The world’s largest ever share sale is officially underway as Saudi Aramco launched its long-awaited Initial Public Offering (IPO) earlier this month. In the coming days and weeks, there will be lots of headlines and analysis about the size of profits, valuation, corporate governance and politics (oil and otherwise) around the company. For those unfamiliar with Saudi Aramco, it is the state owned energy company of the Kingdom of Saudi Arabia. It is one of the world’s largest oil producers with enormous oil reserves (257 billion barrels) and is reportedly the world’s most profitable company.
As bottom-up fundamental investors, we love digging into the details of these types of situations. One of the items in the IPO prospectus that caught our attention is Aramco’s royalty framework. For commodity investors—oil in particular—local governments have several means to extract wealth from resource companies. One obvious route is to collect taxes on corporate profit (bottom-line) and another traditional method is to impose royalties on revenue (top-line).
In the oil business, royalties are charged by governments (or in some cases private land owners that own the mineral rights) based on the amount of oil produced. Royalties are considered a normal cost of doing business and are usually imposed regardless of company profitability.
For Aramco, there is a new royalty framework that takes effect in 2020. To put it mildly, it is somewhat investor unfriendly. When oil prices are below $70 per barrel, the royalty rate paid to the government has been lowered from 20% to 15%. However, when oil prices increase to $70 to $100 per barrel, the royalty rate goes from 40% to 45%.
The real shock for investors is what happens if oil rises above $100: the royalty rate jumps from a current rate of 50% to 80%, leaving little upside for investors who will then be paying most of their presumed windfall back to the Saudi Government. By way of contrast, conventional oil produced in Alberta, under the Modernized Royalty Framework, hits a maximum royalty rate of 40% only when oil is above $160.
To invest in oil today, you have to be somewhat optimistic about rising oil prices. With the benefit of rising prices effectively being capped, the valuation of Aramco will most certainly be negatively impacted. The Kingdom of Saudi Arabia has effectively taken some of the fun out of investing in Aramco, particularly in a scenario where conflicts in the Middle East or a rollover in U.S. shale production propels oil above $100.