The financial press has given extensive coverage to the initiative by King Salman of Saudi Arabia and his nephew, Crown Prince Mohammed Bin Salman, to float public shares of the Saudi Arabian Oil Co. (Saudi Aramco). The IPO is scheduled to debut later this year in the form of a 5% splinter of the world’s largest sovereign oil producer. Some reports speculate the giant IPO could establish a new publicly traded investment that could rival Apple Inc.’s nearly $1-trillion market capitalization. This sounds exciting to oil investors, but why do we remain skeptical?

The IPO has been delayed due to recent turmoil in Riyadh, Saudi Arabia, derived from an “anti-corruption” campaign affecting members of the royal family and led by the crown prince. Investors may also question why they are being asked to underwrite a public Saudi Aramco when the crown prince is making sizable non-energy acquisitions, including Leonardo da Vinci’s “Salvator Mundi” for $450 million, the Chateau Louis XIV outside Paris for $300 million and a superyacht for $549 million, during a period of supposed government austerity. It is no surprise the kingdom wants to diversify and is facing enormous budgetary shortfalls, but what’s in it for investors?

A $2- to $3-trillion EV?

Saudi officials have expressed hopes that the offering will provide funds the kingdom will deploy to diversify its petro-dominant economy. Figures exist that place the 5% stake’s worth at $100- to $150 billion, suggesting a Saudi Aramco enterprise value of $2 trillion.

A multitrillion-dollar valuation for Saudi Aramco is a pipe dream; in an over/under, the under would be the better bet.

The rationale: bottom-up analysis and discounted present value modeling based on the old school of oil analysis. A rough appraisal of Saudi Aramco centers on a range of $500- to $600 billion at the January 2018 oil price. A 5% IPO would, thus, be priced at between $25- and $30 billion.

This valuation model incorporates continuing current exports of 7.2 million barrels per day (MMbbl/d) of oil and 1.3 MMbbl/d of NGL. It assumes a modest base production decline rate of 5% per annum, production costs of $5.50/bbl and a (recently lowered) 50% Saudi tax rate.

Reserve replacement

The “Saudi Aramco 2016 Annual Review” reported that it added reserves of 4.2 billion barrels (Bbbl) in 2016 and had year-end reserves of 260 Bbbl. Barclays, in its 2017 global E&P forecast, reported that Saudi Aramco invested approximately $18 billion on upstream development. Thus, the reserve-replacement cost was $4.30/bbl.

Historical data support the kingdom as having the world’s lowest-cost oil resources. Consider that Saudi Arabia has produced 100 Bbbl since 1985, according to OPEC data, and its stated proved reserves have been roughly unchanged. Assuming cumulative upstream investment of $300 billion during this period, this implies a reserve replacement cost of roughly $3/bbl.

Looking ahead, we model that Saudi Aramco will invest $215 billion of upstream capex during the next 10 years and $332 billion in 15 years. While the official Saudi 10-year spending target is $334 billion, this figure includes capex on infrastructure and incremental refining assets. Further, the Saudi Aramco IPO faces a Catch 22: Accelerating investment could increase export volumes faster than the oil market would tolerate while supporting a reasonably healthy global oil price.

Utilizing these assumptions, our model supports a future of moderately steady annual export growth of 100,000 bbl/d for the next 10 years. Continued investment in the five years following peak production softens the decline rate until the end of the 15-year timeframe. After this, the lack of new investment results in overall production falling at the assumed 5% per year. Including remaining barrels that are developed during this 35-year period, but produced after the study period, total production would be 154 Bbbl, which is approximately 59% of Saudi Aramco’s 2016 stated reserves of 260 Bbbl. We believe that this is a fair assumption as most public E&Ps support valuations that assume only partial development of large resource bases.

What about downstream?

Saudi Aramco is a mega-integrated, sporting refining capacity of 3.1 MMbbl/d net to its interest owned in a total of 5.4 MMbbl/d at year-end 2016. Of this, 2 MMbbl/d was in Saudi Arabia and 1.1 MMbbl/d was in various countries, including in the U.S. at Port Arthur, Texas. (Since 2016, Saudi Aramco gained the other 50% interest in the Texas refinery, which has total capacity of 1.1 MMbbl/d.) Independent refiner Valero Energy Corp. has similar refining capacity and traded at a market capitalization of approximately $40 billion in early 2018. (Should the comparison become past tense?

In addition, Saudi Aramco has petrochemical production capacity of approximately 30 billion pounds per year. This is closely equal to Phillips 66 Co.’s chemical production capacity. Phillips’ net-interest refining capacity is smaller at 2.2 MMbbl/d, but it also has sizable midstream assets. Phillips had a market capitalization of approximately $50 billion in January. Given these examples, a valuation of $50 billion for Saudi Aramco’s refining and chemical assets would be fair. While not insignificant, downstream and petrochemical assets figure to be less than 10% of Saudi Aramco’s total enterprise value.

The result is a valuation of Saudi Aramco of between $500- and $600 billion, depending on the discount rate and oil price assumed.

A $25- to $30-billion offering is no small beer; fees to the underwriters—JPMorgan Chase, Morgan Stanley, HSBC and boutique banker Moelis & Co.—if at 6% to 7%, could total between $1.5- and $2.1 billion.

Time will tell if the syndicate can overcome what will be a “hard sell.” Investors will no doubt demand more disclosure. The savviest investors will question how Aramco will channel its cash flow and to what extent they will be rewarded with regular dividends. The best chance of both growth and yield for investors would be if the IPO is offered under U.S. securities law and on the New York Stock Exchange.

From 1984 to 2007, Art Smith, CFA, was chairman and CEO of John S. Herold Inc., which was sold in 2007 to what is now IHS Markit. Post-closing, he founded Triple Double Advisors LLC, where he is portfolio manager and oversees the firm’s energy research. Smith is a member of the boards of Fairway Energy Partners LLC and Mammoth Energy Services Inc. He received a bachelor’s degree from Duke University and an MBA from New York University’s Stern School of Business. Gabe Chavez analyzes E&P equities at Triple Double. Prior, he was a research analyst at Koch Quantitative Trading and an analyst at Enron Corp. He received a bachelor’s degree in economics from the Wharton School of the University of Pennsylvania with dual concentrations in finance and management.