oil revenue and oil-revenue financed public spending—it would face an economic future consisting of: rapid increases in Saudi unemployment; falling productivity (already low); falling household incomes; and, even were it to implement budget freezes and restrictions on immigration (foreigners comprise a major percentage of the private sector workforce), continued fiscal deterioration. Related: China’s Refiners Report Glut In Distillates
McKinsey proposed however, that Saudi Arabia could, within the next fifteen years double its GDP, and create as many as six million new (for Saudi nationals) jobs through developing the Saudi private sector in general and eight sectors specifically: mining and metals, petrochemicals, manufacturing, retail and wholesale trade, tourism and hospitality, finance and construction and substantial increase in productivity.
Strategic Objective: Encouraging Private Investment
McKinsey estimated the tab for this profound economic transformation at $4 trillion—the bulk, it said, to come from private investors. Domestic and foreign private investors’ propensity to invest in Saudi Arabia will depend on the returns they can expect from their investment and therefore in their confidence in Saudi Arabia’s future.
Selling shares in Saudi Aramco and/or one or more of its downstream subsidiaries could contribute to building that confidence. The cash privatization would generate will provide the Saudi government firepower to fund its share of the $4 trillion—in other words, the funds to invest alongside private investors.
Over time, successful public-private investment would create a positive feedback loop: the greater the confidence in Saudi (private sector) economic prospects, the more foreigners and Saudi nationals will be willing to invest in the private sector, the greater the proportion of each investment they will be willing to finance, the more private investment each Saudi government Riyal will attract, and the more private investors will be willing to invest without government funding.
Strategic Objective: Intimidate Iran (and Russia)
Given the potential value, the prospect of a Saudi Aramco IPO (or IPOs) cannot but cause Tehran and Moscow trepidation. A successful IPO will signal the Saudis can withstand the financial and economic pain from lower for longer crude prices well into the future—and therefore far longer Iran, which, after years of international sanctions and economic and financial isolation, possesses a tattered and investment-starved economy, and Russia, the economy of which is suffering not only from low crude prices, but from European Union and U.S. economic, financial, and political sanctions.
Moreover, neither country has assets that match the potential value of Saudi crude assets. Both have substantial crude reserves—Iran 157.6 billion barrels, Russia 80 billion barrels. That is, however, ~100-to-200 billion fewer barrels than Saudi Arabia’s 267 billion.
Furthermore, the probability that Iran would be willing to sell shares in state-owned National Iranian Oil Company to foreigners in the foreseeable future at best is small, given Iran’s internal political dynamics. In any case, the poor condition of the Iranian oil industry after years of international sanctions has eroded its value. Related: EIA Forecasts Miss the Mark, But Do Better Than Most
As for Russia, a significant share of its energy industry already is in private hands wholly or partially (e.g., Lukoil, Novatek) and the potential value of the Russian government’s share in various Russian energy companies lags far behind the value of a similar share in Saudi Aramco. For example, the Russian government values the 19.5 percent of Rosneft, Russia’s largest crude producer, it is contemplating selling at ~R550 billion (~$7.5 billion at the current RUB/US$ exchange rate). This puts Rosneft’s market value at $37.5 billion. (Rosneft’s CEO, Igor Sechin, puts the company’s value $100 billion-plus). Also, U.S. and European Union sanctions on the Russian government, Russian banks, and Russian energy companies themselves limit the market value of Russian energy companies.
Strategic Objective: Contain Iran (and its Russian ally)
For the foreseeable future, the volume of capital available globally for investment in energy projects will be limited, and will be directed to projects that can succeed in a longer and lower environment. Bluntly, in this environment, a US$ invested in Saudi Arabia is one less US$ potentially invested in Iran (or, for that matter, in Russia), and the less investment in Iran (or Russia), the better for Saudi Arabia.
And, for Iran, a Saudi Aramco IPO—even the prospect of an IPO—could suppress the volume of available investment. It will vacuum enthusiasm from the post-sanction invest-in-Iran’s-energy-industry bubble. Since the P5+1 countries reached agreement with Iran on its nuclear program, Iran’s government (at least some elements of the government) energetically has been soliciting foreign investment in its energy industry. It has developed an extensive list of potential projects, drafted a new (and, it claims, improved) contract for foreign investors and promoted this contract in presentations to potential investors, and announced it would start taking bids on projects in March.
Yet, as Iran courts foreign investment over the next several months, foreigners instead may focus their attention on the IPO of the world’s most valuable company. The following quote, from this Bloomberg article, captures the attention—enthusiasm—the prospect of a Saudi Aramco IPO is drawing:
“Facing the possibility of a record-breaking IPO, bankers are fielding frantic phone calls from head offices asking why they didn’t know this was coming and are preparing to spend the weekend figuring out how serious Salman is, two of the people said.”
Given the fees potential fees a Saudi Aramco IPO could generate for investment banks, and the competition among bankers for a share of the fees, the interest and enthusiasm is unlikely to abate.
A Saudi Aramco IPO will undercut the attraction of investments in Iran’s crude industry. Industry actors—producers, financial institutions, investors—will have to take into account the possibility Saudi Arabia might invest a sizeable portion of IPO proceeds into expanding its crude output capacity. Given the superior infrastructure in Saudi Arabia and greater confidence in investment processes and procedures, it is likely such Saudi projects will come on stream more quickly and at lower cost than similar investments in Iran—and that therefore the market opportunity for the incremental Iranian crude will be constrained when production started.
In other words, companies risking investment in Iranian crude will have to consider their crude capacity could come on stream too late and that when it does come on stream, it could drive crude prices below those necessary to make their investment profitable.
Financial investors and financial institutions, in assessing the creditworthiness of Iranian projects, will have to take into account the potential impact of incremental Saudi output. This will impact their willingness to lend to such projects, the amount they are willing to lend, the interest rate, and the covenants they’ll demand. For their part, Investment funds likely will consider a production company’s exposure to Iran when deciding whether to buy and how much to pay for an investment in the producer’s shares. The value of shares in producers with exposure to Iran should sell at a discount to the shares of producers without such exposure. Related: Get Ready for Iran’s Oil: Sanctions Could Be Removed Next Week
Strategic Objective: Dominate Downstream
In the current (and likely future) market environment, the fates of the Saudi, Russian, and Iranian crude exports will correlate directly to the strength of their relationships to downstream operations in their export markets. Long-term contracts—such as Rosneft’s 2013 deal with China National Petroleum Company to supply at least 360 million metric tons of crude over twenty-five years—are one approach to securing a market for crude.
Ownership of downstream operations in an export market is, however, a more reliable alternative. It is therefore not surprising that both Iran and Russia are pursuing downstream assets in their export markets. Financially-strapped Iran has energetically publicized its efforts in recent months. A December 8 article on Oilprice.com describes Iranian officials’ claims to be holding talks to build refineries in Europe, Africa, Brazil, Indonesia, and India, while a January 10 Wall Street Journal article reports that Iran is offering to help build a 200,000 barrel/day refinery in Spain.
As for Russia, Rosneft, which has refining interests in Germany, has offered to purchase a 49 percent share in Essar, an Indian company with refining assets, and with which it signed a ten year supply contract in mid-2015.
Both countries, however, will have to play catch up with Saudi Arabia. According to the EIA, it already has interests in foreign downstream capacity totaling 2.4 million barrels/day in the U.S., South Korea, China, and Japan through joint ventures or equity investment, to go along with its 2.5 million barrels/day domestic capacity. (Saudi Aramco’s share of output from the foreign operations is 900,000 barrels/day). Also, the Saudis plan to double downstream capacity to ~10 million barrels/day by 2025.
Privatizing between 30 percent and 49 percent of its existing downstream assets could generate $100-$150 billion, according to one estimate. With such firepower, Saudi Arabia could expand its capacity in the U.S., Japan, China, and South Korea as well as acquire downstream capacity in markets in which it lacks such capacity—e.g., Europe, where it has begun to court Russian crude customers. The faster the Saudis expand their foreign downstream operations and the larger their downstream capacity, the more difficulty Iran and/or Russia will have building their downstream presence in such markets.
It will take strong, determined, and bold leadership to meet the domestic and international challenges confronting Saudi Arabia. The proposal to IPO a share of Saudi Aramco indicates Saudi leaders understand the severity of the challenges and that mold-breaking actions will be necessary to succeed.
By Dalan McEndree for Oilprice.com
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