The severe phase of the global banking and economic crisis which began last September put many GCC projects on hold, as banks pulled away from their underwriting commitments and informed project sponsors that debt was simply not available.

Meanwhile project developers have been looking at the theoretical cost of long-term debt once the markets re-open. This could be in excess of 200bp for even top quality transactions, which is a level which will crush the Internal Rate of Return (IRR) on their equity investments.

It is a difficult situation for project sponsors to be caught up in, since they have long term ambitions to do business across the GCC region, which is still expected to need hundreds of billions of dollars worth of power, water, LNG, refining and other infrastructure over the next decade.

Fortunately for the sponsors, the various regional governments are themselves committed to the project finance model for much of their power and infrastructure requirements, and instead of holding sponsors to the letter of loss making contracts may themselves want to re-negotiate some sort of solution.

Relationship banking

Preserving relationships is the name of the game at present, since everyone finds themselves in wait and see mode. For example, having signed underwriting commitments in late 2007 and early 2008, the banks found themselves in a position where they could not possibly sell the debt down. But instead of formally calling a Material Adverse Change (MAC) clause many banks have instead opted to quietly talk to project developers and government officials, informally telling them that financings will not proceed.

"The backstop date by which documentation must be put in place is usually twelve months or perhaps nine months after an underwriting commitment is signed, after which, if there is no negotiated financing, the commitment ends," comments one market observer. "The banks could have filibustered and spent months renegotiating until their commitments simply fell away, but since they have long-term relationships they went to the sponsors and said that financings were not going to happen."

This has left project sponsors in the unhappier position of having to talk to government officials and informing them that construction starts are being delayed, and that some projects such as much needed IWPPs might not move forward at all.

"You put in a bid with a certain tariff, and once you have signed the offtake contract you have undertaken to deliver financial close by a certain date, and put up a bond to back that up," comments a lawyer. "Strictly speaking you have a cast iron commitment to the relevant authority, but your tariff is obviously linked to whatever arrangements you put in place with your lenders. I think that some of the GCC authorities are being quite pragmatic about this, and realise that sponsors are facing real problems."

"Most governments are committed to the project finance model that has been so successful in the Middle East, and they may come to the point where they are willing to make adjustments such as lengthen the term of the PWPA, adjust the tariff or do whatever else it takes to make the economics viable for the bidding sponsors," he says. "They want the IWPP model to keep on working, and at the moment are working hard with developers and lenders to fix the chain on the bicycle."

A return to standard procurement?

He notes however that with bank debt unavailable, and with it likely to cost much more whenever the credit markets re-open, some GCC entities may be tempted to temporarily move away from the project finance model. Instead they may do standard procurements with EPC contractors for refining plants or power stations that will be financed on the sovereign balance sheet.

This tendency may be re-inforced by the fact that, just as the cost of bank debt is shooting up (if available at all) the price of commodities such as steel and copper has been falling.

In addition, the large number of projects across the Middle East means that at any one time engineers are finishing up work and looking for their next assignment. With uncertain employment prospects globally, the upward pressure on wages for civil engineers has eased.

The rapidly shifting economic situation is presenting a moving target for EPC contractors, who have been in a very strong negotiating position for much of the past decade.

In such a deflationary environment fixed price EPC bids might be expected to gradually fall over the course of 2009, giving project sponsors an incentive to delay sending out Requests for Proposals. This in turn will put more pressure on contractors, encouraging them to cut margins and put in tighter bids just to keep their cashflows ticking over through the recession.

Recent examples of this trend include the EPC award for the $1.2 billion Karan Offshore project owned by Saudi Aramco, which involves the construction of three offshore gas drilling platforms and 10km of pipeline. The project is expected to be completed by the fourth quarter of 2011.

In February of this year the EPC winner was announced as J Ray McDermott, and it was widely reported that they had reduced their original cost estimate by $100 million in order to beat out the competition.

Certainly Saudi Aramco has made no secret of the fact that it is looking for lower prices from equipment suppliers, after experiencing a few years of inflationary pressures. For example, Aramco has separate joint ventures with both Total and ConocoPhilips for two refineries which will each process 400,000 barrels of oil a day upon completion. The Total joint venture was announced back in May 2006, with an estimated cost of $6 billion, but by last year Total was suggesting $6.7 billion as a more likely price tag.

But that upward trend has now gone into reverse gear. Last November Aramco and ConocoPhillips announced that they had agreed to temporarily delay the bidding process on their export refinery, located at Yanbu Industrial City.

The bidding process had originally called for bids to be put in by the end of December 2008, but the process has been moved to the second quarter of 2009.

"ConocoPhillips remains committed to working with Saudi Aramco to complete the Yanbu Export Refinery Project," ConocoPhillips CEO Jim Mulva said at the time. "We believe that this short delay will allow the markets to adjust from the current uncertainties and provide a stronger basis for the long term success of the refinery."

The Jubail refinery joint venture with Total has also slipped behind schedule, with commercial operations now scheduled for March 2013, though various contracts have been awarded, including the contract to build the basic infrastructure for the construction site.

The delay in the award of big multi-billion dollar EPC contracts will add to the pressure on players such as Hyundai Heavy Industries and Technip, or on power project turbine suppliers such as General Electric, who will be happy to have signed contracts in late 2008 rather than see negotiations run into the far more difficult environment of 2009.

EPCs pressured on price again

The savings to be made from sponsors are likely to be considerable. For example, in October 2008 Hyundai signed a $1.7 billion deal as sole EPC contractor to build an IWPP in Bahrain for a consortium led by Suez Energy International and Gulf Investment Corporation. The offtaker for the Al Dur project is the Electricity and Water Authority EWA of Bahrain.

As usual the contract was awarded on a turnkey basis, including design, supply, construction, commissioning and testing, with handover scheduled for 2011.

Bankers suggest that big EPC contractors may be under pressure to reduce their bids by around 10% from 2008 levels. In the case of a $2 billion IWPP, those savings of around $200m will be very valuable in helping claw back some of the costs of higher bank debt, which is expected to have risen by around 100bp as and when lending actually re-starts.

The financing solution for Al Dur is for the lead arrangers Calyon, Standard Chartered and Mashreq to syndicate a mini-perm. Elsewhere in the GCC region other projects are being temporarily financed on a short term basis with bridge loans, as is the case with a nine month $900 million bridge loan for the Shuweihat 2 IWPP, with ADWEA as offtaker. Pricing on this loan is around the 200bp level.

"Sponsors are trying to reduce EPC costs, and because of the global downturn contractors are looking to win some business and get paid," comments an Emirates based banker. "Project sponsors who do not have deep pockets may have to wait, but sponsors with a lot of financial muscle will be able to go ahead – but will push down EPC prices since they are paying more for debt. It is an extra-ordinary situation where all parties are trying to renegotiate."

So far the biggest single casualty of the global crisis has been the cancellation of the $17.4 billion petrochemicals joint venture between Kuwait and Dow Chemical. The new joint venture was supposed to help them capture a bigger share of the global chemicals market, but the terms of the deal generated a lot of controversy within Kuwait, and the deal was scrapped in the final days of 2008.

Also in December, Rio Tinto Alcan announced that it was pulling out of a $7 billion aluminium project in Saudi Arabia, because of the effects of the weakening global economy. The joint venture was with Saudi Arabian Mining Company, Maaden.

But for most project sponsors the preference will be to push back construction start or try to re-negotiate contract terms rather than have a high profile deal fall through.

"Sponsors need to square the circle of how to put a project in place which needs more equity, and where debt is much more expensive, but which still makes a decent IRR," comments a banker in Dubai. "Some sponsors may be delaying negotiations to get a cheaper EPC contract, but the overriding problem for most projects remains the lack of bank debt. There is a much reduced liquidity pool, and the banks that are still in do not wish to underwrite or go out long on tenor."

"GCC governments will want to push through some important projects with government funding," he says. "But for non-recourse projects it is an incredibly difficult situation, and everything is going to take a long time to put in place."