The Kingdom Goes Broke: The Saudi Aramco IPO And A Hilariously 'Crude' Debacle

| About: The United (USO)


Unfolding before your very eyes is the most spectacular example of a country cutting its nose off to spite its face the modern world has ever witnessed.

In 2014, Saudi Arabia put itself on the path to bankruptcy.

The scramble to clean up the 'oil spill' - if you will - is set to create the largest IPO in history.

Behold! Unfolding before your very eyes is the most spectacular example of a country cutting its nose off to spite its face the modern world has ever witnessed.

Who knows why exactly the Saudis decided to deliberately kill the golden goose in late 2014 by catalyzing not only a precipitous decline in crude (NYSEARCA:USO) prices but also a further sell-off in the broad commodities complex (which hit a 21st-century low last year).

Conventional wisdom holds that the kingdom decided to go to war with ascendant (if cash flow negative) U.S. shale producers in order to "preserve market share." That explanation has been parroted ad nauseam. And while there's almost undoubtedly some truth to it, you should be wary of any account that has been repeated so often as to become the consensus.

A more nuanced explanation says Riyadh had a number of political considerations in mind when the kingdom chopped off its own hand (that's the Wahhabist version of shooting oneself in the foot).

As The New York Times put it last year, there are "ancillary diplomatic benefits" to keeping oil prices low. That's a nice way of saying "oil prices can be used as a geopolitical weapon."

There are number of possible political advantages Riyadh might have hoped to derive from "temporarily" suppressing crude. First, as mentioned previously, the Saudis might have hoped they could pressure the Russians into abandoning their support for the Alawite government in Damascus. That didn't work. Second, and perhaps more importantly, Riyadh might have anticipated (or might have simply "known" via diplomatic channels to the White House) that come hell or high water, the Iran nuclear accord was going to get done because like it or not, Obama's legacy comes before Saudi and Israeli security concerns in the grand scheme of things. If that's the case, the move to crush crude might have been a preemptive attempt to undermine Iran's production ramp.

The truth is probably some combination of the above (i.e. some conflagration of economic and political fires the Saudis thought they saw burning on the horizon). Unfortunately, for Riyadh, they lost all control of prices and watched in horror as the crude train careened off the tracks, crashed, and promptly exploded triggering a swift drawdown of the SAMA war chest and unheard of speculation against the three-decade-old riyal peg.

Have a look, for instance, at the explosion in implied vol for the riyal that unfolded over the latter half of 2015 (the left pane is FX reserves):

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(Chart: BofA)

And that's just the SAMA and SAR situations.

By the end of last year, the fiscal situation had turned into a complete joke. That is, the deterioration was so dramatic, it became laughable. Here's a pair of graphics from Deutsche Bank which show the budget gap and the debt-to-GDP projections (note: the deficit turned out a little better than DB's -19% projection, but when you're talking double-digit budget gaps, -16% isn't much better than -19%):

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For those unfamiliar with how all of this fits together, here, roughly speaking, is how this works. The government employs pretty much the entire country (that's an exaggeration, but it's a convenient way to conceptualize the dynamic). That costs money. The government is also keen on preserving the riyal's peg to the dollar. That also costs money when the market starts to test the peg.

When oil revenue collapses, there's not enough money to cover everything (hence the giant budget gap). The money has to come from somewhere, so the Saudis are forced to either i) spend their FX reserves (i.e. sell U.S. Treasurys they accumulated in better times), or ii) tap the debt markets. How long you can hold out with prices this low depends on two things: 1) how large your FX reserves are, and 2) how much room you have to borrow.

Fortunately, for the Saudis, their reserves stood at $700 billion (give or take) and their debt-to-GDP ratio was basically 0% when this whole debacle started. But as you can surmise from the charts above, the kingdom probably hadn't planned on losing total control of prices because one certainly imagines that the royal family didn't plan on burning through $100 billion in 12 months and increasing debt-to-GDP fifteen-fold in the space of five years.

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Hopefully, you're beginning to see why I contend that this is a historically hilarious example of how hatred for political rivals can produce cloudy judgment.

As 2015 drew to a close, the monarchy had its back against a (probably gold-gilded) wall.

So what did they do?

Well, first they screwed the oppressed masses by reducing subsidies thus driving up prices on everything from fuel to electricity to water. And that's likely to continue. Here's BofAML:

We expect a VAT with 5% yield to be implemented in 2018, alongside further administered price adjustments for energy, water and electricity. Using solely the recurring existing proceeds of the December administered price adjustments and a VAT introduction, we still see a need for further fiscal restraint in the order of 1ppt of non-oil GDP annually.

And here's a look at the likely effect these "adjustments" will have:

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(Chart: BofA)

But that's not all they did.

Next, they decided to transform the kingdom's crown jewel (no royal pun intended) Saudi Aramco into a giant $2 trillion sovereign wealth fund. The move was telegraphed months ago, but it was made official on Monday morning. Concurrently, the Saudis will list "less than 5%" of the world's largest oil company (worth somewhere in the neighborhood of $2.5 trillion) setting up one of the biggest IPOs ever, at around $125 billion. Let's go to BofAML again to explain the details:

Government ownership of Saudi Aramco would be transferred to the Public Investment Fund ("PIF"), which will be transformed into a SWF that will look to increase its overseas assets (from 5% of total to 50% of total by 2020) following its recapitalization and the proceeds of Aramco IPO. The PIF would hold on-paper a vast amount of wealth post-IPO (US$2T, according to the Deputy Crown Prince, the bulk of which would be Saudi Aramco) as ownership of Saudi Aramco is transferred to the PIF, but it would only be able to deploy the cash proceeds of the monetized Aramco stake in the near-term, in our view. We think the PIF's transformation is still at a relatively early stage for now.

The PIF started paying dividends to the budget last year (SAR15bn). It now reports directly to the Council of Economic and Development Affairs headed by the Deputy Crown Prince, after reporting to the Ministry of Finance in the past.

It will be interesting to see how the restructuring of the PIF into an SWF works out in practice. We hypothesize that it may be that, on top of the monetization of Aramco's stake sale, PIF could get a portion of the assets of the Saudi Arabian Monetary Agency ("SAMA"). In this case, we would effectively transition to the Abu Dhabi and Kuwait model where the central bank holds little reserves and non-transparent SWFs are what matters both in terms of flow and stock.

Got that? No? That's okay. Basically, they're going to turn Aramco into an SWF but try to say that the only thing that can be spent invested initially will be the cash from the 5% public listing. Additionally, BofAML thinks they'll likely transfer a portion of the country's FX reserves to the SWF, setting up the possibility that investments could be diversified away from safe havens and into higher yielding assets. Or at least that's what it sounds like (incidentally, one wonders what the effect on core paper yields will be if the SWF decides to take more risks with the kingdom's reserves than the central bank).

Anyway, Riyadh is pitching this as though it were all a part of some master plan (they even gave it a funny codename: "Vision 2030"). But the real story seems to be this: the kingdom tried to throw its weight around in late 2014 for the three reasons outlined above (two of which are political). Only this time, they simply screwed it up, lost control, and panicked when they realized they were on the fast track to going broke with no way to unilaterally reverse the slide.

Here are some amusing quotes from 30-year-old deputy crown prince Mohammed bin Salman, who has effectively consolidated his influence and become the most important (if not the most powerful in absolute terms) person in the country (via al-Arabiya):

"We have an addiction to oil . . . this is dangerous. It has delayed development of other sectors."

"After the IPO, the Aramco board can take its own decisions."

"Aramco's listing has many benefits, the most important and before everything is transparency."

"It will be under the supervision of all Saudi banks, all analysts, all Saudi thinkers. Even more, all international banks and research and planning centers in the world will monitor it intensively."

Right. So the prince wants you to believe that 1) this was the plan all along, and 2) the listing will usher in a new era of transparency at Aramco.

You'll be forgiven for laughing.

"The listing would create a new threshold of public accountability for a secretive state-run company that currently doesn't disclose its annual revenues, profits and debts," WSJ notes, adding that "the plan was initially met with skepticism by bankers who said Saudi Arabia was unlikely willing to share with the world some of its most closely held financial information, but bankers now regularly travel to Riyadh in the hope to win an advisory mandate on what could eventually become one of the world's largest IPOs ever."

So the takeaway as far as the celebrated Aramco offering is pretty simple: if you're one who gets excited about gargantuan IPOs and you're in a hurry to own a stake in the completely opaque energy arm of an entrenched monarchy that is itself effectively beholden to a cabal of religious authorities, then you will soon get your chance courtesy of JPMorgan or some other "reputable" bulge bracket. Caveat emptor courtesy of Heisenberg.

More broadly, it's important to understand that "Vision 2030" is effectively a consequence of one country's errant attempt to play power politics by manipulating a market it thought it effectively controlled.

I have my own "vision" for how the kingdom will look in "2030" and I can tell you that despite prince Mohammed bin Salman's contention that Riyadh "doesn't care about oil prices" and that "$30 or $70, they are all the same to [the kingdom]", if crude doesn't stage a sustained comeback, my vision doesn't look anything like the following snapshot from King Salman's visit to the White House late last year...

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.