Here's One Spin Saudi Aramco Should Avoid Spinning

The idea that higher oil prices make an IPO unnecessary should make investors nervous.

The latest bombshell in the Saudi Aramco IPO saga wasn't a complete bombshell. But it could still do some damage.

Saudi Arabia is reportedly scaling back plans to debut its national oil champion on an international stock exchange, according to a Wall Street Journal article published Monday afternoon. Instead, according to the unnamed sources in the story, Aramco may float on the domestic exchange next year and take its time to decide if a foreign listing is even worth it.

The story offers further corroboration of what many suspect already: that the biggest IPO ever simply may not happen beyond a token listing at home. Nothing was officially confirmed, though, and other options, such as getting a strategic investor to take a stake, apparently remain on the table (as they have for at least a year.)

What was interesting, however, was one of the rationales given: With oil having recovered to about $65 a barrel -- roughly double what it was when plans were first revealed -- the IPO can apparently wait or simply be dispensed with altogether.

Delayed IPOs are fairly commonplace. But dropping the Aramco IPO completely due to higher oil prices is a very different proposition. Even just raising the idea is, well, not a good idea. 

For one thing, $65 oil helps Saudi Arabia but doesn't offer deliverance. The country needs oil to average $70 a barrel to balance public spending this year, according to the International Monetary Fund's latest regional outlook, published in October. Deficits are forecast through at least 2022:

Better, But ...

The recovery in oil prices and Saudi Arabia's own steps have curtailed spending deficits but the government is forecast to be in the red through the early 2020s

Source: International Monetary Fund

Note: Data for 2017 onward are estimates.

And with Crown Prince Mohammed Bin Salman staking his leadership on an ambitious effort to remake the country's economy and society -- the only way to keep reducing that breakeven oil price -- extra dollars to lubricate the process help. He is also personally identified with the IPO and using it to seed a giant sovereign wealth fund. As I wrote here, backing away would risk damaging his credibility and raise further doubts about Saudi Arabia's willingness to really change.

Yes this latest addition to the annals of rumor and spin around the Aramco IPO make it even harder to pull off.

Last week, I took a stab at a back-of-the-envelope valuation of Aramco. The main conclusion was that the $2 trillion figure the prince has repeatedly spoken of looks wholly unrealistic, because foreign investors will primarily want free cash flow -- and will price it at a yield reflecting Aramco's peculiar risks:

One of those risks is that investors would be holding a sliver of a 5 percent stake in Riyadh's crown jewel. Which means a portfolio manager sitting in New York or London would have about as much clout as, well, minority shareholders in a lot of other national oil companies have.

Now consider this idea that $65 oil makes the IPO unnecessary. The implication is that, far from being predicated on the grand, long-term vision laid out by the prince, Aramco's flotation is a budgetary stop-gap, done grudgingly when times are tough. As IPO pitches go, a new shale upstart in Texas would sound less cyclical.

This is a problem in an industry whose history is littered with examples of governments' friendliness to outside investors waning fast when oil prices rise. 

Consider that valuation table above. At $65 oil and a 7 percent discount rate (which is generous), Aramco is worth an implied $1.107 trillion. This assumes a 20 percent royalty rate and a 50 percent corporate tax rate. Say long-term oil price expectations rose to $80. Under the same assumptions, and discount rate, Aramco's valuation rises to $1.473 trillion -- like adding the market cap of Exxon (and then some). Cue cheering from our portfolio managers in New York and London.

Unless ... that higher oil-price outlook causes Riyadh to question the wisdom of selling off even a spoon's worth of the family silver when oil was at $65. One tried and tested way to address this would be to raise taxes. Bumping the rate to 60 percent would bring in extra revenue -- even allowing for the potential impact on dividends -- but also knock down the implied valuation to $1.15 trillion, negating virtually all the gain from the higher oil price. Indeed, the risk premium would also rise, dropping the valuation further. Cue the opposite of cheering in New York and London. Cue also any prospective buyers raising the risk premium in their heads right now.

Like that totemic $2 trillion figure, talk of $65 oil rendering Aramco's share debut superfluous sounds like bravado. And like that $2 trillion figure, it serves to push the IPO ever further out of reach.

-- "A Princely Sum" graphic by Lauren Leatherby

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