Why Saudi Arabia's oil price war could hurt ordinary Saudi investors and U.S. shale producers

Saudi Arabia’s earth-shaking decision to launch an oil price war in the depths of an all encompassing markets crisis has sent the share price of its state oil company plunging below its initial public offer price, putting a strain on government finances and essentially killing off any plans for an international listing for now.

Shares in Saudi Aramco, which became the world’s most valuable public company following its IPO in December, fell by as much as 10% on Monday before recovering slightly. That’s the second straight day of heavy losses since Saudi Arabia failed to persuade Russia to join OPEC in cutting back oil production to support prices.

At 28 riyals, the shares is now down 26% from its December 16 high, a moment that briefly valued the company at the $2 trillion long dreamed of by Saudi Arabia’s de facto ruler, Crown Prince Mohammed bin Salman.

Oil prices briefly plunged by up to 30% Monday, on track for their biggest daily drop since the 1991 Gulf War, at the prospect of sharply increased supply at a time when demand is slumping because of the global coronavirus outbreak. Shares in oil majors also slid, with Royal Dutch Shell down 14% and BP falling 21%.

After failing to drive through deeper production cuts this weekend, Saudi Arabia, the world’s biggest oil exporter, has embarked on a completely contrary policy, cutting its official selling price for April and pledging to boost production, moves that all but guarantee a brutal price war.

While some analysts think the Saudi move may be a tactic to coax Russia back to the negotiating table, others believe it is aimed at driving U.S. shale producers, who have transformed the oil market in recent years, out of business. It’s tried something similar in the past, but this time it has Aramco shareholders who are likely to get caught with an under-water stake.

$2.80 a barrel

As the world’s lowest cost producer (it costs Aramco just $2.80 to extract each barrel of oil) and with plenty of output in reserve, Saudi Arabia is well placed to emerge a winner in any battle for market share. However, a previous attempt by OPEC a few years ago to put U.S. shale producers out of business failed as the U.S. industry cut production costs and it is a more resilient competitor now.

“We’re calling this ‘Shale War 2’. 2015-2016 was the first shale war which lasted for 2 years, and which was ultimately unsuccessful. Whether OPEC has stumbled into this or whether it was by grand design, I don’t think we really know,” Neil Beveridge, senior oil analyst with Bernstein in Hong Kong, told Fortune. “We are now back into a war for market share at a time when the global economy is heading into potential recession, which makes it a very toxic combination of events.”

Beveridge says the low prices could trigger a wave of bankruptcies among U.S. shale oil producers. “I think you’re talking significant percentages, 20% plus of companies, going bankrupt as a result of this potentially, depending on how long it lasts.”

While Bob McNally, president of market research firm Rapidan Energy Group, told Bloomberg TV on Monday “we are headed to closer to $3 a barrel than $30”, Beveridge said he believed $30 “is going to be something of a floor for oil prices.”

Analysts at German investment bank Berenberg predicted pain on both sides of the Atlantic, with a sharp drop in rig count and production outlook from U.S. shale companies in the coming months.

“If this is not enough to rebalance the market in the short term, then oil prices could approach cash cost levels to force shut-ins of existing wells to reduce production immediately, and historically that has required oil prices below $30 a barrel (for) Brent. Such a price is not sustainable for a prolonged period, in our view,” they said in a note shared with Fortune.

Ehsan Ul-Haq, lead oil research analyst at data company Refinitiv, said that, while the breakdown between Russia and Saudi Arabia spelled turmoil for sovereign producers, it would bring much needed relief for buyers. Cuts to prices for Saudi Arabia’s main export grade, Arab Light, is “great news for its biggest buyers China, South Korea and India, and some compensation for the economic losses because of coronavirus.”

“We expect producers to mount a short-term race to maximize output to take market share from rivals … With prices falling, profitable extra production comes down to how cheaply you can pump out the product.” With the largest volume of spare supply, Saudi Arabia is in the best position to take advantage of the situation, Ul-Haq says. “Gulf allies the United Arab Emirates and Kuwait can also open up the taps.”

“The consequences could be profound. Expect straitened times for major oil companies already under huge pressure from ESG (environmental, social and governance) investors and the hit on oil demand from coronavirus, for the heavily indebted U.S. shale industry, for budgets and spending across oil-producing nations and a knock-on effect for industries and companies in oil-dependent regions like the Middle East.”

Saudi investors under water

But a prolonged oil price slump would also have painful consequences for Saudi Arabia.

Many Western investors steered clear of the Saudi Aramco IPO in December, believing the company was worth far less than the $1.7 trillion price tag Saudi Arabia placed on it. Saudi authorities encouraged thousands of ordinary Saudis to buy into the offer, and they will now be nursing significant losses. At Monday’s price, the company is valued at around $1.5 trillion, closer to what many Western investment banks believed it was worth before it went public.

“It was an overvalued stock. Maybe this will mean that people recalibrate it,” Beveridge said, although he pointed out that with some stocks falling 30% Monday, a 10% drop was “pretty good today.”

He believes the Saudi Aramco share price could have further to fall. “Our price target for Aramco is still around 25 riyals in the short term, so there is still some ways to go down, I think,” he said.

The Saudi government sold 3.45 billion shares (equal to a 1.725% stake in the company) for 32 riyals each in December’s IPO, raising $29.4 billion.

The oil price plunge has also raised questions about the sustainability of the dividend promised by Aramco, which is one of the main reasons for holding the shares. In its IPO prospectus, Aramco pledged to pay annual dividends of at least $75 billion between 2020 and 2024. If the board decides the dividend should be lower than that during that five-year period, the government would take a hit on the dividend it receives to ensure private shareholders get the full amount.

“You need a $60 oil price to generate the cash flows to cover the $75 billion dividend that they’ve pledged. At current oil prices it raises questions about the financing of that dividend,” Beveridge said.

A hole in revenues

Not only could the Saudi government take a hit by subsidizing the dividend, the low oil price also means it will receive much-reduced royalties from Aramco, punching a hole in its already strained finances.

The slump in Aramco’s stock price is a blow to Saudi prestige as it undermines plans for a second, international IPO aimed at raising funds for Prince Mohammed’s “Vision 2030” programme, a grand plan to modernize the Saudi economy, reduce its reliance on oil and open the way for foreign investment.

Saudi Finance Minister Mohammed Al-Jadaan told Bloomberg TV in January that an international IPO was “still on the cards” although it would not be “any time soon,” and the news agency reported last month that Saudi Aramco was in discussions with Wall Street banks to draw up scenarios for a second listing overseas.

However, Beveridge said he believed that, in the current environment, “it’s just not going to be possible to progress” a second listing.
“We are still a believer that oil demand will continue growing over the next decade and with the under-investment in the industry there will be supply problems leading to higher prices over time, so this year I think it’s challenging but could it happen in the future? I think it’s certainly possible, so I wouldn’t rule it out completely,” he said.