WHILE there is consensus that the public listing of the Kingdom of Saudi Arabia's crown jewel, Saudi Aramco, could very likely be the biggest the world has ever seen, valuations of the state-owned oil company vary widely. Some have put forward a valuation of $400 billion, a far cry to the $2 trillion valuation touted by Saudi Arabia's Deputy Crown Prince Mohammed bin Salman. Bassel Khatoun, Chief Investment Officer of MENA Equities at Franklin Templeton Investments (ME) Ltd, discusses what he sees as a set of ‘known unknowns' that could influence the valuation of Saudi Aramco, and suggests an accurate valuation is premature pending further clarification of some of these issues. The valuation spectrum for oil players varies immensely, and Saudi Aramco is no exception. Given its historical preference for opacity, the reality is that there is a lot of guesswork that goes into sizing up a company which has never divulged financial statements, operating in a sector that naturally attracts huge valuation variations in any market, let alone Saudi Arabia. Capital markets around the world are certainly encouraged by the potential mammoth public listing and welcome the important milestone in the Kingdom's progress to diversifying its economy and to reduce its heavy reliance on oil. However, investors require a certain degree of transparency to make informed decisions about the value of a company. Key to an accurate valuation, for example, is the defining of ownership boundaries of what parts of Saudi Aramco are to be listed; while some may value the company up to $2 trillion, there is no clarity on exactly which parts of Aramco will be included in the IPO, and just as importantly, which will be excluded. Furthermore, questions remain over whether both the upstream and downstream businesses and non-core areas such as petrochemicals are within the ownership boundaries. In addition, until an independent audit has been completed, investors are basing valuation on the same oil reserves that have been reported by Riyadh for nearly three decades – 261 billion barrels. That said, Saudi Aramco has committed to an independent audit while hinting that any audit will find its reserves to be similar to figures currently reported, but questions remain about whether the audit will unearth the quality of the oil reserves, rather than just the quantity. Either way, Saudi Arabia's Deputy Crown Prince Mohammed bin Salman recently confirmed that the Saudi government would retain sole control over Aramco's oil and gas reserves and would also decide on production levels. Another key area to an accurate valuation are costs — a crucial part of financial modeling. Disclosing production costs of oil wells and revealing operating and financial costs will enable investors to make more accurate projections of the value of the business. Ultimately, we are trying to understand how much it costs Aramco to extract oil from the ground. Aramco has said its costs are among the lowest in the world and, if the $5 to $20 per barrel public estimate range is accurate, then this is most certainly the case. The difference between an extraction cost ranging from $5 to $20 per barrel makes a significant difference when oil is $50 per barrel. Also, production costs will vary from field to field so providing average operating costs will only go so far to facilitate forecasting. Another key cost to consider is staff. To accurately estimate staff costs, investors need to understand Saudi Aramco's long-term strategy with regard to ‘Saudization' given the cost implications of maintaining a very high percentage of Saudi Arabian nationals. Clarity on the Kingdom's tax policy is another key to an accurate valuation of Saudi Aramco. In March, the government announced that it was reducing Aramco's tax rate on net income to 50% from 85%, bringing it more in line with global players, although there still exists a huge difference globally in tax rates. This recent change begs the question: what protection can investors expect against the rolling back of the tax rate to 85% at any point in the face of continued fiscal pressures? In addition, investors are seeking clarity over whether the 20% royalty on revenue will remain in the event of an IPO. Another area where insight is valuable to an accurate valuation is clarity on strategy and governance. While these may be difficult to quantify, they do have a significant impact on valuation metrics. Generally speaking, investors demand a discount for state-controlled companies, given the requirement to balance the objectives of the government with those of investors. In the case of Saudi Aramco, investors will need to accept that the government will be the majority shareholders. Regardless, the kind of governance structure, Board of Directors and Independent Directors Aramco puts in place, as well as how it executes its strategy, will still have an important impact on the perception of the company. This is particularly true for institutional investors. A solid corporate governance framework will also placate anxiety over how the sometimes conflicting objectives of a state-controlled company and a listed company can be addressed. Long-term investors also need to understand Saudi Aramco's business strategy in more detail to gain a better appreciation of what the company will look like in 10 to 20 years. Aramco has announced it is expanding its refining business with an aim to almost double capacity to 10 million barrels a day. We also know it is moving aggressively in the downstream area through its petrochemicals business. However, how much of their new funding will be dedicated to this part of their business? Saudi Arabia's National Transformation Plan identifies renewable energy as a growth sector with an aim to have 10% of the country's electricity from renewable sources by 2023. Saudi Aramco is now developing solar and wind projects in the north west of the Kingdom, begging the question of how much of management's time and funding will be directed towards these new energy sources. Investors will also want to understand whether environmental consciousness or future shareholder value is driving its diversification into renewables and whether these new businesses are within the realm of the IPO. These ‘known unknowns' are serious considerations when valuing Saudi Aramco, and while clarity would be most helpful, we cannot discount the impact of the price of oil, given varying forecasts on future prices that could result in a massive range of valuations. Whether one is of the opinion that the world is headed for an oil supply shortage and therefore higher prices, or alternatively if other forms of energy will take over powering the world in the next few decades, these factors will have an enormous impact on valuations of any oil company, including Saudi Aramco. With what we currently know based on oil prices, the tax rate, reserves, there is a scenario under which Saudi Aramco could be worth around $1 trillion. However, as the company delivers on its commitment for further transparency and ‘unknowns' shift to ‘knowns', we are likely to see a tightening of the valuation discrepancy, which is currently challenging an already complex and colossal public listing. * The writer is Chief Investment Officer of MENA Equities at Franklin Templeton Investments (ME) Ltd
