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By rights, long-sighted oil investors should be zeroing in on the companies with the lowest-cost reserves. After all, global oil demand is expected to peak within this decade, according to the International Energy Agency, before slowly dwindling. That makes producers at the bottom of the cost curve — those who stand to make money for longer — relatively attractive.
Yet this reasoning only partly applies to Saudi Aramco, the $1.87tn national oil company which is the world’s largest and lowest-cost oil producer. The Kingdom of Saudi Arabia, its majority shareholder, is selling roughly $12bn of stock in a secondary placement. At the midpoint of the range, the shares will price at a 13 per cent discount to the group’s listing price at the end of 2019, although adjusting that for bonus shares more than closes the gap. But even at this reduced valuation, the stock is not a straightforward proposition.
One issue is that Saudi Aramco has the task of containing supply to help keep oil prices high. That makes sense for a Saudi government intent on maximising revenues, but it is a double whammy for the company’s attractiveness relative to the broader oil sector.
It means Saudi Aramco produces less than it could, as shown by the 6 per cent decline in 2023 volumes and the state-mandated decision to ditch a major capacity addition. And it also creates a price environment that puts Saudi Aramco at a relative disadvantage: higher-cost producers with greater operating leverage are more sensitive to increases in the oil price.
That helps explain the group’s underperformance so far this year. With oil up 9 per cent, and the S&P Global Oil index up 6.3 per cent, its stock is down 12 per cent.
None of this negates Saudi Aramco’s unique position in the world of oil. It costs the company $3.19 to produce each barrel of oil, making its upstream division a huge — and long-term — cash gusher. It is also a big spender: dividends and capex exceeded operating cash flow in 2023. But low net gearing at 4 per cent puts it in good stead to continue to juggle both for some time to come.
That goes some way towards justifying Saudi Aramco’s premium valuation: it trades at a 5 per cent free cash flow yield, on Bernstein estimates, compared with European majors at 11 per cent. But as long as the Kingdom is committed to propping up oil prices, others in the sector will benefit more.