Saudi Aramco's $2 Trillion Valuation Has Too Many Assumptions

Saudis seek $2 trillion valuation for oil company.

Photographer: Marwan Naamani

Changing a tax system that has endured since the 1970s is no small matter, especially when it concerns what could be the world’s most valuable company. Saudi Arabia’s announcement on Monday that it was cutting the tax rate on large oil companies to 50 percent from 85 percent is crucial for the fate of the initial public offering of state oil giant Aramco. But is it enough to bridge the gap between a $2 trillion aspiration and independent estimates of $400 billion?

When the IPO was first publicly suggested in January 2016, a notional value of $2 trillion was given, and it has become important to justify a figure around this level. The problem is that this number, based on a simplistic multiple of the company’s reserves, overlooked two factors: Aramco’s high tax rate, and the long period over which reserves are expected to be produced.

The original tax rate of 85 percent was set back in the 1970s, when Aramco was still a consortium of U.S. majors: Exxon, Mobil, Chevron and Texaco. Nationalisation was completed in 1982. The company also pays a royalty on gross revenues of 20 percent, which has apparently not been affected by the latest reform.

In a sense, the tax change is largely an accounting trick. With more than 80 percent of government revenues coming from Aramco’s production, the amount of money flowing from Aramco has to be maintained. Instead of paying most of its profits to the state via tax, Aramco will instead pay them as dividends. This has the welcome effect of better aligning the interests of state and the future private investors.

Instead of a multiple of reserves, private investors will look instead to value Aramco based on the free cashflow it generates. On this basis, the consulting firm Wood Mackenzie was said to value Aramco’s core production business at $400 billion, using a standard 10 percent annual discount rate. Our estimates come to a similar range, allowing for a moderate increase in oil prices over current levels.

This assumes, though, that all Aramco’s barrels are sold at world market prices. Of its 12 million barrels per day of crude oil and natural gas liquid production, almost 4 million is consumed at home where, despite 2015’s subsidy reforms, gasoline still sells at around $32 per barrel. Even though natural gas prices doubled to $1.50 per million British thermal units, they remain well below the U.S.’s $2.84, and even further below prices in Europe or Japan.

So how does Saudi Arabia bridge the valuation gap? It’s simple enough to see that cutting the tax rate to 50 percent from 85 percent would increase an initial value of $400 billion to $1.333 trillion. A moderate increase in domestic natural gas prices could add another $100 billion or so. Refining, petrochemical and shipping assets, net of debt, may be worth around $60 billion, but their operating performance has not been very impressive.

This may get Aramco close enough to its original figure to declare victory, but it assumes that investors do not discount heavily for factors such as high political influence, lack of transparency, and possible misalignment between the objectives of government and investors. Other listed national champions, such as Russia’s Gazprom and Rosneft, and Brazil’s Petrobras, trade at multiples far below those of their non-state peers.

Aramco may shed its non-core activities, but it will still carry the national mission, including enforcing the Kingdom’s OPEC policy. On the other hand, strategic investors, such as the Chinese state entities being wooed by Beijing, might pay a premium for access.

Beyond that, there are not many levers to pull. Cost cuts, the usual panacea, do not affect valuation much. While there is no doubt room for more efficiency, Saudi Arabia’s favorable geology and huge economies of scale already give it the industry’s lowest costs per barrel.

The company's growth is constrained, in that its dilemma is essentially that of Saudi Arabia itself. It cannot expand production rapidly, despite its giant reserves, since this would crash oil prices. Conversely, as the current OPEC deal is demonstrating, cutting production boosts prices only modestly while giving up market share to OPEC colleagues, Russia and U.S. shale producers.

Much is made of the company’s 261 billion barrels of claimed oil reserves, the audits it is carrying out, and the requirements for disclosure on different stock exchanges. As noted, a multiple of its reserves was the basis for the original $2 trillion estimate of the company’s value. So what impact do the reserves have on its valuation? The answer may be surprising: absolutely nothing.

This is because, unless Aramco’s reserves are far below the claimed number, it can sustain current levels of production for decades. Even if its reserves were half the official figure, its notional reserves life -- reserves divided by annual production -- would be 34 years. That compares with 14.1 for the five largest international oil companies.

Of course, these figures should not be interpreted simplistically, but with improved recovery and new discoveries, Aramco should be able to maintain steady production growth for decades. Revenues that far out will be discounted to negligible levels.

This is even more so given the doubts over long-term demand, and the impact of growing efficiency, climate policies and electric vehicles. There may be reasonable skepticism over their impact within a decade or two, but it will surely be significant by the 2040s. In most projections, oil will remain a valuable fuel for aviation and feedstock for petrochemicals. The last barrel in the world will probably come from under Saudi sands -- but it may not be worth very much.

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