The Underwriter

The Saudi Aramco Oil Put Problem

Keeping prices afloat helps the IPO, but also boosts U.S. rivals.

Speaking at an energy conference earlier this month, Saudi Arabia's energy minister echoed none other than Alan Greenspan:

I am optimistic about the global [oil] market outlook in the weeks and months ahead. Though I would caution that my optimism should not tempt investors into what I would call irrational exuberance, or wishful thinking, that OPEC, or the Kingdom [of Saudi Arabia], will underwrite the investments of others at our own expense.

Yet Khalid Al-Falih's warning also unintentionally emphasized another parallel with the former Federal Reserve chairman. Instead of a Greenspan put in stocks, there now appears to be a Saudi Arabian put in oil.

Al-Falih's appointment last May came amid a shift in Saudi Arabia's strategy. Under his predecessor, Ali Al-Naimi, the country opened the taps, relying on its cash reserves to take the strain of lower oil prices as it squeezed out higher-cost producers. That strain was evidently too much, though, especially as Deputy Crown Prince Mohammed bin Salman was simultaneously pushing a radical reform program, including the once-unthinkable IPO of national champion Saudi Arabian Oil Co., known as Saudi Aramco. By November, an old-style deal for a supply cut had been reached between OPEC and some other countries.

Shifting Sands

Saudi Arabia's oil policy has undergone huge shifts in the past two years

Source: Bloomberg

Note: Nymex front-month oil futures price.

A committee to monitor the cuts meets this weekend. Ministers across the OPEC countries, meanwhile, have been trying out their Greenspan voice. Only this week, Venezuela's President Nicolas Maduro said he was discussing a new plan aimed at getting oil back above $70 a barrel. Brent was, understandably, unmoved by this latest declaration from Caracas. In truth, Al-Falih's voice is the only one that counts.

Even so, as any central banker knows, jawboning the market into submission isn't easy. Al-Falih's speech at that conference delivered a decidedly nuanced message, telling the global oil industry it must invest to meet long-term demand -- but not too much and only in the right kind of projects -- and that Saudi Arabia was sacrificing supply to support prices, but wouldn't be played for a sucker.

The added complication concerns that Aramco IPO slated for next year.

Saudi Arabia may threaten to scuttle the supply deal if others don't pull their weight. But those others are aware the Kingdom also cannot allow a slide in oil prices to jeopardize the success of a deal so loaded with fiscal and political baggage. Oil prices must be seen as strong and getting stronger if Aramco is to be valued anywhere close to the fantastical figures thrown around so far. You can't put something up for sale while simultaneously trashing the market that thing relies on. Imagine an investment banker during the tech bubble fretting in public about peaky multiples.

So as intrigue mounts ahead of May's meeting on whether to extend the supply cuts, the Aramco IPO is a critical variable. If Saudi Arabia remains committed to it, then it will ensure the supply deal is maintained.

And if that's the put in the oil market, then the guys who will make use of it are the irrationally exuberant crowd: U.S. shale producers and their financiers. 

Besides severe cost-cutting and working smarter, E&P companies have kept themselves going through the crash by raising cash. In that latter respect, though, this is nothing new; the sector hasn't lived within its means for many years:

An Old Flame

The E&P sector didn't start burning cash in the crash

Source: Bloomberg, Bloomberg Gadfly analysis

Note: Free cash flow (operating cash flow less capex) for a sample of 85 U.S. E&P companies with a market cap. of $100 million or more.

Tapping investors to bridge the gap was pretty easy when oil topped $100. Surprisingly, it wasn't impossible when oil ducked below $50, either:

Can We Help?

When the E&P sector's cash burn ramped up, capital markets stepped up

Source: Bloomberg

Note: Data reflect high-yield bond issuance for the broader energy sector and equity issuance for the E&P sector. Data for 2017 are annualized based on issuance through March 23rd.

Notice how equity issuance filled in when high-yield markets did buckle briefly in 2016. So far this year, new high-yield issues from the sector have averaged $514 million each, the highest since at least 1999, according to figures compiled by Bloomberg. On the equity side, investors on Thursday handed $900 million to a blank-check company backed by Riverstone Holdings LLC to go out and acquire E&P assets.

Besides providing a psychological tonic, the supply cuts gave a brief boost to oil futures. It is imperative for OPEC to at least flatten out the oil curve if it is to clear the glut of inventories weighing on the market (see this for an explanation). But the side-effect was providing an opportunity for E&P companies to hedge some production at higher levels: 

Curve Ball

OPEC helped flatten the oil futures curve, but also provided a hedging opportunity through February

Source: Bloomberg

Note: Nymex crude oil futures curves just before the November 2016 OPEC agreement, the end of February 2017, and March 23rd, 2017.

There is also private equity to contend with. As of last June, there was $156 billion of dry powder sitting in energy-focused  funds, according to a report published this month by Preqin, an alternative-assets research firm based in London. The vast majority of that money is targeted at North America. Assuming leverage of one-for-one, that is at least $300 billion or so of firepower to scoop up oil-and-gas assets or companies, financing potential production that might otherwise go begging.

Some of that cash may never be invested or will be used to buy things like pipelines or power plants instead. Even so, the dry powder alone is bigger than the value of all North American E&P acquisitions by private equity over the past decade:

Private Life

Buyouts took a breather in North America's E&P sector in 2015 but have since bounced back

Source: Bloomberg

Note: Private equity acquisitions of North American E&P companies and assets.

As of February, Preqin was tracking 252 natural resources funds on the road aiming to raise another $105 billion, with most of that likely to target the energy sector, too.

And yet, the rewards hardly seem to warrant such, er, exuberance. The median rate of return on funds that began investing between 2005 and 2013 hovers around 5 percent, with a few vintages rising into the high single digits, according to Preqin's data. The boom in energy-sector valuations prior to the crash weighs on funds that got to work post-2012. Nevertheless, new money kept on pouring in:

Fresh Powder

Private equity funds targeting energy raised even more money in the crash

Source: Preqin

Given that 2010-vintage funds scored by picking up assets in the aftermath of the financial crisis, perhaps the current enthusiasm makes sense.

As with public equity and debt markets, though, the Aramco put is also keeping animal spirits alive. Even if the formal IPO roadshow hasn't started yet, the informal one in the oil market has -- providing free marketing for Aramco's shale-focused rivals to raise money for more drilling.

This is Saudi Arabia's quandary. In order to make others look truly irrational for their exuberance, it would have to let oil prices sink to a level that make its own expectations for Aramco's value, or even the very idea of an IPO, look equally irrational. For now, at least, the put is in.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Liam Denning in New York at

    To contact the editor responsible for this story:
    Mark Gongloff at

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