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U.S. And China To Face Off Over Aramco IPO

US China

Speculation continued into early 2018 about who — or which organization — would be the ultimate buyer of the five percent stake being offered for sale in Saudi Arabia’s national oil company, Saudi Aramco.

As political and economic crises mounted in Saudi Arabia, and oil prices continued to remain relatively low on world markets, there was also speculation as to whether the offering in Saudi Aramco would even be viable.

While courted by Western stock exchanges due to the size and prestige of the listing, it has been suggested that a trade sale to a People’s Republic of China (PRC) consortium would serve the objectives of both the PRC and Saudi Arabia.

This would increase the PRC’s ability to pressure for oil to be priced and transacted in the PRC currency, renminbi. It could have broader strategic implications and would also put a spotlight on evolving U.S.-Saudi Arabian relations.

Saudi Aramco — which had its origins as a U.S.-owned private company with Standard Oil of California and Texas Oil Company — is now the state-owned national oil company of Saudi Arabia and has a major role in the national economy and funding the Government.

According to official company reporting, it produced 10.5 million barrels of oil a day in 2016 and holds 260.8 billion barrels of oil reserves. Global oil demand is around 96 million barrels a day. As the leading, low-cost and swing producer, Saudi Aramco is a key driver in international energy markets and energy ge-opolitics.

At present, most crude oil trade is transacted in U.S. dollars, which has been the case since the so-called 1973 petro-dollar agreement.

Evolving U.S.-Saudi Arabia Relations

The U.S. shale revolution — which reversed the decline in U.S. oil production and put downward pressure on global oil prices — has had a substantive impact on energy geopolitics. In 2017, domestic U.S. produc-tion passed 10 million barrels a day for the first time since 1970. Further expansion of production is ex-pected and total output could reach 12-million barrels a day by the end of 2019.

Shale production has had another impact on energy markets: to create a de facto price ceiling for crude oil and, according to some analysts, put it into a lower, long-term average of perhaps $60 to $80 a barrel.

After Saudi efforts largely backfired when it allowed the oil price to drop in order to weaken shale produc-ers (after which U.S. firms were able to aggressively reset their cost profile), OPEC and its partners have attempted to coordinate cuts in order to put a floor under the oil price.

Within the U.S., growing oil production has had different political and economic dimensions.

Rhetoric about “independence” (a slogan since the 1970 OPEC oil crisis) is politically popular but does not reflect the integrated nature of oil production patterns, especially within North America. The economic impact of shale production, while less well understood and reported, is a critical development.

Lower energy prices have helped the economy grow. It was the key factor in stimulating commercial activ-ity during the Obama Administration era, despite the fact that the Obama Administration had imposed a series of anti-business policies.

The election of President Donald Trump — who took office on January 20, 2017 — marked a turning point for the U.S. oil and gas industry, which was hampered during the Obama Administration due to its prefer-ence for renewable energy and placing a quasi-price on carbon. Trump’s deregulation agenda and tax cuts further spurred economic growth, leading to increasing inbound capital flows and domestic investment. Like economic policy, foreign policy under Trump has been almost completely opposite to that of his pre-decessor.

Trump’s May 2017 visit to Saudi Arabia represented a positive shift after Saudi relations with Obama soured. However, with Iran on the ascent, regional dynamics are evolving at a fast rate, as they did during late 1970s.

From Riyadh’s perspective, low oil prices caused by shale production and an unreliable and sometimes hos-tile U.S. relationship forced a rethink of domestic and international priorities.

Vision 2030 and Aramco Privatization

The privatization of Saudi Aramco and Vision 2030 are among the efforts of a new, young crown prince to reform and modernize the Saudi economy. Certainly, attempts to diversify the economy were critical to the Saudi leadership and the survival of the Saudi state.

The motivation was mainly to reduce the impact of volatile oil prices on domestic budgets rather than the stated reason of expected diminishing global oil demand. As with a great deal of commentary on oil mar-kets, peak oil demand may pass as quickly, as did expectations of peak oil supply.

Instead, Vision 2030, the anti-corruption drive, and the apparent embrace of a post-fossil fuel economy merely disguised (and complemented) the larger aim of Mohammed bin Salman (MBS), who is the king-dom’s crown prince, first deputy prime minister, and minister of defense and aviation — in order to consol-idate power and ensure his accession to the throne and to keep the nation a united entity, avoiding break up and fragmentation.

Like his predecessors, MBS is dealing with competing tribal ambitions and efforts by external powers — including Iran — to break up the nation. He has the added challenge of addressing a distorted budget that is premised on significant spending and allocation of funds to its citizens in the form of growing demands for social benefits and infrastructure in a country where the overwhelming majority of the 30 million+ pop-ulation is non-Saudi.

In practical terms, this means Saudi Arabia has a deficit of around $100 billion a year (known as the “burn rate”), with diminishing reserves now estimated to have shrunk to around $250 billion.

Such economic reality means that the reported May 2017 deal with Trump for defense deals and invest-ments worth $350 billion won’t be manifested. Accordingly, the Trump administration has been discreetly improving its relations with Qatar and repositioning itself as Iran seeks to increase its influence in the re-gion and consolidate its access to the Mediterranean.

In this context, the Aramco IPO is a subset of Saudi Arabian internal dynamics and motivated by the survival of the Saudi leadership. It would have not occurred with such speed if oil had remained at or above $100 a barrel. However, like most nations which have a large part of the economy linked to commodity exports, once revenues increase, social spending matches income. Markets may shift, but there are few instances when significant cuts to social programs do not threaten the longevity of ruling elites.

Aramco’s value is based on the expected price of oil, driven by both demand and supply expectations as well as its reverses. The value is likely to be much lower than the $2 trillion figure that has been mooted, and the enterprise value may be closer to $1 trillion or less.

Efforts have been made to legitimize stated reserves as well as the value of the overall entity. This was reportedly one of the reasons for the establishment of the King Abdullah Petroleum Studies and Research Center, which, through generous contracts and research grants, has drawn in many leading energy econ-omists.
The problem for Riyadh is that if Aramco is listed on a stock exchange, it would put a spotlight on underly-ing assets that would place a valuation on the company as well as a more transparent understanding of oil reserves and production.

Transparency represents another problem for Saudi Arabia, as it would diminish the kingdom’s ability to influence the oil price, and possibly accelerate internal expectations and perceptions of the populace get-ting the benefit of a local resource. Dividend payments would highlight these issues.

For Beijing, the acquisition of a part of Aramco isn’t as critical as it is for Riyadh. It is, however, attractive to the PRC for the following reasons:

• Buying part of Aramco through a confidential trade sale from a buyer with limited options implies a discount. The PRC holds significant financial reserves, so the quantum of the deal isn’t necessarily a problem and could be digested by its sovereign wealth funds and national oil companies.

• The PRC has become the main importer of Middle East oil and has already completed various deals involving downstream operations both in Saudi Arabia and the PRC. At the beginning of 2016, Sau-di Arabia was the PRC’s largest supplier. While dropping behind Russia and Angola in 2017, Saudi Arabia will remain an important supplier of crude oil to the PRC over the long term.

• A deeper economic relationship with Saudi Arabia would serve as a Middle East anchor for the PRC’s Belt and Road Initiative, which aims to create a series of Sinocentric infrastructure routes. This would imply a greater presence on the Arabian Peninsula and could potentially create even greater ownership and control of ports, such as is already the case in Djibouti and Massawa (Eri-trea) on the Red Sea.

• It would increase Beijing’s leverage to shift to renminbi as the medium of exchange for crude oil. This ambition has been flagged for some time, with renminbi oil crude futures to begin trading on the Shanghai Futures Exchange on March 26, 2018.

A Beijing Aramco acquisition isn’t without risks…

Despite U.S. decline in the Middle East during the Obama era, it appears that the Trump administration is repositioning itself and will be a more formidable player. The shift to renminbi-denominated oil exchange would also present problems to Beijing. The U.S. would exert enormous pressure on Saudi Arabia to con-tinue with the status quo.

It would also bring into focus the role of the U.S. dollar as the global reserve currency.

The PRC isn’t ready or willing to allow markets to drive the pricing of its currency, and doesn’t have mar-kets that are as deep or as liquid as those of the United States. Furthermore, should the U.S. shift to a higher economic growth rate, at 4 or even 5 percent, the strength and flexibility of its economy would stand in contrast to the challenges of a rigid and brittle PRC economy that is being artificially inflated by sub-optimal infrastructure investments.

Another complicating factor for the PRC becoming involved in the upstream industry is dealing with volatile energy prices and a shift toward greater use and deployment of digital technologies in oil and gas extrac-tion — recent reports about talks between Aramco and Google parent Alphabet Inc. are part of this trend.

Suggestions of jointly building a large technology hub within Saudi Arabia may further complicate PRC am-bitions for part acquisition of Aramco. This mooted $1 billion deal includes building three data centers in Saudi Arabia. While linked to the Vision 2030 plans, the main benefit is to optimize oil exploration and pro-duction; this has the potential to increase productivity of existing fields and further reduce Aramco’s cost structure.

A scenario that involves both the PRC acquiring a stake in Aramco and the Alphabet-Aramco deal progress-ing may positively favor the U.S. more than the PRC. The injection of capital by the PRC, with only minimal influence over company decision making, may not be as attractive as having a U.S. firm embedded in data analytics and growing part of the business.

While talk of the Saudi Aramco transaction may dominate the business press in 2018, competition between the U.S. and the PRC will be conducted by increasing different economic growth strategies; this will be a critical factor in the performance of the Republican party in its mid-term congressional elections (2018) and the 2020 presidential election cycle. Similarly, while PRC President Xi Jinping has consolidated power, satisfying ever-expanding expectations of a restless populace and improving living standards is at the top of his and the Chinese Communist Party’s minds.

Both the U.S. and PRC presidents will be keenly attuned to the prestige of their currencies, which will be put into the spotlight as Saudi Arabia negotiates its own internal challenges.

By Andrew Pickford via Defense and Foreign Affairs Special Analysis

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