An estimated $20 billion worth of financing will be needed this year for Middle Eastern projects being planned in the oil & gas, petrochemicals, power and infrastructure sectors. And roughly the same again will be required in 2006, which means that funding requirements in the region have more than doubled since 2003.

Remarkably this increase in demand has thus far been accompanied by extremely tight lending margins on conventional bank debt. But many bankers feel that, going forward, there is going to be a greater need to tap into regional sources of finance, and in particular Islamic leases that run alongside bank loans.

The use of Islamic tranches for project financings in the Gulf has up to now been an optional extra, with many arrangers preferring to avoid the added complexities of combining bank debt with Islamic leases. With conventional bank debt so readily available, many deals have taken a pass on using Islamic tranches.

But that may soon change for many projects. Even a highly favoured country such as Oman, which has attracted so much international bank interest that it has never sourced Islamic tranches on projects, and has often dispensed with the need for ECA cover, is expected to feature Islamic debt in 2005, as part of a long term strategy to ensure that future projects will get financed.

The advantage is a clear one. Anywhere in the world, domestic or regional finance is less prone to sudden shifts in investor sentiment, and so is less likely to be subject to a sudden credit crunch. Including Islamic tranches will help reduce the risk associated with dependence upon international bank lenders- many of whom have temporarily pulled back from the region before, most recently in 2000.

In addition, with oil priced at above $50 per barrel, the Gulf region is currently awash with liquidity, with banks, corporates and retail accounts all looking for places to invest, in both Islamic and conventional asset classes.

Growing demand for Sukuk

Most Islamic finance is done pari passu with bank debt, in the form of Islamic leases. Tenors and pricing are comparable, and over the past few years the various intercreditor issues have been ironed out by bankers and lawyers.

Project bonds are less likely, just as the use of conventional project bonds on the international capital markets is relatively small compared to bank loans. In fact bankers suggest that Islamic bonds, or sukuk, are more likely to take the form of corporate offerings to raise cash for infrastructure, power and petrochemical projects.

There is extremely strong demand for sukuk across the Islamic world. Earlier this year a $600 million sovereign offering from the Government of Pakistan was two times oversubscribed, with the deal led by HSBC and Citigroup. Around half of this was sold in Saudi Arabia and across the Gulf, with Islamic banks, asset managers and state agencies the main buyers.
And with the wave of liquidity in the Middle East, the next 12 months look certain to be a highly attractive market for issuers of sukuk, including for sponsors of infrastructure projects.

Some major sukuk

In 2004 there was a highly successful deal for the Department of Civil Aviation (DCA) in Dubai, which was upsized from an original $700 million to $1 billion. Dubai Islamic Bank was mandated lead manager on the five year deal, while the co-leads included GIB, Citigroup, Kuwait Finance House, HSBC, and Standard Chartered Bank.

The sukuk were compliant with Sharia Law, since the SPV purchased certain assets at Dubai International Airport, and leased them back, creating a flow of lease rental payments.
The record breaking size of the DCA offering illustrates the depth of the sukuk investor base, and the DCA is considering using the Islamic bond route for the financing of the Jebel Ali Airport project.

The Dubai Light Rail project is also seen as a candidate for a sukuk offering. In order to speed up the bidding process the Dubai Municipality announced in January that bidders would not need to include financing packages with their proposals.

The contract is expected to be formally awarded in May to a consortium led by Mitsubishi Corporation, under the name Dubai Rapid Rail Transit (DRRT). Thus far the Dubai Municipality has declined to specify what its financing plans are. Around $1 billion of debt is needed.

By doing some projects on balance sheet, governments in the region will help take the strain off project lenders. But nonetheless, the big international and regional project banks are going to be lending at full capacity over the next few years.

"There is a lot of conventional bank debt available at the moment and, for example, though ADIB led an Islamic facility for the Taweelah A2 IWPP, the recent Taweelah B financing did not feature an Islamic tranche," notes Rauf Ahmed, Head of Structured & Project Finance at Abu Dhabi Islamic Bank.

The growth in general liquidity

"But GCC countries generally see Islamic finance as a good additional source of liquidity, and Islamic tranches will continue to play an important role in project financings," says Ahmed. "There is currently a lot of liquidity around in the Islamic market, especially with some investments coming back from the US, and with the high level of oil prices."

The Taweelah A2 Islamic facility was led by ADIB, along with Dubai Islamic Bank and Kuwait Finance House. Since then ADIB has had a strategic review, and is now focusing more on short and medium term business rather than the very long tenors seen in project financing.
But the general trend across the region is one of project finance departments being strengthened, and there is now often a conventional project finance department alongside an Islamic finance division within the same institution.

The result is that it is now possible to put together experienced groups of lead arrangers on complex projects, which can do both conventional bank debt and Islamic finance. And European houses such as Paribas and HSBC, plus Citigroup from the US, have also built up solid distribution capabilities in Islamic banking.

Multi-sourcing Bapco

This trend was illustrated in the recent deal for Bahrain Petroleum Company (Bapco). The $1.011 billion financing is being used to upgrade the refinery in Sitra. The financing has been under discussion for several years, but was finally signed on 7 February. It was split into one third ECA covered, one third conventional bank debt, and one third Islamic.

During the past three years Bapco evolved from a transaction with an effective sovereign guarantee to a hydrid project, commodity and export structured finance deal. So it was a highly complex structure that was finally signed, featuring two project contracts with the Kingdom of Bahrain which enhance the credit position of Bapco, plus a Japanese ECA facility, a conventional debt facility and an Islamic lease.

The Islamic lease runs for 11.5 years, identical to the term loan facility. The lead arrangers are Kuwait Finance House, Dubai Islamic Bank, BNP Paribas, Gulf International Bank, HSBC, Arab Petroleum Investments Corporation (Apicorp), National Bank of Bahrain, and ABC Islamic Bank.

And the commercial facility shares many of the same lead managers, both regional and European banks. Arab Banking Corporation, BNP Paribas, HSBC, Gulf International Bank, Apicorp and National Bank of Bahrain. Only Mizuho Corporate Bank is not on the Islamic syndicate, since no Japanese bank has as yet attempted to get involved in Islamic banking.

"The Islamic tranche was structured in accordance with Ijara principles utilising a number of Bapco's existing assets," explains Nadim Kahn, senior associate at Norton Rose, which acted for the borrower. "Successful integration of the Islamic tranche into a financing package comprising conventional facilities in itself presented a number of difficulties that we were able to overcome with the assistance of the participating institutions."

"We were required to come up with some innovative structural solutions to a number of key Shari'ah concerns which ensured that the compliance requirements of each participating institution could be satisfied," Kahn says.

Another major deal in 2004 was Qatargas 2, one of the blockbuster project financings in the Gulf, also illustrated the depth of the Islamic market. Qatargas 2 involves new LNG trains, plus terminals and ships. And this deal is a likely blueprint for multi-sourcing, since the sheer size of the financing at $4.5 billion meant that many sources had to be tapped. Qatargas 2 benefited greatly from the high quality of the two project sponsors, Qatar Petroleum and Exxon Mobil, and ECA tranches covered by US Exim and Sace.
Deepening Islamic capability
But the size of the Islamic tranche, at $530 million, showed the depth of the market. This tranche was arranged by Dubai Islamic Bank, Gulf International Bank, HSBC Bank Middle East, Kuwait Finance House, Qatar Islamic Bank, and Qatar National Bank.
"For some projects, the availability of an Islamic finance tranche is an option, but on others it has been a necessity, on the basis that there would have not otherwise been sufficient funding available," comments John Inglis, partner at Norton Rose in London.
"A deal like QatarGas II could probably have been done without an Islamic tranche, but it is being used to broaden the funding base for one of the sponsors, Qatar Petroleum," Inglis says. "QP have a huge volume of transactions in the pipeline, and in a few years time it could be more difficult to fully fund on a conventional basis. So it is a form of insurance for sponsors to get up the curve and learn how to put together a project financing with an Islamic tranche. Broadening the investor base will give them more flexibility going forward."
But some other notable deals in 2004 did not feature any Islamic financing. Taweelah B, the Independent Water and Power Project which involved a consortium led by Marubeni Corp acquiring the plant from Abu Dhabi Water and Electricity Authority (Adwea) and expanding it, did not raise Islamic financing. Instead there were substantial direct loans from JBIC, while there was a strong appetite from international and regional banks for the uncovered bank debt.
And nor did Qalhat LNG use the Islamic option. This was the third LNG train in Oman, owned by the Omani Government together with Oman LNG and Fenosa Gas.

This latest deal from Qalhat LNG, which is already a well established project with LNG trains in place, was relatively small at $648 million. There was no ECA cover needed on the debt, though the project does benefit from a $40 million Letter of Credit. Equity amounting to $76 million was put up by the sponsors, which are the Oman government, Oman LNG and Union Fenosa gas of Spain.

"The use of Islamic tranches in project financings has not become quite as universal as people had initially predicted, and since there is plenty of commercial bank debt available at tight pricing clearly we will not see Islamic tranches on every deal," comments Bimal Desai, partner at Allen & Overy in Dubai, which acted for the borrower on the Qalhat LNG financing.

"But some very large deals which want to diversify their funding will probably want to include an Islamic element," says Desai. "And with so many projects in the pipeline, even countries such as Oman are expected to include Islamic tranches on some upcoming deals, in order to diversify their funding sources."

But in Oman it will be more a matter of choice than necessity. In spite of the very large financing requirements, most projects are still do-able with conventional bank debt.
"We have seen the volume of projects grow a lot over the past two to three years, but I think that at least in the short to medium term the appetite from lenders will still be there," says Rajshekhar Singh, Head of Project Finance at Bank Muscat in Oman.

"There is talk about one of the larger upcoming projects in Oman involving Islamic finance," adds Rajshekhar. "But at the moment it is still too early to say whether the financing structure will finally include an Islamic tranche."

Cash rich governments

In the meantime some projects will simply be financed by governments, which are currently awash in oil Dollars.

For example, the $1 billion wastewater project in Oman is expected to select an international partner by September of this year, and Oman's status as a top credit would have made it a favoured deal for project finance arrangers attaching themselves to bidding consortia.

But in March the government of Oman announced that all the financing will be undertaken by the government of Oman, with Oman Waste Water Services Company (OWSC) simply looking for a joint venture partner.

This combination of governments doing some infrastructure deals on balance sheet, and tapping into conventional bank debt and Islamic leases for big projects, should ensure that the market manages to keep up with the formidable financing requirements over the next few years.