Finally it is happening. Talk about potential private involvement in Saudi Arabia's energy and industrial sectors is now being put into practice. And, given the sheer enormity of its demand, the Kingdom is well placed to become the focus of regional project finance activity in the coming years ? if, that is, it continues to follow the private prescription.

Underpinning the private push is an extensive economic reform package, which spells out in fiscally prudent detail the government's tactics to tease it away from over-dependence on oil, through economic liberalization and private sector efficiencies. Certain key targets are highlighted ? among them is the recently formalized (and much applauded) gas initiative, as well as the overhaul of the telecommunications sector, for which a regulator has been secured. Also to be announced soon are the reform of capital market, companies, tax and insurance frameworks.

Says one foreign businessman familiar with the kingdom, ?the vigor and vision of the crown prince's initiatives is very apparent. There's an encouraging sense of urgency in Saudi ? it's real.?

First IPP

But key to the industrial and gas initiatives is power. And this year the power sector has embraced the private sector with the Kingdom's first independent power project (IPP) for Saudi Petrochemical Company (Sadaf). Sadaf, a pioneer on the Saudi petrochemical scene, is set to sign an energy conversion agreement with CMS Energy for the $120 million project, thus heralding a new way to do power projects in the country ? more cheaply and efficiently.

Sadaf, a 50/50 joint venture between Saudi Basic Industries Corporation (Sabic) and Shell Chemicals Arabia, is one of the largest electricity consumers in the Kingdom.

CMS, together with local AH AL Zamil Group, picked up the developer mandate in April, fending off competitor Enron after intense negotiations. At 242MW, the proposed plant is relatively small. But its smooth implementation will provide the most concrete and compelling argument yet for private power ? it is expected to cut Sadaf's bills by up to 40%.

But this is no regular IPP ? it is being done on an energy conversion agreement basis (as opposed to a traditional power purchase agreement), whereby Sadaf will provide the plant's fuel while also offtaking the entire power output under the 20 year agreement. The plant will also produce 510 t/h of steam, to be supplied by CMS for use at the company's styrene complex.

The captive plant, given its specifications, is therefore unlikely to serve as a template for future private projects on the domestic generation network. Instead, it is more likely to act as a model for other captive industrial power projects. Given the Kingdom's industrial expansion drive, there is no shortage of candidates for similar developments. And other major industrial players are eagerly eyeing the project's development. Among them are Saudi Iron & Steel Company (Hadeed), which is looking at a possible 1000MW plant, and Jubail & Yanbu Power & Water Utilities Company (Marafiq), also in dire need of surplus power. And with the gas kingdom's vast gas initiatives swinging into place, captive power project financing Sadaf-style will become ever more applicable.

But regardless of the model's specific applications, simply demonstrating the cost-effectiveness and viability of a private power scheme is certain to buoy up investor confidence, which had ebbed for some time due to lack of perceived commitment to private sector input.

CMS will look to raise the bulk of funding through commercial debt. Industrial Bank of Japan is advising the consortium. At present, debt requirements vary depending on Sadaf's final generation requirements (the company is considering a third turbine to increase generation capacity to 350MW). The final debt package, also to be arranged by IBJ, may total up to $200 million, and is likely to be in place by the end of the year.

IPPs for SEC?

But so far Sadaf is an isolated case of private power. As pressing is whether the Saudi Electricity Company (SEC) will harness the powers of private development for the Kingdom's immense domestic generation needs ? it needs to build some 50,000MW of new capacity until 2023 to keep up with burgeoning demand.

Any way it is sliced, the problem is daunting. Even more so considering that the Saudi Arabian Monetary Authority (SAMA) is apparently unwilling to extend guarantees for IPPs ? a fact which may have to change if willing private cash is to be secured swiftly. ?The government's ability to provide adequate guarantees is crucial. But with the government recoiling, as it is, from contingent liabilities, I'm not sure how keen developers will be,? queries a foreign power sponsor. Of course, the lack of such government support will be factored into the terms offered by the banking market.

But nonetheless SEC, following the regional cue, has begun power sector reform in earnest with the appointment of international consultants: White & Case (legal), Arthur D Little (Technical) and Gulf Investment Corporation (financial). The more extensive restructuring of the electricity sector is still pending the appointment of an independent power regulator, after which point a more thorough examination of IPP introduction will be possible ? the regulator will supply the framework for the liberalization of the sector and SEC's ultimate privatization. The appointment will take place after the summer. In the meanwhile, the Industry & Electricity Ministry is acting on behalf of the regulator.

The SEC's relatively modest budget for 2001, at $497 million, suggests, according to some, that private power will be pursued. But if SEC does go down the IPP route, financing requirements will be massive.

Given the absence of sovereign guarantees, the development of IPPs and IWPPs is likely to be driven largely by the success of tariff reforms and their support of SEC's profitability and its cash flow position.

Says one Dubai based foreign power developer, ?Saudi is making steps to increase tariffs. But with political pressure, they decrease tariffs again. The question is how serious the government is about removing the subsidy and ensuring that the price is profitable. Backtracking by the government does not leave the investor community confident.? This, of course, is not to belittle the government's effort ? clearly such reform is politically charged and takes time.

There are other alternatives. Sponsors and lenders could also develop credit enhancement mechanisms to appropriately support SEC's payment obligations. The development of the right support structures, explains one Riyadh based banker, will be imperative for future projects.

Earlier this year, SEC successfully tapped the market to restructure its existing $500 million international debt. Says one banker close to the deal, ?none of the banks balked at the rescheduling of SEC's debt which suggests they're all very upbeat about the company's position.?

Overall, ?demand is rife but international banks are as yet unable to get a handle on creditworthiness, given the lack of transparency in the current climate,? says one Bahrain based international banker.

?The laws passed to date are insufficient to deal with private infrastructure projects ? a lot of work remains to be done. The principal people taking risks will be foreign parties but the laws are not yet favorable for inward investment. There have been inroads but there is a way to go to improve the position before we'll see substantial limited recourse financings,? explains one Bahrain based international lawyer.

The climate is being enhanced perceptibly with new laws being etched to smooth investment and foreign participation. But one issue that is likely to cause some concern for private power, as well as the more prevalent industrial projects, is security ? the kingdom currently lacks clear enforcement procedures for mortgages.

This issue, at least for the industrial schemes, has, to date, been largely theoretical, given the overarching support by the Saudi Industrial Development Fund (SIDF), on whose security commercial lenders have typically relied. But for private power projects, adequate security packages will have to be developed, perhaps drawing from other regional models, with all the standard elements of project finance security ? escrow accounts, debt service reserve accounts, strong covenants and so on.

Gas and petrochemicals

Perhaps most exemplary of the kingdom's commitment to economic reform is its gas initiative. It involves setting up a privately financed gas system encompassing everything from upstream gas development to downstream petrochemicals and power generation. And it will bring in $25 billion in upfront investment while inspiring other associated projects, employment and further foreign investment over the next two decades.

The initiative, and the momentum with which it has proceeded, has been much vaunted by the international business and financial community ? consortia for three core ventures were announced in May, and financial, legal and technical negotiations are now under way, due to be wrapped up by the beginning of 2002.

For the first core venture, the exploration and development of gas fields in the South Ghawar area, a consortium of ExxonMobil (35%), Royal Dutch/Shell (25%), BP (25%), and Philips Petroleum (25%) have been lined up. Investment will be between $12 billion ? $16 billion. The project also calls for gas transmission, power, water and desalination schemes. More specifically, it includes up to 4,000MW of power generating capacity, with integrated desalination facilities, as well as petrochemical plants.

The second venture calls for exploration in the Red Sea area and the development of Midyan and Bargan fields. A consortium fronted by ExxonMobil (60%), in partnership with Marathon Oil Company (20%) and Occidental Petroleum (20%), was formed. The initiative will require between $5 billion ? $10 billion. The scheme will also require further investment and development in power and desalination projects, as well as related petrochemical projects.

A consortium of Shell (40%), TotalFinaElf (30%) and Conoco (30%) formed for the third core venture ? the exploration of blocks in Rub al-Khali, and the development of gas in the Kidan and Shaybah fields. Again, total investment will be between $5 billion ? $10 billion. As with the other two schemes, power, water and petrochemical facilities will be part of the package.

Preparatory agreements have been signed with the lead developers of each consortium. The teams are working to tight deadlines, with six months left before the implementation stage.

Saudi Arabia has also made bold advances in developing its petrochemical industry. Over the last two decades, Saudi Basic Industries Corporation (SABIC), majority owned by the government, has been at the forefront of this drive, propelling itself, with a 35 million t/y capacity, to the top ranks of global petrochemical producers. It has several more projects in the making, including the new Jubail United Petrochemical Company complex, for which four separate projects with foreign private partnerships, will be carried out.

In addition, the gas initiatives undoubtedly will have a stirring effect on the domestic petrochemical industry and the private opportunities therein, particularly given SABIC's ever evolving relationship with the private sector.

With such a glut of opportunity, then, privately sponsored projects will be biting into the international debt markets. And project financing will have to grow up ? fast.

To date, the Saudi project finance market has seen scant international bank activity. Most attribute this to the low pricing achieved by highly liquid and domestically focussed local banks on many industrial deals (most SABIC corporate transactions). The forthcoming transactions (gas, industrial and, possibly, power) finally will open up much anticipated terrain to hungrily vying international banks.