Saudi Aramco has announced its intention to sell up to 5 percent of itself to investors as part of a larger plan by the House of Saud to diversify the Saudi economy through government investments in some group of industries yet to be specified. It is no secret or surprise that government officials generally, and those surrounded by royal sycophants in particular, would view themselves as smart central planners able to see the future and to determine which government investments will yield solid economic growth conditions.
That bit of self-delusion on the part of the House of Saud is revealing and amusing simultaneously, but is a topic outside the focus here. Of greater interest is the sum that this sale might attract; the recent claim by Deputy Crown Prince Mohammed Bin Salman that Aramco is worth more than $2 trillion is intriguing, as 5 percent of that figure would not be chopped liver. But recent news items report that Aramco officials believe that the firm “is likely worth at least $500 billion less than the government previously suggested.” So a rough calculation of that value — and the parameters underlying it — might be a useful conceptual exercise.
An engineers shows visitors a model of Saudi Aramco’s maritime yard in Ras al Khair, Saudi Arabia, November 29, 2016. Reuters
We begin with the obvious: Aramco exports of crude oil and related products. For crude oil, exports are about 2.6 billion barrels per year, and it is reasonable to assume a price of about $50 per barrel, as that is the current price, so it is an unbiased estimate of the expected future price. Accordingly, revenues from exports of crude oil are about $130 billion per year. Similarly, Aramco exports about 230 million barrels of refined products per year, and a reasonable price assumption is about $72 per barrel, for annual revenues of $16.6 billion. Finally, Aramco sales of natural gas liquids are about 330 million barrels per year, at about $6 per million btu, or $22.50 per barrel, for total revenues of $7.4 billion. Accordingly, the grand total for annual export sales revenue is about $154 billion.
Estimates of long-run (including investment costs) production costs for Saudi crude oil vary somewhat in the open literature, but a common figure is around $9 per barrel, or 18 percent of the assumed $50 price. If we assume that same 18 percent cost figure for all Aramco production — that is a conservative number, as the mere cost of the crude oil used to produce refined products would be almost 70 percent of the $72 price — net revenues would be about $126 billion per year.
The “value” of Aramco is the present value of that net revenue stream over some time horizon, adjusted for various threats to the revenues. There are also the taxes and royalties paid to the Saudi government, which from the Saudi viewpoint are irrelevant as a first approximation: The lower the (expected) tax/royalty rate, the higher the price that buyers of Aramco shares would be willing to pay now, and vice versa, so that one main effect of the announced tax/royalty rate is a shift in the timing of the revenue stream to the Saudi government. At a sufficiently high tax/royalty rate, of course, outside investors would buy no shares in Aramco, so that the choice of the tax/royalty rate that maximizes the present value of the revenue stream is an important question. Accordingly, the recent Saudi decision to cut the Aramco tax rate from 85 percent to 50 percent is interesting.
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Another important effect of the tax/royalty rate is a shift in the risks posed by future fluctuations in the prices of the crude oil and other products sold by Aramco: The lower the (future) tax/royalty rate, the greater the risk borne by buyers of Aramco shares, and the higher the tax/royalty rate, the higher the risk borne by the Saudi government. Accordingly, the choice of the tax/royalty rate would affect the allocation of these risks and thus the price of Aramco shares.
Moreover, there is always the “holdup” problem: Whatever the tax/royalty rate announced before the Aramco shares are sold, the buyers face some risk that it will be increased in the future despite promises made now. How the House of Saud would make credible a prior promise (“commitment”) not to raise the tax/royalty rate is not entirely clear; one answer might be the possibility that additional sales of Aramco shares would be made in the future, and a broken promise not to raise the tax/royalty rate on the initial 5 percent sale would reduce the market value of the possible future sale.
Consider first the case in which the net revenues would be earned every year in perpetuity. At a real discount rate of 10 percent, Aramco would be worth 10 times annual net revenues, or $1.26 trillion. If a real discount rate of 5 percent is more reasonable, then the value of Aramco would double to more than $2.5 trillion.
Perpetuity, of course, is forever, and forever is a very, very long time. Is a 100-year time horizon — a 100-year annuity of $126 billion — reasonable? In terms of present value calculations, a century is not very different from perpetuity: Over a 100- year time horizon, Aramco again is worth $2.5 trillion currently at a 5 percent discount rate and a bit less than $1.3 trillion at 10 percent. How about a 50-year horizon? At 5 percent, Aramco is worth $2.3 trillion, but “only” $1.25 trillion at 10 percent.
And this is the point at which things get interesting. That the Middle East is a dangerous neighborhood is no secret, a reality that has afflicted the House of Saud for decades in terms of threats both internal and external. Only a few examples from a chronology of events should suffice to illustrate the point. The seizure of the Grand Mosque in Mecca in late 1979 was a violent rebellion put down only after almost two weeks, and with the unofficial aid of French troops. The bombings in Riyadh in May and November of 2003 exposed the violent rifts between the monarchy and the Wahhabi religious establishment. More generally, bombings and shooting incidents aimed at the regime have occurred on a regular basis, too numerous to detail here given the central theme of this essay.
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The central long-term external threat has come from Iran in the wake of the overthrow of the Shah of Iran in 1979 and the establishment of the Iranian theocratic regime. One result has been a series of proxy battles in Lebanon, Iraq, Afghanistan, Syria, Bahrain, and Yemen. The more-recent development of the Iranian nuclear weapons program poses a direct and enormous perceived threat to the House of Saud.
The implications of these threats for Saudi production policies and the market value of Aramco are substantial, as illustrated by Saudi production and reserves during two periods. From 1973 through 1986, Saudi production was consistent with the goal of protecting the official Organization of the Petroleum Exporting Countries price; the Saudis acted as the “swing producer,” increasing or cutting output so as to maintain that price. This led to a decline in Saudi output from 9.9 mmbd in 1980 to 3.4 mmbd in 1985. Saudi production then increased more or less monotonically beginning in 1986, a year in which market prices for Brent crude oil fell by almost half, from $27.56 in 1985 to $14.43 (in nominal dollars). Saudi production increased from 3.4 mmbd in 1985 to 12.4 mmbd in 2016.
One interpretation of this shift during the mid- to late-1980s is consistent with a straightforward effort by the Saudis to protect their market share and sales revenues. Any individual producer faces elastic demand — price and sales revenues move in opposite directions, other things equal — so that a cut in price and increased production would increase (or protect) sales revenues. Another interpretation is consistent with “market punishment” behavior designed to increase the riskiness of foreign investment in competing crude oil reserves. That model would suggest an increase in reserves and production capacity, so as to create a threat to flood the market in the face of increasing potential competition. That indeed is what we find: an increase in proven Saudi crude oil reserves from 173 billion barrels in 1989 to 258 billion barrels in 1990. (Investment in the discovery and development of new production capacity would be expected to show up in the data suddenly, as new fields are “proven” in an engineering sense.)
Note, however, that Saudi reserves since 1990 have changed virtually not at all, increasing from that 258 billion barrels in 1990 to only 266 billion barrels in 2017, even as Saudi production increased from 5.6 mmbd in 1989 to 12.4 mmbd in 2016. The Saudi market share of world crude oil production for the period 1991–2016 has remained fairly stable at approximately 13 percent, even as world production increased from 65.3 mmbd to 94.6 mmbd, or by almost 45 percent. This raises an interesting question: Why have the Saudis failed to increase capacity so as to profit from this growing market?
One answer might be related to the growing threats perceived by the House of Saud: an increased risk of an overthrow by domestic opponents or an attack by a foreign power. In the first case, the Saudi ruling family might have increased incentives to maximize sales revenue over a shorter time horizon. That can be interpreted as “dynamic profit maximization” with a much higher discount rate. After all, in the extreme case in which the private jets are kept fully fueled and ready for quick departure to Switzerland, the suppression of investment incentives for international competitors becomes far less important.
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Accordingly, it may be useful to conduct a rough conceptual exercise to see what change in Saudi Aramco exports from current levels might result from (1) increased fears of some sort of coup d’état, that is, an increase in the discount rate used (implicitly) by the House of Saud to evaluate the value of future export revenues; and (2) increased fears of a military (nuclear) attack from Iran. I focus here only on exports of crude oil, as exports of products and natural gas liquids are relatively small, and complicate the analysis without adding anything conceptually, in that the value of Aramco is driven largely by its crude oil operations. I assume here that the Saudi maximand is the present value of sales revenue, and a price elasticity of demand for Saudi oil of three (in absolute value). Obviously, other figures could be substituted, but the qualitative nature of the analysis would not change.
At a conceptual level, there are three cases. The first is a “status quo” case, in which the threats of an overthrow of the House of Saud and of an Iranian military strike are perceived as small. I assume that this yields current Aramco exports of crude oil, with sales revenues of $130 billion per year, perceived to persist over a 100-year horizon, with a discount rate of 5 percent. After deducting production costs of 18 percent, this yields a value for Aramco of about $2.1 trillion.
The second case is the “coup d’état” scenario, in which there is a substantial fear of an overthrow of the House of Saud, perhaps by an extremist Wahhabi rebellion or because of ISIS attacks. This reduces the time horizon to, say, 10 years, and increases the discount rate to 10 percent. These changes in perceived parameters induce the Saudis to cut their prices and increase their sales, in an effort, loosely speaking, to grab as much revenue as possible before being forced into exile. In a simple maximization model for the House of Saud under these assumptions, the export price that maximizes the value of Aramco over the 10-year horizon is $35 per barrel. Annual exports rise to 4.9 billion barrels (from 2.6 billion), annual export revenues are $172 billion, and the value of Aramco from the viewpoint of the House of Saud, again after subtracting production costs, falls to under $872 billion.
The third case is the Iranian military/nuclear threat scenario, in which the Saudis are forced (that is, blackmailed) to cut their exports so that some substantial share of the market is shifted from Aramco to Iran. Even in the short run it is clear that Iranian output could be increased by about 1 million barrels per day, and it is reasonable to assume another, say, 250,000 barrels per day over the medium term. It is reasonable also to assume that most of this increase in Iranian production would be exported, and as a first approximation that an export shift from Aramco to Iran would not affect the world price of crude oil.
That scenario is too conservative, as the Iranians would be likely to prefer an increase in both their market share and the world price. Assume that they are able to force the Saudis to reduce their exports by another 1 million barrels per day; given market demand conditions and other factors, market prices would increase by about 2 percent, or $1 per barrel. Annual Aramco exports would fall from 2.6 billion barrels to about 2.2 billion barrels, at a price of $51, yielding annual revenues of about $112 billion. The present value of that stream depends upon the discount rate, which I assume in this case to be 10 percent, and also the perceived time horizon. The latter is wholly subjective; it is likely to lie somewhere in the interval between the status quo case (100 years) and the coup d’état case (10 years). Given the nature of nuclear threats, perhaps 25 years is reasonable simply for discussion purposes. Under these assumptions, Aramco would be worth about $834 billion after deducting production costs.
The “value” of Aramco under these varying scenarios would be the outcome of a state options analysis, which lies outside the focus of the simple discussion here. Instead, it is useful to examine the value of Aramco using the numbers derived above combined with alternative assumptions about the probabilities of the cases. Table 1 shows these calculations under a simple linearity assumption about the effect of differing probabilities. The Aramco valuations under the coup d’état and Iran threat scenarios are relative to the status quo valuation with probabilities of 100 percent minus the given probability of a coup d’état or Iranian threat, respectively.
Note: n.a. stands for not applicable.
Source: Author’s computations, available upon request.
Interestingly enough, the value of Aramco in this admittedly simple analysis is about the same in the coup d’état and Iran threat cases. In the larger context, it is unsurprising that the value of Aramco begins to fall well below $2 trillion as the probability that the House of Saud might face a serious threat to its control of Saudi oil reserves reaches 50 percent and higher.
In terms of the partial sale of Aramco planned for the near future, the amount that potential investors might be willing to pay depends on whether a new “Arabian” (that is, non-House of Saud) government taking control after a coup d’état would honor the ownership shares of the buyers, many of whom presumably would be foreigners. Accordingly, the actual price that emerges will tell us a good deal about the market evaluation of these threats.
This conceptual exercise is far from obviously “correct” in the sense that several alternative quantitative assumptions would be equally plausible and might yield different numbers. Moreover, we have not discussed in detail the perceived possibilities that the House of Saud itself might find it advantageous over time to erode the value of the current investments in Aramco; see the discussion above on the tax/royalty rate. But neither does the discussion here seem obviously flawed, and it is clear that the estimate offered by Deputy Crown Prince Mohammed Bin Salman is based upon an implicit assumption that the coup d’état and Iran threat scenarios are unimportant. Should we believe that? Does the market believe that?