The Saudi Aramco IPO finally started trading on the Riyadh stock market this week.
On its first day of trading the IPO exceeded expectations. As CNBC reported shares increased by 10% reaching the daily limit.
That gives Saudi Aramco a valuation of a whopping US$1.88 trillion, much higher than Apple’s US$1.20 trillion valuation. Not too shabby! Even though this is a lower amount than the US$2 trillion Saudi Arabia had been looking for.
Yet the company has met a lot of scepticism as it is only trading a very small number of its shares, 1.5%.
Saudi Aramco is quite an interesting business. Before interest and taxes, the company makes much better profits and margins than its competitors, as you can see below.
Source: Financial Times
So if it’s so profitable why does the company needs investors?
Problem is, the company is very much dependent on oil prices.
Here is what Bloomberg have to say about it after Aramco opened their accounts to the public earlier this year:
‘In 2016, when the price of Brent crude plunged to average $45 a barrel and OPEC cut production, the company struggled to break even. Net income for the full year was just $13 billion and free cash flow a tiny $2 billion.
‘The kingdom’s dependence on the company to finance social and military spending, as well as the lavish lifestyles of hundreds of princes, places a heavy burden on Aramco’s cash flow. Aramco pays 50 percent of its profit on income tax, plus a sliding royalty scale that starts at 20 percent of the company’s revenue and rises to as much as 50 percent with the price of oil.’
Saudi Arabia is the world’s largest oil exporter and has the second largest proven oil reserves in the world. Oil is crucial for the kingdom, 87% of Saudi Arabia’s revenue comes from oil.
Oil prices have been trending lower in recent years with the emergence of US shale oil.
Shale oil is produced through a process called fracking. The way it works is oil companies’ drill down to where the layers of oil and shale are. Then they pump in water, sand and chemicals to ‘fracture’ the layers of rock and release the oil.
Shale oil has been a big game changer in the industry. It’s driven the US to become one of the biggest oil producers in the world and has pushed oil prices down at the same time.
Back in 2014, the Saudis tried to bankrupt US shale oil drillers by pumping more oil to lower prices. Their idea was that since it was more expensive to drill shale oil, they hoped that lower oil prices would send shale drillers out of business. The move drove prices down to around US$30 a barrel.
Yet their plan failed.
US shale drillers managed to push production costs lower, and instead, Saudi’s took quite a hit on their cash flow.
Not only that, they started to rack up debt. Between 2014 and 2018, debt to GDP increased from 1.6% to 19.1%
By the end of 2016, Saudi agreed to limit production to push oil prices back up.
With oil prices still trending low, Saudi Arabia will struggle and continue to accumulate debt if it continues to rely primarily on oil. It’s why the country has been looking at diversifying, but they need money and higher oil prices to do this.
The kingdom is not only facing increasing competition from shale drillers, but also from renewal energy. Electric vehicles have been making a comeback in recent years with Tesla and more car makers entering the space.
And, of course, there are concerns on how a global slowdown will influence demand.
Yes, we are seeing a mindset shift from worrying about our economy running out of oil to having too much oil. It’s true that Saudi Aramco is going public, which should tell you something about oil.
But, don’t discount oil just yet.
Truth is oil is still very much crucial to our global economy, and we are heavily reliant on it.
While you may be hearing a lot about the electric car revolution, fact is that electric vehicles only make less than 1% of the global car fleet. It’s likely that electric cars will take a lot longer than we expect to become a larger percentage of the fleet as we need more infrastructure.
And the ‘shale revolution’ may not be as miraculous as it seems, because shale drillers aren’t generating enough cash.
Why? Well, with fracking, production declines over time. Record low interest rates have meant that they have been able to survive by taking on more debt.
Yet creditors and investors are starting to grow impatient, as Bloomberg reported recently:
‘Banks have begun trimming back the credit lines of America’s shale producers, further undercutting a beleaguered industry that’s been struggling to rebuild investor confidence.[…]
‘The noose is tightening at a time when producers have seen their market values plunge 21% this year. Meanwhile, at least 15 producers have already filed for bankruptcy during the year.[…]
‘Bondholders and other lenders are increasingly wary of what’s unfolding in shale. Chesapeake Energy Corp., once the nation’s largest gas supplier, warned earlier this month it may struggle to avoid bankruptcy. While fracking has turbocharged U.S. oil and gas output in recent years, that success has helped drive down oil prices to almost half what they were five years ago.
‘In some cases, producers are struggling under debt loads accumulated in earlier, more heady times. But other issues are at play as well: Some have drilled their best locations and are now turning to lower-quality sites. And some have been drilling wells too close together, resulting in a loss of overall performance.’
And of course, oil still faces the threat of geopolitical turmoil and attacks on infrastructure like we saw earlier in Saudi Arabia this year.
So, as I say, while there is a lot of scepticism on Saudi Aramco, don’t discount higher oil prices just yet.
PS: The RBA is now considering negative interest rates.’ Click here to watch this interview with US economist and gold expert Jim Rickards.