The Saudi route to diversification

The record profits reported last week by Saudi Aramco raise hopes that we may yet see a substantial oil producer in the emerging markets (EM) universe achieve genuine economic diversification. Our statement excludes microstates endowed with sizable oil reserves because the challenge is much less daunting for them. Saudi, in contrast, has a population of more than 35 million.

Aramco announced net income of $48.4 billion for Q2 ’22, an increase of 90 percent on the year-earlier period. It is increasing its crude oil production capacity by 1.0mbpd to 13.0mbpd, and looks to boost natural gas output by 50 percent by 2030.

Amin Nasser, the company’s chief executive, was being honest at Davos in May when he said the industry should continue to invest in fossil fuels until such time as renewables could replace hydrocarbons in full. These expansion plans separate Aramco from the listed Western oil majors and their ambitious net zero targets. It is also listed but just 1.7 percent of the stock in 2019 and only on the Riyadh bourse.

Aramco, which replaced Apple as the most valuable listed company globally in May this year, reported capital expenditure of $9.3 billion in Q2. At the same time, it declared a dividend of $18.8 billion for the third successive quarter. In addition to government royalties that reach 80 percent on oil prices above $100/b, we can see that the war in Ukraine has produced a flow of revenue for the diversification plans of the authorities.

The government owns 94 percent of Aramco stock and the sovereign wealth fund, the Public Investment Fund (PIF), a further 4 percent. (It would have sold more stock to offshore investors and may well have opted for a high-profile dual listing in 2019, had it not been for some negative publicity surrounding the death of a prominent journalist and critic of the authorities.)

Our point is that the oil price bonanza has given the Saudi government and its agencies the funds to drive the ambitious modernisation plan of Crown Prince Mohammed bin Sultan, Saudi Vision 2030. A first fiscal surplus since 2013 beckons for the kingdom this year and is set to exceed the budget projection in December of $24 billion. It will probably be deployed to rebuild the kingdom’s foreign exchange reserves and boost the assets of the PIF.

There are some question marks we should mention. Our main reservation is the influence the government exercises on both Aramco and the PIF because we buy into the orthodox view that autonomous public bodies outperform counterparts under government control.

Aramco was directed by the government to pay dividends at set levels and borrowed to meet its obligations to shareholders at times of low oil prices. It was also directed to pay $69 billion to the PIF for a 70 percent stake in the domestic chemicals and fertilizer manufacturer, SABIC.

The assets of the PIF are said to have increased fourfold in the past seven years to $620 billion in Q1 ‘22. The target set by the authorities is $1 trillion by 2025. Its inflows are a combination of dividends, bank loans, and support from the government in the form of cash, land transfers and state asset sales.

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Earlier this year it secured its maiden ratings from both Fitch and Moody’s as if it was the government. This will smooth its proposals to borrow up to $15 billion from banks and to issue green bonds. The PIF needs such firepower if it is to achieve its target to invest $40 billion annually for five years in domestic projects within Saudi Vision 2030 such as the flagship Neom megacity.

The pursuit of diversification may or may not succeed. In contrast to most African crude producers, Saudi has managed not to shoot itself in the foot when the oil price has been strong. That the PIF and Aramco are vehicles of government economic policy rather than autonomous bodies may not prove the disadvantage we have suggested: the said ‘Western model’ is not the only one that can succeed. We are not doctrinaire on the point.

The broader point relevant to all investors is whether the PIF can generate the funds for the government’s objectives in a difficult economic climate. The world’s largest sovereign wealth fund, run by Norges Bank Investment Management, last week reported a woeful H1 ’22: the $1.2 trillion fund suffered a 14.4 percent decline in its portfolio, which was broadly in line with the year-to-date performance of the MSCI all-world index.

Only the energy holdings managed an uptick in the first half. The fund made smart investments in listed Western oil majors when the crude price tanked in April/May 2020. It is better known for its holdings in the Soft Bank Vision Fund, Carnival and Uber.

Ultimately the expertise of the investment professionals, a large slice of luck and the crude price (via Aramco) will determine whether Saudi is placed to become the first sizeable producer in the EM universe to achieve bona fide diversification away from oil. The current economic slowdown across the world suggests that patience is required to meet the objective.