In a climate where project finance transactions elsewhere are suffering from the so called "credit squeeze," the refinancing of the US$1.8 billion Jubail Acetyls Complex in Saudi Arabia illustrates the continued buoyancy of big-ticket project financing in the Middle East.

The transaction, which signed at the end of April this year, also addressed another key issue plaguing projects worldwide - massive increases in construction costs.

The sponsors of the project were Saudi International Petrochemical Company (Sipchem), Helm AG and National Power Company. Their advisory team included HSBC, as financial advisors, and Allen & Overy as legal advisors.

Jonathan Robinson, the HSBC director who led the advisory team, called the refinancing "a highly complicated deal executed in record time and one that is bound to set the precedent for other construction phase refinancings in the region."

In this article, Ian Ingram-Johnson and Sachin Karia of Allen & Overy detail how rising project costs - together with rising oil prices - have created a unique opportunity for sponsors to finance construction phase over-runs with debt instead of equity.

Construction Cost Exposure

Unlike power, large petrochemical projects are heavily exposed to cost increases due to the lack of contractors willing to enter into lump sum turn key (LSTK) contracts for multi-plant complexes or for plants involving "exotic" technologies with which they have little experience.

The Jubail Acetyls Complex featured both characteristics, as the project consisted of five separate units - a carbon monoxide plant, an acetic acid plant, a vinyl acetate monomer plant, a shared utilities plant and port facilities - two of which involved proprietary "black box" technologies licensed from Eastman Chemicals and DuPont.

The initial commercial financing was signed in December 2006 with a consortium of eight regional and international banks. In the intervening period, due to the inflationary state of the contracting market in the region, construction costs for the project soared.

Crude Oil Prices

But the news was not all bad. In the same period, crude oil prices doubled (from US$62 in December 2006 to over US$120).

This has resulted in substantial profits for regional petrochemical producers which benefit from discounted feedstock supplied by state-owned oil and gas companies. In this case, the key feedstock, natural gas, is going to be supplied by Saudi Aramco at a price of US$0.75/mmbtu compared to the market price (at the Henry Hub) of over US$11/mmbtu in May 2008.

As the price of most petrochemicals correlate to crude oil, crude oil price forecasts are used as the basis for revenue forecasts in financial models employed by lenders. The recent rise in crude prices has manifested itself in lenders now assuming base case crude prices of between US$55-$60, up from US$30-$35 two years ago.

Higher crude prices mean higher projected profits, the net result of which is that new projects in the sector are able to support much greater levels of debt.

Construction Phase Refinancing

Previously, construction phase refinancings only tended to occur when things went badly wrong and sponsors needed to inject more equity to fund cost overruns.

However, the paradigm shift in lenders' crude oil pricing assumptions has enabled sponsors to take advantage of a unique opportunity to fund post-financial close increases in construction costs through additional debt rather than equity.

Ian Ingram-Johnson, a partner at Allen & Overy, believes this is the shape of things to come, commenting "for the first time in as far as I can remember, massive cost overruns are not leading to sponsors abandoning or postponing projects, as they now have the option to fund a large part of the cost overruns with additional debt. We expect this window of opportunity to be open in the near term as more projects that suffer from increased costs examine their options in relation to refinancing with higher debt levels."

Contracting Strategy

The sheer volume of new projects in the Middle East is putting enormous pressure on the prices of raw material and the availability of contractors.

As well as the petrochemical and oil and gas capacity expansion projects, there is a raft of new IWPPs across the region as well as other infrastructure projects such as the Saudi Landbridge. Additionally, the region is experiencing a massive real estate boom - Saudi Arabia alone is planning to build at least five entire new cities, including the King Abdullah Economic City, being developed by the UAE property giant, Emaar Properties, through a company listed on the Saudi Stock Exchange (Tadawul).

With the pipeline of projects stretching out well into the horizon, there does not appear to be an end in sight to the escalation in construction costs. Whilst the additional funding flexibility does provide some respite, the advice to sponsors is to get their construction and technology contracting strategy right.

Sachin Karia of Allen & Overy, who has advised on project contracting strategy on many of the largest projects in the region, recommends:

• get LSTKs, where possible - whilst that 15 per cent or 20 per cent premium for a LSTK may look too high at first blush, it is insurance against a doubling or tripling of cost going forward
• take into account that in the current inflationary construction market, and given the size of projects, it may not be realistic to expect contractors to bid for LSTKs.  Where LSTKs are not available, implement a detailed plan in respect of each construction package and an overall construction coordination strategy that addresses the interface between the contracts
• ensure the technology licenses and construction contracts are as tightly integrated as possible. There are various contractual solutions available to address this issue including tripartite agreements and other forms of technology wrap
• manage the interface risk between the contractors working on different parts through contractual mechanisms and project management contractor supervision
• closely examine the testing and liquidated damages provisions of technology licenses and construction contracts and how they inter-relate

At best, failure to get the contracting strategy right can delay financing by months as lenders request that the construction contract and technology license provisions are renegotiated. In a worse case scenario, the lenders can refuse to bank the project without full blown sponsor guarantees for the completion phase.

In light of the ever increasing size of these projects (the latest mega project, the Ras Tanura project being developed by Saudi Aramco and Dow Chemical is rumoured to cost US$22 billion), sponsors are increasingly reluctant or unable to give full blown sponsor guarantees.

Government Demands

Sponsors are also facing increasing demands from government entities as a pre-condition to being awarded projects or being given discounted feedstock allocations.

In Saudi Arabia, for example, increasingly projects have strings attached which include:

• aggressive timelines for each phase of project development up to completion
• requirements to conduct an IPO of the project company (to enable the Saudi public to participate in the benefits of the cheap feedstock)
• requirements to build other down-stream plants (that increase capex and interface risks) in order to promote industrialisation and diversification and create employment opportunities for their fast growing populations

These pressures only add to the complexity and financial cost of projects. With all the variables that sponsors have to juggle, a key element of success in project implementation is a cohesive approach to the development and financing with experienced financial, technical and legal advisors on board.

What "Credit Crunch"?

A unique feature of the Jubail Acetyls Complex Refinancing was that a single lender, the Saudi British Bank, demonstrated continuing confidence in the sector by underwriting the entire financing and taking out the existing lenders.

This was a particularly attractive proposition for the sponsors as it substantially reduced the timeframes entailed in completing a refinancing of a project that involved significant complexity. Furthermore, as a private sector petrochemical project, the deal did not benefit from the sovereign (or quasi sovereign) credit that is often applied to projects developed by the two regional giants in the sector - Saudi Aramco and SABIC.

With new projects mushrooming across the Middle East, it appears that the credit crunch affecting the West has had little impact in the region.

So what makes the region any different from elsewhere?

Well, the answer probably lies in the perfect storm of good fortune arising from the combination of, amongst other things:

• Regional Banks' Liquidity - the leading regional banks were not particularly exposed to the sub-prime market and thus are only indirectly affected by the collapse of that sector in the US.  Although the relative cost of their US$ funding has increased (due to US banks restraining their US$ credit lines to regional banks), oil prices being at an all time high has seen the coffers of regional banks swell with new local currency deposits. Whilst, in the short term, this may mean a shift in the currency funding mix and the resulting implications (such as un-hedged FX exposures) for projects, regional banks are optimistic that the US$ squeeze is easing and will not last much beyond the end of this year.
  
• Development Funding - a significant portion of debt funding for the mega projects is available from local and international government funding agencies that have not been affected by the credit crunch.  In Saudi Arabia, for example, the state owned Saudi Industrial Development Fund and the Public Investment Fund routinely provide a large portion of the funding required for projects.  In addition to this, export credit agencies (such as SACE, US Exim, ECGD etc.) are very active in funding projects that benefit exports from their home countries.
  
• Attractiveness of Projects - the availability of cheap feedstock gives regional producers a competitive edge over their western counterparts making new projects particularly attractive to both sponsors and lenders; so much so that some major international sponsors are relocating their production from the US and Europe to the Middle East.
  
• Demographics - on the infrastructure side, the rapidly rising populations and GDP per capita in the Middle East is resulting in surging demand for key infrastructure including power, water, roads, airports, ports etc. With regional governments running record budget surpluses, there is the willingness and the government financial resources available to ensure that the infrastructure requirements are met. This is accompanied by a growing realisation by the governments that they do not have the human resources to ensure timely development of all the projects and creating the opportunity for private sector involvement.

Will It Continue?

The sceptics will point out that the regions' prospects will, by definition, be limited by the fact that oil and gas are a finite resource.

There are two obvious reasons why this is an overly pessimistic view. Firstly, unlike during the oil boom of the seventies, regional governments are investing their budget surpluses in the development of industry and infrastructure. A consequence of that is likely to be that the population and GDP growth will continue to create business opportunities.

Secondly, based on the current levels of reserves in the Middle East, oil may run out one day, but that day will not be anytime soon. In the meantime, sponsors, lenders and advisors in the Middle East will continue to be busier than ever.

This article has been contributed by Ian Ingram-Johnson and Sachin Karia of Allen & Overy's Dubai office.