Saudi Aramco: Yield is the key

Summary: Saudi Aramco’s IPO faces significant hurdles related to valuation, oil price and yield.

We regret to announce the death of former Arab Digest editor Oliver Miles at home in Oxford on 10 November following a short illness. A memorial service will be announced in due course. Donations in his memory to Medical Aid for Palestinians.

We are again grateful to Alastair Newton for the article below. He worked as a professional political analyst in the City of London from 2005 to 2015. Before that he spent 20 years as a career diplomat with the British Diplomatic Service.

“If this IPO was 15 years ago, it would be a compelling investment opportunity. But the outlook for oil demand and the energy sector is opaque.” Oswald Clint, Sanford C Bernstein Limited (quoted in the 2 November 2019 edition of The Economist)

Our 7 November Newsletter set out a range of reasons why, although the Saudi Aramco IPO

“…is a highly attractive investment opportunity…, questions swirling around the IPO and [Saudi Crown Prince] Mohammed bin Salman are unlikely to go away.”

Source: Bloomberg TV

This follow-up article focuses on just one of the specific hurdles confronting MbS and which is of particular relevance to potential investors, i.e. the relationship between Saudi Aramco’s valuation, the oil price and yield.

Writing in The Wall Street Journal on 5 November, Rochelle Toplensky argued that Saudi Aramco will struggle to achieve its stated target of seeing at least half its IPO taken up by non-domestic investors. Ms Toplensky cites several factors supportive of her case. First and foremost is the company’s valuation, most estimates of which (as has been widely documented) currently range from the $1.5tn, which is about the mark among independent analysts, to MbS’s claimed $2tn (the $0.5tn difference, to put it in perspective, being roughly equivalent to the GDP of Sweden which the IMF ranks as the world’s 23rd largest economy!).

The key issue here is yield on investment. As Ms Toplensky notes: “The company has promised a guaranteed dividend of $75 billion annually for the first five years. That gives a yield of 5% on a $1.5 trillion valuation, which looks more reasonable than 3.75% at a $2 trillion valuation. Royal Dutch Shell’s dividend yield is 6.3% and Chevron’s 3.9%.”

 Yield (or, if you prefer, the annual dividend to investors) is central to the way in which the IPO is being pitched to non-domestic investors, ie not in the manner usually associated with sale of equity but more like a bond issuance, thereby looking to repeat the success of Saudi Aramco’s debut bond last April, which was oversubscribed to the point of generating a yield of 3.1%. Add to this the global context — i.e. that 11 years after the demise of Lehman we are still living in a world where, thanks largely to easy monetary policy on the part of major central banks, cash in the system continues to scrabble for yield — and it is clear that this emphasis on yield by banks commissioned to promote the IPO should come as no surprise.

One such is Bank of America Merrill Lynch (BofA) which has a very cautious (and, therefore, implicitly indicative of concerns among the investor community at large) valuation range for Saudi Aramco of $1.2tn to 2.3tn. According to an 8 November article in the Financial Times (subscriber access only), in a report for investors BofA is echoing Saudi officials in flagging “the possibility of additional distributions to shareholders above and beyond the minimum dividend pledge”

 However, underlining the potential importance of bonus payouts and in similar vein to Ms Toplensky, the BofA report gives “a 2020 dividend yield range from 3.6 per cent at a $2.1tn valuation, to 6.7 per cent at a $1.1tn valuation, compared with an average yield of 4 per cent for US oil companies and 6.4 per cent for European majors.”

In other words, in the absence of bonus payouts, the percentage yield on MbS’s $2bn valuation does not compare well with the average for US and European oil companies (around which, additionally, the perceived political risk is significantly lower and the risk/return ratio therefore more favourable). Indeed, based solely on comparative yield $1.5bn looks to be about the most generous valuation which would stimulate wholesale interest among non-domestic investors.

Herein, of course, lies the proverbial ‘Catch 22’, i.e. although, according to BofA, a $2tn valuation of Saudi Aramco would likely raise between $20bn (for a 1% float) and $60bn (for a 3% float) on the Tadawul exchange, the proceeds from a $1.5tn valuation should, ceteris paribus (as my economist friends like to say!), fall some considerable way short of those marks. It is fair to assume therefore that potential non-domestic investors will weigh carefully the likelihood of bonus payouts actually being forthcoming, even though the consensus valuation among them is significantly closer to $1.5tn than $2tn.

So, just how likely are bonus payments? Again according to the FT, the BofA report “sets out how higher oil prices, rising free cash flow and borrowing towards the company’s self-imposed limits could make additional payouts possible. The dividend would also grow in line with Saudi inflation or economic growth, which BofA forecast at 3 per cent a year.”

The oil price is, therefore, not the only factor at play here. But it is hard to believe it would not be a pretty critical one, as is underlined by BofA’s own estimate that Brent crude at $60pb could raise the average annual total dividend to $86.5bn from 2020 to 2023; and Brent at $70pb could see it at $105bn.

Today, benchmark Brent crude is hovering at around $62pb. Other than a brief spike in the immediate aftermath of the strikes against Saudi Aramco installations in September, it has not topped $65pb since mid-July; and, even taking into account the September spike, it hasn’t reached $70pb since 28 May.

Two factors in particular seem to be underpinning the low-60s price range which has largely prevailed since the end of May, i.e. clear evidence that the global economy is slowing in any case and concern that US President Donald Trump’s trade-related actions against China in particular will continue to exacerbate that slowdown. Both weigh significantly on the supply/demand equation.

On the demand side, although even the probable conclusion shortly of a modest trade agreement between China and the US — the so called phase one deal — could offer a boost to market sentiment, this would likely be only modest and short-lived.

As for the supply side, the near-consensus among oil analysts is that Saudi Arabia is not only pressuring Opec+ members (notably Iraq and Nigeria) to comply more strictly with the 1.2mbpd cut in output agreed at their meeting in late 2018 (an agreement which is currently due to expire on 31 March 2020) but also lobbying for a further cut to be approved when the group next reviews policy on 5-6 December. However, especially given global economic growth prospects, there are real reservations — including, importantly, in Moscow — over the need for fresh cuts. These make it more likely that Riyadh will have to settle, at best, for a further extension of the December 2018 agreement. But even if the Saudis were to achieve both their reported aims — and, in so doing, managed to push up the price of Brent by the odd dollar or two per barrel — I doubt this would have any significant impact on sentiment over the IPO given the way oil markets move short-term and the inherently long-term nature of the investing in Aramco.

In short, a target of 50% of the IPO being taking up by non-domestic investors does look to be decidedly ambitious. In principle at least, it is, therefore, fortunate for MbS that, as Ms Toplensky puts it:

“The rest of the money will come from Saudi Arabia itself. The country’s tight network of very wealthy citizens is likely to buy in, not least to keep in the prince’s good books. Interest from smaller domestic investors, who get a 10% share bonus, is also expected to be high—Aramco is a source of national pride.”

However, this leaves open the question of how much “the rest” will need to be, especially if the float is at the upper end of the 1-3% scale, as it may have to be to raise the sort of capital from it on which MbS has likely set his sights. Furthermore, and irrespective of how forthcoming domestic investors are, as Ms Toplensky concludes “Saudi Arabians… aren’t a good guide to what the company is worth to global investors” — taking us back to the 2 November article in The Economist (subscriber access only) and the following: “The trouble with letting the market loose on Aramco, however, is that it tends to make up its own mind about valuations”.

 Even if reports of MbS accepting a $1.6-1.8tn valuation to help draw in non-domestic investors are correct, the risk of significant volatility in the share price therefore remains, especially given the range of movement frequently seen in the price of oil. And the greater the percentage of shares held by non-domestic investors, the greater the risk of such volatility.

This, in turn, conjures up a  very plausible scenario where a lengthy global economic slowdown (but still short of a recession) between now and 2023 sees Brent consistently below $60pb. As the aforementioned article in The Economist puts it, even if the commitment to maintain a minimum total payout to non-state shareholders of $75bn a year proved, in such circumstances, still to be legally sacrosanct (which some experts question): “Some investors remain squeamish about what might happen if oil prices were depressed for a long period. Aramco would still be profitable, but profits might not be high enough to sustain the Kingdom’s budget.”

Persistent downward pressure on Saudi Aramco’s share price; lower dividends for non-state shareholders and/or reduced state spending (despite, possibly, higher taxes); more glitches in the roll-out of MbS’s 2030 vision: this is not a pretty picture. Indeed, even if MbS does indeed yield to pressure for a lower valuation of Saudi Aramco, as The Economist concludes: “Such uncertainties will weigh on Aramco, before and after any listing… Saudi Arabia’s transition to oil’s new era is tortured.”

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