At the start of the month, in preparation for its first bond offering, Saudi Aramco released a 469-page prospectus that provided the first real public look into the oil company’s books. The media was astounded by the $111 billion profit figure for 2018, and a bond market hungry for returns oversubscribed to the offering by ten times, with $12 billion in bonds finally issued. The initial enthusiasm said more about the state of the bond market than the value of Aramco and is not a good proxy for equity interest in the company ahead of an IPO (now delayed until 2021).

Credit investors are more passive than equity investors, and a hugely profitable stalwart state-backed corporation making its debut on the market at a discount to its own sovereign is attractive to conservative corporate debt traders. Traditional emerging market investors would be more interested in the sovereign debt itself, while equity investors are a different crowd altogether. Those who still anticipate an Aramco IPO on the horizon face some of the broader risk factors associated with the company’s long-term value—like the trajectory of oil demand and the country’s economic future.

Those long-term structural risks are less of a concern to debt buyers, but even they should still be aware of the particularities surrounding debt from a company like Aramco—especially its exposure to oil prices and to capricious tax rate and dividend decisions by a government making big bets with the national budget. The decline of the bond’s value in the days following its issuance implies that the market is coming to terms with those risks on the heels of heady purchasing.

A Good Moment for High Prices

As for the first of those two risks, the prospectus makes clear how exposed the company is to oil prices. 2018 profit figures may have caused a stir, but the numbers from 2016 (when barrel prices averaged $45) showed a company on the edge of profitability. Free cash flow was only $2 billion on $13 billion of net income, versus $86 billion cash flow on $111 billion of net income in 2018. On its face, that may seem to imply a “breakeven” oil price for Aramco of about $40, but that ignores big 2017 changes to the tax regime and compensation for subsidized domestic fuel. The company still pumps oil at record low costs. Even if it keeps less from each barrel than other majors, that’s because the state takes a big cut. Aramco is profitable at prices well below $40, but the national budget breaks even at about $80. Luckily current prices are not too far off that.

High oil prices certainly contributed to the attractiveness of the Aramco bond. Since the end of 2018, the decision by OPEC+ to cut back production has successfully buoyed prices, helped by production constraints on Venezuela, Libya, Nigeria, and Iran. Inventories are falling and the market is tightening, but Saudi officials have indicated that they may extend the cuts (despite the US stand on Iran waivers). A decision will likely be made when they meet with the Russians and other partners at a ministerial meeting on 19 May in Jeddah. Even though high prices will spur ever more US production, they are well timed to put the shine on a slew of Saudi debt offerings this year. That includes Aramco, but also the sovereign debt issuance in January, and direct borrowing by the Public Investment Fund (PIF, the Saudi sovereign wealth fund) itself.

Sprucing up its image at auction has been a guiding theme of Saudi oil policy for the last few years. After embarking on a market share strategy to battle shale (and to send a message to OPEC colleagues), Riyadh changed course in late 2016 when it coordinated production cuts with Russia and other non-OPEC partners. This renewed enthusiasm for market management stemmed from a new national development strategy—leveraging near-term Saudi assets to facilitate massive investments and orchestrate an economic transition away from oil. Major Saudi assets are all linked to its greatest one under the sand, so the price of oil is crucial for making the books look good while the market sizes up what the Kingdom has and where it is likely to go.

That was certainly true during Crown Prince Mohammad bin Salman’s 2018 tour through the US to drum up investment, and also in the run-up to an anticipated Saudi Aramco IPO. Aramco’s valuation was always going to be a wider public judgement about the viability of Vision 2030, and driven by oil price expectations. Even with the IPO shelved and the country’s image battered by the Khashoggi affair, Saudi Arabia is still working hard to attract interest in its financial markets and boost foreign direct investment (FDI). Showing that the Kingdom is willing to be an active steward of the oil market improves the value of Saudi assets.

But as a steward, Saudi Arabia will need to be responsible as well as active. The calculation seems to be that since US production will grow anyway, it is best to seize the moment and maximize available liquidity to the Saudi state for investment. Plus, Trump’s tweets urging lower prices have been falling on deaf ears since November, when his administration surprised Riyadh by granting unexpected waivers for Iran oil export sanctions. Saudi production had ramped up in advance and the price tanked on the news, so it’s no wonder the Kingdom is less inclined to cooperate over Venezuela sanctions and Iran waiver renewals (the Trump Administration has said that it will not grant any next month). But a tight market this year will be susceptible to price shocks, and consolidation in US shale indicates a more stable production elasticity as long as prices don’t spike for a sustained period. It would behoove Saudi Arabia to pump more and at least meet OPEC targets, while billing it as a favor to Washington in the process.

Aramco and the State

The increasingly active nature of the Saudi state also poses unique risks for Aramco and the value of its debt. Aramco’s relationship to the state is hugely important, given the new style of governance in Riyadh and the country’s ambitious efforts to transform its economy. As the sole shareholder, the government has always had a key presence, but over the decades the royal family kept a wise distance from the company’s operations and allowed it to perform impressively compared to its regional counterparts. Recently, that distance has been closing.

In 2015, a new Supreme Council chaired by the crown prince was set up to oversee the company, and Aramco was distanced from the technocratic oil ministry. In early 2016, the crown prince’s decision to take the company public caught many senior executives off guard. Preparations for the IPO were diligently pursued at break-neck speed, but, even within the company, analysts could not arrive at a valuation near the crown prince’s declared $2 trillion figure. In 2017, the state lowered the tax rate from 85 percent to 50 percent and boosted dividend payments, as well as improved transparency by formalizing the company’s legal structure. When the IPO was shelved in 2018, Aramco was pressured to buy Saudi petrochemical major SABIC from the PIF to pump liquidity into the sovereign wealth fund (the deal was finalized in early 2019). The PIF, where assets and power have been centralized, is directly controlled by the crown prince and acts as the primary financial vehicle for his Vision 2030 investments. The Aramco bond offering, which is meant to help fund that acquisition, is really a way for the PIF to tap international capital markets through the back door.

By linking Saudi Aramco’s revenue, debt, and equity standing directly to the national transformation program, it raises questions about domestic policy stability during a moment of huge transition. Overhauling the system of Aramco tax, dividends, and royalties that fund the state—while clarifying the system of subsidized domestic fuel provision—was critical to gaining market confidence. But if the transition bet fails to deliver returns that compensate for all the spending, or if oil prices fall off thanks to new production or weakened demand, “a shortfall in funding to the Government…may lead the Government to change the fiscal regime.”

The problem with autocracy is that reforms can be changed just as quickly as they are implemented, and there is no guarantee that transparent fiscal governance or prevailing rates would survive a national budgetary crisis or a crown prince looking to defend his legitimacy.

Equity investors would probably demand further assurances ahead of an IPO, as well as more clarity about the company’s legal recourse toward the government. Saudi officials insist even in private that the IPO will go ahead, but for now the Kingdom still has a great deal of cheap borrowing open to it. At about 3.75 percent, Aramco borrowing rates are only slightly lower than the Kingdom’s, but well below the 4-6 percent dividend rates that equity investors demand of similar oil majors.

Even if bonds yield cheaper cash, an IPO will still be a big step toward greater confidence in the steady governance of both Aramco and the country. A lot could happen in the oil market by 2021, including more clarity about the oil demand curve and about the myriad political uncertainties marking 2019. It will also be clearer whether Vision 2030 investments and reform are bearing fruit. Both will be critical to valuing Aramco, and by proxy, the crown prince’s agenda.

Phillip Cornell is a senior fellow with the Atlantic Council’s Global Energy Center.