"There is no market at the moment." One banker's statement on the Middle East project finance market, but a view shared by many. The syndication market is closed, and the notion of bank underwriting now exists in an inhospitable legal space between market flex and material adverse change clauses.

The stream of bad news has been continuous as the US sub-prime crisis turned global and most of the developed world grapples with recession and more potential damage from the onset of deflation. The Gulf Cooperation Council (GCC) nations were largely insulated from the initial effects of the credit crunch because of the buffer of high oil prices; however that buffer has been dramatically eroded as prices per barrel have fallen from $147 in July to around $55 a barrel late November.

The regions' equity markets have taken a pounding, with the Saudi exchange – the worst hit – falling 45% in the last 12 months. Kuwait's Gulf Bank, widely regarded as a conservative lender, suffered a run on its shares and had to be bailed out by government, which led to region-wide adoption of government guarantees for depositors.

Immediate outlook

Perhaps the two most significant events likely to shape the near-term course of projects in the region is the resolution of the financing of the Shuweihat 2 IWPP and the details of the 2009 Saudi budget.

The $2.6 billion project financing of the Suez/ADWEA-sponsored Shuweihat 2 IWPP in Abu Dhabi is the highest profile deal in which banks have triggered a material adverse change clause (MAC). Invoking a MAC has allowed the three initial lead arrangers BayernLB, Calyon and Natixis to back out of a 23-year debt facility with a three-year merchant tail – a tenor that was far too long given current credit committee appetite.

Suez and ADWEA are now in the process of putting together a 10-month $900 million corporate bridge to get construction underway and have gone to ADWEA's relationship banks, without any pricing guidelines, to ask for bids with credit committee approval. The sponsors are likely to have to agree to all-in fees of at least 200bp. Five to nine banks are expected to fund the bridge with HSBC, BNP Paribas and Calyon seen as certainties and BayernLB, SMBC, SG and Citi as possibles.

Despite the generous pricing and the potential to have first run at the project financing, some banks were reluctant to consider the credit because they have commitments to other projects in the region which are near to market (for example the Ras Al Zour IWPP, Abu Dhabi wastewater, Abu Dhabi motorway PPP, Al Dur IWPP and Salalah IWPP). Also, the nature of the credit meant that at some banks cross credit-committee approvals from both project and corporate teams were required, a double headache for the sponsors.

Both Suez, in terms of internal rate of return (IRR), and ADWEA, in terms of the tariff it pays (via subsidiary, ADWEC), will need to make concessions. Suez is perhaps in the weakest bargaining position because the contract would have followed a template request for proposals (RFP) and is unlikely to have a clause that would allow it to pass through the MAC to ADWEA.

As Project Finance Magazine went to press the sponsors were in talks with those banks that had outlying bids in an attempt to coax them to lower their margins. According to a source close to the deal, signatures and first drawdown on the bridge loan is scheduled for mid to late December.

It is expected that a long term project financing will be put in place between May and July 2009. The bridge could cost the sponsors up to $30 million, added to the increase in the cost of the long term financing, the total cost in fees and total interest over and above the original deal could total over $300 million.

Oil – where's the floor?

The Middle East project finance market is polarised between elective and non-elective projects. The 2009 Saudi budget will provide a good guide to the priorities of the region. A source close to the government says IWPPs, IPPs, health and education projects are most urgently needed. "We have no option but to go for projects, especially water and power, otherwise we will have a crisis in four or five year's time."

The elective or discretionary projects such as petrochemicals, mining and leisure are likely to suffer most from delays. Both of Aramco's 400,000 barrels a day refineries, at Jubail and Yanbu have already delayed EPC bidding deadlines to benefit from lower capital costs.

While the Gulf begins to adjust to a world with lower oil prices, one benefit for projects from the inflection of commodity prices is lower EPC costs. But it may take some six months or more for deflationary prices to work their way through the large EPC contractors, which just a few months ago were proud owners of bumper order books. Contractors have hailed the robustness of their business models, particularly given many governments around the world have linked fiscal stimulation to spending on infrastructure. For example, Alstom has an order book worth Eu47 billion ($61 billion), equivalent to more than two years of revenue.

However, EPC contractors' order books will begin to shrink as projects are pulled and delayed. Although, contractors can claw some of the returns back through lost deposits and compensation, EPC prices will start to fall quickly as contractors move to cover their huge overheads.

Regionally, key infrastructure projects will benefit from the burst bubble of Dubai's property market as more EPCs move away from real estate. HSBC reported that property prices in October fell 4% in Dubai and 5% in Abu Dhabi. Emirati developers, Emaar, Damac and Omniyat have borne the brunt of the investor no-confidence and are shedding staff.

While sponsors wait for capex costs to come down, the economics of the export projects that are principally reliant on cheap feedtstock and power, their comparative advantage over existing plant elsewhere in the world is not so compelling. Also, project margins are being squeezed as processed products are sold into a declining commodity market.

The Saudi budget for 2008 was based on an oil price of $45. This was a very conservative approach, but looks less so now. Saudi projects slated for 2009 and beyond will depend on where the floor price is set.

Besides the refineries, this means other petrochemicals projects such as the $25 billion Ras Tanura project and the slated bauxite processing plants could be delayed by at least a further 12 months – first to wait for EPC costs to fall and then to wait for the projects ahead of them to work through the limited financing market.

Bridged

While it is clear that the dealflow will slow for all projects, with non-essential projects waiting for the margins to improve and EPC deals to fall, how will future projects get banked? Opinion is divided on the significance of the Shuweihat 2 IWPP, whether it was just an aberration caused by a group of underwriters being too aggressive, or whether it sets a precedent for deals in the market. Together with the S2 IWPP there are five or six deals that could close by the end of January.

A restructuring is the preferred option for the Sumitomo, Malakoff International and Al Jomaih Automotive, $5.5 billion Ras Al Zour IWPP. Lead arrangers RBS, Citi, SMBC, Mizuho and BTM are keen to bring in local banks.

A bridge solution appears possible for the $2.2 billion Al Dur IWPP in Bahrain as Suez received underwriting commitments from Calyon, Mashreqbank and Standard Chartered in mid-August before Lehman Brother's collapse. Similarly poised is the $500 million Veolia-Besix sponsored Adu Dhabi/Al Ain wastewater project. Given that the financing requirement is relatively small at $400 million and there are four arranging banks – Calyon, Natixis, KBC and Mizuho – it may be possible for the lenders to stomach take and hold positions with limited or no syndication.

Of the remaining upcoming projects – Mubadala's Abu Dhabi highway PPP, Salalah IWPP, Yanbu IWPP and Rabigh IPP – the projects have not recieved firm bank commitments, so a future MAC call by banks would be highly unlikley. However, sponsors may take the view that a bridge is necessary to expedite the start of construction without being tied to a long term financing that could be cheaper in four or five month's time.

Back to the future

In terms of long term project financing the market will revert back to the benchmarks of previous projects, possibly nine or 10 years back to the first Taweelah A2 financing in 1999. Funding and risk pricing margins have increased, next will be changes to tenors and structure. Projects will be financed with shorter tenors, below 20-years, with greater refinancing risk placed with the sponsor, such as more cash sweeps around year 7 to encourage a refinancing.

Projects will also look to tap alternative sources of funding to make up the shortfall in international bank liquidity. Both Jubail and Yanbu refineries have sought to secure ECA funding first.

Local bank dollar funding for tenors longer than 10 years is almost impossible in the current market given that the swap market has contracted from offering 12-13 year swaps to five year swaps. The recent strengthening of the dollar (but with the perception of long term weakness), the weakening of the Euro and the likely revaluation of GCC currencies have made banks skittish about accepting any form of long term currency risk.

The option of banking non-export Saudi projects in riyals gained traction in the last three months, but there is now diminished likelihood of multi-billion, purely local bank project financings given that SIBOR, which had dipped below LIBOR, is restored to its historical position of being slightly higher than the international bank benchmark.

PIF and SIDF should play increasingly important roles, as will Islamic banks such as Al Rahji. Greater government support in projects is probable. For instance when times were good, the Saudi authorities made concessions to help EPC contractors for directly procured projects by reimbursing contractors if they were subject to adverse movements in commodity prices, and providing advance payments before completion of between 10 to 30%.

Opinion is again divided about how best to engineer deals. Underwritten deals are a non-starter, but methods of clubbing deals also differ. The RBS arranged Ras Laffan C model seems the most logical next step for IPPs and IWPPs.

RBS argues that the model prevalent in the region of asking to developers to work up competing underwritten bids is an overhang from the emerging markets mentality. Instead, the RBS model allows developers to bid without financing. The project vehicle – normally a joint venture with state-owned entities – is then presented to the whole of the bank market for a club financing, thus avoiding the cost of competing underwritten bids and not dividing an already reduced universe of potential mandated lead arrangers.

Which banks will remain active arrangers in the region and to what extent is still unclear. It is possible that the banks that are part nationalised will find some restrictions on their ability to spread capital away from domestic markets. In this regard RBS's position at the pinnacle of arranging league table looks vulnerable.

All banks, to a lesser or greater degree, are assessing their capital positions on a daily basis, and many are making wholesale revisions of their business strategy and cost base. Even the core capital of the Japanese banks has been severely dented as the slide in the Nikkei has eroded the value of their substantial corporate shareholdings.

Uncertainty abounds on all sides: EPC costs, currency valuation, liquidity, risk perception and bank priorities – the lot. All project finance participants are hoping for a return to stability – albeit along more conservative lending lines.