Investor Risks associated with Saudi ARAMCO IPO

Saudi ARAMCO Heat Map Risk Analysis

It is said that “Risk is measurable uncertainty while Uncertainty is Unmeasurable Risk“. Investing in securities is risky, but,  IPO’s carry unique risks for investors and require significant due diligence. Investing in sovereign fund IPO’s further compounds the risks due to the possibility of the multiplier effect playing itself out. There are two significant risks related to investing in stocks i.e. Volatility Risks and Absolute Risks. All other risks financial, political, operational, governance, legal etc create Volatility and Absolute Risks.

Volatility Risks – The fluctuation in the share price guides market sentiment where people want to either get in or get out of the market. The fluctuation can be caused by market conditions, economic conditions and even a looped back effect of investor sentiment. Too much volatility in a share price can drive away long term investors, attract short sellers and lead to significant loss of invested capital.

Absolute Risks – At times, the company may go out of business and everyone invested in the company may be left holding worthless securities. Absolute risk is the worse type of risk in any investment scenario.

We should also consider the inherent risks and the dynamics risks in any opportunity. Inherent Risks are unique to the industry or domain, but dynamic risks are the result of many factors converging together over time. Institutional Investors usually have a team of analysts who examine the securities with a historical track record. Even institutional investors find it challenging to analyze Pre-IPO companies as objective research is not easily available in the market. If we transpose all these challenges to secretive sovereign funds which run under the cloak of opacity, even big investors find such investments extremely risky.For individual investors, these problems get further compounded as investors remain at significant information asymmetry disadvantage. The discount rate used by Investors in the valuation of a company is significantly influenced by many factors most importantly the risk premium they are paying for an investment versus the risk-free investments. Basis this, evaluating the same set of assumptions and risks, investors may discount the cash flows differently.

Our post is aimed at outlining those risks so that investors can get a holistic perspective of the risks around the Saudi ARAMCO IPO. The IPO will potentially be the biggest IPO in trading history and for some, it is no brainer to invest in this potentially huge opportunity. Saudi ARAMCO is likely to release a public listing of 5% its shares either on London Stock Exchange (LSE) or NYSE (New York Stock Exchange) sometime in early 2018.

Saudi ARAMCO is beset with legal, geo-political, security, market and other risks which can end the party abruptly. As highlighted in the risk heat map below, the two major risks are acceleration in the EV industry and the eventual breakdown of the dollar peg breakdown. The less probable risks are integrity of reserves data, valuation challenges, short term and long term security threats as well as the potential of a coup d’etat.I have tried to list the risks without categorizing them and it should be noted that all the risks in any situation can rarely be listed, discussed or articulated. Investors should be wary of the following risks in the upcoming IPO:

  • Challenges in Achieving Consensus on the Valuation Range
  • Overstated Reserves
  • The Saudi Duality and the birth of a Nation
  • The Sunni-Shia Schism
  • The Siege of the Grand Mosque
  • Potential of Coup d’état within the Ruling Family
  • Long Term Threat from Iran
  • Transparency and Governance Issues in ARAMCO
  • Risk of Stranded Assets (Climate Change, Dropping Demand, Electric Vehicles)
  • New Discovery of Oil in the Arctic Ocean
  • Loss of Aramco’s Sovereign Immunity
  • An Urge to Fix the Kingdom’s Ailing Balance Sheet
  • Dollar Peg Breakdown

Valuation Range Consensus

In the previous part of this post, we have already discussed three approaches to valuing a company i.e. the Income Approach, the Asset Approach and the Market Approach. It is extremely hard to come up with objective data about ARAMCO assets, specifically when data on reserves is unlikely to be made public. Using Market Value approach will lead to significantly lower valuation when we compare ARAMCO with similar sovereign funds (Petrobas, Petro-China etc.). The best way to value ARAMCO is using the Income Approach (the Discounted Cash Flow model). Our full DCF model and it’s assumptions are outlined in the previous post. Most of the analysts have used the Income Approach and arrived at a wide range of valuation scenarios from $ 250 B to $ 1.6 Trillion.

Wood Mackenzie Ltd has come up with a valuation of $ 400 Billion based on DCF model, American Enterprise Institute has come up with$ 1.26 Trillion based on revenues multiples method (10 X $ 126 Billion Annual Net Revenue), ARAMCO Insiders have suggested a value of $ 1.5 Trillion (method unknown). EFG Hermes survey surveyed investors at a conference in Dubai, 39% of respondents think the company is valued between $ 1 Trillion to $ 1.5 Trillion, 36% expect a value below $ 1 Trillion and only 24% of respondents believe the value is above $ 1.5 Trillion.

Our hands on DCF valuation explained in Part 3 led to a valuation of around $ 715 B (Base Case Scenario), using 10% discount rate and $ 50/bbl oil. We built a DCF model using Aramco’s own 2015 reports as well as other public data and struggled to come up with a value of more than $ 700 Billion. We also used a revenue multiple approach and came with a value of less than $ 500 Billion. (Note that in the revenue multiple method, we added an offset of 1.5 X to the average multiple factor as ARAMCO has significant cost advantages over other players in the market.)

Saudi ARAMCO

(Click to see Larger Image)

The biggest challenge is for investors to arrive at a consensus on a valuation number for the company. Lack of data and opacity increases the uncertainty and confusion around this subject. ARAMCO will be well served to publicly release as much data as possible so that investors can remain at ease while evaluating the company. Leaving individual analysts and investors to compute the value will only increase confusion and risk in the minds of the investors. Investors may shy away from this IPO inspite of the possibility that it is a promising investment for those who are familiar with commodities sector.

Overstated Reserves

The most important risk in this IPO is “Overstated Reserves“. The amount and quality of reserves directly impact the Terminal Value and even the Cumulative Value (as calculated in the previous step). In 2011, Wikileaks, released leaked diplomatic cables where the US diplomat urged Washington to sit up and take notice of the possibility of the Saudi reserves being grossly overstated. The leaked cables describe US Ambassador’s discussions with a senior Saudi government oil executive, Adad al-Husseini, a geologist and former head of exploration at the Saudi oil monopoly Aramco. Husseini claimed that the kingdom’s crude oil reserves may have been overstated by as much as 300 billion barrels – nearly 40 per cent. The revelations came when the oil price soared to around $ 100/bbl due to geo-political tensions in the Middle East and Washington hoped that Saudi Arabia would ramp up production to cool the prices in the market. However, Sadad al-Husseini, told the US consul general in Riyadh that Aramco’s 12.5 million barrel-a-day capacity could not be reached. Emphasizing that Saudi Arabia might reach an output of 12 million barrels a day in a decade, but he believed that by then, the global oil production would have reached it’s highest point known as “peak oil“.

Quoting one of the cables “According to al-Husseini, the crux of the issue is twofold. First, it is possible that Saudi reserves are not as bountiful as sometimes described, and the timeline for their production not as unrestrained as Aramco and energy optimists would like to portray.”. Related cable also stated “In a presentation, Abdallah al-Saif, current Aramco senior vice-president for exploration, reported that Aramco has 716 billion barrels of total reserves, of which 51% are recoverable, and that in 20 years Aramco will have 900 billion barrels of reserves. Al-Husseini disagrees with this analysis, believing Aramco’s reserves are overstated by as much as 300 billion barrels. In his view once 50% of original proven reserves has been reached … a steady output in decline will ensue and no amount of effort will be able to stop it. He believes that what will result is a plateau in total output that will last approximately 15 years followed by decreasing output.”Husseini later told WSJ that these comments have been taken out of context. The US consul also reiterated to Washington, so as not to lose the message in all the noise “While al-Husseini fundamentally contradicts the Aramco company line, he is no doomsday theorist. His pedigree, experience and outlook demand that his predictions be thoughtfully considered.”

The cable triggered an intense debated in Washington and among other analysts that the Saudi Reserves may indeed be overstated and questioned the influence of Saudi’s in the oil market. Quite recently, Saudi Arabia has claimed that based on a Western audit of its reserves, they still have around 260.8 billion barrels, not much different from 261.1 billion in 2015. In the previous section, we have already discussed that a “growth rate of zero” for Oil & Gas companies is more plausible as a decline in existing wells is offset by the discovery of new oil wells. Hence, from my perspective, a zero growth rate is actually indicative of positive growth. ARAMCO also told Reuters that they have discovered new oil fields in Jubah and Sahaban, and one new gas field, Hadidah, all located in the Eastern Province, the main oil region in Saudi Arabia.

Saudi Arabia does have a lot of oil and it is probable that much of oil is still undiscovered, the last drop of oil will probably come from the Kingdom. However, even if the investors ignore the rumors around overstated reserves, they should note the production delays between discovery to commercial exploration. They should also consider the fact that the quality of oil wells discovered may be poor.

Overstated Reserves - Saudi ARAMCO

Stuart Staniford of the Oildrum.com has been engaged in a forensic study of some of the Saudi Oil fields and he claims that some of the well-known oil rich wells in Ghawar are experiencing significant depletion levels. He also claims that forensic analysis of oil wells shows that more water than oil is being discovered in some of these oil wells.

Secondly, in a well-researched book “Twilight in the Desert” written by an industry veteran and Investment banker specializing in energy investments, late Matthew Simmons digs deep into the technical records of Society of Petroleum Engineers (SPE) and make a troubling proclamation. Before Saudi Arabia was nationalized, transparent and comprehensive geological records were available. Simmons extrapolates those records to 2004 to arrive at depletion levels of various Saudi oilfields. He claims that the decline in the star oil wells Ghawar, Abqaiq, Safaniya, Berri, Marjan, Zuluf & Shaybah is grossly understated by ARAMCO. He also believes that the new oil well discoveries are unable to offset the declines and we have already crossed the peak oil phase.  Attached below is a brilliant presentation by Simmons to the Hudson Institute titled ” The Twilight in the Desert – The Fading of Saudi Arabia’s Oil“.

We also have a problem with a complete lack of clarity on what are the proven reserves as per Saudi’s definition.  As we can see below, all reserves are not created equal. Technically recoverable reserves may be economically nonviable and economically recoverable are market price dependent.

Oil and Gas Certainty

Needless to say, investors will seek more transparency from ARAMCO on both the volume and quality of their reserves. Compounding the problem is the fact that Khalid A. AlFalih, Minister of Energy, Industry and Mineral Resources of Saudi Arabia recently told WSJ that “Oil Reserves will not be included in the IPO“. The cloak of secrecy around the quality and volume of reserves will generate investor skepticism and rumor mills will work overtime to seep doubts in the Saudi reserves proclamation. The only factor positively impacting transparency in this area is the fear of SEC in case the IPO is listed in NYSE. While listing on NYSE compound legal risks for Saudi ARAMCO, it may signal to investors that the kingdom’s claims on reserves are still credible.

In 2016, SEC forced Exon Mobile to “write down their reserves” after triggering an investigation. Unlike Chevron and other BP, Exon had resisted reducing the net worth of their reserves after the oil prices crashed. If ARAMCO chooses to list on LSE, who eagerly bends the rules on disclosure, investors can expect sustained opacity on the quality and volume of reserves. A NYSE listing versus an LSE listing will lead to investors using lower discount rates pushing up the valuation, if supported by other factors.

Security Issues, Internal Strife, Religious Sectarianism & Warring Neighbors

The Saudi Duality and the birth of a Nation

Nejd-Najd ArabiaMost of Saudi Arabia’s current problems can be traced backed to the inherent duality that surrounded the formation of the ancient Arabia. The last mile work was done by the British “divide and rule” policy driven by commercial and imperialist interests when working with the French, they carved out borders of the modern Middle East. The Sykes-Picot agreement led to the division of Arabs provinces due to the decline of the Ottoman Empire and sowed the roots for constant conflict in the region.

In 1930’s, the two co-founders of the kingdom, Muhammad ibn ʿAbd al-Wahhab, a religious leader and Muhammad bin Saud, a tribal leader found common ground in spite of their conflicting goals. Abd al Wahhab was born in Uyaynah, a desert oasis in the south of Najd and practiced Hanbali Islamic law, inspired by the teachings of Ibn Taymiyah, who relegated the function of the state as secondary to religion. Al Saud lived miles away in Ad Diriyah, the geographical center of Najd. Their union was conditional based on the fact that Al-Saud strictly conforms to Al-Wahab’s religious ideology by embedding it in the political structure of their ruling empire. Their union led to many conquests and they succeeded in unifying the tribes as they together captured more and more land around Arabia. In 1900’s, Arabia looked as in the map below, but, by 1930’s, the conquest seeking duo had captured all the zones in white and yellow creating the modern day Saudi Arabia.

Modern Day Saudi Arabia

Modern Day Saudi Arabia – (Click to see Larger Image)

Al-Wahhab was the founder of Wahhabi movement based on “Jihadi Salafism” at the center of constant strife within the Muslim world. Wahhabism is the austere, puritan form of Islam which relies on a literal interpretation of the Quran rather than intellectual, moderate or more innovative interpretation as practiced by many other sects (see graphic on various Sunni Shia sects in the section below). The hardcore Wahhabists fiercely and violently protect the concept of monotheism (existence of only one god) and denounce polytheism (the belief in the worship of more than one god). The origin of the Takfiri doctrine also has its roots in Wahhabism, which has the absolute power of declaring non-Muslims and even fellow Muslims Kafirs (Unbelievers), who refuse to follow their fundamentalist” or “puritanical” religious ideology. Al Qaeda, Isil (Daesh), Al Shabab and Boko Haram follow the Wahhabist ideology. While the historically rooted Sunni-Shia schism can be predominantly credited for the tensions in the middle east, within the Sunni sects also, there is constant jostling for supremacy and religious hegemony. Juhayman al-Otaybi, the leader of grand mosque siege felt motivated to rise against the dilution of the Puritan Wahhabist ideology by the Wahhabi Ulemas (religious leaders) of Saudi Arabia.The deeply ingrained duality in the fabric of Saudi Arabia, where the ultra-orthodox group keeps resisting the dilution and moderation of the original Wahhabist ideology keeps surfacing from time to time.

The Sunni-Shia Schism 

 

Sunni-Shia Divide

We have to look at all the problems in the region through the prism of the Sunni-Shia schism prism. These problems have become more complex and intertwined with more layers of geostrategic, geopolitical as well as sectarian issues. The 1400 old year religious divide remains the common denominator. However, as PBS documentary “Lawrence of Arabia” chronicles, the schism transformed into nation state political ideology when the British and French divided ancient Arabia into how it looks today. Saudi Arabia and its neighbors are microcosms of the macrocosms that have led to analogies of the dragon trying to eat its own tail. Sunni and Shia Muslims have lived peacefully together and even intermarried within the sects for hundreds of years. While they share the same faith in Quran, the holy book for Muslims, they differ in the interpretation of the hadith. Such divide exists in all religions across the world, but, what makes this divide unique is how divisions morphed into state boundaries. Iran is predominately Shia while  Saudi Arabia is predominantly Sunni and both are constantly involved in proxy wars to gain supremacy in the region. Among both the sects, there are scholars who follow a moderate Sufi form of Islam. A very small segment (around 3-4%) shares the theological, Puritan, intolerant ideology. To see an interactive graphic on the Sunni-Shia sects, click on the image on the left (new link opens).The birth of the schism can be traced back to 632 when Prophet Muhammad died without leaving instructions on who would succeed him. Some wanted the closest advisor Abu Bakr to succeed the Prophet while another group wanted Ali, the son in law of the prophet to take over the mantle. The Sunni’s prevailed, but eventually, Ali became the fourth Caliph. Ali was assassinated in the year 661 when war broke out between supported of Ali and others. The seeds had been sown for the divide that would ensure that both the sects would never unite again.

As per Wikipedia ” Sunni Islam and Shia Islam are the two major denominations of Islam. Their division traces back to a Sunni–Shia schism following the death of the Islamic prophet Muhammad in the year 632AD. A dispute over succession to Muhammad as a caliph of the Islamic community spread across various parts of the world, which led to the Battle of Jamal and Battle of Siffin. The dispute intensified greatly after the Battle of Karbala, in which Hussein ibn Ali and his household were killed by the ruling Umayyad Caliph Yazid I, and the outcry for revenge divided the early Islamic community.The present demographic breakdown between the two denominations is difficult to assess and varies by source, but a good approximation is that 85–90% of the world’s Muslims are Sunni and 10–15% are Shia, with most Shias belonging to the Twelver tradition and the rest divided among many other groups. Sunnis are a majority in most Muslim communities: in Southeast Asia, China, South Asia, Africa, and most of the Arab world. Shias makeup the majority of the citizen population in Iraq, Bahrain, Lebanon, Iran, and Azerbaijan, as well as being a politically significant minority in Pakistan, Syria, and Yemen. Azerbaijan is predominantly Shia; however, practicing adherents are much fewer. Indonesia has the largest number of Sunni Muslims, while Iran has the largest number of Shia Muslims (Twelver) in the world. Pakistan has the second-largest Sunni. India has the second-largest Shia Muslim (Twelver) population in the world.Today, there are differences in religious practice, traditions, and customs, often related to jurisprudence. Although all Muslim groups consider the Quran to be divine, Sunni and Shia have different opinions on hadith. In recent years, Sunni–Shia relations have been increasingly marked by conflict, particularly the Iran–Saudi Arabia proxy conflict. Sectarian violence persists to this day from Pakistan to Yemen and is a major element of friction throughout the Middle East and South Asia.Tensions between communities have intensified during power struggles, such as the Bahraini uprising, the Iraq War, and most recently the Syrian Civil War[and in the formation of the self-styled Islamic State of Iraq and Syria that has launched a genocide against Shias”

Over and over again, these unresolved wounds surface in the region and mired with the complexity of financial and political hegemony lead to sustained conflicts in the region. All conflicts can be traced back to a core denominator of the thousand year old divide and they are unlikely to abate. Unless of course, a major peace initiative is launched by politicians in the region. Till then, peace will remain an existential threat to some leaders in the region.

Saudi Arabia is surrounded by Bahrain, a Shia majority, Sunni ruled nation and on another side by Yemen, which is mired in a proxy war and unprecedented humanitarian crisis. Towards the east of Saudi Arabia is a town called  al-Awamiya, which holds most of the Saudi oil, there is ongoing unrest between security forces and Shia minority.  There are frequent attacks on the oil installations which are quickly stopped in their tracks. However, there is always a potential for a risk to the Saudi infrastructure, due to attacks on the installations sending the future Saudi IPO stock into a tailspin downwards. More recently, there have been missile attacks by Houthi Rebels on Saudi Refineries causing extensive damage to the infrastructure. We also have significant marginalization of Shia sects in Sunni controlled Bahrain, an adjacent neighbor to Saudi as well as on the east end of Saudi Arabia. As reported by Humans Rights Watch, the anti-establishment feeling amongst the oppressed Shias provide enough opportunities for opportunistic neighbors to ferment unrest in the country.

As if the internal strife due to significant differences in opinions with the Wahhabi think tanks, the Shia unrest in the eastern province which holds most of the Saud Oil, the “game of thrones” within the ruling family as they jostle for the ruler’s position was not enough, here comes the war in Yemen, the Qatar crisis and the perpetual danger from Iran. We should also not ignore the rising conflict between Muslim Brotherhood and the rest of the Sunni sects polarizing Saudi Arabia, Bahrain and the United Arab Emirates against Qatar, Turkey and potentially Kuwait. The Qatar crisis has generated cracks in the Sunni Unity which may have unintended consequences in the future.

The Siege of the Grand Mosque  

The Grand Mosque siege remains the most under-reported  event in the history of journalism.While the Iranian Hostage drama after the overthrow of the Shah was entering it’s third week, another significant event that trapped more than 100,000 pilgrims was unfolding in Saudi Arabia that got buried in news for most non-Muslims. The day was Nov 20, 1979 when hundreds of gunmen stormed the holy Grand Mosque in Mecca, took hostages and kept siege for many days. The siege was broken once unofficial help from French commandos (without them ever entering the holy mosque) enabled the Saudi forces in taking back control of the situation. The date was First of Moharram of Islam’s year of 1400 and most of the conspirators were of the Saudi Bedouin tribe. After gunshots rang, within few minutes, Juhayman ibn Muhammad ibn Sayf al-Otaybi, the leader of the group emerged from the depths of the mosque and his supporters declared that his authority extended beyond Saudi’s commercial capital to the holy cities of Mecca and Medina. Juhayman embraced Wahhabi teachings early in his life and as he dug deeper to find the meaning of life, he discovered his purpose and predictive lineage in the teachings of the Hadith. He thought himself to be the Mahdi (not to be confused with the Shia Mahdis), which based on Islamic theology would be the prophetic redeemer dispatched by god to establish an ideal society after an deadly clash with those will resist it.  He was the leader of the hostage gang who wanted to rid Saudi Arabia of the tyranny and corruption of the Al-Saud rulers.  The perpetrators followed the puritan strain of Islam, Wahhabism and wanted to wrest away control of the holy cities from the Al-Saud ruling family. Extended siege and a concerted effort by Saudi government to conceal the real identity of the attackers, sparked rumours that American interests had send in their agents to hand back control of the holy mosques to the Saudi family. It led to demonstrations and even the burning of the American embassy in Pakistan and Libya. Yaroslav Trofimov, an award winning journalist chronicles the terrifying, nail biting well researched report into how close the Saudi Ruling family came to being overthrown by the tribal ideologues. The aftermath of this major event in the history of Middle East led to the assassination of Egyptian President Anwar Sadat as well as the birth of the Carter Doctrine.

The ensuing rumors and the deep animosity for the ruling family amongst the Bedouin tribes and even the religious leaders led to the birth of Al-Qaeda culminating in the Sep 11 attacks on the World Trade Center. The Saudi reaction to the siege further crystallized existing faultlines within the Sunni sects in the country jostling for supremacy. Similar to dormant volcanoes, the faultlines remain buried but alive well below the surface in the Saudi culture itself. Violently repressed and controlled by the regime, periodic attempts at surfacing by these sects are brutally repressed waiting for the next cycle of surface and repression. In May 2003, members of the Osama Bin Laden’s al-Qaeda network, remnants of the divide created by Juhayman siege and brutal killing of worshipers, drove cars packed with explosives at three foreign housing compounds, detonating them with devastating effect. In Nov, 2003, they struck again in the US Consulate residential compound killing and injuring many. The rise of the radical strain intent on getting their way has led to more and more attacks on the Saudi Forces and Western compounds.

Potential of Coup d’état within the Ruling Family 

Saudi Royals Lineage

 

The Ruling family constitutes the king and approximately 1500 princes divided between sons, grandsons and grand grandsons. Across ruling monarchies, there are different types of succession methods used to appoint successors to the throne. Across the six commonly accepted types of Primogeniture, Saudis have traditionally used Lineal Primogeniture which is male only inheritance. In the absolute lineal method, the oldest surviving child is a successor to the throne. However, King Salman has shaken the tradition by first deposing Crown Prince Muqrin and then by sidelining MBN (Mohammed Bin Nayef) creating a clear path to success for his son Mohammed Bin Salman. There have always been internal problems within the Royal family which frequently come to a head leading to removal or assassination of one or more royals. Kind Saud was deposed while King Faisal was assassinated and this cycle will likely likely continue.

More recently Mohammed bin Nayef (MBN), the deposed crown prince, also known as the “Prince of Counter Terrorism”,  a favorite of Washington has been reportedly confined to the palace. A CIA favorite who was also awarded “CIA Award for Counter Terrorism” has been sidelined for now, but, one can expect the foreign intelligence services to keep throwing a spanner in the works for the new regime. For now, things seem calm, however, infighting within the family descendants create uncertainty for the future.  Similar to the suppressed news of the “Seige of the Grand Mosque“, there was another story leading to the current “soft coup” in Saudi Arabia.

In 2015, one of the senior princes of the Saudi Royal family had petitioned other members for a change in the country’s leadership. The publicly available letter also casts aspersions on the recently appointed Crown Prince Mohammed bin Salman. The petition was in response to the tricky Yemen War, the deaths of Haj tourists in Mecca and the increased apprehension from the normal public that corruption in the royal family is the root cause of misery for commoners.To make matters worse, due to leaked cables, public anger in Saudi Arabia has been building up after reading about the $ 40 Billion annual welfare system created for the Royals. The leaked cables also allege that corruption is deep-rooted as some royal princes take meager amounts from migrant labor workers as fees for getting them work visas in the kingdom. As such, there is always a potential for coup d’etat in the ruling family which may upend any gains investors may anticipate in the IPO itself.

Related Reading: Challenges for the Saudi Family : Succession 

Long Term threat from Iran

It is important to discuss how the persistent threat from Iran and its proxy wars in Shia majority Lebanon, Syria, Bahrain and Yemen pose a constant long term threat to the stability of the kingdom. As cited in this detailed essay, starting with the Iran-Iraq war, the countries have been embroiled in a cat and mouse game trying to assert its influence and supremacy in the region. It has led to violence, protests, accusations over the killing of Shia Haj pilgrims in Meccas twice as well as retaliatory strikes on Saudi diplomats and Saudi Oil fields. More recently the sandal wearing Houthi militants have launched sophisticated drone controlled boat attacks on the Saudi -UAE coalition warships as well as launched long range missile towards ARAMCO facilities. It is presumed that Iran is providing them with clandestine support and intends to shake up things in this inconclusive war. The Saudi facilities are within an arms reach of these insurgents and these risks should not be undermined.

Looking at the above risks, there are so many opportunities for a blow up in the region and more and more opportunities for a blow up are being added every day. Needless to predict, someone may seize the opportunity and send the region down a vicious path of violence, conflict, and instability. Imagine the sudden impact on investors whose investment suddenly has to deal with an absolute risk of losing it all. The worst case scenarios are the forcible removal of the Saudi ruling family followed by the seizure of the oil rich eastern region by warring Shias, Monarchy, and the Wahhabi elements.

Transparency and Governance Issues in ARAMCO

It is likely that the rulers themselves are not involved in maintaining oversight over the day to day running of Saudi ARAMCO. All government organizations tend to become bloated over time.  Power centers develop which eventually lead to corruption in contracting, purchasing, inventory management, and even sales. To the credit of the crown prince, he has openly cited that the upcoming IPO will enable transparency and subsequent exposure of corruption. Though the intent is noble, such a radical transformation takes a long time and is easier said than done.

Transparency International has ranked ARAMCO 36th out of 44 companies in terms of ‘reporting on anti-corruption. In September 2016, the company reported that it has discovered a potential corruption case involving Embraer S.A., a Brazilian company. This may be just the tip of the iceberg and the company will have to do a lot more to assuage investor fears that significant anti-corruption and compliance controls have been instituted in the company.

Due to the lack of freedom of expression and to avoid riling the powerful rulers, many employees aware of ongoing corruption activities may be very hesitant to report such issues. Saudi ARAMCO would be well advised to set up whistle-blower hotlines and anonymous reporting tools outside of the country to ensure that violations are promptly reported and resolved. It may also have to allow unbiased auditors to audit all financial trails for the company and the kingdom. Such an audit may be discomforting as it may reveal the welfare state that takes away oil revenues to distribute it as stipend within the ruling family members. In a leaked US embassy cable titled ” Saudi Royal Wealth: Where do they get all that money?“, Reuters cites  “In a meeting with the U.S. ambassador at the time, one Saudi prince, alluding to the off-budget programs, “lamented the travesty that revenues from ‘one million barrels of oil per day’ go entirely to ‘five or six princes,'” according to the cable, which quoted the prince.”

In spite of all its problems, Saudi ARAMCO is undoubtedly the most efficient entity in the state. And they have a price to pay for their efficiency. In a policy brief titled ” Saudi ARAMCO as a National Development Saudi Agent” written by Steffen Hertog, an associate professor at and author of “Princes, Brokers, and Bureaucrats: Oil and the State in Saudi Arabia, ARAMCO is considered a Program Management Office (PMO) for non-oil related projects.

For investors, it may not bode well that the commercial focus of Saudi ARAMCO is getting mixed with state welfare projects.  Quoting from the report, Hertog says “Saudi Arabia’s national oil company, Saudi Aramco, has been a critical agent for the social, economic and infrastructural development of Saudi Arabia; its managerial capacities are unrivaled in the Kingdom – and, indeed, the Gulf region. After it played a rather limited role outside the hydrocarbons sector in the 1980s and 1990s, its range of tasks and ambitions has recently again expanded drastically into a number of new policy sectors, including heavy industry, renewable energy, educational reform, infrastructure-building and general industrial development. This presents both opportunities and risks for Aramco, which has started to operate far outside its traditional politically insulated “turf” of running the upstream oil and gas infrastructure in the Kingdom. It is now involved in activities that are more political and more closely scrutinized by the Saudi public, and will have to build up new institutional and political capacities to maintain its reputation for clean and efficient management.”

The fate of ARAMCO and the Saudi Kingdom is so politically intertwined together that it may be hard for the monarchy to maintain a hands-off approach into the functioning of the company. Sovereign Funds IPOs have dis-proportionally got a bad rap but there are some role models that the kingdom may want to use. The success of Temasek Holdings in Singapore can be solely attributed to the hands off approach the government has maintained.

Can the Saudi Monarchy commit to similar meritocracy, commercial discipline, and accountability in the running of Saudi ARAMCO? If they can and they have the political will to do so, investors will look for actions rather than proclamations of corporate governance. While such proclamations will be welcomed and will ramp up investor sentiment, the success of those initiatives will be closely watched by critics who will not leave any turn un-stoned.

Risk of Stranded Assets (Climate Change, Dropping Demand, Electric Vehicles)

“The Stone Age didn’t end for lack of stone, and the oil age will end long before the world runs out of oil. – Saudi oil minister Ali al-Naimi “

A couple of years ago, J. David Hughes, a geoscientist at the Post Carbon Institute launched scathing attacks on the Shale Oil industry and the fossil fuels industry in general. A report authored by him “Drill Baby Drill” highlighted the risks faced by Shale industry due to the advent of the renewables industry. Ironically, in the same year, the report was published, Saudi Arabia launched a price war with the Shale industry forcing many North American Oil & Gas companies towards bankruptcy or to seek shelter in fire sales or Mergers & Acquisitions. While launching an attack on the proponents of “American Supremacy in the Oil Sector”, he claimed that renewables will eventually usher in a new future as our increasing demands will never be fully met with increasing supply of fossil fuels. Indirectly, he also talked about peak oil, an event-based on M. King Hubbert’s theory, is the point in time when the maximum rate of extraction of petroleum is reached, after which it is expected to enter terminal decline. Hughes claimed that supply is the real problem and the sooner we switch to renewables, the better it is for the world. He may have been right in some ways, but we now face a demand problem flipping the supply side peak oil prediction on its head.

Slowing global economic growth creating significant structural economic shifts in economic powerhouses such as China, the Gig Economy increasing the trend of locally home based workers serving global worker demand, the Paris climate agreement, increase in ride sharing services, increasing competition in Electric Vehicles and Millennial’s changing preferences for living in denser, urban areas have created this shift. We will briefly discuss these and then discuss the potential impact on fossil fuel rich states specifically Saudi Arabia.

a) A Shift in Millennial’s Preferences – Buying a house and car has become less enticing to the millennials who like to live in urban and denser areas, serviced by city transits, city mini-markets and ride sharing services. A generational shift is occurring in the buying and spending preferences of millennials at a time when half to one-third of family budgets are spent on housing and transportation. While some people are choosing against ownership of bigger detached houses and cars, there are others who are forced by economic circumstances to stay with their parents. To add to the woes, more and more millennials are choosing to be single forever  impacting the population growth rate.Either way, the common usage of single family homes and vehicles (ride shares) is indirectly leading to more yield from these assets. There are social issues problems that accompany these structural changes, however, for now, they are contributing to reduced demand for fossil fuels and this trend is not abating.

b) Global Slowdown – In spite of the low-interest rate fueled cheap money and credit fueled growth, the markets are struggling to maintain sustainable growth. From Venezuela to Nigeria, from Japan to China, the story is same and is having a significant negative effect on oil demand. Since the beginning of 2016, the global oil demand has plunged almost 20%, mainly thanks to China, the world’s second largest economy. China’s own domestic production has increased by more than 20% in the last two decades and so has its crude inventories. China was the manufacturing hub of the world and spurred unprecedented growth in manufacturing, trading hubs, and shipping sectors. The past few years have seen China shifting from manufacturing to a service oriented sector reducing its overall demand for crude. In addition, a significantly over-leveraged economy and rising debts, unsold inventory of housing have led to unprecedented slowdown which is having ripples effect across the global economy and reduced oil demand. We believe that all signs are that we are heading into a global depression and the problems are only going to get worse.

c) Increased Competition of Electric Vehicles – Tesla was somehow the pioneer in the Electric Vehicle industry, however, the pace of competition is rapidly accelerating. Recently, BNEF (Bloomberg New Energy Finance) reported in a research report that as early as 2025, on a life-cycle cost valuation, EV’s will become more affordable and less expensive than IC’s (Internal Combustion). Reduced Lithium battery costs and increased competition will only increase the pace of shift to Electric Vehicles. BNEF reports also make a bold claim that “Electric vehicles will make up the majority of new car sales worldwide by 2040, and account for 33% of all the light-duty vehicles on the road, according to new research published today”. They may be right as Volvo and other major car manufacturers have recently vowed to start phasing out current models and replace them with hybrid models. Other manufacturers will race to catch up and it will create the inflection point for electric vehicles in the industry plunging demand for gasoline, similar to how semiconductors transformed the technology industry many years ago. Recently, the CEO of Saudi ARAMCO scoffed at the idea that oil will become irrelevant in the next few years. He may be right or may a CEO whose quotes will be used in future classrooms to discuss how some people missed the next big thing. Currently, the EV vehicles are unable to scale rapidly as there are no inexpensive solutions for the EV batteries. As Tony Seba discussed in his brilliant keynote at Oslo in March 2016, a future breakthrough may unstuck the domain and make a significant leap as made from Diode Tubes to Semi-Conductors. It will be a game changer for the industry as Internal Combustion engines will themselves become stranded assets. One should note that investors do not need comprehensive EV vehicle adoption across the world to perceive risk in certain environments. A sustainable trend towards EV infrastructure and subsidies for EV vehicle adoption will push investors away from risky fossil fuel investments.

EV Vehicles Impacting Oil Demand

d) Paris Climate Agreement – The Paris Climate agreement charts a new course in the global climate effort by bringing all nations into a common cause to undertake ambitious efforts to reduce the carbon emission by 80% before 2050. It has forced many Oil Majors to create an investment fund in renewable energies. While most of the impact of the Paris Climate agreement is yet to lead to demonstrable results, major climate disasters combined with a sudden shift in political will amongst some countries will necessarily create more compliance burdens for car manufacturers. Burdened with increasing costs of compliance, the manufacturers will make a quick race towards Electric Vehicles creating a paradigm shift in the industry.

All of the above factors, directly and indirectly, impact the demand for gasoline and crude oil. These factors also create significant challenges for countries like Saudi Arabia where they may ring in a harbinger of the instability for the monarchy.  Due to the reduction in oil revenues, the kingdom has been forced to initiate austerity measures such as removal of subsidies from gasoline and diesel and even increase in pilgrimage fees for domestic pilgrims visiting the holy site of Mecca. However, the monarchy was quick to reverse some of those measures due to the potential of social instability and domestic violence. Even Kuwait, Venezuela and Nigeria have been impacted by the same problems where violence and civic unrest have created political instability for those in power. Countries with diversified economies run the risk of becoming another Venezuela as oil prices remain at sustained low levels.

As oil prices keep dropping, the anticipated risk of lower oil prices may lead companies to sell off inventories, carry out a fire sale of assets and new investments will drop in fossil fuel based projects. All these will have the undesired negative impact of Oil Majors and their investors holding stranded assets creating an absolute risk of worthless securities.

New Discovery of Oil in the Arctic Ocean 

We have already discussed the challenges faces the demand side of the equation, however, there is still another wild card on the supply end of the equation which makes matters worse. As glaciers melt and Arctic regions become more accessible and inexpensive to drill, we may find a significant amount of proven reserves in the Arctic.  Recently, Statoil claims to have discovered 50 million barrels in the Barents Sea, while Rosneft has found a significant amount of oil saturation in the Laptev Sea.  Norway has not remained behind and is looking to auction 102 blocks up for exploration in Norwegian Continental Shelf.  Investors should definitely imagine a scenario where a cumulative discovery of 20-100 billion barrels of oil in the Arctic may upend the supply side equation strongly.

Loss of Sovereign Immunity & Justice Against Sponsors of Terrorism Act

An IPO will also strike at Aramco’s sovereign immunity in the United States. In Jan 1998, Tom MENDENHALL filed a lawsuit against Saudi ARAMCO  claiming that he contracted an illness while working on an oil rig in the Persian Gulf. The plaintiff claimed that SAUDI ARAMCO, a company with a single shareholder i.e. the Kingdom of Saudi Arabia that because of its extensive business dealings in the United States, Saudi Aramco has implicitly waived its immunity. The court dismissed the plaintiff’s claims arguing that Aramco does not answer to the U.S. court system in dispute as it has sovereign immunity.

Saudi Aramco is the national oil company of Saudi Arabia, created by a Royal Decree of the Kingdom of Saudi Arabia. The parties in this case agree that Saudi Aramco is wholly owned by the government of Saudi Arabia and that its principal place of business and headquarters is in Dharan, Saudi Arabia. The Court finds, and both parties apparently agree, that Defendant Saudi Aramco *858 is an “agency or instrumentality of a foreign state” making it a “foreign state” under the terms of the FSIA. See 28 U.S.C. §§ 1603(a), (b). – Court Ruling

Post-IPO, once there are multiple foreign shareholders, the sovereign immunity defense will no longer be valid. Contingent lawyers will not fail the seize the opportunity to sue Saudi ARAMCO on multiple grounds to milk the wealthy cow owning tons of black gold. OPEC is practically a cartel where demand and supply variations are induced into the market to control the oil price. Innovative lawyers will surely come up with contingent lawsuits under the antitrust framework to act as a thorn for ARAMCO.

We also have the recent US legislation “Justice Against Sponsors of Terrorism Act” which allows families of the victims of the 9/11 attacks of 2001 to sue Saudi Arabia. Already, multiple lawsuits are making their way across the court system in the United States. Saudi ARAMCO is considered a state asset and while the entity is not directly impacted by the Terrorism Act, it risks getting scooped up under civil forfeiture laws if the state fails to comply with a court order. Hence, The IPO and the loss of sovereign immunity may enhance the risk of asset seizures for the company. Throw in the possibility of class action lawsuits on strict reserves and data disclosure rules for US listed companies and the risk of a civil forfeiture of assets quadruples potentially sending the share price into a tailspin.

An Urge to Fix the Kingdom’s Ailing Balance Sheet

The core reasons forcing Saudi Arabia to even think about selling shares of its Crown Jewel has been reduced revenues from oil combined with reduced foreign reserves. 85% of Saudi ARAMCO’s earnings used to fund the state and its various subsidy programs. This prompted the ambitious vision 2030 which aims at diversifying the economy away from dependence on the oil revenues.

However, a core problem still remains. Diversification will take few years, atleast 5-7 years to start showing some effect and the state still needs funds from the oil-rich ARAMCO to sustain itself and maintain a social contract with its citizens.  Initially, Saudi ARAMCO had to pay an 85% tax rate to the Saudi Government over and above the 20% royalty on all products. Faced with a valuation shock, where Wood Mackenzie came up with a valuation of $ 400 Billion while others came up with $ 1 Trillion, the government promptly announced the reduction of the tax rate from 85% to 50%.
The shift in taxes is mostly an accounting trick as the majority shareholders can pay themselves a higher dividend than usual to offset the loss of tax revenue. Dividends, paid after taxes are discretionary which are signed off by the board. Investors must consider the fact that after the IPO, Saudi Arabia may lose more foreign reserves and oil prices may further drop (due to supply or demand issues). The Kingdom dealing with an ailing balance sheet may arbitrarily change the tax rate, the royalty rate or even the discretionary dividend. Of course, such an action will spook the markets and drive away the investors, however, few investors may have lost their money while the kingdom tries to recover from a potential situation.There is also a worst-case scenario here, which is the prospect of a “negative free cash flow“. Imagine everything going wrong at the same time, increasing royalty, taxes, dividends while reducing oil price. Over some time, this will create a “negative free cash flow situation” sending the share price in a downward spiral. The kingdom may buyback shares at this point, take the company private and then inject significant cash to get it back to profitability.

The Dollar Peg Breakdown

** Note 06 Aug 2017Based on multiple requests from some of our regular readers, we have recently released a more detailed piece on dollar peg, history and how the peg break impacts global markets. You can access the post here – “Saudi Arabia Dollar Peg -Keep  it or Abandon it : A Primer on the Dilemma”

Can the dollar peg followed by Saudi Arabia break down at some stage?Since the 1980’s Saudi Arabia has pegged its currency to the US Dollar at 3.75 Riyals/Dollar. It made sense as Oil has been its central export resource and the United States being its key customer.  The peg has also enabled stability in the Kingdom as well as shielded the country from oil and gas price volatility.

When the peg was decided, the kingdom implicitly and explicitly traded its monetary independence for military and political support of the military-industrial support of the United States. While the economic justification for such a peg is clear when export prices are high, it is less defensible when the prices drop, as it happened in 2015. Saudi Arabia has a 20% GDP surplus in 2011 and in September 2015, the GDP surplus dropped to 20% deficit. The number of short sellers in the forward market spiked by 1000%  till Saudis shut down forward trading by pressuring local banks. China unpegged its currency versus the dollar and Hongkong has remained at a record low valuation since many years. So, it is very likely that given the right conditions, Saudis will do the same. Such an action will allow them to offset all US dollar losses in the previous years, but, will also lead to a major drop in crude oil price across the global markets.

Saudi GDP Deficit

Saudis discussed the unpeg when Obama administration took a hardline stance on Saudis while loosening sanctions on Iran. Saudis have around $ 116 billion in US treasuries which is a small amount in the overall scheme of things. Saudi Arabia may be forced to abandon the peg leading to further drop in oil prices, hyperinflation at home as well as a surge in the US Dollar. With the peg, the kingdom essentially imported the monetary policy of United States as it had to remain in sync with its interest rate increases and decreases. Not maintaining such a sync would lead to capital outflows from low-interest rate regimes to high-interest rate regimes. In addition, arbitrageurs would take advantage of the pricing mismatches and market inefficiencies as such activities involve only limited risks.

Saudi Riyal US Dollar Peg

 

With the oil price drop since 2015, Saudi Arabia has experienced a deficit of $ 97.9 Billion (2016) versus a surplus of $ 165 Billion (2002). While the rulers maintain that they will maintain the peg, in few years the situation may force them to break the peg. Maintaining a peg is expensive when the local currency experiences devaluation versus the pegged currency. The only way to maintain the peg is to keep buying more local currency to reduce supply in the market thereby increasing the currency price. Breaking the peg right now may be challenging for as Saudis import most of the equipment, consumer goods, and cereals. However the more they delay, the more pain is in the offing. Not surprisingly, IMF has recently warned Saudi Arabia of significant headwinds around GDP growth.

A forced peg break will suddenly damage investor confidence and create ripe conditions for social unrest and Arab Spring in the country. For countries like the United Arab Emirates, where the economy is well diversified, an unpeg from US dollar will not have a substantial impact. For Saudi Arabia, which is atleast 6-10 years away from sustainable and proven diversification, it can become a big challenge sooner and even a bigger challenge later. As such, they are already late to the party which is going to end sooner than scheduled. The Saudis have managed to maintain the peg in-spite of previous oil price downturns, but, the next few years may create significantly different market conditions. As we have already discussed elsewhere, the gap between consumption and production is fueled by unpayable debt, which requires a reset through hyperinflation in the global economy. Secondly, the tech bubble is slowing losing steam, majority of the startups are unprofitable with no clear path to profitability. The majority of the investor money is unlikely to be recouped. Basis this, if oil remains at or below $ 50/bbl and the world enters into a long depression cycle, the break in dollar peg will become inevitable for the kingdom.

Saudi Arabia still has foreign exchange reserves of around $ 550 billion, so it can hold water for some time. However, the Yemen War is reportedly costed the nation around $ 3 Billion so far and they still bear a recurring cost of anywhere from $ 500 Million to $ 700 Million every month. Since the Qatar Blockade, Saudis are estimated to have lost $ 100 Million per month in export, customs and transportation fees. No wonder the foreign reserves have been rapidly depleting. If the kingdom maintains its provocative and combative foreign policy, they will deplete these foreign reserves faster. Iran will seize on this opportunity to launch multiple low key, long sustaining and money draining conflicts where Saudis will potentially take the bait and get involved in costly wars.

Overall, the situation looks bleak unless a major shift in foreign policy and more manageable relationships with its adversaries leads to a fundamental shift in the middle east politics.  On this basis, the breakdown in the “dollar peg” is a major possibility within the new few years.

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