Project arrangers and sponsors in the Middle East are watching one another closely to establish the pricing trends that will govern the market during 2008 in the wake of the credit crunch.

A number of requests for proposals (RFPs) are circulating, but the first quarter is expected to be very quiet, as sponsors and lenders try to hammer out conditions that reflect the new market environment and get those deals held over from last year into the debt market at more realistic margins.

Higher margins on bank debt are inevitable, with some bankers suggesting an average 20bp to 25bp increase versus deals signed in the buoyant first half of 2007, and an extra 30bp on more challenging transactions. But with crude oil still trading in the $80 to $90 per barrel range, the region is awash with money, and the Middle East remains one of the more attractive destinations for global project lenders, especially with Europe and the United States headed for potential recession.

Changing project conditions

"In comparison to financings in the leveraged market, GCC projects have been quite conservatively structured even in the market environment of early 2007, so we don't anticipate any major shift in general terms and conditions because of the credit crunch," says John Dewar, partner in the global project finance group at Milbank Tweed, and most recently advisor to Fujairah Asia Power Company on the $2.8 billion Fujairah F2 IWPP which reached financial close in December.

"Instead, the main focus for lenders as we go into 2008 is to increase margins on bank debt to address their higher cost of funding, the inclusion of flex and a tightening Material Adverse Change (MAC) provisions," Dewar explains. "Prior to last August we saw mandates being signed without any flex provisions or with watered down MAC provisions, but credit committees at the leading banks are now giving a great deal more attention to mandate letter terms."

"We expect that well structured deals with good quality sponsors will continue to be successfully syndicated in 2008, as the GCC region remains attractive to lenders," he says. "However there will be a big reduction in refinancing activity, because after factoring in the costs of a refi, and the margins on bank debt currently available, the net present value may not make it worthwhile. In addition, many project sponsors will want to use the capacity in the market to do new deals, rather than reduce overall capacity by pushing through large refinancings."

The Fujairah F2 IWPP deal signed in early September 2007, so negotiations between sponsors and bank MLAs largely pre-dated the credit crunch. The MLAs were Calyon, Citigroup and SMBC, who underwrote the $900 million of commercial bank debt, but the deal relied heavily on the support of Japan Bank for International Cooperation (JBIC) with a $1.3 billion direct loan.

It then had to be syndicated in more difficult conditions in December, and 14 banks came in – BoTM, National Australia Bank, Standard Chartered, National Bank of Abu Dhabi, ING, HSBC, Mashreq Bank, Dexia, Caja Madrid, DZ Bank ,BBVA, Sumitomo and Shinkin Central Bank.

Bankers point out that names not traditionally associated with the Middle East, such as syndicate members BBVA, Caja Madrid, DZ Bank and Dexia, have become more of a feature on large projects over then past few years, and that MLAs will be keen to widen the net in 2008 to include more banks.– notably the Spanish banks and some of the German Landesbanks, And given some of the big European banks will be less willing to go into deals that they are not lead arranging, that broadening of the syndication net may o even further

Sponsor pull still strong

Nevertheless, strong relationships with sponsors will mean that some debt syndicates on important deals will still look like a Who's Who of GCC project finance banks. For example, despite fairly tight pricing the recent syndication of the Saudi Al Kayan petrochemical project in Jubail – 35% owned by Saudi Basic Industries Corp (Sabic) and with wide public ownership after the successful Initial Public Offering in 2007 – pulled in very strong bank response.

Underwritten and syndicated by Arab Banking Corporation (ABC), BNP Paribas, Samba Financial Group, ABN Amro and HSBC, the project financing features $1.8 billion of uncovered commercial bank debt, a $1.5 billion ECA covered tranche backed by ECGD, Sace and KEIC, a $500 million direct loan from Kexim, a $1 billion tranche from the Kingdom's Public Investment Fund, and a $530 million tranche from the Saudi Industrial Development Fund. The deal also features a $640 million Islamic facility lead arranged by Al Rajhi.

The 15-year commercial loan has a margin of 50bp over Libor, rising to 75bp. Fees on the commercial tranche are 100bp, and up to 22bp on the ECA backed tranches.
"The margins are clearly more in line with levels seen before the credit crunch rather than today's market, but it has been well taken up, and syndication has gone well in a challenging environment," says John McWall, head of syndications at Arab Banking Corporation. "The commercial tranche has been oversubscribed, with banks expected to be scaled back. Clearly one factor in the success of the deal in syndication is the strong relationships that Sabic has developed over the years with banks."

The new round of projects to be financed will be signed in a very different market environment compared to early and mid-2007, and McWall says that sponsors and bank lenders across the Middle East are negotiating not only new pricing levels, but flexible underwriting arrangements.

"To mitigate syndication risk arranging banks require flex language in mandates, and that is one of the effects that we have seen from the fallout of the subprime crisis," he says. "There has also been an upward repricing of risk, which will become increasingly evident in the first quarter of 2008 for project finance, as new deals start to appear in the marketplace."

Project lenders are taking a much longer term view than, for example, bond market investors, so despite of higher pricing the money is likely to be there for big project sponsors. Late in 2007 Sabic had to scale back a bond offering from $2.7 billion to $1.5 billion, which formed part of the acquisition finance package for GE Plastics. Most of the bonds were sold to GCC region investors. The total acquisition finance package was around $8 billion, and bank debt made up the shortfall from the bond market.

But while international bond market appetite wavers, bank lending to such a huge borrower as Sabic is heavily relationship driven and as long as it is well structured, any project featuring Sabic as a main sponsor should not have too much difficulty raising bank debt.

New deals underway

With the last of last year's big syndications – Fujairah and Al Kayan – out of the way, the market is now focusing on new deals that will give some definite indication on pricing and the appetite of lead arrangers for large underwritings.

Saudi Arabian Mining Co (Maaden) – with 30% joint venture partner Sabic – is looking for around $3 billion of debt for a $4.5 billion phosphate and fertiliser plant. The deal will be an early test for the market. Emirates Aluminium is also currently negotiating final structuring and pricing on a large project loan.

Also being negotiated is the long-running Yemen LNG project, which will give some clue as to pricing and structuring for more difficult transactions. Total, Hunt Oil, Yemen Gas Co, Korea Gas and Hyundai are sponsoring the $5 billion project. Sponsor loans and ECA covered tranches are likely to make up much of the financing, with uncovered commercial bank debt amounting to less than $1 billion.

"I still think there is a lot of liquidity for good projects, and even if you look at the cancelled project refinancing for Qatar Steel it was not a question of debt not being available, but just that they did not want to pay that kind of pricing," comments a banker based in the Gulf.

"However, clearly international and regional banks are now more cautious from an underwriting perspective," he adds. "Banks will prefer to keep their underwriting to under $400 million, since even a big bank may not be able to get internal approval for very large amounts. You may also see some deals which are partly underwritten or on a best-efforts basis, though we may be told that they are underwriting the project."

He notes that Saudi Arabia is the only country where local banks could put in a very substantial amount, maybe 60% of a project up to $1 billion or $1.5 billion, followed by UAE to some extent, with perhaps 40% from UAE banks. But other countries depend very much on international liquidity for large projects.
But with JBIC direct loans and sizeable ECA tranches, uncovered commercial bank debt of $1.5 billion or $2 billion on bigger deals should still be comfortably arranged by a group of four or five MLAs, particularly with the safety net of market flex provisions in place.

Japanese banks are still seen as asset hungry, and can take big pieces of project loans. And the liquidity in Islamic funds across the region means that sizeable $500 million-plus Islamic tranches will still be a feature of many big project financings.

Forget credit crunch – EPC crunch the issue

In fact the biggest challenge may not come from the problems in the European banking sector (and the United States, where one of the hardest hit banks, Citigroup, is far and away the biggest US player in the GCC region), but strained capacity within the global EPC contractors.
There are a number of projects in the pipeline where an EPC contract has not yet been finalised, and some may be delayed because of the rapid rise in construction costs.
"Compared to the increase in EPC costs, a 20bp or 25bp increase in borrowing costs is not going to stop someone from going ahead with a project," says one banker.
This sentiment is echoed by other observers, who feel that with the help of heavy ECA involvement, the problems in global debt markets should not have a severe negative impact on GCC projects moving ahead in 2008. It is spiralling EPC costs that remain the key negative factor in the GCC project market for 2008, and not the credit crunch.