MBS faces tough dilemma ahead of IPO launch

As the date of the Saudi Aramco IPO draws closer, Crown Prince Mohammad bin Salman (MBS) faces a difficult decision. Does he accept a valuation below the USD2 trillion target, or risk damaging the IPO’s symbolic value by leaning on domestic and international cornerstone investors who see the IPO as much as a strategic opportunity as a commercial one?

The current schedule could still be derailed by events such as attacks against Saudi energy infrastructure or insufficient buy-in from investors. But the IPO now for the first time has a clear path towards implementation.

IPO brought back to life through scaled-back proposal

The main priority for MBS now is to get the IPO over the line. There is no doubt that the IPO – if and when it takes place – will be a compromise on the initial vision of a predominantly international listing, with 5% of the company on offer.

MBS has only been able to revitalise the IPO, effectively vetoed by King Salman in August 2018, by pursuing a more staggered and conservative strategy. The biggest compromise so far has been to only list domestically. MBS still harbours ambitions to list internationally, but only by removing this part of the plan and scaling the listing back to around 2% has he been able to move it forward.

In short, MBS is hoping Saudi Aramco’s status as the world’s most profitable company will be enough to secure significant buy-in from investors.

MBS knows international interest in world's most profitable company will be huge

Investors still have concerns over governance and geopolitical risks

Over the last two months, government and Aramco officials have turned every stone to boost the company’s valuation. In early October, Saudi Aramco proposed a USD75 billion “base dividend” for 2020 to entice investors. Similarly, changes to Saudi Aramco’s royalty rates – effective from 2020 – have been designed to reduce government take in a sub-USD70 per barrel environment.

High base dividend designed to entice investors to Saudi Aramco

For Saudi Aramco, unique features such as its low production cost per barrel warrant a valuation premium. In contrast, many potential investors argue that a wide array of issues ranging from governance to geopolitical risk carries equal – if not greater – weight.

Saudi Aramco production costs significantly lower than for majors

The Saudi government has sought to address investor concerns over governance by separating the leadership of Saudi Aramco and the energy ministry. Although the removal of Khalid al-Falah’s energy portfolio and Aramco chairmanship in September was a necessary step, many investors still view the Saudi state and Saudi Aramco as one and the same.

Even with greater separation on paper, it is still unclear how Saudi Aramco can fully protect shareholder interest while performing its current strategic role for the Saudi state. For example, spending big to expand production capacity to maintain Saudi Arabia’s status as the world’s only real swing producer makes sense from a political standpoint; but for shareholders, spending money on spare capacity that may never be used makes little sense.

Governance is not the only investor concern which is likely to impact the Saudi Aramco’s valuation. After the attacks against Abqaiq and Khurais in September, geopolitical risk will weigh more heavily on the minds of potential investors. Ultimately, unless Saudi Arabia can find a solution to diffuse regional tensions or deter hostility from regional state and non-state actors, its energy infrastructure and tankers will remain vulnerable to attack.

Russia and China eye strategic opportunity as MBS seeks to boost Aramco valuation

MBS will be acutely aware that focusing solely on valuation risks damaging the symbolic value of the IPO and the prospects for an international listing further down the line. With the September 2017 ‘anti-corruption’ crackdown still fresh in mind, putting pressure on wealthy Saudi nationals to act as cornerstone investors to boost Aramco’s valuation will only reinforce concerns about governance.

Although less damaging than strong-arming local investors, relying too much on international institutional investors to ‘anchor’ the IPO also risks damaging perceptions. Bridging the gap in expectations will be easier with domestic investors and international institutional investors that also see a broader strategic value in the IPO. For both China and Russia, the forthcoming IPO’s reliance on cornerstone investors represents a clear opportunity to strengthen energy ties with Saudi Arabia.

For Saudi Arabia, securing buy-in from Russian institutional investors carries the additional benefit of strengthening energy ties with Russia at a time when Riyadh is working to formalise Russo-Saudi oil supply coordination.

With China, there is also a clear overlap between commercial and strategic energy interests; China is already Saudi Arabia’s biggest importer of oil, and, as the table below shows, China’s share of total exports set to grow further over the next five years.

China consolidating its position as Saudi Arabia's biggest oil export market

Compromise on valuation will be needed to get the IPO over the line

The scaled-back IPO plan already represents a significant compromise. But, it will be difficult for MBS to avoid one final concession; despite a broad range of measures to boost Aramco’s valuation, the USD2 trillion target is likely to be beyond reach.

The need to compromise is understandable. So far, MBS has very few policy ‘wins’ under his belt. And on the other side of the ledger, there are several clear failures: stalemate in Yemen, a stalled Vision 2030 reform programme, and the September 2019 attacks against the heart of Saudi Arabia’s energy infrastructure. Achieving a nominal USD2 trillion valuation through strong-arm tactics will be a hollow victory if it reinforces existing concerns over governance and the rule of law.

Torbjorn Soltvedt

Principal Analyst