World’s largest oil company needs debt to fund dividends

Debt. It’s like that “rough” close friend you had at school who was great to have in your corner during a fight, but who would ruin your chances of being made a prefect.

Used correctly, debt is incredibly powerful. It can be the difference between success and failure. Used incorrectly, it can also be the difference between success and failure. Companies that use a lot of debt are constantly walking a financial engineering tightrope.

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Why do companies use debt?

Companies harness the power of debt to achieve more efficient shareholder returns. This is known as financial leverage as returns are “leveraged up” by using debt.

There’s a rather important equation that you need to understand even if you’ve never studied accounting:

Assets = Equity + Liabilities

The assets of the company are used to generate cash flows. The way the assets are funded by the company is reflected on the other side of the balance sheet. Assets are either purchased with money from shareholders (equity) or from banks and other debt providers (liabilities).

I’m vastly over-simplifying it of course, but the above principle is key.

The more debt that is used to buy assets, the less equity you need. This allows the same assets to be acquired and cash flows to be generated through using more money from the bank and less from shareholders. Once the bank debt is serviced by those cash flows, the smaller number of shareholders get to share in the pie. Provided that the assets yield a higher return than the cost of the bank debt, shareholders make money and their returns (Return on Equity) were turbocharged through the use of debt.

When shouldn’t you borrow money?

These are some examples of when companies shouldn’t borrow money:

  • When there is a high fixed costs base and high operating leverage (more on that topic here)
  • To pay operating expenses
  • To acquire a risky business
  • When debt levels are already too high
  • To pay dividends

I shouldn’t even need to write down the last point, but this is 2020 and weird things happen. Not only is there a company borrowing money to pay dividends as we speak, but it is one of the most powerful companies in the world.

Before we discuss Saudi Aramco, I want to highlight that financial restructurings do sometimes see companies take on debt and pay out dividends to shareholders. This happens more in the private company space and allows a company to restructure its balance sheet to have a much higher proportion of debt than equity. A restructuring like this is very different to what Saudi Aramco is doing.

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Under pressure

Saudi Aramco still holds the record for the world’s largest Initial Public Offering or IPO (which would’ve been broken by Jack Ma’s Ant Group but that listing was cancelled). It was the first company in the world to achieve a market cap of $2 trillion.

We can all agree that this is a big company. In fact, Aramco is the world’s largest oil company.

The government of Saudi Arabia owns 98.5% which means plebs like you and I can fight over a piece of the remaining 1.5%. The share price is back to where it was around the time of listing in December 2019.

With the oil price under pressure this year and while South Africans have traded Sasol like mad, Aramco has suffered financially just like the rest of the big oil players.

The biggest problem for the company is perhaps also the largest benefit to minority shareholders: the Saudi government depends on dividends from Aramco, not least of all as that country runs a significant budget deficit.

In the third quarter of 2020, Aramco generated free cash flow (cash used to pay shareholders) of $12.4 billion, way down from $20.6 billion in Q3 2019. Because of the pressure from the Saudi government, the company nonetheless declared a dividend of $18.75 billion (same as in 2019).

That means the company is burning through $6.35 billion of saved cash. That’s as financially sensible as finding out you are getting retrenched and immediately going out to buy a fancy car on credit.

Interestingly, Aramco’s total payments to the Saudi government fell 30% to $24.6 billion over that three-month period. In addition to dividends, Aramco pays the government royalties and taxes as well, which are based on financial performance.

But how will the company fund the gap between free cash flow and dividends?

Debt to pay dividends

Aramco is expected to issue around $6bn in bonds. It’s no coincidence I think that this is similar to the gap between free cash flow and the total dividend in Q3 2020.

Last year, Aramco issued bonds in one of the most oversubscribed offers in history. It managed to borrow money at a cheaper rate than the Saudi government itself, which is remarkable.

The vaccine news and general feeling of recovery in the market at the moment will greatly assist with this bond raise.

This is obviously not something that the company can keep doing. It works for a short while because Aramco’s market position is so powerful that a reasonable recovery in oil will quickly see Aramco return to strong profitability. If there is a protracted issue in the oil market though, Aramco (and the Saudi government) could end up in trouble.

I personally don’t believe that’s on the cards. While Aramco is breaking every rule in the book by issuing debt to help it pay dividends to shareholders, this has been a rule-breaking year.

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