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Saudi Aramco: what history's largest IPO could mean for investors
June 22, 2017

In 1912, long before he was prime minister, Winston Churchill made perhaps his most far-reaching contribution to world history. As first lord of the admiralty, he successfully argued that Britain's continuing naval power could only be assured if its ships would switch from coal to oil. Securing access to oil, particularly the huge reservoirs newly uncovered in the Middle East, would allow Britain to "raise the whole power and efficiency of the navy to a definitely higher level; better ships, better crews, higher economies, more intense forms of war power", was how Churchill described it. "Mastery itself was the prize of the venture."

Since Churchill's prescient bet, Middle East oil has remained the great prize of geopolitics. More than a century on, one iteration of this battle is being fought between the world's largest stock exchanges, each of which are bidding for a slice of Saudi Aramco's initial public offering (IPO), the largest listing in securities history. The enormity of the float - the state oil company is hoping for a $2 trillion price tag – is not the only remarkable thing about the proposed share sale. In fact, almost every facet of Saudi Arabia's decision to take its crown jewels public is unprecedented and could carry large ramifications for investors.

Logistics and objections

First off, Riyadh is relinquishing control of a witheringly small portion of the company – up to 5 per cent. Of course, offering any more would surely test the absorptive capacity of equity investors, because 5 per cent of $2 trillion is $100bn. According to analysis from pwc, this is not far short of the €119bn raised in primary listings globally in 2016, and around three times larger than the total IPO proceeds raised in any one market. Even if Aramco and its advisers can only achieve a $1tn valuation for the company - equivalent to the combined valuations of ExxonMobil (US:XOM), Royal Dutch Shell (RDSB), Chevron (US:CVX), Total (Fr:FP) and BP (BP.) – raising $50bn from global markets would still be a book-building exercise like none other.

At the time of writing, Aramco has not decided where it will sell shares outside of Saudi Arabia's Tadawul exchange. London, New York, Hong Kong, Tokyo, Toronto and Singapore are all in the frame. But given the size of the IPO, we would imagine Aramco will have no choice but to select at least two major stock markets if it is to raise the cash it needs. That would make London a strong candidate.

The City has certainly made little secret of its attempts to secure top billing. When she visited Riyadh in April, the prime minister was accompanied by London Stock Exchange (LSE) chief executive Sir Xavier Rolet, in a clear signal that a London listing had Conservative government backing. Of course, handing Saudi Arabia billions of dollars for a stake in its national oil company will be a highly combustible political exercise, outside of any market-specific issues. Indeed, the listing will likely be fraught with controversy, wherever it lands. Legal commentators have already speculated that a New York floatation could trigger a raft of class action lawsuits from families of victims killed in 9/11, who have sought to sue Saudi Arabia for the country's alleged role in harbouring the attackers. When asked about potential litigation risks from foreign exchanges, Aramco declined to comment.

Another question concerns the company's inclusion in index funds such as the FTSE 100. This seems unlikely. First, because companies wanting inclusion – and thereby attracting the huge sums of institutional money and passive funds that track the largest indices – are required to float at least 25 per cent of their shares. So-called 'premium listings' also require companies to meet the UK's highest standards of regulation, unless the Financial Conduct Authority (FCA) makes an exception. Aramco is not pressing for index inclusion, or for these rules to be bent in its favour, but the issue was highlighted by Ashley Hamilton Claxton, a governance manager at Royal London Asset Management, earlier this month.

"Any attempt to bend the listing rules in order to facilitate the IPO is highly inappropriate and flagrantly ignores the principles that the UK's listing rules were designed to defend," said Mr Claxton. "While the listing would be a prize asset on the exchange due to the sheer size of the firm, the attempt to list just 5 per cent of the total share capital flies in the face of what is acceptable." He added that Royal London feared the IPO would set a precedent for companies wishing "to access UK capital markets without playing by the rules".

Nor is it true to say that a 'standard listing' in London would necessarily put investors off. The market capitalisation of South32 (S32), the mining group spun out of BHP Billiton (BLT) in 2015, would make it eligible for inclusion in the FTSE 100, were at least a quarter of its shares invested in London, but that hasn't stopped active trading in the stock.

 

 

It may be that all of this is bypassed. Aramco could instead go the way of many emerging market natural resources companies and elect to issue global depository receipts (GDRs), which are issued by banks representing Aramco shares, and could be traded on foreign exchanges like other stocks. The LSE rules state that GDRs can be listed on either the main market through a standard listing, or on the so-called Professional Securities Market, which is closed to retail investors.

Alternatively, there is the possibility that Aramco could join the mooted international segment of the market. The FCA is currently consulting on the proposal, which would require a fair amount of regulatory work to develop protections "appropriate to the segment's aims and capable of fostering investor confidence".

Timing and valuations

The IPO was first proposed in early 2016, and until recently was not expected to occur until 2019. However, recent comments from Aramco chief executive Amin Nasser (pictured above right) suggest the listing is planned for the second half of 2018, meaning we should have a good understanding of the investment case and the nature of the offer by this time next year. That's a sizeable lead time, but indicative of the listing challenge. Not only does Aramco need sufficient time to allow a proper financial and corporate restructuring to take place, but the broking and legal challenges will require a small army of lawyers, accountants and bankers. Saudi Arabia will also do all it can to ensure it is selling its prized asset at a time when oil market fundamentals are tighter, and its resources can attract a premium.

The House of Saud's pulling power on this front has diminished in the last few years, along with Opec's status as the global swing producer. In spite, or perhaps because of this, the bankers charged with selling Aramco shares to the investment world are likely to stress that cash generated from the sale of oil should be seen alongside the company's other assets, including its enormous refining operations and proprietary technology and field management. Until then, and even after the prospectus is published, the true extent of the company's asset base, its resources, field decline rates, cost profile and downstream portfolio will be contested. And while the group is widely acknowledged as the largest single producer - and owner - of hydrocarbons in the world, there is little clarity about cash flows and the myriad connections between the company and the state.

The accuracy of the $2tn price tag is therefore anyone's guess, even if a recent survey by EFG Hermes suggested that institutional investors have not entirely rejected Aramco's own calculations and expect the oil giant to have a market capitalisation of $1 trillion to $1.5 trillion. This was at least partly aided by the Saudi government's decision in March to lower the tax rate on Saudi Aramco from 85 to 50 per cent, in a bid to lure investors and increase the net income available for dividends.

The governance question

Dividends are crucial, as they are probably the prime reason why investors are likely to want to own a piece of Aramco. Expansion is a political non-starter, given Saudi Arabia's plans to diversify the economy away from oil (see box), and either way, shareholders will not have much of a say on strategic direction, given the size of the offering. Newly appointed crown prince Mohammed bin Salman (pictured above left) confirmed as much in an interview with state-owned news channel Al Arabiya, when he said that the Saudi government will continue to specify the production ceiling for Aramco, "according to the price that suits the company". That said, he did state that the goal of the floatation would be to "increase Aramco's profit", suggesting that there will at least be an attempt to align the interests of both domestic and international owners.

This is likely to be the IPO's biggest sticking point, and could ultimately dictate whether the IPO can get off the ground. Shareholders will be asked to sacrifice their voice and oversight in exchange for the promise of future income. Jeremy Baker, a senior commodity strategist at Vontobel, has repeatedly raised this issue when asked by potential investors for his views. "You would be buying five per cent of a national oil company that's driven by Saudi geopolitics," he told us. "It's a black box, and so at the moment I don't buy the valuation, I don't buy the corporate governance, and I'm not sure I buy the shareholder value argument."

Ultimately, the success of Saudi Aramco's proposed IPO will hinge on the preparedness of a huge amount of institutional money to make a huge exception to their minimal investment criteria. That, at a time when institutional money is fretting about the risk of stranded resources, climate change, corporate governance and political risk, means Aramco's offer will have to be uniquely attractive.