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The Globe and Mail

Saudi Aramco’s $2-trillion valuation a matter of accounting tricks

Robin M. Mills is chief executive of Qamar Energy, and author of The Myth of the Oil Crisis.

Changing a tax system that has endured since the 1970s is no small matter, especially when it concerns what could be the world's most valuable company. Saudi Arabia's announcement on Monday that it was cutting the tax rate on large oil companies to 50 per cent from 85 per cent is crucial for the fate of the initial public offering of state oil giant Aramco. But is it enough to bridge the gap between a $2-trillion (U.S.) aspiration and independent estimates of $400-billion?

When the IPO was first publicly suggested in 2016, a notional value of $2-trillion was given, and it has become important to justify a figure around this level. The problem is that this number, based on a simplistic multiple of the company's reserves, overlooked two factors: Aramco's high tax rate, and the long period over which reserves are expected to be produced.

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The original tax rate of 85 per cent was set back in the 1970s, when Aramco was still a consortium of U.S. majors: Exxon, Mobil, Chevron and Texaco. Nationalization was completed in 1982. The company also pays a royalty on gross revenue of 20 per cent, which has apparently not been affected by the latest reform.

In a sense, the tax change is largely an accounting trick. With more than 80 per cent of Saudi government revenue coming from Aramco's production, the amount of money flowing from Aramco has to be maintained. Instead of paying most of its profits to the state via tax, Aramco will instead pay them as dividends. This has the welcome effect of better aligning the interests of state and the future private investors.

Instead of a multiple of reserves, private investors will look instead to value Aramco based on the free cash flow it generates. On this basis, the consulting firm Wood Mackenzie was said to value Aramco's core production business at $400-billion, using a standard 10-per-cent annual discount rate. Our estimates come to a similar range, allowing for a moderate increase in oil prices over current levels.

This assumes, however, that all Aramco's barrels are sold at world market prices. Of its 12 million barrels a day of crude oil and natural gas liquid production, almost four million are consumed at home where, despite 2015's subsidy reforms, gasoline still sells at around $32 a barrel. Even though natural-gas prices doubled to $1.50 per million British thermal units, they remain well below the United States' $2.84 and even further below prices in Europe or Japan.

So how does Saudi Arabia bridge the valuation gap? It's simple enough to see that cutting the tax rate to 50 per cent from 85 per cent would increase an initial value of $400-billion to $1.333-trillion. A moderate increase in domestic natural gas prices could add another $100-billion or so. Refining, petrochemical and shipping assets, net of debt, may be worth around $60-billion, but their operating performance has not been very impressive.

This may get Aramco close enough to its original figure to declare victory, but it assumes investors do not discount heavily for factors such as high political influence, lack of transparency and possible misalignment between the objectives of government and investors. Other listed national champions, such as Russia's Gazprom and Rosneft, and Brazil's Petrobras, trade at multiples far below those of their non-state peers.

Aramco may shed its non-core activities, but it will still carry the national mission, including enforcing the kingdom's OPEC policy. On the other hand, strategic investors, such as the Chinese state entities being wooed by Beijing, might pay a premium for access.

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Beyond that, there are not many levers to pull. Cost cuts, the usual panacea, do not affect valuation much. While there is no doubt room for more efficiency, Saudi Arabia's favourable geology and huge economies of scale already give it the industry's lowest costs a barrel.

The company's growth is constrained, in that its dilemma is essentially that of Saudi Arabia itself. It cannot expand production rapidly, despite its giant reserves, since this would crash oil prices. Conversely, as the current OPEC deal is demonstrating, cutting production boosts prices only modestly while giving up market share to OPEC colleagues, Russia and U.S. shale producers.

Nonetheless, Aramco should be able to maintain steady production growth for decades. Revenue that far out will be discounted to negligible levels.

This is even more so given the doubts over long-term demand, and the impact of growing efficiency, climate policies and electric vehicles. There may be reasonable skepticism over their impact within a decade or two, but it will surely be significant by the 2040s. In most projections, oil will remain a valuable fuel for aviation and feedstock for petrochemicals. The last barrel in the world will probably come from under Saudi sands – but it may not be worth very much.

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