With the natural advantage over Asian competition of lower cost feedstock, the Middle East is leading the boom in petrochemicals projects. From a slow start in 2004, deal flows took off in 2005 and are expected to continue until the end of the decade.

"There are now more petrochemical projects coming on to the market than ever before – particularly in the Middle East. You just have to look at the massive level of investment in countries such as Saudi Arabia, Kuwait, Oman and Qatar, all of which are using petrochemicals as a way to monetize their hydrocarbon reserves," says Erol Huseyin, partner in Norton Rose's energy project finance team.

By 2030, the Gulf Cooperation Council (GCC) region is likely to produce the bulk of petrochemicals worldwide. According to Mark Yassin, global head of corporate finance at Arab Bank in Bahrain, "If you compare cash production costs per tonne between the Middle East and Asia, the cost differential for some petrochemical products may well be in the region of $150 to $200 per tonne. These other regions just cannot compete with the producers in the Middle East."

The Middle East has become Asia's key supplier for petrochemicals and demand in Asia is set to equal that of the US and Europe by the end of the decade.

Over the past few years, ethylene has been produced far more competitively in the Middle than in Asia, the prime destination for the region's exports. Naphtha-based ethylene in Asia can cost five times as much as ethane-based ethylene in Saudi Arabia. It is estimated that over the next decade, ethylene capacity in the region will double to some 30 million metric tpy (tonnes per year) while propylene capacity will hit the seven million tpy mark.

Saudi leads the way

The decision to focus on petrochemicals – a policy led by Saudi Arabia – has been part of a longer-term policy designed to reduce dependency on oil-based economies and to diversify into other industries. More importantly, Saudi Arabia has been looking to create thousands of jobs in downstream manufacturing by securing the involvement of the private sector in the diversification process.

"You have to remember that oil is not a particularly high provider of employment," says one Bahrain-based lender. "Whereas petrochemicals is a good example of how to provide a downstream business which sits beyond, say, a polyethylene plant. The Saudis are driving this process and this will add value to the national economy."

With the market developing at such a furious pace, some industry commentators believe that the number of projects coming onstream may not be positive for the industry in the long term. There are concerns that some countries in the region have neglected the natural supply-demand balance of the petrochemical industry, and thus create a glut in production by the time the decade is out.

Furthermore, if Saudi Arabia is to keep to its ambitious schedule of projects then it will need to increase its supply of natural gas: By 2009, Aramco's production is expected to rise from 5 billion cubic feet per day (cfpd) to 7 billion cfpd.

Much of this year's action is likely to be concentrated in Saudi Arabia. The kingdom provides 75% of GCC petrochemical production and 7% of global supply. Saudi petrochems borrowers are expected to tap the market for around $4 billion in debt financing.

The more high-profile deals to come to market recently include the Rabigh Refining & Petrochemical Company (PetroRabigh) project, Eastern Petrochemical Company (Sharq) expansion, Sahara Petrochemical Company's Al-Waha polypropylene scheme, the Saudi International Petrochemical Company (Sipchem) acetyls complex and the propane dehydrogenation (PDH) plant.

The preliminary information memorandum (PIM) is out to banks on the financing of the Yanbu National Petrochemicals Company (YanSab) project in Saudi Arabia. The project is expected to tap the market for around $2.4 million in commercial debt. The UK's Export Credit Guarantee Department (ECGD) will cover $100 million and Italy's Sace $500 million. The Public Investment Fund is providing $1 billion, while international banks are being asked for tickets of at least $250 million and domestic banks $200 million. The tenor is 12 years. Sponsors on the ethylene plant include Saudi Basic Industries (Sabic), Saudi Pharmaceutical Industries & Medical Appliances Corporation (SPIMACO), Saudi Arabian Fertilizer Company (SAFCO), Apicorp and General Organization for Social Insurance (GOSI).

In early March, PetroRabigh closed its $9.8 billion refinery and petrochemicals project in Saudi Arabia. The $5.84 billion debt package – which necessitated the participation of 17 financial institutions – comprises a $2.5 billion loan from JBIC, a $1 billion loan from Saudi state investment vehicle Public Investment Fund of Saudi Arabia (PIF), a $1.7 billion commercial facility and a $600 million Islamic facility.

The initial forecast of $4.3 billion had to be increased due to a rise in EPC costs and inflation in materials, which also necessitated modifying the debt-to-equity ratio to 60:40. Sponsored 50/50 by Saudi Aramco and Sumitomo Chemical, the project will upgrade Saudi Aramco's existing refinery at Rabigh and develop petrochemical production units. Once the project is up and running, Rabigh is expected to rival the complexes at Jubail and Yanbu.

The Eastern Petrochemical Company (Sharq) expansion project in Saudi Arabia has also attracted attention from the funding community. The deal's sponsors are Sabic (50%) and a group of Japanese companies led by Mitsubishi (50%), advised by Bank of Tokyo Mitsubishi. Banks invited to participate on the $1.2 billion commercial debt facility for the $3.6 billion project last month include Arab Bank, Apicorp, Bank of Tokyo Mitsubishi (also financial adviser), Banque Saudi Fransi, BNP Paribas, Calyon, GIB, HSBC, Mizuho, Riyad Bank, Royal Bank of Scotland, Saudi British Bank and SMBC.

The 10-year commercial debt has been priced at a flat 50bp – compared with 35-65bp for the 15-year Rabigh project – even though initial expectations were higher. The commercial tranche may well be scaled back, depending on the level of participation of the Public Investment Fund and confirmation of up to $1.5 billion in the form a JBIC direct loan. Stone & Webster is the contractor for the 1.3 million tpy ethane/propane cracker. The project is slated for completion early in 2008.

Both Rabigh and Sharq have shown that these deals can be successfully structured in Saudi Arabia, and where Saudis lead, others are beginning to follow. Last year, Qatar's minister of energy and industry, Abdullah Bin Hamad al-Ateyah, stated that the emirate would allocate $20 billion to petrochemical projects, around $7 billion of which has already been committed: The balance would be invested in projects that will start by the end of the decade.

Other countries in the region looking to get on the petrochemical bandwagon include Kuwait. Last month, a preliminary information memorandum (PIM) was released to banks for a 14-year $2.9 billion facility for the Equate II project. Societe Generale is acting as financial adviser, and responses were due by the end of the first quarter. Equate Petrochemical Company – a joint venture between Petrochemical Industries Company and Dow Chemical Company – has already tapped the project debt market with its 1996 Equate I financing and subsequent refinancing in 2001, and will have no trouble finding takers in the bank market.

Making the margins

With banks falling over themselves to get in on the project boom, margins have taken a hit. According to one regional expert, the number of potential participants on transactions has gone from 20 to 25 banks a few years ago to 140 to 150 in 2005.

Margins are down to, and expected to continue at, 50bp to 60bp, though funders are hoping for a correction to a longer-term average nearer the 100bp mark. But even with low margins, "If you're looking at a $3 billion to $4 billion deal, $1 billion will be taken out by the local banks and another billion will attract an ECA. So there's really enough there to keep the international banks interested," says an industry expert.

Local bankers, however, are starting to get frustrated at their lack of influence on pricing and structure. As one banker in the region says, "The structures for these deals are now very much the same. All I need to do is look at who the sponsors and financial advisors are, as well as the pricing, and I can sign blindly."

International players are, however, telling another story. "Local banks in the region don't have to apply Basel I and II, so we've seen incredible aggressiveness in the market," says a GCC-based banker. Be that as it may, the current climate is such that some international banks have also become more relaxed in their lending requirements.

Market conditions are very favourable for equity investors "with returns from petrochemical projects in the Middle East being extremely attractive, due largely to high energy prices. Additionally, it is currently a borrowers' market with sponsors being able to obtain impressive financing terms including a relaxation of lenders' requirements in these projects. For instance, we are now seeing projects with reduced or little long-term offtake support and no pricing support. EPC prices and availability are the only real stumbling block at the moment," says John Inglis, head of energy project finance at Norton Rose.

Last year's Qatofin project financing – sponsored by Total Petrochemical (36%), Qapco (63%) and Qatar Petroleum – typifies these new types of deals. The 450,000 tpy linear low density polyethylene plant, based in Messaieed, is the first to raise financing without long-term offtake support for its key production. The $760 million deal was oversubscribed to the tune of $830 million, with 24 lenders finally committing to the commercial debt facility.

Rising EPC costs

Given the current glut of petrochemical projects, engineering, procurement and construction (EPC) contractors are in an enviable position. And since banks tend to be risk averse when dealing with lesser-known EPCs (especially when they are no longer offering LSTK (Lump Sum Turn Key) contracts), the major contractors seem to be calling the shots.

According to Huseyin, "Investment growth is being constrained by pressures on the construction industry, due to the recent glut of these and other energy projects. Prices for steel and concrete have risen considerably over the last few years, and there is a shortage of trained manpower. Some contractors are therefore able to be quite choosy over which projects they tender for."

There is a growing concern among funders that EPCs are driving up prices. "EPC costs are going through the roof. There is a huge pressure to meet building requirements, which means higher pricing structures," says Yassin.

The $940 million Al Waha Petrochemical Company in Saudi is a case in point. It is rumoured that EPC costs on the project went up by 60% to 80%. And these figures are by no means meant to be the exception rather than the rule.

The project is being touted as the first project to be financed solely with 'commercial side Islamic debt'. Sponsored by Sahara Petrochemical Company and Bassell Polyolefins (with HSBC as financial advisor), the polypropylene project comprises a $106 million soft loan, together with a $525 million Islamic financing.