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Saudi Aramco, the state-controlled oil company, looks appealing based on its enormous reserves and high free-cash flow, but it has a royalty arrangement with the Saudi government that could limit the upside potential for investors in a coming initial public offering.

The company is reportedly aiming for a valuation of $1.5 trillion to $2 trillion when it sells a small stake of less than 5% publicly next month and lists its shares on the Saudi Arabian exchange known as the Tadawul.

Saudi Aramco has proved reserves of 226.8 billion barrels of liquids reserves, including crude oil and natural gas liquids (NGLs), according to an offering document released on Sunday ahead of the full prospectus on Nov. 9.

The Saudi reserves greatly exceed that of Exxon Mobil (XOM), the largest investor-owned energy company in the world, which ended 2018 with 24.3 billion barrels of reserves. The Exxon Mobil reserves include natural gas in addition to liquids. Saudi Aramco also has 186 trillion cubic feet of gas reserves.

Saudi Aramco reserve life is 52 years, against 17 years at Exxon Mobil. Its crude reserves are about five times that of the combined oil reserves of the five largest international energy companies.

Saudi Aramco produced 13.6 million barrels of oil equivalent a day last year including 10.3 million barrels of crude. Exxon’s production is around 4 million barrels a day. Saudi Aramco has produced one in eight barrels of the world’s crude output from 2016 and 2018. The Saudi oil giant had net income of $68 billion in the first nine months of 2019 against $8.7 billion for Exxon.

The combined value of Exxon, Chevron (CVX), Royal Dutch Shell (RDS/A), BP (BP) and Total (TOT) is just over $1 trillion.

Saudi Aramco plans to pay a dividend of at least $75 billion in 2020. At a $1.5 trillion market value, the yield would be 5% and at $2 trillion, the yield would be 3.75%. There are 200 billion shares outstanding.

In the first nine months of 2019, the company would have covered a $75 billion annual dividend -- but not by a lot -- given $59 billion of free cash flow.

One intriguing disclosure is the royalty rate levied by the Saudi government. Under an agreement reached by Saudi Aramco and the government, the royalty rate starting in 2020 drops to 15% from 20% when Brent crude prices are below $70 per barrel (they now stand at around $62 a barrel). That is favorable for investors, but the royalty rate rises to 45% from 40% when Brent crude is above $70 a barrel up to $100. And the royalty rate rises to a punitive 80% starting next year from 50% at Brent prices above $100 a barrel.

This means that investors will participate less in any upside in crude prices than holders of Exxon, Chevron and other major energy companies.

This effectively makes Saudi Aramco more utility-like and could hold down the valuation that investors are willing to assign to it.

At $1.5 trillion, Saudi Aramco would be valued at about 17 times the company’s 2019 earnings, based on the net income of $68 billion so far this year. That would be a discount to Chevron and Exxon, and a premium to Royal Dutch Shell.

Investors likely will reward the company for its ultralong reserve life but could penalize it for the royalty arrangement, political risk and governance issues.

Write to Andrew Bary at andrew.bary@barrons.com