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.