The oil market began its new era in 2017 quietly with the price above the $50 per barrel level. January 1 marked the beginning of OPEC production cuts which the cartel agreed to and announced at their November 30 meeting. While January 1 was the big day for OPEC, January 20 will effectively start the new energy era in the United States when Donald Trump is sworn in as the forty-fifth President. President-elect Trump's appointments already indicate that the incoming administration will set U.S. energy production and independence as a priority.
The price of oil has doubled from the February 11, 2016 lows at $26.05 but it remains at half the price in was in June 2014 when the energy commodity traded at over $107 per barrel. It remains to be seen whether the cartel will stick to its production schedule or production figures will be rife with cheating and output will begin to slowly climb in the months ahead.
The largest producer of the cartel, Saudi Arabia, has a vested interest to keep production under control as they prepare to offer 5% or more of the state oil company, Aramco, via an initial public offering. After all, the higher the price of oil when the IPO comes to market, the more the Saudis will get for their shares. Perhaps Saudi Arabia should look east for a strategy when it comes to plans to sell shares in the crown jewel of the Saudi Royal Family and the company that provides the bulk of revenue for the nation each year.
The Alibaba Model
The largest IPO in history was the Alibaba (NYSE:BABA) IPO in September 2014. On September 18, 2014, the BABA IPO received a final pre-trading price of $68 per share and the company opened for trading the next day on the NYSE at $92.70. The initial offering was the biggest in U.S. history an d on September 22, the company announced that they exercised their greenshoe option to sell 15% more shares than they originally planned bringing the total proceeds to $25 billion.
Alibaba gave the market the best of both worlds in September 2014. In a market hungry for Chinese and internet exposure, the IPO combined the two golden e-commerce virtues to take advantage of the burgeoning China market. The shares of Alibaba were trading at the $93.40 per share level on Thursday, January 05, 2017. The stock reached a high of $115.10 in November 2014 but it remains not far from the level where trading opened during the IPO. As the largest and perhaps most successful offering of shares ever, it is likely that the BABA experience will soon be overshadowed by what promises to be an even bigger offering sometime in 2018.
The biggest IPO ever
Aramco is the crown jewel of the Saudi Royal Family and it is the bedrock of the Saudi economy. Saudi officials expect a valuation of around $2 trillion which would make the IPO four times the size of the BABA offering. If the market agrees with their opinion, a 5% sale of Aramco would yield the Saudis a whopping $100 billion when it finally comes to market. A generous valuation would likely lead to an even bigger sale by the Saudis as they look to raise funds for a sovereign wealth fund which will diversify the Kingdom's financial exposure away from just petroleum.
There is a great deal of investment talent in Saudi Arabia. Prince Al-Waleed bin Talal bin Abdulaziz al Saud is a 61 year old magnate, investor and philanthropist who has amassed a $19 billion fortune with investments outside the world of oil. In 2016, the Saudis were active in bidding for some businesses on the world scene to diversify. They were interested in Glencore's agricultural business but lost out to Canada. The proceeds to the Aramco IPO will go to work around the world resulting in a more balanced economy in the Kingdom. However, the proceeds of the offering will be a function of the price of crude oil and the market's perception of the future path of least resistance for the price of the energy commodity. Right now, things are looking a lot better for oil than last year at this time when it was on its way to the lowest price since 2003.
Oil has a lot going for it now
When crude oil began its descent from $107 in June 2014, OPEC led by the Saudis decided to flood the market with crude oil. The cartel's strategy was to build market share by making North American shale production uneconomic. However, the strategy bombed as U.S. output did fall commensurately with the number of rigs removed from production as technological advances in drilling and extraction helped to ease the blow of lower prices. Pressure on OPEC mounted to take a proactive approach towards the oil price as many member nations saw economic conditions begin to crumble with the falling price of petroleum. Even in Saudi Arabia and the rich Gulf States, financial reserves started to decline at a frightening pace. In the poorer member nations like Venezuela, Nigeria, Ecuador and others the low price of oil made bad economic conditions even worse. With assistance from the Russians, OPEC capitulated at their November 30, 2016 meeting and agreed to cut production with the Saudis taking the majority of those cuts on their shoulders. However, with the IPO coming up in a year or so, the capitulation is likely to fill the Saudi coffers with cash if they can stay on course with other members to restrain the desire increase production from the agreed upon level.
As the monthly chart of NYMEX crude oil highlights, the price has not looked back from the February 2016 lows and has steadily climbed since. The trend shows positive momentum with rising volume and open interest, which provides technical validation for the move off the lows. The next level of technical resistance for NYMEX crude is at the May 2015 highs of $62.58 and support seems to be at just above the $50 per barrel level. From a technical perspective, crude oil seems to have entered a range between $50 and $60 per barrel.
As the weekly chart of the price of WTI-Brent crude shows, the Brent premium has increased from under $1 per barrel in the lead up to the last OPEC meeting to over $2.25, a sign that the cartel means business when it comes to the promised production cut. Additionally, there are other signs that tell us that demand for crude oil is picking up. Source: CQG
The weekly chart of the gasoline crack spread shows that the refining margin has increased from lows of $9.71 per barrel in mid-November to around $15 after trading to highs of over $17.50 over recent weeks. Source: CQG
The heating oil crack shows an even steadier appreciation from lows of $8.06 per barrel in the beginning of 2016 to its current level of over $17. Finally, term structure or the forward curve in crude oil has been tightening since the February 2016 lows, and traded into a small backwardation at the end of December.
The prospects for the oil price look a lot better than they did last year at this time and that is good news for the Saudis.
Saudi Arabia diversification depends on the new strategy
Perhaps the biggest reason that crude oil fell to the lowest price in thirteen years in early 2016 was the Saudi insistence that the cartel needed to flood the market with oil to make shale production uneconomic. Their attempt to build market share backfired and along came Russia, another massive producer of the energy commodity to talk sense into the Royal Family.
Russia's economy also was reeling from a combination of sanctions from the West and the falling oil price. Russian production of over 10 million barrels per day is the only output that rivals the Kingdom's. In a case of if you cannot beat them then join them, the Saudis decided that it was better to shoulder the lion's share of the output cuts. The agreed to let their mortal enemy, Iran, continue to pump up their volume, in the interest of a longer term goal of diversifying the nation away from such dependence on oil revenues. It is likely that we will see lots of Saudi money chasing assets around the world after the Aramco IPO. Commodity assets are likely to be hot prospects for the Saudis as the raw materials business is close to their hearts. After all, crude oil is the King of commodities and metals, minerals, and agricultural commodities are similar businesses, those the Saudis understand well from decades in and controlling the flows of crude oil around the globe.
The Saudis also know that things are going to change dramatically with the election of a U.S. President that has promised energy independence. The harsh regulatory environment that stood in the way of America's ability to compete will give way to falling U.S. production costs and more output from shale regions of the nation. Therefore, it is now in the best interest of all parties involved that the price of crude oil remain in a range from $50 to $60 per barrel. This level is a sweet spot for producers who saw the price as low as $26.05 and for consumers with memories of the energy commodity trading over $100 per barrel.
As the Saudis embrace changes in the international oil market which has seen the rise of Russian power and will like see an increase of U.S. output, they will stick to the new game plan as their IPO is just around the corner.
Have Jack Ma consult!
The Alibaba IPO is the biggest in history and the Aramco offering is likely to make it look small by comparison. Saudi Arabia has stated that they intend to sell 5% of their holdings but they could increase that to 49% and still maintain total control of the state oil company in the aftermath of going public.
The regulatory rules around a publicly traded Aramco will change the way that Saudi Arabia can operate in the oil market. The interest of the shareholders will supersede OPEC and the Royal Family's historic desire to control world oil prices. However, they will be compensated handsomely for giving up that control in a world that seems destined to adopt alternative energy sources in the years to come. Every 5% of Aramco sold could yield the Royal Family and nation $100 billion meaning that 49% could create a $1 trillion windfall. If the current trend in oil continues and the cartel members behave and adhere to the November 30 deal, we could see an oil price that is 20% higher next year at this time.
Jack Ma did a brilliant job of bringing a company to market that combined the best of both worlds, exposure to China and e-commerce. However, Chinese investments always come with a greater degree of risk. Oil is always a popular investment and the world's biggest oil producer is likely to attract massive interest when it finally comes to market. An investment in the Middle East is risky, to say the least. However, there are plenty of similarities between the BABA and Aramco IPOs. The Saudis will have investment bankers from all over the world swarming around them as the details of the IPO are worked out over the coming months. Perhaps the greatest asset they will find to help negotiate their way through the spider's web of an offering would be the man who did just that for Alibaba. Jack Ma would be a great consultant for the Saudis and for a very small piece of the IPO the Chinese billionaire may just add huge value to BABA and help the Saudis squeeze the market for every last penny when those Aramco shares finally begin trading.
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