After two years of unprecedented growth the Middle East has, for the first time, emerged as the world's biggest project finance market. In the first nine months of 2006 nearly $40 billion of project debt was raised for developments in the Middle East & Africa (the majority for the Middle East), compared to $32 billion in Western Europe and $29 billion in North America.

The project finance debt raised in the Middle East in 2006 will equate to over 5% of the region's GDP compared to less than 0.25% in Western Europe. The sheer scale of the market begs a number of questions, the most significant being can this activity be sustained?

Whilst the volume of project finance transactions has risen in 2006, the size of the projects has played a bigger role in pushing up the amount of debt raised. In 2005, there were almost 50 project finance transactions in the region with an average debt size of $0.9 billion. In 2006 (to date) there have been around 30 transactions but with an average debt raised of $1.4 billion.

The reasons for the rising project sizes are twofold. Firstly, the physical scale of projects has risen as developers seek to capture economies of scale to compensate for higher capital costs. In addition, the projects are sized according to an end user requirement, for example in the power sector where government led programmes require large scale plant build to meet rapidly rising demand resulting from rising populations.

Secondly, the investment cost of new projects has risen extremely quickly as the costs of construction materials and labour rise – exactly what should be expected when a shortage of supply meets rapidly rising demand. A particular problem for many developers is that for the largest projects there are few contractors able to take on the financial risks associated with those projects. But even further down the food chain, the sub-contractors to the lead contractors, the companies supplying equipment or constructing the civils work associated with the major projects, are stretched to capacity and either unable to take on further work or accepting contracts only on highly inflated term. Furthermore, the contractors working on many of the industrial projects in the region are equally busy meeting the demand from the extremely active commercial and residential real estate sector.

The oil, gas and petrochemical (OGP) sectors have led the way in terms of growth with major projects raising debt in Kuwait, Oman, Qatar, and Saudi Arabia. Although power and water projects have continued to develop at a relatively steady pace, there has been little overall growth in the sector despite increased activity in Qatar and Saudi Arabia. Outside of these sectors, there has been very little activity this year, notably in the metals sector which has in previous years been a regular contributor to demand for financing. Infrastructure remains a very limited market also although there are some signs of change in this sector.

Saudi project market emerges

Geographically, activity has been widespread with major projects in almost every country in the Middle East. But one of the major themes, and one set to continue, is that Saudi Arabia has emerged as a very important project finance market.

Riding a wave of new projects over the past few years, Saudi Arabia has undergone a metamorphosis in its financing marketplace – from what was largely the exclusive domain of the domestic and select regional banks, to one of the most important project finance markets globally with a reputation for high-profile big-ticket transactions, attracting many of the leading global financiers.

Saudi Arabia has dominated the Middle East project financing market in 2006, attracting in excess of $20 billion (or approximately 55% of the total Middle East & Africa market) in commercial funding from GCC banks, and to a considerably greater extent, a broad base of international banks and Export Credit Agencies (ECAs).

The significant increase in liquidity from international banks, supported by the increasingly important ECA cover and support (whether as direct lenders or insurers) has had a commensurate effect of reducing margins to those more in line with other similar GCC projects, almost eliminating the premium previously paid by Saudi based projects.

Numerous significant precedents were set throughout the year for both public and private sector transactions, kicked-off with the signing of the $2.5 billion Shuaibah III IWPP in January. In addition to being the largest ever project financed oil-fired IWPP, it set the basis for the upcoming Shuquaiq and Raz Azzour IWPPs expected later this year and in early 2007. Having established the longest tenors to date for project financing in Saudi Arabia, at 19 years, it is expected that subsequent IWPP transactions will push tenors out again to over 20 years, with aggressive pricing firmly in line with other similarly structured regional transactions.

In petrochemicals, 2005 developments set the stage for an unprecedented year of activity in 2006, starting in March with the signing of the $5.8 billion debt package for the massive $9.9 billion PetroRabigh petrochemical project, the first ever project financing from Saudi Aramco and the world's largest ever petrochemical project financing. Similar to the IWPPs, the project further developed the market by achieving the longest tenor for a petrochemical project in Saudi Arabia to date, at 15 years and suitably aggressive pricing reflecting an Aramco/Sumitomo completion guarantee. SABIC similarly attracted substantial participation in the $5 billion Yansab project, another in the long-line of successful financings that have been the hallmark of SABIC in recent years.

Not to be outdone by the public-sector project financings, the private sector in Saudi Arabia, and in particular petrochemicals, also had a banner year in 2006, setting numerous significant precedents. In June, the eagerly anticipated $2.5 billion Saudi Ethylene and Polyethylene project signed with 6 regional/international banks and 4 ECAs, firmly establishing a number of benchmarks for mega private sector project financings, including; the largest amount of funding ever committed to a private sector GCC transaction (the transaction was almost four times oversubscribed), no completion guarantees, and broad ECA participation alongside government development finance from the SIDF. In September, the $1.0 billion Al-Waha Petrochemical project signed its ground-breaking Islamic financing with 6 regional banks; representing the first ever fully Sharia'h compliant greenfield project financing in the GCC – destined to be the benchmark for more such transactions in the coming years. A number of other key transactions are expected to sign prior to year-end including the complex 3-plant Sipchem Acetyls project, a re-financing of the International Methanol Company project, and the APPC Polypropylene project amongst others.

Qatar, Oman and Kuwait keep up the pace

Elsewhere in the Gulf, Qatar has continued to be a staple of the international project finance market and in keeping with the past, has continued to set benchmarks for the industry. Notable in 2006 has been the continued accessing of the 144a bond market for its projects including the financing of the Nakilat LNG tanker fleet which is on course to become one of the world's largest fleets. LNG has continued to be the dominant sector in Qatar although major IWPP projects such as Messaieed have offered some diversification for project finance lenders to the country. Oman also continues to box above its weight with a steady stream of project finance deals, notably this year with the closing of financing for its $1.5 billion Aromatics Oman project – a deal that only five years ago would have been regarded as large but which now seems quite modest. Further north in Kuwait, another major aromatics project is expected to be financed before year end, following on from the hugely successful debt raising exercise for Greater Equate earlier this year and topping off what will possibly be Kuwait's most active year in the project finance market.

2007: the boom continues?

There are a number of variables that could impact deal flow in 2007-8. The continued pace of investment in the region is likely to keep sustained pressure on the contracting market and our view is that the current high-priced environment is unlikely to abate in the foreseeable future, and certainly not in 2007. Competition with the real estate market for contractors is unlikely to lessen and it is possible that construction costs could continue to increase although we consider it unlikely to meet the recent growth rates.

Furthermore, given the activity in the OGP sector it is important not to forget the impact of product price cycles. Although most analysts agree that the oil price is unlikely to drop below $40 per barrel in the medium term, the outlook for refining margins and petrochemical prices is less certain.

In both refining and petrochemicals, there is considerable new capacity due to come on stream over the years to the end of the decade and it is almost inevitable that in the next two to three years a drop in refining margins and petrochemical prices will be seen. Whilst projects in the petrochemical sector in the region have the in-built protection of a competitive advantage due to low feedstock pricing in the Middle East, operators in the refining sector will be more vulnerable given that there is no fundamental cost advantage to refining in the region. A combination of high investment costs and approaching market weakness could possibly deter some investors from proceeding with some of the announced refining and petrochemical projects.

One question raised by some analysts is whether the higher investment costs negate the Middle East's competitive advantage in feedstock for petrochemical production. Whilst there is certainly a negative effect on competitiveness, new production facilities being built elsewhere in the world are suffering the same investment cost problems and thus the higher investment cost is affecting the entire industry and not simply the Middle East producers.

The situation in the power, water and other infrastructure sectors is likely to be quite different. Investment in these sectors is driven more by government requirements to meet the needs of rapidly growing populations; for power and water in particular, the reality is that high investment costs will not deter continued activity in the sector although it will mean that the cost of power and water production in the Gulf will rise. This rising cost will most likely be absorbed into government spending rather than being passed to the end consumer not least due to the healthy government finances currently being enjoyed by regional economies.

Our conclusion is that the flow of projects over the next two years looks set to continue at a similar level as 2006, although given the long lead times and unpredictable nature of project development schedules it is difficult to be precise on which projects will hit the market in 2008 rather than 2007.

New debt sources

Beyond the difficult investment decisions for developers, the other major challenge will be funding, particularly the mega-projects.

There has been a heavy reliance in this region on bank debt to finance projects. As international lenders' risk perception of the Middle East has improved in recent years, there has been a huge inflow of foreign bank liquidity to the region driven in part by the premium pricing that projects in the region were paying in comparison to similar projects elsewhere in the world, particularly Western Europe. However, the influx of liquidity has had the inevitable effect of reducing pricing such that regional lenders, who have a relatively high cost of funds and limited access to long-term capital, find it increasingly difficult to justify providing debt to projects priced at the tight end of the market. In addition, the low level of pricing reached in the Middle East has shown some signs of deterring some international lenders who can no longer obtain the premium pricing of a year or two ago.

There was hope just a few years ago that the Islamic financing market could become an active provider of liquidity but whilst structured Islamic debt is now widely accepted by conventional banks, the additional liquidity from Islamic institutions has reduced to almost nothing as the Islamic institutions suffer from the same problems as other regional financial institutions, i.e. pricing and asset/liability tenor mismatches. There is no sign that this will change in the near future although efforts are underway to address some of these issues.

For the largest projects, bank lending capacity is not sufficient to meet the debt requirements. Over the last year this has meant that there has been a resurgence in the use of export credit agency financing, through either covered facilities or direct lending – the $2.5 billion JBIC loan to the Petro-Rabigh facility being particularly noteworthy.
This will continue to be an important source of finance for the larger projects but again, with the exception of JBIC, the capacity of ECA financing will in some cases be below that needed to top up conventional bank capacity. In our view, this is likely for projects seeking debt of more than around $4-5 billion although the threshold would be lower for projects without any government ownership.

We believe that the answer to this potential funding gap will come from the capital markets. Qatar has shown the way in executing a well-managed series of 144a issues which have attracted investors from the US as well as Europe and Asia but outside of Qatar, no major project in the region has yet tapped this market. For the larger projects having sponsors with an international profile, we expect this market to be a realistic option in 2007 although as ever, international investor appetite can be fickle and can disappear quickly in the face of a change in sentiment in the market. Regionally, the bond market has yet to develop beyond short-term instruments although issues such as the SABIC sukuk earlier this year give rise to optimism that the regional bond market is beginning to make significant progress. This is important because a key challenge for banks in the Middle East must be addressing the need to divert at least a portion of the regional liquidity that is currently pouring into the equity markets, into the corporate and future project debt markets.

Internal and external risks

Beyond the challenges of investment costs and debt capacity constraints, there remain risks that are more difficult to analyse and predict. An obvious vulnerability that the region has at present is that the debt capacity available for funding all the projects in the region includes a large component provided by international lenders. This is a relatively recent phenomenon and it is open to question just how much of the international bank money would stay in the region if some kind of political or economic shock occurred. The shock could come from inside the region although with buoyant oil prices it is unlikely to be an economic one. Even politically, notwithstanding the uncertainty caused by Iran and Iraq which have to date not affected lending appetite in the wider Middle East, there is no obvious area of new concern to the Middle East's political environment which could cause international investors and lenders to retreat.

Because of that, it is perhaps the potential for external shocks that should be of most concern. For example, after the Russian crisis of 1998 there was a clear retrenchment of international capital which affected global markets including the Middle East where capacity dropped and pricing increased. These external factors are often very difficult to predict but there is some concern that the major economies of the United States and China could experience slowdowns over the next few years, albeit for different reasons. Certainly, a global economic recession, could have an indirect effect of reducing international capital flows on top of the effect of reducing the oil price which would hit the region directly.

Less dramatic but potentially important may be the effect of banks' portfolio management on their appetite for Middle East risk. The unprecedented activity in the project finance market in the region over the last few years means that many banks now have relatively high exposures to the region. It may be that in the near future some banks, particularly the smaller institutions from outside the region, will begin to limit the growth in the balance sheet exposure to countries in the Middle East.

Overall, however, our view of the prospects for the Middle East remains positive. Strong economic growth coupled with well planned government investment strategies for the use of the windfall oil revenues means that much of the infrastructure being established will form the basis of long term future growth even in the absence of 'excess' oil revenues. Economic and political advancement in the region has pushed the Middle East up the agenda of international investors and even a slow down in the current frenetic level of activity should not jeopardise the long-term future of the region as a major source of project finance business. For the project finance banker and developer alike, 2007 holds the prospect of a market which will continue to provide opportunities but that will require innovation if the demands of this market are to be met.