Saudi Arabia Has 2 Trillion Reasons to Continue Pumping Up Oil Prices

By Matthew DiLallo Markets Fool.com

Saudi Arabia, like the rest of the world, has an addiction to oil. However, instead of a thirst for consuming crude to power its economy, the Middle Eastern nation's economy runs on oil money. That works out splendidly when crude prices are high but is a significant problem when prices crash as has been the case the past few years.

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It's a problem that the kingdom's Deputy Crown Prince Mohammed bin Salman hopes to solve by selling a slice of the country's oil company, Saudi Aramco, to investors via an IPO. That would give the kingdom a cash infusion to start diversifying its economy away from crude. There's just one problem with his plan. His hope was that the IPO would value the company at around $2 trillion. However, those working on the deal are having trouble coming up with that value in the current market environment, suggesting that even $1.5 trillion would be a stretch. Given that dilemma, it's no surprise to see the country's energy minister, who also happens to be the Chairman of Saudi Aramco, hinting that Saudi Arabia would be in favor of extending OPEC's output cuts to boost oil prices since that could raise the value of the company.

Image source: Getty Images.

The $500 billion valuation gap

When bin Salam floated the $2 trillion valuation for Aramco, he did so based on some simple math. The company controls 261 billion barrels of proved oil reserves -- which is the second largest in OPEC behind Venezuela -- that he valued at the country's oil benchmark price of just $8 per barrel. However, there a couple of problems with that methodology. First, the market has long questioned Saudi's proved reserves -- its skeptical that the company has that much oil still in the ground. Second, this method isn't the way the market values oil companies. If that were the case, ExxonMobil (NYSE: XOM), which is a nearly $350 billion company that has 20 billion barrels of proved oil equivalent reserves, would only be worth $160 billion. Instead, what the market values above reserves are a company's ability to turn production into cash flow.

Because the market values cash flow above all else, many see Saudi Aramco's value coming in well below the $2 trillion mark because of the tax regime in Saudi Arabia. In fact, by using more traditional valuation metrics, industry consultant Wood Mackenzie came up with a valuation of just $400 billion for the company's core business. Meanwhile, company insiders are struggling to justify a $1.5 trillion price tag even after taking into account the country's recent tax cuts that reduced the company's tax rate from 85% to 50% in an attempt at wooing investors.

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Minding the gap

Saudi Arabia is shooting high on Saudi Aramco's valuation because selling a slice of the company is a key to the country's plans to get off its oil addiction. The kingdom hopes that by selling 5% of the company at a $2 trillion valuation, it would raise $100 billion in an IPO, giving it quite the war chest to begin diversifying its economy. However, if the market won't give Saudi Aramco the valuationbin Salam wants, then he would have much less cash to work with, which could hold back his ambitious strategy.

That said, he does have an ace up his sleeve so to speak in that Saudi Arabia, through its control of OPEC, still holds a lot of sway in the oil market. As such, if the country can boost oil prices, it would lift Aramco's cash flow, which would go a long way toward closing the valuation gap. That seems to be just what the country is doing by signaling to the market its willingness to support prices by extending OPEC's output cuts well past the initial six-month plan. Just recently Saudi Energy Minister/Aramco Chairman Khalid al-Falih said that "there is a consensus [to extend the cuts] building but it's not done yet." That said, the country will likely push for that consensus because it needs to drain the market's oversupply to get supply and demand back into balance, which is the ticket to higher oil prices.

Image source: Getty Images.

Driving in neutral

That said, Saudi Arabia's plans to boost oil prices haven't exactly worked as intendedthus far. That's because it has pushed prices just high enough to incentivize shale drillers to get back to work, which led to a flood of new oil that has kept crude's ceiling in the mid-$50s. That's because at $50 oil shale drillers likeEOG Resources (NYSE: EOG) can generate explosive growth due to the high returns of certain shale wells. In EOG's case, it can generate enough cash flow at $50 crude to boost oil production 18% this year. The reason EOG Resources can grow at such a fast clip is that it spent the oil market downturn focused on improving well productivity and driving down costs, which has dramatically improved cash flow and returns. We see a similar story at Devon Energy (NYSE: DVN), which has the financial capacity and incentives to spend the money to double its rig count by year-end. Those rigs should boost Devon's oil output 13% to 17% by the end of the year, putting it on pace for 20% oil growth next year.

Needless to say, Saudi Arabia is in a tight spot. If it pushes crude prices too high, then shale drillers will accelerate production growth. EOG Resources, for example, can boost its long-term oil growth rate from 15% annually at $50 crude up to 25% annually at $60 oil. That said, if the country doesn't boost the cash flow of its oil company, then it won't pull in the money it needs to fuel its ambitious diversification plan. Suffice it to say; the country has a couple trillion reasons to push for higher oil prices in the near term even if that would fuel another shale boom.

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Matt DiLallo has no position in any stocks mentioned. The Motley Fool owns shares of Devon Energy, EOG Resources, and ExxonMobil. The Motley Fool has a disclosure policy.