(Bloomberg Opinion) -- Most any given day, Saudi Aramco’s stock price is about as useful a yardstick of value as one of Eric Trump’s tip tweets. That’s because, in an effort to get Saudi Arabian Oil Co. market cap to the magic $2 trillion figure beloved of the country’s crown prince, the biggest IPO ever was confined to Riyadh’s tiny market and bolstered with inducements such as guaranteed dividends.
Aramco’s stock had been drifting lower on very thin volume even as coronavirus-shaped clouds gathered over the global economy. Something changed this weekend, though: The stock dived following the bust-up between Saudi Arabia and Russia.
Leaving aside its peculiarities, Aramco is now cheaper than it was. Or is it? The Kingdom, which still owns about 98.5% of the company, guaranteed dividends to minority shareholders for five years at a minimum of their share of $75 billion. At IPO, that implied a yield of 4.4%. As of Monday’s close, that had ticked up to 5% (the stock recovered some ground on Tuesday). Before you wannabe Buffetts dive in on that value, though, consider that the average yield of the big five Western majors has jumped from 5.5% to 8.6% in that time. So in relative terms, Aramco’s premium has tripled.
More importantly, Aramco doesn’t look cheaper when you consider the number that’s supposed to support the dividend: free cash flow. Under the guarantee, minority holders get their dividend payment — collectively a minimum of $1.13 billion — and the state takes whatever’s left, regardless of whether it reaches $75 billion. When I last valued Aramco just before the IPO, I noted its production of 9.74 million barrels a day — in line with December’s OPEC+ agreement — implied about $70 billion of free cash flow in 2020 under my assumptions, including a Brent crude oil price of $65 a barrel.
Now Brent 2020 swaps trade below $38 and Aramco is opening the taps. So what does more oil but lower prices do? Under my assumptions , if Aramco’s crude oil production averages 11.4 million barrels a day in 2020 and Brent averages $40, then free cash flow falls to about $45 billion. Using that number — still, let us acknowledge, gargantuan — Aramco’s free cash flow yield has actually dropped from 4.1% at IPO to 3% at Monday’s close (the consensus estimate implies 3.6%).
Clearly, while the commoners should still get their dividend, the state eats a lot less. It isn’t just their share of free cash flow; the government also gets royalties and income tax from Aramco. Under my December assumptions, the government’s total take for 2020 added up to almost $200 billion. Opening the spigots drops that to $130 billion. The difference is equivalent to about 14% of Saudi Arabia’s official reserves.
Therein may lie a better rationale for a weaker stock price. As has always been the case, the biggest needle mover for Aramco’s behemoth valuation is the discount rate applied to the cash flows.
In theory, despite the immediate mayhem, opening the taps could help to better preserve the long-term value of Aramco’s oil reserves by undercutting competitors like Texas and encouraging more demand. Yet a world where OPEC is clearly dead on its feet and OPEC+ clearly has its limits is also one where oil prices should stay much closer to the marginal cost of production — and pressure on Saudi Arabia’s public finances and economy intensifies. Just as several of the oil majors are borrowing or selling assets to fund their obligations at current oil prices, so Saudi Arabia’s finances don’t balance at these levels.
That should mean a higher risk premium. Assuming long-term output of 11.5 million barrels a day but Brent at $50 and a free cash flow yield of 5.5%, the implied valuation is about $1.1 trillion, 27% below where Aramco closed on Monday. If anything, the yield demanded should be higher than that; at 6.5%, the value drops to just over $900 billion.
Exact numbers from a model may be about as useful as that quarantined stock price on any given day. It may be better to think of them, as well as the weekend’s dive in Aramco’s market value, more in terms of their direction than absolute figures. The forces that have underpinned the position of Saudi Arabia and its national champion — primarily, outsize influence over an ever-expanding oil market twinned with security guaranteed by a distant superpower — are disappearing. The weekend’s events, including further palace intrigue, add to a growing list of surprises demonstrating how the world has changed. The bear case for Aramco is less about the whiplash of oil prices and more about fear of the rug being pulled out from under it.
For the full set of assumptions, see this. For the 2020 scenario, I trim capex by $5 billion and cut net income per barrel in the refining business to $2. In addition, It was reported on Tuesday that Saudi Arabia seeks to quickly boost sales to north of 12 million barrels a day, implying it means to liquidate some inventory. This would tend to boost cash flow, albeit by weighing on prices further. For the purposes of this analysis, I have left out the uncertain impact of liquidating inventory.
To contact the editor responsible for this story: Mark Gongloff at mgongloff1@bloomberg.net
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Liam Denning is a Bloomberg Opinion columnist covering energy, mining and commodities. He previously was editor of the Wall Street Journal's Heard on the Street column and wrote for the Financial Times' Lex column. He was also an investment banker.
©2020 Bloomberg L.P.