Project finance bankers based in the Middle East have listened to predictions of the imminent rise of project bonds throughout their careers. The aftermath of the 2008 financial crisis looked especially promising, because bonds were suddenly able to compete with bank loans on pricing.

The $2.23 billion three-tranche project bond issue by Ras Laffan Liquified Natural Gas Company (RasGas), which financed its sixth and seventh natural gas production facilities in Qatar closed on 17 July 2009 and was priced at 300bp, 312.50bp and 325bp higher than US three-, five- and 10-year treasuries. The bond attracted $17.5 billion in orders. At the same time, the bank loan for Bahrain’s Al Dur IWPP – which had a tenor of just eight years – came in at a broadly comparable level, with step-ups from 265bp to 365bp over Libor. Later that month, the first refinancing of Dolphin’s gas pipeline involved a $1.25 billion 10-year bond that came in at 12.5bp inside price guidance and around 100bp below that of a bank tranche that priced in March of that year.

Rise, fall, and rise again But as the sense of urgency from the crisis receded, so did the chance for a project bond market to establish itself. Bank debt tenors increased, while its pricing fell. However, despite banks’ efforts to stay competitive, and the perceived inflexibility of capital market debt issues, there’s been a renewed focus on the development of conventional project bond and sukuk markets, as the region faces the possibility of a prolonged liquidity squeeze.

European banks, the traditional stalwarts of the Middle East project debt market, have already been forced to cede market share, which has dropped from 44% in 2004 to just 18% in 2011. In preparing for Basel III’s new capital adequacy rules, former lending heavyweights will need to evolve into debt capital markets powerhouses in order to maintain a presence in the region. Jean-Christophe Durance, regional head of BNP Paribas Middle East, says: “It is clear that traditional long-term financing is changing and will be done differently. We will have a bigger use of capital markets like bonds and sukuk.”

Regional lenders and export credit agencies have so far filled the lending gap opened up by the European retreat. But even ECAs cannot finance the estimated $1.8 trillion in capital investment either underway or planned over the next fifteen years in the GCC region. “There are clearly constraints and they will probably become stretched in terms of manpower,” says Ivan Woods, director and head of infrastructure advisory at BDO Corporate Finance. “Anecdotally, you hear about their institutional capacity being tested. There is a financial capacity issue as well. Given how much they have extended their reach over the last three to four years, I would be surprised if their share of the overall Middle East project finance debt market grew.”

Two recent bond issues have renewed hopes that the debt capital markets can gain a sustainable footing: the $1 billion sukuk from the SATORP refinery, which closed in July 2011, and the more recent $1.3 billion refinancing of the Dolphin gas pipeline. Indeed, both of the main sponsors of the issues say that the deals could spark an expansion in issuer’s ability to access their respective markets.

SATORP’s sukuk succour

In the case of SATORP, a joint venture between Saudi Aramco and Total to build a $14 billion 400,000 barrel-per-day refinery, the issue marked a step up from smaller sukuk issues with maturities stretching to seven years. “SATORP, with support from its shareholders and more particularly Saudi Aramco, was keen to develop the debt capital markets in Saudi Arabia by introducing a project sukuk,” says Salah Al-Garawi, a member of Saudi Aramco’s project finance group. “It has an extended tenor of 14 years, a size of almost R3.75 billion [$1 billion], is the first of its kind in Saudi Arabia, in terms of tenor, type, format and the underlying innovative Shariah structure was approved by the highly respected Shariah boards of Alinma Bank and Albilad Bank, in addition to the Shariah boards of the joint lead manager.”

The SATORP issue, which was 3.5x oversubscribed and priced at a tight 95bp over six-month Saibor, could have a galvanising effect on the wider market though it is likely to remain the preserve of highly rated sponsors. SABIC and Saudi Electricity Company have both since approached Saudi Aramco, according to one source, and are interested in executing similar sukuk issues in the future. “I certainly think that having the SATORP transaction there is a big help in the region,” concurs Mark Jones, managing associate at Linklaters, which was legal counsel to the underwriters on the SATORP sukuk. “It showed that a relatively complicated Islamic sukuk can form part of an already-complex project financing. It clearly demonstrates that challenges can be overcome in what is a fairly difficult jurisdiction in which to document financing transactions.”

But Saudi Aramco, along with other large sponsors in Saudi Arabia and the wider region, will need to make a sustained commitment to use sukuk bonds for future projects, which would effectively institutionalise the Shariah-compliant bond market. “We intend to capitalise on SATORP to issue future sukuk,” says Aramco’s Al- Garawi. “We plan to utilise sukuk in the financing of our future projects whenever it becomes feasible, as it represents a very viable source of funding and further diversifies our funding sources.” Other supply-side factors are also helping to put sukuk issuance on a firmer footing. “Sukuk are very much on people’s radar,” says Richard Odumodu, investment director, fixed income, at Silk Invest. “We’re seeing big money centres looking to get the jump on being the destination of the issuance of sukuk ... the outlook is good for increased issuance.”

The willingness of sponsors of the largest, most complicated, projects to spend the time to make sure that a sukuk issue is Shariah-compliant is another variable, which will determine whether the SATORP sukuk proves to be a one-off or a landmark issue. “We had a very high-level of interactions with the scholars,” says Linklaters’ Jones. “That did take a bit of time. As the market sees more of these deals, they will become easier to execute and easier to document.” Other sources familiar with the SATORP sukuk compliance process are more explicit. “It was very onerous,” suggested one source.

But Jones argues that “the transaction took the best part of two years, it was not as if we were having constant negotiations week in and week out with the other lenders [with respect to the sukuk].” Existing lenders a voice in the decision about whether the sukuk would happen: “Inevitably, there were certain pinch points within the overall timetable, when either the intercreditor documentation had to be agreed with the core principals to allow the sukuk to come on board or subsequently actually putting the sukuk to the vote of the other lenders to allow the sukuk to come on board. We weren’t aware of dissenting votes. We prepared memoranda while our colleagues acting for the lenders prepared their memoranda in respect of the sukuk issue. There was a lot of hand-holding that went on to make sure that we got the right result when that vote came along.” Most parties involved in the issue suggest that its precedent will allow similarly-sized and structured sukuk issues in multi-sourced financings to take around one year from conception to execution.

Saudi Bin Laden adds sukuk depth

Given its sheer scale and tight pricing, the SATORP issue has inevitably captured most attention, but recent sukuk issues by construction company Saudi Bin Laden Group point to depth in the short-term market. Saudi Bin Laden issued a longer-term corporate sukuk in 2008 before delving into the short-term sukuk market two years later.

“[Non-project finance sukuk issuance] is a plus for the project finance market because it gets investors accustomed to the instrument, so selling them a project finance sukuk is much easier,” says Baker & McKenzie partner Bilal Kahlon, who advised SBLG on its project finance sukuk issues. “Bin Laden are an example of that. They issued a long-term sukuk in 2008 but then they came back to the market in 2010 and 2011 to issue project- specific short-term ones.”

Moreover, the positive reaction to the group’s first project finance sukuk, which helped to finance construction of a National Guards barracks, prompted a second, in the form of R1 billion issue for the Haramain high-speed rail project, according to Kahlon: “When the National Guards sukuk matured in April of 2011, there was so much goodwill and appetite in the market as a result of that maturity that we were actually pushed quite hard to get the documentation in place as soon as possible. SBLG wanted to go back into the market and take advantage of that goodwill. It was in the middle of the summer in Saudi when a lot of people were away and there were questions about whether that was the most appropriate time to issue, but despite that, it was oversubscribed by three to four times. Since then, we’ve had enquiries from other major contractors to see how they can utilise short-term project sukuk.”

Saudi Arabia will be the predominant source of sukuk paper in both the short and long term, many investors suggest that other jurisdictions in the MENA region, particularly those that experienced recent political turmoil, could be the source of project finance sukuk issues. “There’s a clear link between sukuk issuance and the issues that were being championed in the recent revolutions,” argues Richard Odumodu. “We’re very interested to see whether Egypt makes good on its proposed diaspora sukuk-based certificate deposit. Though it’s being used to fund a budget gap, it will have broader ramifications.” Countries that have experienced upheaval will need to build up the institutions necessary to support new issuance. Morocco, whose experience of the Arab Spring was relatively benign, plans to launch its first wholly Islamic bank in 2013.

Dolphin directs

Just as SATORP stands as a benchmark issue for the project sukuk market, the Dolphin Energy bond refinancing could serve as a template for the conventional project bond market. Mubadala-backed Dolphin was able to pay down almost all of the $1.42 billion bank tranche that it closed in July of 2009.

Derek Rozycki, Mubadala’s executive director of structured finance and capital markets, suggests that the Dolphin issue could be a model for the future of project finance and the recycling of bank liquidity. “With the stresses and new rules that the banks will see, there is a real need to develop the project bond market further,” he says. “When the project bond market has failed to develop in the past, you didn’t have this kind of established demand, supply and facilitators. It’s completely different now.”*

Rozycki describes the Dolphin issue as representing a “flight to diversity and quality”, part of a wider phenomenon observed by a Odumodu, which could support the project bond market. “The flight to quality is already happening,” says the Silk Invest director. “I wouldn’t be surprised to see more. You look at the macroeconomic indicators of some countries in the region. They put the US in its heyday to shame.”

A lack of project bond issuance in the first quarter of 2012 has made it difficult to assess the current state of the market. Odumodu contends that the pricing of the Dolphin refinancing issue may not reflect the wider market. “We own the bond and we like it. The yield has already gone up since the issue, which suggests that perhaps it wasn’t priced correctly.” A better gauge of the market – and its ability to compete with bank pricing – could be in the offing as arrangers are currently pushing for a second quarter close on the refinancing of the $2.2 billion Shuweihat 2 independent water and power project in Abu Dhabi. The refinancing is expected to include both bank and bond debt.

Given that sukuk issues for the largest projects in Saudi Arabia will almost certainly happen, the outlook for 144A bond issues is necessarily more obscure. “If bond pricing comes within spitting distance [of bank loans], only then will issues happen,” says Craig Nethercott, a partner at Latham & Watkins. “In that event, sponsors will want to diversify.” Whether project bonds can stay competitive could depend on several factors, not least the continuation of the bull market for regional sovereign bonds, which some analysts suggest is coming to an end.

*Correction 17/4/12. An earlier version of this article included incorrect quotes.