How the Saudi Aramco ini­tial pub­lic of­fer­ing pits for­eign in­vestors against Saudi cit­i­zens.

The Washington Post Sunday - - BUSINESS - BY JIM KRANE

Imag­ine how share­hold­ers would re­act if ExxonMo­bil gave away a third of the oil it pro­duced, rather than sell­ing it at mar­ket prices. There would be hell to pay, right?

But state-owned Saudi Aramco does some­thing al­most as ru­inous, sell­ing a third of its oil in­side the king­dom for less than $6 a bar­rel. That’s a dis­count of 87 per­cent on the in­ter­na­tional price.

For would-be sub­scribers to Saudi Ara­bia’s forth­com­ing IPO, the na­tional oil com­pany’s huge sub­sidy bur­den is emerg­ing as a ma­jor bone of con­tention.

A few decades ago, pro­vid­ing dis­count oil and gas to Saudis wasn’t such a big prob­lem. Only 6 per­cent of Aramco’s oil was con­sumed do­mes­ti­cally in 1980. The other 94 per­cent was ex­ported.

But the ex­ported share of Saudi Aramco’s pro­duc­tion de­clines ev­ery year. Now the king­dom gets full price for only two-thirds of the oil it pro­duces. Next year, it will prob­a­bly be even less.

What about Aramco’s nat­u­ral gas ex­ports? There are none. One hun­dred per­cent of Saudi Aramco’s nat­u­ral gas is con­sumed do­mes­ti­cally, which is un­sur­pris­ing be­cause it is priced un­der $2 per mil­lion Bri­tish ther­mal units, which means there is more de­mand than sup­ply. Coun­tries that bor­der Saudi Ara­bia, in­clud­ing Kuwait and the United Arab Emi­rates, im­port nat­u­ral gas at in­ter­na­tional prices about three times as high.

The king­dom’s lav­ish en­ergy sub­si­dies ought to give pause to in­vestors giddy over the prospect of buy­ing into the world’s largest IPO, and the world’s largest com­pany, pe­riod, in rev­enue terms.

Do­mes­tic prices are shap­ing up as a ma­jor stick­ing point be­tween pri­vate in­vestors and Aramco’s man­age­ment. Ul­ti­mately, Aramco share­hold­ers must con­tend with the Saudi pub­lic, which views ul­tra­cheap en­ergy as a birthright.

The king­dom’s crown prince, Mo­hammed bin Sal­man, un­der­stands the stakes. He aims to dis­man­tle some of the more oner­ous state claims on Aramco. In March, the gov­ern­ment cut Aramco’s tax rate from 85 per­cent to 50 per­cent. Mo­hammed has also said the gov­ern­ment aims to grad­u­ally take away en­ergy sub­si­dies, re­plac­ing them with cash.

The king­dom made im­pres­sive strides in this di­rec­tion in 2016, rais­ing prices on en­ergy prod­ucts across the board. Un­for­tu­nately, Saudi prices were so low in 2015 that the new prices are still a frac­tion of in­ter­na­tional bench­marks.

It re­mains to be seen whether the royal fam­ily can go all the way — im­pos­ing full in­ter­na­tional prices on cit­i­zens al­ready vexed by the dou­bling of gaso­line prices and the near-dou­bling of res­i­den­tial elec­tric­ity bills.

Re­tract­ing en­ergy sub­si­dies is a well-known trig­ger for so­cial un­rest. Regimes that at­tempted sim­i­lar aus­ter­ity mea­sures in OPEC mem­ber states In­done­sia and Venezuela found them­selves over­thrown by an­gry mobs. Gaso­line price ri­ots in Nige­ria in 2012 and in Mex­ico this year pro­vide fur­ther warnings. The Saudi gov­ern­ment un­der­stand­ably treads with cau­tion.

The val­ues of Aramco’s pub­licly traded shares are ul­ti­mately go­ing to re­volve around the gi­ant com­pany’s abil­ity to max­i­mize prof­its. When share price dis­ap­points, for­eign in­vestors are bound to de­mand that Saudi Aramco start treat­ing do­mes­tic con­sumers the way it treats ev­ery­one else.

Of course, for­eign in­vestors’ voices might be loud, but their in­flu­ence won’t be huge. The Saudi state will re­tain a 95 per­cent stake in Saudi Aramco.

In­vestor in­ter­ests will bump against Aramco’s typ­i­cal op­er­at­ing strat­egy in other ways.

A Saudi de­ci­sion to go along with a pro­duc­tion cut by the Or­ga­ni­za­tion of the Petroleum Ex­port­ing Coun­tries might be irk­some to share­hold­ers, par­tic­u­larly if com­pet­ing pro­duc­ers such as Venezuela or Rus­sia aren’t shar­ing the load.

Saudi Aramco’s vaunted spare pro­duc­tion ca­pac­ity, a strate­gic as­set that al­lows the king­dom to bal­ance oil mar­kets dur­ing price swings, could be an­other ir­ri­tant. Pri­vate share­hold­ers might grum­ble that valu­able cap­i­tal as­sets are sit­ting idle, in­stead of pro­duc­ing oil and prof­its.

A big at­trac­tion of Saudi Aramco stock is the juicy div­i­dend pay­ment ex­pected to flow to share­hold­ers. What if Aramco some­day finds it nec­es­sary to cut those div­i­dends? You can bet for­eign in­vestors won’t sit qui­etly, es­pe­cially if Saudi driv­ers are pay­ing less than $1 a gal­lon at the pump.

Else­where, Aramco of­fi­cials have pointed out that the com­pany is ac­tively try­ing to jet­ti­son its role in na­tion-build­ing projects around the king­dom, such as erect­ing mu­se­ums, sta­di­ums and uni­ver­si­ties.

Saudi Aramco’s do­mes­tic sub­si­diza­tion prob­lem eclipses th­ese other risks. Sub­si­dies, if left un­re­formed, pose a ma­jor threat to the long-term health of Aramco. Share­hold­ers will soon be a party to those risks.

Saudi do­mes­tic oil con­sump­tion has in­creased by an av­er­age of 5 per­cent a year since 1970. In the 2000s, do­mes­tic oil de­mand grew an av­er­age of 6 per­cent per year. In the 2010s, it has slowed, av­er­ag­ing just 4 per­cent.

Po­ten­tial in­vestors can take heart that Saudi oil de­mand grew by just 1 per­cent last year, due to the in­creased lo­cal prices as well as an in­crease in nat­u­ral gas pro­duc­tion, which sub­sti­tutes for oil in elec­tric­ity gen­er­a­tion.

Still, decades of com­pound­ing growth has left Saudi oil de­mand on par with that of Rus­sia, a com­pa­ra­ble oil pro­ducer that has five times the pop­u­la­tion and a much larger econ­omy. On a per capita ba­sis, Saudi res­i­dents con­sume 46 bar­rels per year, vs. eight bar­rels per capita in Rus­sia. (By con­trast, per capita oil de­mand in the United States is 22 bar­rels per year.)

What hap­pens if Saudi en­ergy sub­si­dies can­not be re­formed? At some point, con­tin­ued growth in do­mes­tic de­mand could leave only half — or even less — of Aramco’s oil pro­duc­tion for ex­port.

There have been rum­blings among Saudi cit­i­zens who op­pose sell­ing off a por­tion of the com­pany, see­ing it as invit­ing for­eign in­ter­fer­ence in the king­dom’s sov­er­eign af­fairs.

A lot is at stake. On the one hand, the Aramco IPO could be rocket fuel for the Saudi econ­omy, pro­vid­ing the cash for a long­promised di­ver­si­fi­ca­tion into busi­nesses that can soak up the le­gions of Saudi un­em­ployed.

On the other hand, the IPO will in­sert for­eign in­vestors into the pe­cu­liar in­ter­nal pol­i­tics of an ab­so­lute monar­chy. Many Saudis will re­sent it, es­pe­cially if it means the end of cheap gaso­line and elec­tric­ity. Krane is the Wal­lace S. Wil­son Fel­low for En­ergy Stud­ies at Rice Uni­ver­sity’s Baker In­sti­tute.

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