For the first time in many years engineering, procurement and construction (EPC) contractors are in a strong bargaining position in the GCC region and, by extension, the Middle East. Order books are full and many contractors are using their new-found leverage to raise margins – which have long been frozen – and transfer construction risk to project sponsors and lenders.

Major EPC contractors such as Technip of France, and Chiyoda of Japan, both of which are heavily involved in building the Qatargas project, currently have in excess of $4 billion worth of EPC contracts in the GCC region alone, and an $11 billion worldwide backlog.

And other players such as JGC Corporation of Japan, Snamprogetti of Italy, and Halliburton and Bechtel of the United States also have multi-billion dollar flows of business, along with a raft of other EPCs from South Korea, Spain, and local firms in the Gulf region.

Reviewing the first nine months of 2005, Technip CEO Daniel Valot noted that "operating income and earnings per share continue to outpace revenues," and that "the growth in Technip's backlog should lead to a very significant increases in the group's revenues and earnings in 2006 and 2007."

And in its most recent interim results statement, Yokohama-based JGC Corporation pointed to higher net sales through robust new contract volume, coupled with higher gross profits. And like Technip, most of the growth for JGC is coming from the Middle East.

A sellers market

Only two years ago fierce competition was forcing EPCs to make very low Lump Sum Turn Key (LSTK) bids for contracts, often with profit margins down around the 2% level.

Now, "getting lump sum EPC contracts is becoming a lot more difficult," comments one lawyer based in the UAE. "There are often project management agreements on the basis of sub-contracting different bits of the project – and if risk is too great the sponsors are being pressured to step in."

EPCs are demanding flexible cost reimbursement contracts under which any cost increase for equipment hire, raw materials or labour is shared with the project sponsor. And sponsors are having to decide whether, for example, to pay an extra 10% for a lump sum EPC contract, or sign up to these flexible contracts at a lower price.

Some sponsors have the capacity to model the risks, and to avoid delays or overruns by efficiently managing the project in co-operation with the EPC, and can thus go the flexible contract route. But it is an option not open to all in what is a relatively new project market.

Furthermore, in the current environment, the risk of inflation leading to cost overruns is actually increasing There are raw material supply bottlenecks appearing, while labour costs are on the increase, particularly at the top end for experienced project managers.

The situation is adding an extra layer of complexity for project lenders. Banks were happy with LSTK bids from well known and well capitalised international EPC contractors, which would be hit with penalties for delays and absorb any cost overruns. It was up to the EPC to take a three-year view and do their own cost modeling.

Reassessing project risk

Now the banks must address project cost risk in a different way. Some lenders are turning to project sponsors for guarantees or standby equity or letters of credit that can be activated if rising project costs push debt-to-equity ratios to dangerous levels.

And for oil and gas projects, getting a sponsor guarantee may be the simplest route. High oil and gas prices have left regional and global oil sponsors flush with cash, and increased their creditworthiness. They want to move forward with new projects, and may simply guarantee a loan pre-completion, and agree to put up extra equity if the debt to equity ratios or interest coverage is affected by cost overruns.

But in the booming power, desalination and petrochemical sectors, some sponsors are resisting demands to provide guarantees. Consequently, banks are taking on additional risk pre-completion but asking for higher margins – though often the extra spread does not adequately cover the risk – while other banks are staying away from projects they view as too risky pre-completion and where cost overruns will eat into project cashflows.

Attempts by some banks to enforce pricing discipline do not seem to be working. Fierce competition for GCC lending market share, the new EPC/sponsor risk equation and the race to get projects done has opened a niche for second-tier project banks that is widening into a gap. If traditional lenders will not take on more risk at lower margins, others will.

Whereas 10 years ago GCC sponsors were heavily reliant upon a half dozen big international banks, now there are more international, European and regional banks taking large tickets as mandated lead arrangers, and the growing use of sizeable Islamic tranches has further undermined the ability of a handful of international banks to set pricing in the market.

Too much risk for too little margin?

"As of now there is substantial liquidity, especially since it has become a fashion to get into this market, and in certain transactions extraordinary risks are being assumed by banks that do not have a full appreciation of the risks involved," notes a regional banker.

From the lenders' point of view, banks with very large books of Middle East project debt may be willing to take more risk, because it is spread across a lot of projects. But they are undoubtedly keen to bring some price discipline to a highly liquid market, and have stayed away from some large syndications in order to send a signal to sponsors that relationship banking at cut-throat pricing will not always be available.

"We are asking for standby facilities, whereby if there were to be cost overruns from estimates that we have put in place then there would be provisions such as letters of credit or standby equity that we can immediately call upon," comments one banker with a European institution. "It is better than waiting until there is a problem, and then having all the banks sit down with the sponsors and reevaluate the impact on the project model."

"But it is difficult, because it is not usually possible to ask sponsors for very large amounts, so you may end up with provisions that are around $30 million to $50 million, which on a very large project is not ideal," he says. "They go alongside other instruments such as the performance bond, if the problem is with the EPC. But if it is just the cost of steel, aluminium or whatever, then we are going to have to go to the sponsors."

More contract flexibility

He points to one case where a well-known sponsor has agreed to review its models on new projects. It had traditionally favoured lump sum turnkey bids, but now puts together a number of packages that give it a certain flexibility to award sub-contracts in tranches later on, without being able to come to the banks with a fixed estimate.

"This is a major sponsor so we are happy with that," the banker says. "We can sit down three years down the line, and redo the model, and the sponsor will accept the impact on the model, and if that was to derail the debt equity ratio or some other ratio he would make certain changes. Unfortunately it doesn't mean he will put up another $100 million of equity, but we are nonetheless comfortable."

The problem with such complex financing arrangements is that it opens the door for competing banks to come in with more straightforward but riskier debt at a slightly higher margin.

"There is a lot of liquidity, and banks are getting a bit aggressive on some projects, while in others the sponsors are willing to compensate with margins that are a bit higher," he says. "But, for example, on Qatari projects pricing has already gone to such a low level that if we want to fish for more remuneration then it is still not enough. It is not ideal but it does compensate for certain extra risk that we are taking."

"Because of local liquidity, or relationships with European or Japanese banks, we have been going to a certain floor of pricing in the region, 40bp to 50bp pre-completion, sometimes below," he adds. "It is too low, and certainly not the kind of returns that international banks have been looking for."

"We have seen two or three petrochemicals projects that have had difficulties in attracting the top tier of arranging banks, and we have seen second-tier banks step in on the financing of these projects, and sponsors have been a little bit disappointed."

Sponsors have also been disappointed on the small number of bids on some projects. There is a an EPC shortage, and some sponsors do not think it is worthwhile to implement a contract right now because the EPC contract prices are so high. As a result there are some delays in implementing new projects: For example, a recent project was expecting EPC contractors to come in on an LSTK basis, but after an eight-month tender the bids from the EPC contractors did not meet the sponsors requirements. And another project only received one bid.

Contracting new EPCs

With a shortage of EPCs, contracting a lesser-known contractor would appear to be a solution – but often it isn't. Banks will lend to lesser-known sponsors, as long as they are comfortable with the project cashflows, but they are normally more conservative when it comes to involving themselves with lesser-known EPCs.

In short, the quality and track record of contractors is even more important in an environment where they are no longer offering LSTK contracts. "If a bank decides to take added pre-completion risk, and if they don't have a provision to exactly cap costs, they will only want an EPC they know very well and that has a good track record of being on target with price," says one lender. This puts the big name EPCs in a very strong position and means a quick resolution to rising EPC costs is unlikely.

After many years of being forced by competitive pressure to load their balance sheets with high risk, low margin LSTK contracts, the EPC market is arguably going through a price correction that should have been foreseen by project developers. With the vast volume of new projects getting started in the GCC region – in excess of $500 billion over the next five years – sponsors and bankers are going to have to rethink project costs and risk management if the pace and stability of GCC projects is to be maintained.