22 May 2006
'Proceed with due diligence': what does it mean in construction contracts and development agreements?
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For those who thought 2005 was a busy year for project activity in the Middle East, 2006 is busier still. Flush with liquidity from high oil prices, many Middle East countries are looking to increase their hydrocarbon production capabilities and build downstream industries based on these hydrocarbon reserves, as well as forging ahead with non-oil-based economic diversification programmes.
The strong oil price has been one of the key drivers of development in the Middle East and now many countries are looking to develop their upstream reserves, particularly Saudi Arabia, Qatar and Abu Dhabi.
Gas projects were a major feature of 2005, with the Qatari liquefied natural gas (LNG) projects leading the way. Gas projects will still be a significant feature of 2006, but coupled with downstream industries, particularly refining, petrochemicals and independent water and power projects (IWPP). Recently, two of the Gulf's largest utilities, Abu Dhabi Water & Electricity Authority (Adwea) and Qatar General Electricity & Water Corporation (Kahramaa), announced significant upward revisions to their projections for electricity and water demand. Both states expect demand to double between 2010 and 2013.
The high oil price has also provided the necessary liquidity to enable countries to fund the development of essential infrastructure and economic diversity programmes, such as retail, real estate and tourism.
The countries to watch in 2006 are Saudi Arabia, Qatar (despite its self-imposed halt on development after QatarGas 4), the United Arab Emirates (UAE) and Egypt. Iran, too, has several projects on its drawing board, but these remain in the balance given the current political situation. Most countries will seek a high level of private sector involvement in downstream industries. Most Middle East countries have adopted the private power model, including most recently Jordan, Algeria and Morocco. Dubai and Kuwait are notable exceptions.
However, it is not all good news. The huge demand for new projects has been constrained by pressures on the construction industry operating in the region, both in terms of capacity and rising costs. Engineering, procurement and construction (EPC) costs have risen dramatically, in some cases by 30 per cent. EPC contractors complain of the rising costs of raw materials such as steel and concrete, but also specialist equipment such as cranes, and also labour. There is also a shortage of qualified staff, such as engineers, welders and electricians.
Often the problem in relation to projects in this part of the world now is not a lack of finance, but finding the raw materials to build them and the contractors capable and with the capacity to do so. As a result, the contracting structure is starting to change. EPC contractors are being more selective about the contracts they bid for and the level of risk they will assume. They are bidding in consortium with other international EPC contractors to spread the risk and workload.
Clients have had to become more flexible. Some clients are seeking to lock in material supplies for the long term by carrying out key material procurement themselves. They are also starting to offer EPC contractors more flexible contractual terms. New contracting strategies include front- end engineering and design (Feed) contracts linked to EPC contracts, as well as engineering, procurement and construction management (EPCM) contracts. Clients are also showing more flexibility on other fronts, such as splitting the size of contracts and loosening restrictions on the technology that can be employed.
Given the scale of project development, the question then is whether there is enough debt finance to meet the challenge. Conventional debt has its limits and there has been an increasing necessity to tap other markets and other sources of funds, such as the Islamic market, the Export Credit Agency (ECA) and multilateral financing. This is particularly so on the large-scale deals now coming out of the region, where we are not seeing a single source of financing, but rather multi-sourced financing for these deals.
Of course, multi-sourced financing is not a new phenomenon - it has been around for many years. An early example in the region was the first Oman LNG project, which involved five ECAs (ECGD, Sace, NCM, USEXIM and JBIC) as well as conventional debt finance. However, what is a more recent phenomenon is a combination of Islamic, ECA, conventional and bond financing in some of the more recent deals. Each of these sources of finance is becoming more flexible and the providers of such finance are becoming more aggressive when looking at projects. Also, we should not forget the role of the IPO market in bringing liquidity for infrastructure development in the Middle East.
Islamic tranches have also been in vogue for a number of years. The very first Equate deal had an Islamic tranche, as did the initial financing of the Rousche Power Station in Pakistan. However, it is only in recent times that the structures, such as Morabaha and Ijara, have been used in a more sophisticated and flexible manner and have been combined with other financing structures.
Commercial tranches from international banks continue to form the bedrock of most financing deals due to the long-term tenors they offer and the competitive margins. Arguably this has been at the cost of developing the local bank market and the debt capital market.
2006 is likely to be another record year for project development and financing in the Middle East. It remains to be seen whether construction capacity constraints will put a dampener on this activity. However, sponsors will need to adopt more flexible approaches to contracting structures and risk sharing. Lenders, too, will need to consider their stance on key project risks such as completion risk and cost overruns.
Lawyers can play an active role in bringing the parties to the table and looking at new ways to balance the risks involved given the state of the construction market.
Jeffery Barrett is head of property at Norton rose