Saudi Aramco: sand trap
Justifying a $2tn valuation for the state oil company requires hard persuasion
Some might say portfolio managers live in gilded cages. But plush surroundings offer little comfort given the pressures of performing, and the scraps of information fed to them from some companies.
The flotation of Saudi Aramco — now reportedly delayed into 2019 — will no doubt bring up this issue of disclosure. The kingdom believes its state oil company deserves a $2tn valuation. Achieving that high number requires some hard persuasion. Locking up senior portfolio managers in a luxury hotel might do the trick. A better way would be to improve profitability, not to mention the transparency of financial accounts.
Another way is to tweak the assumptions used in valuing the group. A key driver for Saudi Aramco’s future cash flows, and thereby its valuation, is the oil price. Assuming the Brent benchmark rises to $85 per barrel over the next five years, hardly unimaginable given oil’s history, helps the valuation considerably — though it is not enough on its own to get to $2tn. And controlling that factor seems tricky. Yes, the country could push Opec (with Russia) to withhold production — Saudi produces more than a tenth of the world’s crude. But that risks longer term demand effects, at a time when renewable energy looks a better investable prospect than ever.
Imagine an alternate universe where Saudi Aramco can raise production while energy prices rise, too. If it could increase its production at its historical yearly trend of about 1 per cent when crude prices rise, and keep it up over decades, then the kingdom could expect to come close to its own high valuation estimate. Big if.
Even better, give the new minority shareholders more of the cash flows, via dividends, rather than routing these back to the government via taxes. The corporate income tax rate is expected to be about 50 per cent. Dropping the relatively steep royalty rate, effectively a revenue tax, by half to 10 per cent would boost the valuation even more. But it is not in the plan. Raising a currently uneconomic natural gas price for industrial users would help, too, but nothing like as much as long-term growth does.
Without the prospect of decent long-term growth, not many investors will find Saudi Aramco palatable. Only, perhaps, when viewed as a high-yielding bond proxy can the high valuation be justified.