As investors and world leaders all gathered in Saudi Arabia this week to host its version of "Davos in the Desert," the Kingdom announced Saudi Aramco's long awaited crown jewel IPO of the region, will debut on December 11 on the local Tadawul Exchange. On November 3, the exchange will decide the timetable -- including the release of the price level on November 17. As with most IPOs, the book building process is when demand is built for the select issue and the price is gauged and allocated to investors ahead of the opening day on December 11.
This IPO has been long discussed and is one of Saudi Arabia's key initiatives to diversify its economy away from oil into other forms of revenue. It is not the company assets that are in question, but perhaps the price at which it will be floated that is concerning investors. The Kingdom is hoping to achieve a $2 trillion valuation to be able to raise about $100 billion from selling about a 5% stake.
Saudi Aramco has the world's second-largest proven oil reserves of about 270 billion barrels, and second-largest daily production. It is no doubt a prized asset. Despite its many troubles over the past few months, the management has shown its ability to cope with geopolitical pressures and maintain its production even after the latest attacks. However, for any oil major -- in this case Supermajors like ExxonMobil (XOM) , British Petroleum (BP) , Total (TOT) , etc. -- the valuation is dependent upon the oil price one uses for not only the near term but for the long term as well.
This is the key issue at hand. Using a normalized long term WTI or Brent price to back out what discounted future cash revenue potential is worth will dictate what price it trades at today. Call it a curse or a privilege, oil majors or Exploration & Producing companies' share price are dictated by the oil price.
Brent oil prices are trading close to $60/bbl, down from a high of $74/bbl earlier this year. Over the past five years, Brent oil has averaged around $50/bbl -- touching as high as $85/bbl and falling to as low as $30/bbl. In summary, oil market has been quite boring to stable with rising supply offsetting any demand pick-up. It is one of the largest commodities consumed in the world and price action goes through seasonality given winter and summer demand, but at end of the day it is about excess inventory balance. The more pertinent question is, what is the long-term price of oil? Now the debate gets even more interesting.
The long-term value of oil should be where the oil price is just high enough to incentivize marginal cost of production so supply keeps up with demand. U.S. shale, which took industry by surprise, is the swing producer, as it needs about $45-50/bbl WTI to incentivize U.S. E&P companies to keep fracking and producing oil. Saudi Arabia's breakeven oil price is much lower, given its massively low cost of production. Russia is happy with about $50/bbl Brent or higher to keep producing.
Assuming $50-$55/bbl Brent as the long-term price in one's model, it would be a fair assumption to back out what future reserves are worth in a prudent manner. After all, investors also need some sort of a price discount, or incentive, to buy into a listing.
Bankers have been swarming Saudi Arabia in packs, pitching their best valuations to get the mandate and execute on the deal. Pricing has ranged from $1.2 trillion to $1.7 trillion, a level which has been unacceptable to the Kingdom. The key to getting any IPO off the ground is to secure a few key subscribers, known as cornerstone investors, to commit verbally to a level whereby they know that they can manage to get the rest of the herd to follow after. Cornerstone investors are crucial to providing support for the issue longer term, with various lock ups in place so they do not sell after the placing. This is an ongoing issue, and we have yet to hear who and at what level these cornerstone investors would be tempted to get involved.
What does it mean for the energy sector? When an issue this big comes to the market, institutions and fund managers generally try to make room in their portfolio ahead of the IPO to be able to take the issue in size and keep the risk of the portfolio neutral. Global funds will want to short the larger Majors like (BP) , (TOT) and Equinor (EQNR) -- other oil price proxies -- and go long Aramco ,which should in theory be cheaper than its peers, this way keeping the oil price risk neutral in their portfolio. Most funds will not want to take any specific oil price risk, but be involved more for the "value" case of the deal.
Oil majors have been in perennial decline for the past five years, even longer in some cases. Income-oriented investors talk about the attractive 5% dividend "yield," but more return-oriented Hedge Fund investors will argue that stock price is in decline, which offsets any income gained from the yield.
At the end of the day, it is all about earnings. Earnings are volatile and dependent on the oil price. This past quarter is a prime example. BP's third-quarter 2019 profit was down 41% on weaker oil and gas prices. Upstream earnings suffered as oil prices collapsed, helped by downstream with better margins. Equinor reported a similar picture: Q3 2019 profits were $15.6 billion, down from $17 billion in Q2 2019. Oil prices were lower, but so was production due to natural decline. Total's Q3 2019 net income came in at $3 billion, with operating income in E&P division at $1.7 billion, down 29% year over year.
At the end of the day it boils down to valuation. Equinor has a P/E of 7.7x compared to peers XOM, Chevron (CVX) , Royal Dutch Shell (RDS.A) and BP -- ranging from 12x-17x P/E. There is always a price for everything.
Aramco has to take a look at the broader universe of oil peers to gauge at what multiple it can attract investors so the issue is successfully eaten up. These U.S. and European oil majors have rallied 10% off the lows during the market rally in October -- and given the lacklustre results and an oil price that is dogged by too much supply near term, these stocks are a source of shorts for any portfolio.
Being schooled in the Hedge Fund doctrine, a stock's investment case is predicated on its earnings trends, no matter how cheap. We all know cheap can get cheaper. Over the past five years, TOT and BP are down 8%, EQNR down 15% and XOM is down 30% vs. the S&P 500 up 48%.
Like I said, a source of shorts in any portfolio.
