The success of the UAE's Shuweihat power deal in 2001, followed in 2003 by the UAE's Umm Al Nar water desalination and power upgrade, and (Alba) Aluminium Bahrain's expansion for its fifth potline, established a precedent for Islamic finance tranches to fit alongside conventional debt, commodities-backed debt and ECAs in large projects.

But Islamic tranches have not become the major funding source in multi-sourced financing that some predicted. For example, Qatar's RasGas 3 project, which closed in August, is being funded by conventional bonds and bank debt.

Despite the massive dealflow in the Middle East, around $20 billion expected this year and the same volume in 2006, and the tidal wave of oil dollars needing investment havens, there seems to be a measure of caution among policy makers and sponsors in not wanting to go too far too fast with Islamic finance. The authorities are keen to promote regional and local banks and Shariah compliance, but they are wary of over-stretching local bank capacity and losing their natural advantage to international banks with Islamic departments.

Tenors, pricing and innovation

With more innovative instruments used in recent Islamic project deals, the sector has proven that it can fit Islamic tranches alongside conventional bank debt with the same 15-year tenors and effectively the same pricing.

However, some bankers worry that there may still be a mismatch in the pricing, especially over longer tenors, if Islamic banks have to source funds at normal bank rates. There have been no Islamic deals of more than 15 years so far, and conventional bankers doubt Islamic banks could cope with 20-year tenors or more.
Some local bankers predict that Islamic finance will help make pricing tighter on conventional debt in the long term. But pricing is tight anyway because of hot competition for conventional debt, and that competition is increasing.

The classic Islamic project deal, Ijara, consists of an asset purchase by the bank and lease to the sponsor. Advance leases, Istisna'a, are issued for greenfield projects, but pricing and intercreditor issues can arise in the event of problems, such as delays or cancellation. Umm Al Nar, where the assets already existed, was an Ijara financing. Shuweihat, a new project, was a three-year bridge finance. Many bankers still consider Islamic finance is best suited to bridge financing, although some warn of a problem of outtake with so many very large schemes in the market.

The Dolphin Gas Project, which involves gas extraction and processing in Qatar and the construction of a pipeline to the UAE, secured $1 billion in Ijara and Istisna'a bridge financing for four years in July. The Islamic mandated lead arrangers (MLAs) are ABN Amro, BNP Paribas, Citibank, Dubai Islamic Bank, and Gulf International Bank. The deal fits alongside $2.45 billion of conventional debt and is the largest ever Islamic facility for a structured oil and gas financing in the region.

Faster and more flexible

Murabaha, or commodity purchases, often on preferential terms, for Islamic banks to sell at market rates to raise project finance, have featured more strongly in recent deals and offer a greater amount of flexibility. They can be put together fast, unlike Ijara.

The $2.35 billion Emirates Telecommunications Corporation (Etisalat) murabaha financing of the Saudi Arabian GSM licence in 2004 proved that Islamic finance could match the speed required to win a mobile telephony deal. Despite the extra documentation involved for Islamic finance, the time lines were met within conventional finance benchmark costs in legal and financial advice. This was a pure Islamic package and sources close to the deal predict more pure Islamic deals, especially in Saudi Arabia.

Etisalat is back in the market now in consortium with Dubai Islamic Bank to raise $2.114 billion to finance its purchase of a 26% stake in Pakistan Telecommunications Co. Ltd. (PTCL). HSBC Amanah is adviser. The seven MLAs are Barclays Capital, Citigroup, Deutsche Bank, National Bank of Abu Dhabi, National Bank of Dubai, Calyon and HSBC Amanah. HSBC Amanah structured the bridge facility as a share murabaha using the underlying shares of PCTL for the trade transactions to purchase the equity.

Solid state

Commodity arrangements underlie the financing of many of the major Middle East projects.
The tight pricing which drove some international banks out of the market remains, but the banks have returned to take advantage of commodity safeguards against risk, including long-term vertically integrated supply contracts, in hydrocarbons and petrochemicals projects.

With conventional and Islamic finance dovetailed together in a large deal, the conventional debt benefits from some of the conditions set for Islamic finance. When the project sponsor is an oil company and the commodity offered at concessional rates as a result of government policy is oil, as in Bahrain Petroleum Company's $1 billion financing for the upgrade to its Sitra refinery in 2004, the deal has the added advantage of being effectively sovereign-backed.

The commodity aspect of the $4.5 billion financing for Qatargas 2, put together in 2004 by Royal Bank of Scotland for Qatar Petroleum and Exxon Mobil's gas production and LNG facilities in Qatar and LNG terminal South Wales, hinged on future UK gas prices and global gas spot prices over 15 and 25 years.

Despite tight pricing, the solidity of the sponsors and the integrated supply chain made the deal attractive to 36 banks as mandated lead arrangers (MLA) for the 15-year $3.6 billion commercial debt and six MLAs for the 15-year $530 million Islamic tranche on the upstream part of the project, and 12 MLAs for the 25-year $420 million commercial debt for the downstream section.

The $2.9 billion financing for Qatargas 3, a joint venture between Qatar Petroleum and US firm Conoco to build the 6th LNG liquefaction train at Qatar Liquefied Natural Gas, is likely to have a similar structure to that of Qatargas 2, with a mix of 15-year commercial debt, Islamic finance and export credit agency loans. Closure is expected in early 2006. The financial adviser is France's Societe Generale.

Another major deal due to close towards the end of 2005 or in early 2006 is the $1.2 billion financing for the construction of the 325,000 tpa Sohar Aluminium smelter and 740-780MW power plant in Oman.

Sohar Aluminium Company (SAC) held preliminary discussions with banks earlier this year for the 15-year commercial debt and Islamic tranche. This is the first time Islamic finance has been sought for an Omani project and UAE banks are expected to take the lead. Citigroup is adviser to the sponsors. Oman Oil Company (OOC), which has a 40% shareholding in the project, is providing a pre-completion guarantee. Abu Dhabi Water & Electricity Authority (ADWEA) also has 40%, and the remaining 20% is held by Alcan, which will supply all the alumina and buy all of the metal produced by the smelter at a variable price based on London Metal Exchange values.

SAC could probably have sourced financing through commercial bank debt without an Islamic tranche. But the presence of ADWEA among the sponsors offered experience of Islamic project financing, notably for the Shuweihat and Umm Al Nar water and power projects, to Oman's first outing in this arena. It makes sense to diversify financing options for large projects, especially as most Arabian Gulf countries have major investment programmes to fund.

Although there are no Islamic banks in Oman at present, bankers there are not concerned that they will be squeezed out. "It is a market worth looking at," says one, "but it involves more work. If we need to find the expertise, we will be able to do so without any problem."

Sukuks and secondary markets

When the Islamic Development Bank (IDB) launched the first sukuk (Islamic bond) in 2001, it was aiming to deepen the market for Islamic finance. Corporate and sovereign sukuks, most with five-year tenors, have been raised as a means of financing major projects. They have been well received, are traded on stock markets around the world and are included in portfolios for general investment. Non-Islamic issuers of sukuk include the World Bank, Asian Development Bank, Nestle and the Government of Saxony-Anhalt in Germany. Sukuks worth $30 billion had been issued by the end of 2004. A further $20 billion reached the market by August this year, according to some reports.

There are various forms of sukuk, including bonds that convert to shares at a given trigger price and asset-backed bonds. An example of the latter is the five-year $134 million Istisna'a-Ijara sukuk, which closed in July, for the first phase construction of the Bahrain Financial Harbour, a $1.3 billion complex offering a new financial centre, business and leisure premises. The bond was structured by Bahrain-based Liquidity Management Center, with Gulf Finance House, Commercial Bank (Bahrain) and LMC as senior underwriters, and Islamic Development Bank, Dubai Islamic Bank, Emirates Islamic Bank and Bahrain Islamic Bank among the lead underwriters.

The UAE's Department of Civil Aviation launched a $1 billion sukuk in 2004 to part-finance the expansion of Dubai International Airport. Sukuks are also being considered for the Jebel Ali Airport and Dubai Light Rail schemes.

Dow Jones is planning to launch the first global index in sukuks, the company announced this summer. This should help define secondary market pricing of the bonds. New money markets in the Middle East, the International Islamic Financial Market (IIFM) in Bahrain and the Dubai International Financial Exchange will give impetus to trading in sukuks and Islamic stocks and the development of Shariah-compliant instruments.
Dow Jones and FTSE both have indices for Shariah-compliant stocks tailored for Islamic investors but which mostly feature non-Muslim companies. Singapore will launch a similar stock index, the Lion 30 this November. The Parsoli Islamic Equity Index was launched in Ahmedabad, India in February to give Gujarat's Muslims an alternative to property investment, the main vehicle for individual investors.

Taking the idea of Shariah-compliant non-Islamic investments a stage further is American hedge fund manager Eric Meyer and his company Shariah Funds Inc's proposed "fund of funds". Speculation is forbidden under the Shariah. Meyer and other financiers, in consultation with Islamic scholars, have been trying to devise methods to present high-yielding funds in a non-speculative way for some years. Shariah Funds Inc plans to launch equity- and real estate-based funds this month.

Some Gulf bankers reckon that there will be Islamic hedge funds in the future, but for the moment Islamic scholars are not keen.

Size matters

The number of regional and local Islamic banks and conventional banks with Islamic windows is increasing rapidly, attracted by the awesome profit growth of some of the key players. For example, Dubai Islamic Bank saw profits rise by 97% in 2004 on the back of a real estate boom, while those of Abu Dhabi Islamic Bank grew by a highly respectable 22% partly on account of strong oil prices.

But building capacity among local banks is a concern. One Emirates project banker points out: "$100 million is a significant amount for Islamic banks." Conventional banks are regularly asked to commit to tickets of this size on commercial debt for large projects. And when local Islamic banks are stretched, the international banks, with their broad base, use their Islamic windows to sweep up the business, as some recent MLA line-ups show.