Saudi ARAMCO Valuation : How much is 5% of the Company Worth ?
We will build a DCF model of the company to ascertain Saudi ARAMCO’s Valuation. In brief my hyperforecast is that the partial IPO of Saudi ARAMCO (5%) is probably worth anywhere from $ 25 Billion to $ 40 Billion. My second premise is that the IPO is closely intertwined with the Qatar Crisis and the geo-political tussle occurring in the middle east. Qatar will potentially face ejection from GCC (Gulf Co-Operative Council) and there may be potential blockades in Suez Canal and other areas. Though these blockades and actions may be in potential violation of International Law, nothing much can be done unless lengthy court cases are resolved. The intent behind this manufactured crisis is to create a best case valuation scenario around the Saudi ARAMCO IPO. As we will discuss in the third part, it may not go as per plan.
A potential Commodity Shock will most likely create the “Best Case Scenario” in our Valuation Scenarios, however, also has the potential of triggering the “Worst case scenario”. A commodity shock can be created without sounding the war bugle and my premise is that these events will unfold before the IPO rolls out to drooling investors. In the upcoming hyperforecast, I will provide a detailed rationale for this forecast. First, we need to start with the valuation framework of potentially the biggest IPO in the history of the world.
I created this complete DCF model after reading a range of financial projections from many analysts. Even after using the numbers mentioned by most of the analysts, I was unable to come up with much cited lower valuations ($ 400 Billion) as well as sky high valuations ($ 1.6 Trillion). The time taken to research and plug in the numbers was around two days (plus one day for discussion with some friends who work in the O&G M&A Sector in North America) . It is possible that some of my assumptions are wrong, but, the process has been vetted by vertical specialists whose bread and butter is Oil & Gas M&A’s. Assuming that the process is correct and some assumptions/inputs may need correction or improvement, we should all arrive at “nearest neighbor valuation approaches“, given the same inputs. A disclosure is mandated, so here is some lawyer lingo.
Disclosure: I/We have no positions in any stocks mentioned, and no plans to initiate any positions within the next few weeks. I wrote this article myself, and it expresses my own opinions. I am not a Finance or Investment expert and I am not receiving any compensation for writing this post. Our consulting company also does not offer any finance, investment or securities advice and I/we have no business relationship with any company whose stock is mentioned in this article. The Amazon books banner has an embedded affiliate URL and I get few pennies on every book purchased through this link which I fully donate to charity. If this may cause any concern, kindly strip the URL of the affiliate code or search for the title or author directly into Amazon or a search engine. I highly recommend reading these books as the mentioned books (selected out of many) improve fundamental research in areas being studied.
In this post, we will build a Discounted Cash Flow Model (DCF) for a Pre-IPO Valuation of Saudi ARAMCO using data from Public Domain. ARAMCO does not publish audited financial statements and neither has audited reserves analysis, so, I am making assumptions after diligently searching for valid information from the public domain.
As per our analysis, Saudi ARAMCO’s valuation is less than $ 1 Trillion US Dollars on a “Base Case” Scenario.The post is divided into three parts, out of which two are scheduled to be released in the near future.
Part 1: Geological History of Saudi, Company Valuations and DCF Valuation of ARAMCO
- The geological history of Saudi Arabia and why does Saudi Arabia has so Much Oil?
- Company Valuation & Basics of DCF (Discounted Cash Flow) Modeling
- DCF Modeling of Saudi Aramco – A lesson in Market Valuation of a Matured Enterprise
Part 3 – Detailed Hyperforecast (Scheduled): ARAMCO IPO & Qatar Crisis – The Manufacturing of a Crisis and the Looming Commodity Shock
Why is there so much Oil in Saudi Arabia?
Oil is mostly localized in the Middle East and many do not know the geological developments over millions of years that created ripe conditions for an abundance of oil in the region. Crude Oil also called “Black Gold” is formed when various organic compounds mix with each other in the right conditions. Most of the crude oil is formed when dead organic matter decomposes in marine environments, undergoes pressurization and gradual heating leading. As per Wikipedia,
Petroleum is a fossil fuel derived from ancient fossilized organic materials, such as zooplankton and algae.Vast quantities of these remains settled to sea or lake bottoms, mixing with sediments and being buried under anoxic conditions. As further layers settled to the sea or lake bed, intense heat and pressure build up in the lower regions. This process caused the organic matter to change, first into a waxy material known as kerogen, which is found in various oil shales around the world, and then with more heat into liquid and gaseous hydrocarbons via a process known as catagenesis. Formation of petroleum occurs from hydrocarbon pyrolysis in a variety of mainly endothermic reactions at high temperature and/or pressure.There were certain warm nutrient-rich environments such as the Gulf of Mexico and the ancient Tethys Sea where the large amounts of organic material falling to the ocean floor exceeded the rate at which it could decompose. This resulted in large masses of organic material being buried under subsequent deposits such as shale formed from mud. This massive organic deposit later became heated and transformed under pressure into oil. Geologists often refer to the temperature range in which oil forms as an “oil window”below the minimum temperature oil remains trapped in the form of kerogen, and above the maximum temperature the oil is converted to natural gas through the process of thermal cracking. Sometimes, oil formed at extreme depths may migrate and become trapped at a much shallower level.
The aggregation creates a kind of water seal which does not allow the condensed aggregate to disperse or oxidize. Perfect warm weather conditions, such as warm oceans slowly boil the aggregate into denser hydrocarbons.Sediment Rocks, Warm Oceans, Hot Climate and a lot of dead organic material sedimentation around shallow oceans creates oil. Margins or Edges of continents create perfect emergent conditions for the proliferation of hydrocarbons. If you instead want to watch a video that explains the process, check this animation.
Saudi Arabia is known to have roughly 260 billion barrels of crude oil which led to the spectacular “petro-dollar” rise of the kingdom. If most of the hydrocarbons are formed under water in marine environments, then, why does Saudi Arabia, which had an arid environment and most of the oil is found in barren land fills (deserts) has so much oil? There is an interesting background to it. More than 250 million years ago, the earth was fused landmass known as Pangea which looked like something in the figure below. The super-continent was surrounded by the warm Tethys Ocean. This ocean vanished around six million years ago and was named after the Greek sea nymph.
The older Arabia was surrounded by a shallower ocean and sediments washed into the shallow ocean slowly aggregating more and drier land mass.The land mass started forming into sedimentary rocks, creating perfect conditions for boiling, cooking and entrapment of dead organic material converting them into hydrocarbons.
Over time, due to shifting of the tectonic plates, the world geography shaped into what it looks like today. However, more than 200 million years ago, Africa, India and Arabia were on the south edge of the super-continent. As the tectonic plates shifted, the margins of the oceans around Saudi Arabia were pushed above sea level as Arabia moved North. Once the warm ocean vanished, right around the same time the dinosaurs vanished, the previously underwater areas of the shallow seas around Saudi Arabia became arid, warm deserts. To see an animation of shifting of Tectonic plates which led to the availability of abundant supply of oil in Saudi, you may watch this video. The tectonic plate shifting and the subsequent elevation of underwater ocean beds to the surface created even better conditions for further cooking of the organic material underneath leading to the creation of sediment rocks. Saudi Arabia found itself abundant in these golden hydrocarbons significantly altering the state’s financial trajectory. A similar thing happened in Iran and Iraq. As the land massed had risen above sea level, it is fairly easy and inexpensive to extract oil from the surface wells. The oil wells that are closer to the surface are much cheaper* to extract than those where most sophisticated drilling techniques have to be used. Combined with proximity to the availability of cheap labour in Asia reducing the extraction labour costs, the geography allows for significant margins between extraction costs and prices of crude/related commodities in the world.
An analogy may help here, so here it goes. Imagine that there are wooden tables with three open racks (one on top, one in the middle and one at the bottom). Also, imagine many tables stacked with each other. The lower rack of tables has accumulated dust, moss and other solid elements (rocks/wood pieces etc.). Over many years, let us say that weather conditions, heat etc started melting the dust, rocks and other materials into a liquid substance. The layout of the tables also prevents this liquid substance from leaking out or getting exposed to weather. Now, imagine that due to some movement in the space, the tables are getting pushed against each other, tilting some of the tables to one side while pushing the third rack towards the top. Many years after these tables were moved, sand and vegetation covers those racks. Over time, some people just start digging in the sand for fun and find some liquid dust, moss and other solid elements. In some areas, it is much easier to dig and explore, in others, it takes a lot more effort. This simple analogy explains how some parts of Saudi Arabia have easier to extract crude while more effortful to extract crude. We can also say that Saudi Arabia (The older Arabia) was at the right place at the right time.
*(This point will be helpful during our valuation modelling of ARAMCO)
A Tiny Tiny Primer in Oil and Gas
*To be updated with more details.
Oil and Gas is an interconnected industry with many sectors. On a macro-level, the industry can be divided into Upstream, Mid-Stream and Downstream sectors. Within the sectors, we have separate verticals namely Transportation, Exploration and Production (E&P), Oil Field Services, Refining and Marketing. Upstream sectors are known to be the most profitable while all other sectors/verticals are dependent on the upstream sectors. I
In O&G Accounting, we have two ways to account the Exploration Costs and they impact the valuation. We do not have an understanding of which method ARAMCO uses. One of the methods is Full Costs Method (FC) and second is Successful Effort Method (SE). As all the exploration initiatives may not lead to the successful discovery of wells (called the discovery of dry holes), in the FC method, all exploration costs are capitalized and amortized making the balance sheet heavy.
In the SE Method of Accounting, unsuccessful wells (dry holes) are expensed while successful wells are capitalized and amortized.In our DCF analysis, we are assuming that Saudi ARAMCO uses Full Cost (FC) method of accounting. If they use SE Method, it will decrease the valuation and the enterprise value of the company. To read more on this method, please read this document by Arthur F. Madsen, M.Ed. “Oil & Gas Accounting – Full Cost Vs Successful Effort – The Grand Debate”.
Oil is measured in Barrels (bbl) and 1 barrel is equal to 42 gallons. We will use a conversion parachute of Natural Gas, so, it may help to know that 1 bbl of oil equal 6000 cubic feet of natural gas. Natural Gas is sold on per unit of energy typically BTU (British Thermal Units). 1 Barrel (bbl) of Oil is equivalent to 5.55 Million BTU or MMBtu.
While Crude is traded predominantly as WTI (North America) or Brent (European), Natural Gas is traded across hubs. Henry Hub is the most well-known trading hub for natural gas.
The Creation of Saudi ARAMCO
In the brilliant book “The Oil Titans: National Oil Companies in the Middle East“, Valerie Marcel writes that 90% of the world oil reserves are entrusted to a State-owned company who use these companies as political instruments. Over time, one the political purpose is served or fails, there is an urge to think of these companies are commercial competitive forces in the market. The challenge remains when these two purposes conflict with each other creating a higher risk for the investors. State-owned companies are usually mired in bureaucratic culture, so, any effort to separate two conflicting goals is largely unsuccessful.
While there is a significant opportunity for Investors here, they also face significant risks while investing in sovereign ventures. As the state perceives these sovereign entities as political instruments, both to maintain stability at home and to maintain competitive forces at play with competing players (Russia, Iran and others), free market policies can be shown the door from time to time. In addition, the opacity behind the running of these firms scares away most of the risk averse investors.
We do hope that Saudi ARAMCO will be able to understand the investor anxiety and pre-empt the IPO with major transparency initiatives. Lack of transparency is why traditionally State owned Oil & Gas companies are valued at a much lower number than their commercial peer companies. We will discuss the turbulent history of Saudi Arabia in the upcoming hyperforecast, however, this brief will help in understanding how Saudi Arabia’s oil reserves led to the creation of a nationalized oil infrastructure.
- 1933 – On May 29, 1933, Saudi Arabia signs a concession agreement with SOCAL (Standard Oil Company of California)
- 1934 – Geological Survey of Oil Rich landmass is completed using aerial survey, conventional exploration techniques as well as with significant help from the Bedouin tribes of Saudi Arabia.
- 1930 – First oil well is drilled at Al-Khobar and 240 Saudi Employees are hired to assist with oil extraction.
- 1936 – Texas Co (now Chevron Corporation) acquires 50% interest in SOCAL concession.
- 1937 – Max Steineke becomes the Chief Geologist and leads the discovery of major oil fields from in Ghawar, Abqaiq and Qatif.
- 1938 – Significant quantities of Oil was discovered in Well No 7 after major drilling challenges and many dead ends creating a surge in oil exports.
- 1944 – Company named changed to Arabian American Oil Company (ARAMCO)
- 1948 – Standard Oil of New Jersey & Socony-Vacuum (collectively known as ExxonMobil) join Socal and Texaco (now Chevron Corporation) as co-owners of Aramco.
- 1952 – ARAMCO headquarters move from New York to Dhahran setting the stage for nationalizing ARAMCO.
- 1960 – OPEC (Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela) form the Organization of Petroleum Exporting Countries (OPEC).
- 1973 – The Saudi government buys a 25% participation interest in Aramco, increasing it to 60% the following year.
- 1980 – Saudi Arabia buys ARAMCO and takes over 100% shareholding interest in the activities.
- 1988 – Saudi ARAMCO (a nationalized entity) is created.
Vision 2030, Saudi ARAMCO IPO and the Valuation Story
OPEC and specifically GCC was hit hard by the sustained drop in oil prices in 2015. Saudi Arabia, Yemen, Oman and Qatar rely on the oil revenues for 75% of their national budgets. A drop from $ 115/bbl to $ 59/bbl shook the industry and the governments that relied on easy revenues to sustain its welfare heavy subsided services to its citizens. Saudi Arabia was particularly hit by the drop in oil prices and it ran a budget deficit of $ 98 billion and $ 79 billion in the year 2015 and 2016 respectively. The pain of an ailing balance sheet was slowly becoming unbearable.
The country had to tap into foreign reserves to offset the deficit. A country which was comfortable due to the oil revenues offered low taxes and heavy subsidies suddenly was forced into thinking about economic reforms. As we will discuss in the subsequent geopolitical risks facing the country, increasing influence of Iran due to the roll back in sanctions by the Obama administration created additional pressure to urgently reform the state economy.
Subsidies were lifted from oil, water, electricity, wages were frozen and other initiatives were taken which had unintended consequences. Saudi Arabia is tightly controlled by descendants of the ruling family and the antagonistic pressures faced due to a potential unrest from the populace combined with modernization capped the degree of reduction in local subsidies. The kingdom had to look outside to offset its depleting foreign reserves and low oil revenues.
Along came Vision 2030, which aims at balancing the budget by the year 2020 and ambitiously strives for transformation of the national economy by weaning it off the oil revenues. Central to the vision 2030 is taking a part of Saudi ARAMCO public potentially creating the biggest IPO in the history. The market value of the company was proposed to be around US $ 2 Trillion. If 5% of the shares are sold at this valuation, it could easily net Saudi Arabia US $ 100 billion in gains. Starting off with 5% and assuming the stated valuation, increasing the public stake to 20% would easily net the kingdom US $ 400 billion. This is close the amount they lost in the last few years as their foreign reserves depleted. Needless to say, the higher the valuation of the company, the more quickly the kingdom can transform the economy. To the investors who are keen on investing in this IPO, the kingdom and it’s valuation pitch should be run through the same due diligence which is accorded to neophyte entrepreneurs who believe their company has the next billion dollar idea.Many may also forget the misery investors experienced when Saudi ARAMCO floated it’s first IPO for PetroRabigh. PetroRabigh raised $ 640 M in two days in an oversubscribed IPO and since then falling share prices and troubled operations have caused enough investor anxiety.
Even Lex claimed in 2010 that ARAMCO is valued at $ 7 Trillion.The Sovereign Wealth Fund Institute more recently pegged the value of ARAMCO as $ 2.1 Trillion USD, while the Crown Prince valued it at $ 2.5 Trillion USD. He wanted to start with publicly listing 5% of ARAMCO on NYSE or LSE. Everyone has been asking this question “How much is 5% of Saudi ARAMCO ?”. Ask the Crown Prince and he thinks it is $ 100 Billion USD while others claim that the figure is between $ 20 – 50 Billion. To answer this question, we need to build a DCF model and outline our assumptions around the discount rate. In an updated post, we will specifically discuss how we arrived at the discount rate we have chosen.
In the next posts, we will build a hands on valuation model using Discounted Cash Flow modelling (also called DCF modelling) using information from the public domain. Over the next series of posts, we will also examine the Sunni-Shia schism, the Qatar Crisis, the geo-political and internal risks surrounding the region as well as create a detailed hyperforecast on what is more likely to happen as time evolves.
Company Valuation and Various Approaches
There are many ways to value a business and the most commonly used approaches are Income Approach, Asset Approach and Market Approach. Income and Asset Approaches are aimed at calculating Intrinsic Value while Market Approach ascertains Market Value (what buyers are willing to pay for the company). Using either or a combination of the approaches, we can arrive at the Fair Value of the company being valued. DCF Approach also called Discounted Cash Flow approach uses the Income approach to ascertaining Value.
The value of a business can be defined as the present value (on the day of valuation or assessment) of all expected future cash flows forecasted over a definite or indefinite period (perpetuity). To calculate Intrinsic Value using DCF Model, we need historical cash flow from company’s income statement, based on which we can reasonably project future cash flows. In the case of startups, where sufficient historical data is not available, we may choose to value the business using comparables i.e evaluating the business with similar businesses in the market whose value is considered fair value. This works well for businesses with negative intrinsic value (negative cash flows), but, may be valued by investors as worthy investments. DCF valuation methodology is sensitive to changes in assumptions by the investors.We can rephrase DCF approach as the “Value of the business is the sum of expected future Free Cash Flows (FCF’s) discounted at an appropriate rate to arrive at the present value“.
We have heard of the term’s hurdle rate, WACC (Weighted Average Cost of Capital) as well as Discount Rate. We can use a proxy term for all of them i.e. “Rate of Return”. Hurdle Rate is an investor’s expected or targeted rate of return on any project or investment. WACC is the “Rate of Return” calculated for a project with a capital structure (some debt and some equity). Discount Rate is the rate used in DCF analysis which takes into account the time value of money and the risk or uncertainty of future cash flows. The higher the risk and uncertainty of future cash flows, the higher the discount rate and vice versa. Hence, discount rate is a much broader term while WACC and COE (Cost of Equity) are incorporated into calculating the Discount Rate (r). When we calculate “Unlevered Cash Flows”, the Discount Rate (r) is equal to WACC, while in “Levered Cash Flows”, it is equal to COE. As with assumptions, the discount rate is also sensitive to investor preference, risk threshold and understanding of future financial as well as geo-political trends. We are assuming a WACC of 10% for Saudi ARAMCO which an industry standard, hence we will use the Discount Rate (r) basis this we will calculate the Discount Factor using the Stub Year.
Out of DCF methods (2 Stage and 3 Stage Method), 2 Stage Method is the most widely used in the industry and we will be using this model for ARAMCO Valuation. In the Two Stage DCF Model, we use the following theory :
a) Stage 1 -Free Cash Flows – What is the present value of the projected operating and financial performance of the business being valued in a typical period of 5 to 10 Years.
b) Stage 2 – Terminal Value (TV) – What is the present value of the projected value of the business after 5-10 years till perpetuity. A business may exist till 20 years, 50 years or even 70 years. Our Terminal Value calculations do not change whether we chose 20, 50 or even 100 years. We can calculate Terminal Value using two methods (we will be using both to arrive at a median TV). One method is “Perpetuity Growth” Method and second is “Exit Multiple Method”.
In the two stages we have chosen i.e. Stage 1 (10 years) and Stage 2 (11-Perpetuity), we may have stable growth across the overall life span of the firm, a decline or improvement in the second phase of the firm. As such, a 2 stage model requires a holistic understanding of the industry in which the business is operating and how the geo-political and other factors impact the business growth. Based on a deep understanding of the industry, investors may arrive at the same Terminal Value (TV) for a firm, but, may further discount it. As such, any valuation approach is extremely subjective. However, the advantage of the DCF model is that given the same set of assumptions and discount rate, each investor should arrive at the same Stage 1 Value as well as Stage 2 Terminal Value.
For calculating the Stage 1 Value of the company, we will need Unlevered Cash flows. Unlevered Cash flows are not provided in financial statements, so, using, basic data, we will have to calculate the same.
It may also be important to mention that valuation is an art as well as science and there is a dark side to the valuation process i.e. Bias, Uncertainty and Complexity.
Unlevered Cash Flows Versus Levered Cash Flows
There is a key difference between Unlevered FCF and Levered FCF. The difference is “Expense Obligations”. Levered FCF is the amount of cash available after a business has met all its financial obligations (debt). Unlevered FCF is the cash available before it has met its financial obligations. Different businesses have a different capital structure (mix of equity and debt). Capital Structure should not affect the cash flow the business generates using operations. As such, investors want to look at unlevered cash flow (before financial obligations) to better understand the intrinsic value of the business.
As earlier mentioned in the Note above, calculating Unlevered Cash Flows from EBIT is a complex process. Using the tax adjusted EBIT (Pro-forma tax), we need to add Depreciation, Depletion and Amortization to it, subtract any increase in Working Capital Assets, Add Working Capital Liabilities, Subtract any increases in Deferred Tax Assets, Add Exploration Expenses (for companies with SE Accounting method), add increase in deferred tax liabilities, subtract capital expenditures and other required investments. As we do not have this data, we have assumed some and completely ignored some data.
Now, it is important to note that a business with more debt is riskier than the one with lesser debt. Investors already have leverage in deciding the discount rate (cost of capital) and technically should incorporate the risk in the discount rate. Hypothetically, let us say there are two businesses, both generating $ 100 M USD in Stage 1 Cash Flows. However, one business has $ 60 M in bank debt and another has $ 10 M in bank debt. Investors could apply a discount rate of 10% for the first business and 5% for the second business. We have already discussed that the lower the discount rate, the higher the valuation and vice versa.There are some investors who would like to use the Leveraged Cash Flows in their DCF models, however, unlevered FCF is the most commonly used approach. Except for Financial Institutions where Levered Cash Flows method is preferred, Unlevered FCF keeps things simpler, so, we will use the same for ARAMCO Valuation model.
Discount Rate (r) is the critical factor which significantly impacts the valuation through the discounting of future cash flows to present value. Choosing a discount rate is both an exercise in Analysis as well as Intuition. We will update this post in few days and discuss how we arrived at a discount rate for carrying this DCF calculation. For now, it will easier to note that we have chosen a rate of 10% given the geopolitical, governance and finance risks associated with this IPO.
Framework for Calculating Stage 1 Free Cash Flows
We will start building a model from bottom up, using revenues, subtracting the cost of goods sold, operating expenses, D& A to arrive at EBIT (Earnings before Interest & Taxes) before applying an offset for taxes. Thereafter, we will add back the D & A, adjust for any changes in working capital assets, working capital liabilities, accounts receivables and payables, exploration expenses, capital expenditures and other required investments. We will arrive at Unlevered Free Cash Flows (FCF).
Creating a Two-Stage Discounted Cash Flow (DCF) Model for ARAMCO
How much is Saudi ARAMCO Worth? It depends on who you ask, but, using various data from the public domain, we can arrive at the present value of Free Cash Flows for the first 10 years and then calculate the Terminal Value (TV) using the Growth in Perpetuity Formula. We can easily calculate the Enterprise Value of the company by combining Net Present Value of Future Cash Flows (Cumulative Value) as well as the Terminal value. We have highlighted a base case scenario below, however, you can check the three scenarios towards the end of this post.
A large number of articles have been written about ARAMCO IPO mostly disputing the proposed $ 2 Trillion Valuation proposed by the Crown Prince of Saudi Arabia. One thing is clear, this is a unique IPO given the economic impact on the world markets, the unique geopolitical situation of Saudi Arabia and even the potential of future promise and disruption. We chose DCF Model for valuation as the company’s IPO cannot be compared with its industry’s peers, hence a comparables approach (Extrinsic Valuation) to valuation may not be suitable here.Saudi Arabia is known to have reserves 268 billion barrels (43×109 m3). The only country with higher proven Oil Reserves is Venezuela with recently updated reserves of 297 Gbbl. – Source – Wikipedia
A number of proven reserves do not directly impact the valuation calculations, however, we assume a lifespan for a company (say 20-100 years). For investors, the significance of proven reserves impacts the discount rate (r) due to upside potential as well impacts the goodwill value investors are ready to pay on top of the conventionally calculated Enterprise Value (EV). However, there is no direct correlation between reserves and overall valuation. The present value of future cash flows is more important. Pointing towards this key factor, Patrick Pouyanne, CEO of TOTAL told Investors in a conference call “I didn’t know that the value of an oil company was a multiplicator of the reserves of the company. Several factors should be “discounted” before “we’ll see what will be the real value of” Aramco”
“I didn’t know that the value of an oil company was a multiplicator of the reserves of the company. Several factors should be “discounted” before “we’ll see what will be the real value of” Aramco” – TOTAL CEO
Profitability of Revenue Streams
Profitability of Revenue Streams is more important than the potential value of reserves, hence, our first step is to understand the revenue streams and their price points. Looking at data from 2015 Annual Revenue of ARAMCO, we can see that overall Crude Production in the year was 3.7 billion barrels, Natural Gas (LNG) Production was 474 million barrels and Refined Goods is 474 millions of barrels. Legacy data from Energy Export Databrowser data shows that Saudi Arabia’ domestic consumption of oil is increasing while Natural Gas has remained same. Please note that in the year 2015, Saudi Arabia got into a price war with Shale and significantly increased the productions levels (10.4 mmbl/day).
A mistake that other analysts are making is that they are considering the full production of Oil & Gas products in the country for their valuation. The country subsidizes the products for local and expat population, sometimes selling it below cost, hence, we need to exclude the domestic consumption numbers. Additionally, some analysts are double counting the crude supply while calculating the total refined products. A portion of crude produced is used for refined products, hence, we need to explore these numbers as well. We have to only take the products that are being exported. Adjusting for the same, Crude Exports, Refined Products, LNG Exports and for 2015 are 2.6 billion barrels, 232 million barrels and 331 million barrels respectively (see figure below).
Different sources claim different figures for the average cost of Crude Production in the kingdom. One source claims that the production costs are as low as $ 5/ barrel, while another claims a figure of around $ 9/barrel. As per independent sources, costs of Producing Crude Oil range anywhere from $5/barrel to $9/barrel. Some oil wells such as Khurais oil field are known to have a production cost of $ 2/barrel and others such as Shaybah field have a production cost of $ 3-5/barrel. On this basis, assuming a production cost of $ 9/barrel is a fairly liberal estimate. Needless to say, if and when ARAMCO releases data about its reserves and cost breakdown, a lower production cost will push the valuation upwards.
The cost of refining crude oil would include the cost of production of crude (at the well), production, transportation plus the cost of refining. The cost of refining of crude oil at larger oil refineries such as Exxon Baytown is $ 4/barrel, while at smaller refineries is known to be around $ 12/barrel (does not include the cost of crude). In Saudi Arabia, labour wages are much lower than those in the United States and we can assume the refining costs to be significantly lower. Hence, an estimate of production cost ($ 9/barrel) plus refining costs ($5/barrel) gives us a total of $ 14/barrel (around 20% of the sale price of refined products.
Finally, we need to estimate the production cost of Natural Gas. Using data from US and Canada, we have arrived at $ 4/Barrel as production costs. Of course, transportation costs play a major role in the overall cost structure, the more geographical distance, the higher the cost and proportionally higher the prices.
We need to make some other assumptions as well, so, will outline the same.
** IMPORTANT NOTE –Please note that companies are valued using a combination of Intrinsic Value & Extrinsic Value methods and some believe that DCF Model is probably not the best way to value an Oil & Gas company. Based on the method of accounting used (Full Cost or Successful Effort – see the section on Tiny Primer), High CAPEX (Capital Expenses) can generate significant negative cash flows and this is why there are different methods of Accounting. Hence, we are making assumptions to keep things simple. Secondly, we have used a Discount rate (10%) used by McKinsey and other M&A banks. Individual Investors may use a much higher discount rate or a lower discount rate, but, our aim is to use the same inputs these firms have used. Lastly, calculating Unlevered Cash Flows from EBIT requires more complex inputs such as CAPEX, Working Capital Changes, Other Investment etc, which we simply do not have. Except the firms retained by Saudi ARAMCO, I doubt that other analysts also have this data. Hence, we have simplified the Financial Model. As these inputs are available, investors or financial analysts can incorporate them into their analysis. The method and process used by us have been checked and vetted by atleast three seniors investment bankers vertically specializing in Oil and Gas Mergers and Acquisitions. We are also not discussing the legal hazards, risks and other issues in this piece, we are simply generating a DCF model based valuation. All analysts may not agree with these assumptions and processes, specifically those who have never modelled O&G Mergers and Acquisitions. Please consider these calculations as “back of envelope discussion” or an “Oversimplified Model” which one can develop further as deemed fit.
Deal Date and Stub Year – If you notice, we have mentioned the date of the deal as 01 Jan 2018. Technically, as the cash flows are generated at the end of the year, we are required to discount the 2018 free cash flows. To keep things simple, we have assumed that the free cash flows for the first year are generated in the beginning of the year. The “discount factor” in the excel datasheet would show less than 1 (< 1) for Year 1 in that case.
CAPEX – We have no clue about the CAPEX investments, so, to simplify the model, have assumed a general conservative figure. In addition, we are assuming that there are no inflows of Working Capital. If there are inflows, we have to reduce it to arrive at the Unlevered Cash Flows.
Revenue Across Years – We have used the historical revenue data from the year 2015 and used the same revenue across the first 11 years for calculating the Present Value of Free Cash Flows as well as the Terminal Values. Revenue(s) rarely remain constant during the life span of a firm, but, we have done this to simply the model.
Growth Rate – Reserves are of three (3) types Proved Reserves, Probable Reserves and Possible Reserves. Under Proven Reserves, we have Proved Developed and Proved Undeveloped. When O & G companies claim to have a certain level of reserves, a little bit of research quickly shows that all Reserves are not made equal, hence, we need to carry out significant research around the reserve numbers. In Oil & Gas industry, the growth rate is usually negative, unless significant bigger and larger oil wells are being found. Even if new oil wells are being discovered, the older oil wells have declining growth. Hence, assuming a zero resultant growth offsets the declines with any new discoveries. New discoveries are not all made equal as we have already discussed. I have come across atleast a dozen Valuation Models of O & G companies and never seen one in which there is a positive growth rate. Assuming Zero Growth Rate is the reason we have used “Growth in Perpetuity Formula” to calculate the Terminal Value. Some analysts may prefer to use the EBITDA multiples method to calculate the Terminal Value. In some time, we will update this post by using the Multiples Method as well to examine the variance.
Discount Rate – In the first analysis, we will use the Discount Rate (r) as 10%, however in a later update, we will use discount rates of 5% as well as 15%. I will also discuss the major risks which will impact our discount rates. Note that investors use a discount rate of 30-40% for certain startups, while use more conservative numbers for enterprises.
Market Price of Crude, Refined and Natural Gas – We are assuming a market price of $ 50/barrel for Crude (WTI), $ 75/barrel for Refined Products and $ 22.50 for Natural Gas (converting MMCF to Barrels). In a subsequent analysis, we will use market peak and market low averages over the last two decades so analyse how it will affect the valuation.
Royalty and Taxes – We are assuming a Royalty of 20% and Taxes of 50%.
Depreciation and Amortization (D&A) – ARAMCO has billions of dollars in assets, however, most of these assets have been deployed for over 60 years in operation. On this basis, we will use a liberal estimate of an annual D&A expense.
Overheads – Saudi ARAMCO has around 65000 employees, and a majority are Saudi nationals with 1/3rd expats. Using this data and average salary range in Saudi Arabia, we have arrived at labour overheads and included it in operating expenses.
Basis the above assumptions, we arrive at a total Enterprise Value for Saudi-ARAMCO to be around $ 715 Billion. (Click on the below image to see a higher resolution Image)
Using the DCF Approach and a base case scenario, we have arrived an approximate Intrinsic Valuation of $ 715 B USD for Saudi ARAMCO. On this basis, Saudi ARAMCO CEO may have more accurately outlined the value of 5% public listing as above $ 25 Billion or so. $100 Billion may be way off the mark.
It is also helpful to study a comparables valuation (Price/Earnings Ratio), to understand whether we need to offset our assumptions somewhere. We will use a reverse valuation method to check how far we may be from a real value.
*Price/Revenues Multiple – P/R Ratio
We have already discussed that the best way to value is a company is to both use Intrinsic Value (DCF) and Extrinsic Value methods (Comparables). We will spend some time discussing how Saudi ARAMCO compares with its peers. Do note that the revenue used in State projections ($ 185 Billion) is different than what we have used in DCF Model (approximately $ 130 Billion) as we have only taken export revenues into consideration.
We use Exon Mobil, Dutch Shell, Chevron, Petrobras and compared their P/R Ratio with Saudi ARAMCO. As we can see, the average P/R Ratio is somewhere around 1.5 X. When we carry out a reverse valuation for ARAMCO based on the projected value by Saudi Crown Prince, we get a P/R ratio of 11.5 X, which is way off the average ratio. Even when we use the DCF Value of $ 715 B USD, we get a P/R Ratio of 5.67 which is 3 X the average ratio.
Now, Saudi ARAMCO does have significant advantages over the other Oil Majors in that its cost of production and cost of labour is significantly lower than its peers. Even if we factor in the advantage, tripling the average ratio requires significant due diligence and vetting of our numbers. In the DCF valuation framework, we have assumed the annual operating costs and the Depreciation and Amortization Costs (D&A). There may be a significant error in our costs assumed as we have taken below average figures while the actual costs may be higher. We have also not included the reinvestment in the exploration of the new oil well to maintain the growth zero (do note that in O&G sector, zero is considered a good growth rate as new oil discoveries offset decline in existing wells). Once we factor in those costs, we may get a much lower valuation.
Surprisingly, in the year 2005, McKinsey valued Saudi ARAMCO at $ 781 Billion USD, roughly the same figure we arrived at using our DCF model. However, the McKinsey analysts would have used a crude oil price of $ 60/bbl prevalent at the time. This is an indication that our valuation is somewhat higher than the actual numbers would reveal.
We can also look at other scenarios where the price of Oil, Natural Gas and Refined Products experience a commodity shock (high price or very low price). To look at these three scenarios, check out this slideshow. Needless to say, change the discount rate to 5% and the value across the spectrum will approximately double, use a 20% discount rate and the value will reduce in half.