What would Aramco do with its IPO proceeds?
The investment community is a buzz with reports that Aramco, the Saudi Arabian state-owned oil company, may sell shares to the public for the first time. Initial public offerings (or IPOs) typically get a lot of attention in the financial media. In this case, the news is particularly huge, because all indications are that this would be one of the biggest IPOs ever.
It is not hard to see why Saudi Arabia would consider an IPO. In an environment of $30 Brent crude, which traded over $110 per barrel at its peak two years ago, energy firms are desperate for cash. This includes not just Big Oil, but governments themselves, particularly when it comes to OPEC member nations that are heavily reliant on oil. Because of that, even though this is a terrible time to be selling assets, Saudi Arabia could use the cash.
If and when Aramco goes public, the energy markets will have all eyes on what it intends to do with the proceeds. This article will discuss what Aramco might do with its potentially massive cash windfall.
The $1 trillion question
Aramco is a truly massive company. Some financial analysts have suggested that Aramco could become the first public company to hold a $1 trillion market capitalization. Even the current top-place holder in the energy sector, Exxon Mobil Corporation (NYSE: XOM), has a $317 billion market cap, which seems relatively paltry in comparison. The scale of Aramco’s operations is truly amazing. Aramco produces 10 million barrels per day, approximately one in every eight barrels produced across the world. It has crude oil reserves estimated at approximately 265 billion barrels, which itself amounts to 15 percent of all global reserves and 10 times Exxon’s reserves. Reserves have increased dramatically in the past decade.
Yearly, Billions of Barrels. Source: BP Statistical Review of World Energy
Based on reserves then, one could make a financial argument that Aramco is actually worth $3 trillion, in a comparable valuation as Exxon Mobil. Even though selling shares now would be disadvantageous given the downturn in the energy markets, the move is part of a broader desire by the Saudi Arabian government to privatize its economy and deregulate various markets, including oil.
In a statement, Aramco said “This proposal is consistent with the broad and progressive direction pursued by the Kingdom for reforms, including privatization in various sectors of the Saudi economy and deregulation of markets, which the Company strongly supports.”
The big question, then, is what exactly Saudi Arabia would do with the proceeds from such a massive offering.
Two possible uses
The first use of cash would be to shore up Saudi Arabia’s budget. The country is overwhelmingly reliant on oil revenue to sustain its budget, and citizens of the nation enjoy substantial entitlement programs. However, in an environment of extremely low commodity prices, the budget is deeply distressed. Saudi Arabia swung to a record $98 billion budget deficit for 2015. As a result, it seems the natural course of action would be to use proceeds from the IPO to reduce the country’s budget deficit.
But that is not the only plausible course. Alternatively, Saudi Arabia could use the proceeds to further invest in oil and gas. While this would defy conventional economic theory, which calls for reducing output in an environment of low prices, Saudi Arabia has not taken the conventional economic path thus far. The country, and OPEC more broadly, have signaled no intention of reducing production, even with $30 oil. It can be inferred that Saudi Arabia’s extremely aggressive production is a covert effort to weaken Iran, Russia, and the United States. After all, a dollar invested in Aramco is one fewer dollar invested in Iran or a publicly-traded U.S. entity.
Moreover, oil and gas complexes in Saudi Arabia are extremely efficient. Its energy infrastructure is superior to that in Iran and Russia. As a result, projects come on-line much faster and at a lower cost than they do in other major oil-producing nations in the Middle East and Europe, making reinvestment an attractive scenario for Saudi Arabia.
Specifically, the downstream segment would be a wise use of capital for Saudi Arabia. Downstream, and refining in particular, is the one area of the energy world that is actually thriving at $30 oil. That’s because lower oil prices reduce refining feedstock costs, which then boosts margins. Saudi Arabia could use the IPO proceeds to meaningfully boost its downstream presence, and it is perhaps no coincidence that Saudi Arabia plans to double its downstream capacity to approximately 10 million barrels per day by 2025. Consider the massive ramp-up in Saudi refining capacity in recent years.
Thousands of barrels per day. Source: BP Statistical Review of World Energy
The key takeaway
Saudi Arabia knows it has the financial flexibility to wait this out. It also knows that smaller highly-leveraged drillers, particularly in the United States, do not have the luxury of time. If the low-price oil environment continues, or perhaps even worsens if Saudi Arabia makes a newfound push toward higher production, a wave of bankruptcies will likely ripple through the U.S. energy industry and could keep Iran from entering the market. At that point, Saudi Arabia could reclaim the market share it lost during the U.S. production revolution. One could even argue that there is a stealth war taking place, only with financial markets instead of missiles.
Companies to Watch
Linn Energy (Nasdaq: LINE): As an exploration and production MLP, shale drillers like Linn Energy are at high risk of bankruptcy. After a costly acquisition of Berry Petroleum right when oil prices were at their peak, Linn now has $10 billion in debt and is losing money. It has already suspended its distribution but that may not be enough. The stock trades for $1.
Breitburn Energy (Nasdaq: BBEP): Like Linn, Breitburn is a non-integrated upstream MLP. It is highly indebted--$3 billion in long-term debt with just $12 million in cash on the balance sheet. Breitburn and Linn both have upcoming asset revaluations to deal with. This spring, banks will re-determine the value of oil and gas reserves. If those values are set lower than last year (highly likely due to the collapse in commodity prices) then the lending spigot may be cut off. Breitburn equity trades for $0.55 per unit—clearly the market is pricing in insolvency.
Bob Ciura is an independent equity analyst. Since 2012, his work has focused on fundamental investment analysis of publicly-traded companies in the energy, technology, and consumer goods industries. Bob has a Bachelor's degree in Finance and an MBA in Finance.