By Greg Priddy

As the Saudi Aramco initial public offering culminates this week with the final pricing announcement on Dec. 5, some observers will tout it as a success for having reached the notional valuation range of $1.6 trillion to $1.7 trillion for the company set on Nov. 17 in its prospectus. In domestic Saudi political terms, the IPO will be seen as a major achievement for Crown Prince Mohammed bin Salman and his Vision 2030 campaign. In reality, though, it will fail on two more important metrics. It will not bring in a substantial amount of foreign money to invest in the economic diversification projects envisioned under Vision 2030, other than $1.5 billion from Abu Dhabi. It also has not played out in accordance with the expectations of transparency and sound management laid out when the crown prince announced the idea more than three years ago in his landmark interview with Bloomberg News, which will have a lasting negative impact on foreign investor confidence in Saudi Arabia.

A Series of Delays, and Then a Sudden Rush

In 2016, the Saudi Aramco IPO was envisioned as an initial listing of 5 percent of the company's equity, to take place in late 2017 or early 2018, and to be traded on a major well-regulated international exchange — London or New York preferred, perhaps Tokyo or Hong Kong. The valuation Crown Prince Mohammed threw out in his Bloomberg interview was a round number — $2 trillion. That was when the Saudis were discussing cooperation with Russia and other non-OPEC members, and the expectation was that with an eventual OPEC+ pact between OPEC and non-OPEC producers achieved, the cartel could reduce the global inventory overhang dramatically and cement an oil price floor above $70 per barrel, preferably much higher, to support the valuation. Had this all played out as the Saudis hoped, it could have brought in substantial foreign capital to fund economic diversification.

That vision was wishful thinking, as some analysts predicted at the time, because of the massive supply response from non-OPEC+ producers, primarily the growth of U.S. production from shale. By mid-2019, it had become evident that OPEC+ had not been able to shock the oil market out of the "lower for longer" scenario. The Saudi Aramco IPO in the meantime had been delayed several times due to a mix of the work needed to undertake it, perceptions that oil prices might improve later on and a lack of enthusiasm by some senior Saudi technocrats, including then-Energy Minister Khalid al-Falih.

But suddenly in August 2019, the IPO was revived and given urgent priority on orders from Crown Prince Mohammed, to be completed before the end of the year. It was not an accident that al-Falih's first public mention of a late 2019 timetable for the IPO was the day after Brent dipped below $60 per barrel in early August. The slide in crude oil prices had led to a broad selloff of shares on Riyadh's Tadawul stock exchange and soured the public sense of optimism in the kingdom about economic reform. The push to accelerate the IPO became more about a need for Crown Prince Mohammed to secure a "big win" to burnish his support, rather than the other goals.

After the acceleration took place, the process clearly became a frantic scramble to get it done while not causing the crown prince a loss of face by coming in at a drastically lower valuation. The first thing to fall by the wayside was an international listing, as talk of listing in Tokyo quickly ended. A listing on the Tadawul would be less complicated, allowing for much less transparency and letting the Saudis control the process. September also saw important personnel changes. First, Yasir al-Rumayyan, the head of the Public Investment Fund (PIF), replaced al-Falih as Saudi Aramco board chairman. A week later, Prince Abdulaziz bin Salman, Crown Prince Mohammed's older half-brother, replaced al-Falih as energy minister. Both of these appointments broke with previous Saudi practice. Unlike all previous chairmen since nationalization, al-Rumayyan had no direct experience managing an oil company other than a couple of years' service on Saudi Aramco's board of directors. And Prince Abdulaziz was the first royal to head the Energy (formerly Oil) Ministry and lacked hands-on management experience at Saudi Aramco despite his many years of service as a ministry functionary. Both choices were clearly more about personal loyalty to the crown prince than managerial competence and experience.

Disconnects, Risks and Issues

The core problem driving the entire process has been the disconnect between what major foreign asset managers would consider a fair risk-adjusted valuation versus Crown Prince Mohammed's need to avoid loss of face over his assertion of a $2 trillion valuation in 2016. In mid-October, when foreign investment banks advising Saudi Aramco met with Saudi officials to discuss the valuation ahead of the date for formally deciding to move forward with the IPO, the crown prince reportedly balked when the bankers insisted that a valuation above $1.5 trillion would attract little foreign interest. This delayed the formal announcement only until Nov. 3, and the later valuation range of $1.6 trillion to $1.7 trillion was touted as a reasonable compromise.

But financial market professionals outside Saudi Arabia do not see it that way. A $1.5 trillion valuation would put Saudi Aramco at dividend yield parity with ExxonMobil, a company with most of its assets in countries with low political risk. The current valuation range prices Saudi Aramco at a premium, let alone discounting it for risk. The entire oil industry faces downward pressure from uncertainty around future oil demand growth — with the International Energy Agency now projecting a plateau after 2030 — but Saudi Aramco also faces other risks. The Sept. 14 attack on the company's Abqaiq facility highlighted the possibility of a "war of attrition" against Saudi installations in the event of a major regional war, driven by the proliferation of precision-guided munitions. The issues of taxes and corporate governance also are paramount. With Saudi Arabia's population still growing at 2 percent, there is reason to question whether the current favorable tax, royalty and dividend structures will remain in place after the Saudi commitment to hold them constant until 2024 ends. There also is no role for private shareholders in corporate governance.

Concerns about corporate governance intensified a bit earlier in 2019 with the acquisition of the publicly held shares of Saudi Basic Industries Corp. (SABIC) by Saudi Aramco from the PIF. Previously, industry experts had expected Saudi Aramco to target specialty petrochemicals for expansion rather than basic petrochemicals, where pricing power was expected to weaken in the face of competition, and SABIC is mostly in basic petrochemicals. The transaction also raised eyebrows among investors because the price agreed to be paid to the PIF did not reflect any premium above the closing price on the Tadawul the day of the announcement — an odd outcome for the acquisition of the majority of shares in a publicly-traded company. Since then, SABIC's profits have declined sharply on the basic petrochemical glut, and the company's shares are down around 20 percent. The lesson seems to be that private investors' interests were overlooked in a transaction between state-owned entities designed to shift $70 billion from Saudi Aramco's balance sheet to the PIF, though payment of part of that amount has been delayed to facilitate the Saudi Aramco IPO.

With these risks, the Financial Times reported that in preliminary meetings with foreign portfolio managers, most said they would be looking at valuations more like $1.2 trillion, reflecting a higher dividend yield to compensate for these risks. These meetings included sovereign wealth funds, which the crown prince had perhaps naively believed would be more amenable to a higher valuation. The notional valuation range of $1.6 trillion to $1.7 trillion is highly likely to be achieved this week, but in an environment in which Saudi institutional investors and wealthy families have been pressured to buy shares, and retail investors have been allowed to put on 2-to-1 margin loan ratios for their purchases in contravention of the normal risk limits allowed by Saudi bank regulators.

The key takeaway from this experience is that Crown Prince Mohammed is personally driving the process and probably will continue to do so for other major transactions. Instead of trying to pursue a more realistic valuation and course of action, planning was thrown by the wayside as the crown prince's Saudi advisers were reluctant to challenge him, and the final push this fall has been a haphazard series of compromises driven by Crown Prince Mohammed's need for a "big win" in terms of domestic prestige and public confidence rather than pursuing the original goal of a major economic diversification away from oil. That also has swept away the prior norms about technocrats taking the lead roles in the oil industry and economic policymaking, with broad guidance from royals but a lot of delegated managerial discretion. One other detriment will be that it is highly unlikely that Saudi Aramco will pursue an international listing once the one-year lockup on doing so expires, or any time in the near future. Doing so would undermine the artificial domestic valuation, which it may be able to prop up in the short term because of the lack of large-scale foreign purchases.

Editor's Note: Greg Priddy, who has recently joined Stratfor as director, global energy and Middle East, will focus his coverage on the space where geopolitics and the global energy industry meet, as well as contributing to broader regional and global macro analysis.