The last 18 months have been troubling for project finance practitioners, yet at the same time heartening: troubling to the extent that the markets were in turmoil and the old ways and rules of doing things no longer applied; but heartening in terms of the resilience of the project finance market and project finance as a structural tool for the financing of infrastructure assets.
Nowhere was this more clearly seen than in the Middle East. Despite early hopes that the Gulf Cooperation Council (GCC) countries would sidestep the worst effects of the global downturn, the effects were felt here too – in terms of collapsing oil prices, the bursting of real estate bubbles and the resulting fallout in GCC labour markets.
However, despite the reappraisal of many of the projects conceived at the height of the boom – when confidence was higher, horizons were further and credit was easy – the fundamentals of the need for infrastructure development in the region remain unchanged, despite market conditions previously unknown in the professional lives of everyone active in project finance today.
So what are the fundamentals that have kept GCC project finance on track?
The first, and strongest, is the demographic. It must be remembered that as recently as 80 years ago, countries that are now driving the regional – indeed global – economy were little more than collections of nomadic tribes. To see how far those countries have moved in a relatively short period of time is extraordinary. This situation presents immense challenges for the leaders and governments of these countries. Add a tradition of religious conservatism to the mix, and the challenge is even greater.
The urbanisation of these countries has also led to a sharp increase in birth rate and a decrease in infant mortality. The extraordinary fact is that nearly 40 per cent of Saudi Arabia’s population, for example, are under the age of 14 and a further 15 per cent are aged between 15 and 24 (source: CIA World Factbook 2009). While the situation in Saudi Arabia is perhaps the most extreme, it is nevertheless a pattern repeated throughout the GCC.
It is the case that the movement of this demographic towards adulthood and the demands that it places on the need for schools, universities, hospitals, roads, power, water and housing will not be halted by a year or two of tough conditions in the credit markets. The leaders and policy makers in the GCC are only too aware of this, and of the need to continue with the programmes of social and infrastructure development.
The second factor in the resilience of GCC projects to recent global events has been the ability of project developers to tap into a significant pool of regional banks, which – for a number of reasons – were able to escape the worst of the stresses felt by the international, global-coverage commercial banks since the onset of the financial crisis.
While it is the case that certain regional banks have had to make provisions for lending to real estate projects at the height of the boom, and the defaulting on personal debt that any downturn brings, they did not, on the whole, have the exposure to the more toxic instruments that clipped the wings of many of the international commercial banks. Part of the reason for this must be the shariah-compliant investment policies that they operate under: policies that see an overall lower appetite for risk than was being observed elsewhere in the banking market. Related to this, regional banks saw an increase in deposits from local individuals as people took fright at the perceived risks posed by the international banks, and reverted to what they regarded as safer and more familiar havens for their money.
For those developers able to access these banks and those willing to embrace the required Islamic financing structures, the regional banks have gone a significant way towards bridging the gap left by the retreating lenders of old.
An illustration of these factors at play is the need for more power generation capacity in the Kingdom of Saudi Arabia. The Electricity and Co-Generation Authority, the industry regulator in Saudi Arabia, forecast that peak demand for electricity in the Kingdom will rise from around 40,000MW in 2010 to 120,000MW by 2030. Taking into account the retirement of older generation capacity, this means that in excess of an astonishing 100,000MW of new capacity will be required over the next 20 years. At today’s prices for oil-fired steam generation capacity, that means an investment is required in the power sector alone in Saudi Arabia that approaches US$150 billion.
As a means to go some way to meet this challenge, the Saudi Electricity Company (SEC) launched an independent power project programme in 2007 to seek private sector partners from the international developer market to develop, build and operate six projects in identified locations in the Kingdom. The first project, Rabigh IPP, was launched in the market with an RFP at the end of March 2008. Despite the world events that unfolded after that time, bids were received in December 2008 and the successful bidder, a joint venture between ACWA Power and KEPCO, reached financial close in July 2009. This project is notable for a number of firsts: the first project in the Middle East and North Africa region to reach financial close after the onset of the financial crisis; the first project in the region to be financed without a sovereign guarantee; the first in the region to utilise a Chinese EPC contractor; and, for the significant involvement of Saudi banks, lending on an Islamic finance basis. Baker Botts LLP is SEC’s legal counsel on all aspects of its IPP Programme.
This is not to say that the last 18 months have been plain sailing for the infrastructure market in the GCC. Some projects that were being developed at the height of the boom have had to be reassessed – often because they were simply too large and expensive to be financed in the new reality of the credit markets. For example, the IWPP being developed in Yanbu, Saudi Arabia, by Marafiq (the Utility Company for Jubail and Yanbu) has been postponed and WEC’s proposed power and desalination facility at Raz Azzur, also in the Kingdom, has been adapted from an IWPP to a straight EPC procurement. Other projects in the region – in Abu Dhabi and Bahrain – had to be financed on a temporary bridging basis by the sponsors before a full non-recourse financing take-out could be arranged.
A further reason, of course, for the strength of the project finance market in the GCC is the abundance of natural resources with which the region is blessed. Historically high oil and gas revenues have undoubtedly assisted governments of countries such as Saudi Arabia and Qatar and emirates such as Abu Dhabi, but, perhaps unlike previous oil price booms, these governments have realised that the price rises of the last decade were an unmissable opportunity to meet the demographic and development needs of the immediate future.
However, for the GCC, the future does not lie solely with oil and gas. The future for today’s oil-rich economies lies in using those revenues to build sustainable and diversified economies that provide employment opportunities for the demographic of the future.
This trend was first seen earlier in the decade by the move to bring the oil and gas value chain onshore. No longer content with simply exporting crude oil for refining value to be added elsewhere, GCC national oil companies (NOCs) entered into joint venture arrangements with international oil companies (IOCs) and others to develop world scale refining facilities onshore, thus ensuring the maximum value from their feedstock product. It is not by accident that oil refining has become a low margin or loss-leading activity in Europe and North America. The rapid advancement in LNG technologies also allowed the likes of Qatar and Oman to exploit their gas reserves to the maximum.
The next logical step was to look to other manufacturing industries where the availability of oil and gas – either as a direct feedstock or via electricity generation – would be an advantage: chemicals, plastics, aluminium and fertilisers. All are activities which fall naturally at the feet of project finance as the most appropriate financing technique.
The future, of course, is always less certain than the past. Nevertheless, Abu Dhabi, Oman, Kuwait, Dubai, Saudi Arabia and others continue with their conventional power and water programmes, providing continuing opportunities for those involved in the project finance market. Rail, airport, road and other social infrastructure projects remain on track and fully supported by governments. Time will tell whether the United Arab Emirates’ nuclear power programme will provide opportunities for project finance professionals.
Most in the region agree that a key area for diversified economic development in the GCC in the future will be alternative energy sources. The Masdar sustainable city development in Abu Dhabi is likely to lead the way for the development of a knowledge base and expertise in renewable and sustainable energy sources in the region. It seems only logical that those countries blessed with the natural resources of oil and gas should turn to harness their other great natural resource: solar energy. Once more, there is an opportunity for project finance to prosper.