In June 2012, Egypt’s $3.7bn Mostorod refinery reached financial close. It was a remarkable achievement that in many ways broke the established rules of the sector. Not only was it the largest project to secure funding in the region during 2012, it occurred against a backdrop of continued political uncertainty in the country, following the revolution of early 2011. It also came at a time when Egypt’s finances were deteriorating and its economy stagnating.

In contrast, project finance activity in the GCC dropped massively, despite the six-country bloc enjoying political stability and strong public finances and economic growth.

In total, there were just $8.5bn of project finance transactions closed in 2012 across the GCC and Egypt. That was down from $23bn in 2011. “There was a marked decline in project finance in 2012,” says Ali Tahir Jaffery, director of project and export finance at the UK’s Standard Chartered. “But it was an unusual year because there was not a fundamental change driving that decline.”

Global decline

The drop in activity is partly a reflection of a global decline. In 2012, global project finance volumes fell 6 per cent to $406.5bn, according to figures from the UK’s Dealogic. This was mainly due to a drop-off in activity in the telecoms and energy sectors.

It also reflects how important timing has become. Many of the largest projects in the GCC slipped into 2013, most notably the $20bn Sadara Chemical project, a joint venture between Saudi Aramco and the US’ Dow Chemical.

“It was surprising really that last year was so slow, but is an indication that the focus is shifting to larger and more complex deals that require much longer periods of negotiation,” says the head of regional project finance at one international bank.

In some ways, the fall in project finance activity is surprising. The Middle East remains dominated by greenfield infrastructure developments. Project finance is still favoured by most regional governments and development companies. Demand has not waned even as supply has dropped. Looking ahead, there could be as much as $80bn-worth of project finance transactions aiming to reach financial close over the next two years. With capacity only thought to be around $25bn a year, that will leave the market significantly strained.

Clearly, there are growing constraints and an increasing gap between the terms on which banks are prepared to lend, and what sponsors expect. The number of banks interested in project finance lending is also dwindling or they are focusing on other markets, where pricing is higher.

Most major US banks are now largely absent from the regional project finance sector. Most are understood to be winding down their teams of project finance specialists. It is a problem about which the region’s largest project sponsors are becoming concerned. “Although a core group of banks will continue to offer project finance, aggregate capacity will continue to be eroded,” said Jamal al-Rammah, treasurer at Aramco, speaking at the MEED Project Finance conference in Dubai in January.

Jaffery adds: “One thing we have noticed is that European banks have pulled away from the market, particularly French banks, which historically have been among the biggest lenders.”

Enthusiasm waning

Even in Saudi Arabia, where bank liquidity has been high over the past two years and competition to lend intense, there are signs that enthusiasm may be waning. Almost half of the $8.5bn raised in 2012 was in Saudi Arabia, much of that coming from local banks. Bankers in the kingdom say that whereas last year their managers were keen for them to keep booking more assets, they are being told to be more cautious this year. “There is still liquidity in the Saudi banks and they will continue to be very active, but the pressure to lend is starting to reduce and that should start be reflected in prices this year,” says the head of structured finance at one Saudi bank.

Of the top 10 lenders to regional project finance deals in 2012, seven were Saudi banks, according to Infrastructure Journal, MEED’s sister title. The highest ranking international bank was the UK’s HSBC.

Banks are finding project finance less attractive for two main reasons. Firstly, new international banking regulations known as Basel III make it less attractive for them to lend on the 15-year plus tenors required for most projects. Secondly, the strong financial position of GCC governments makes their projects more attractive on a relative basis, particularly as they are often vital infrastructure that benefit from solid state support. “Banks are keen to lend in these markets, but it does make pricing exceptionally fine,” says Jaffery.

Banks are keen to lend in these markets, but it does make pricing exceptionally fine

Ali Tahir Jaffery, director of project and export finance, Standard Chartered

Most bankers agree that pricing needs to start going up to attract more lenders and make deals more profitable. There are signs this could be happening in 2013. The $4.6bn financing for phase two of the Emirates Aluminium (Emal) project at Taweelah was oversubscribed, but pricing for the deal was relatively high, starting at 250 basis points above the London interbank offered rate (Libor) and peaking at 325 basis points. During the course of putting the bank group together, pricing was actually increased by 25 basis points from the financial model sent to banks, in contrast to most deals in the region where an oversubscription is used to bring pricing down.

ECA contributions

At the moment, the decline in bank appetite is being made up for by rising contributions from export credit agencies (ECAs). For example, financing for the $20bn Sadara Chemical project is $12.4bn debt, of which $6.7bn is coming from ECAs. Only around $1.5bn is expected to come from commercial bank loans.

“This creates an opportunity for the sukuk (Islamic bond) market to become increasingly important,” Al-Rammah told the conference. Aramco is playing a part in leading the development of project bonds in the region. In October 2011, the company issued a SR3.7bn ($1bn) sukuk to finance the Saudi Aramco Total Refining and Petrochemical Company (Satorp) project.

Later this year, it should issue a larger sukuk to fund the Sadara project. Emal is also looking to raise capital markets funding.

The bond markets have long promised to be an additional source of liquidity for funding projects, but have so far largely failed to deliver. Although there are signs that could be changing, it is no panacea to the funding gap emerging. Even globally, project bonds only raised $26.4bn in 2012, of the total $406bn raised in project finance.

With constrained liquidity, banks have been focusing more on getting advisory work as a way to keep good relationships with clients without having to put their balance sheet to work. But with long project gestation periods, it can be a time consuming process.

France’s Societe Generale had been working on the financing for Egypt’s Mostorod refinery since 2007. It finally brought the $3.7bn deal to a conclusion last year, which alone made the French bank the top financial adviser in 2012 by the total value of deals closed.

The second-most active was HSBC, which worked as financial adviser on all but one of the deals completed in Saudi Arabia. It demonstrated the bank’s tight grasp on the Saudi project finance sector, something which it looks set to maintain. Mandates already handed to the bank to advise on projects like the $2bn Jizan power plant and PetroRabigh phase two (being developed by Saudi Aramco) and Saudi Arabian Mining Company’s (Maaden) $7.5bn new phosphates project. Elsewhere, the bank has a large pipeline of projects on which it is working as an adviser, including schemes in Abu Dhabi, Kuwait, Bahrain and Oman.

Next year, the UK’s Royal Bank of Scotland and the local Riyad Bank should be top of the table for financial advisers, having workedon the Sadara Chemical deal.

Last year was one of the few years when there were no power deals financed, although several have been in planning and were expected to close.

Most notably, the Al-Zour North independent power and water project (IWPP) in Kuwait could have reached financial close in mid-2012, but was delayed by political interference. Plans to close the financing in early 2013 also look set to be scuppered by fresh investigations into the awarding of the contract to a consortium of the UK/French GDF Suez International and Japan’s Sumitomo.

Power projects, along with oil and gas schemes, typically make up the bulk of transactions as they tend to be worth about $2bn and usually come with a repayment guarantee from the finance ministry.

Power refinancings

This year should see the first of several power plant refinancings, led by Abu Dhabi Water & Electricity Authority (Adwea). The first will be the Shuweihat 2 deal, another that was expected to close last year. Delays in a $825m bond issue that forms a key part of the new funding package meant the deal was pushed back into early 2013. When completed, it will be the first time that a regional power project has been refinanced using the bond markets.

If this goes well, Adwea could look at similar plans for other power projects. “Assuming the Shuweihat 2 deal is closed, we will be looking at refinancing another project pretty soon after,” says Charlie Seymour, financial adviser at Adwea.

Despite a poor year in 2012, the outlook for 2013 is good. The Sadara Chemical financing is in place, as is the funding for phase two of Emal. Several power projects should also reach financial close this year. That could easily result in about $30bn of deals closing. The $20bn funding for the UAE’s Baraka nuclear project, though probably more sovereign lending to Abu Dhabi than a real project finance deal, should close in the first half of the year.

This could make for a more optimistic 2013, but the factors depressing the market will remain. Fewer banks have appetite for project finance. Most bankers agree that there is not enough liquidity for any more than about $25bn of transactions to be completed a year, even with attempts to replace bank liquidity with bonds or ECA loans.

Demand should continue to outstrip supply and that will mean only the most attractive projects will get funded. It should also mean that banks may be able to start increasing the amount they charge to borrowers. If they manage to do that, it could tempt a few more banks back into the market.