Islamic project finance’s rapid rise hit snags in 2015 and was slowed down by depressed oil prices. Nevertheless, SAJJAD KHOSHROO expects to see more expansions and more Sukuk and Iran deals in 2016.
Islamic project finance in the Middle East — backed by mammoth public spending on capital-intensive mega-projects funded by healthy oil revenues — grew rapidly in the past few years. This increased deal-flow and liquidity led to the growth of dedicated Islamic finance institutions offering a full range of Shariah compliant products with longer tenors. Sustained downward pressure on oil prices is reversing this trend.
Down in 2015
Oil fell to a six-year low in August 2015 and has not recovered much since. This has caused many energy projects that often use Islamic finance to be shelved. Shell and Qatar Petroleum’s canceled Al Karaana petrochemicals project is a prominent example. As a sign of troubled times ahead, S&P downgraded a slew of Saudi banks and placed others on a negative outlook in November 2015. Most of these banks are key players in the Islamic project finance market.
According to Dealogic, project finance in the Middle East and Africa saw a 10% drop since the first half of 2014. Global project finance volume stood at US$279.5 billion in the first nine months of 2015, the lowest total since the same period of 2012 (US$277.9 billion). Oil and gas volume dropped to US$38.2 billion in the first half of 2015, down 23% year-on-year (US$47.1 billion) and the second consecutive year-on-year decrease since 2013 (US$58.9 billion). But it was not all bad news. The petrochemical sector saw the largest year-on-year increase with a volume of US$12.1 billion in the first half (H1) of 2015, up from US$1.1 billion the previous year and the highest H1 volume since 2013 (US$22.1 billion). This increase was driven by the US$8.1 billion Rabigh 2 petrochemical project in Saudi Arabia — the third-largest project closed globally in the first nine months of 2015.
But not out in 2016
As seen in Rabigh 2, expansion financings of existing projects are set to take on increased momentum. Liquidity constraints of cash-strapped industry players will reshape the investment landscape in 2016. Investors are increasingly wary of greenfield projects, so maximizing returns from existing assets will be the name of the game. The advantages are clear:
- reduced costs through economies of scale and sharing facilities
- expansions are funded with less credit and equity, and
- the project has survived start-up risks and there is value already in the ground.
The Istisnah-Ijarah and Wakalah-Ijarah structures will continue to dominate the Islamic project finance market. These structures are well-suited to project finance. They allow Islamic financiers to combine the phased payments of the construction price with rental payments matching the cash flows of the conventional financiers — achieving the same exposures, margins, and tenors.
Project Sukuk is a recent addition to Islamic project finance instruments. Making its debut on SATORP (2011) and reappearing on Sadara (2013), it is set to become a permanent presence in the Islamic project finance scene, particularly in Saudi Arabia. Sukuk is a low-cost funding alternative and taps into the strong appetite to fund in local currency, such as the Saudi riyal. As a sign of market sentiment, large-scale projects, such as Rabigh 2, often pre-structure the Sukuk in the documentation as replacement financing at a deal’s outset. Strong demand from regional and domestic investors, the lower cost of issuance compared to conventional bonds, attractive pricing, increased standardization and political commitment to develop the region’s capital markets have all contributed to the growth of project Sukuk.
Iran, with its entirely Shariah compliant banking system and the world’s largest pool of Islamic banking assets, can be a game changer for both Islamic finance and project finance. With investment needs estimated at US$1 trillion, it appears to be a great opening at a time when other doors are shutting. Of course, it must first get to ‘Implementation Day’ under the nuclear agreement (expected first quarter of 2016) when it will receive relief from certain sanctions.
But the opportunity is undeniable. According to BP, Iran holds the world’s largest gas reserves and fourth-largest oil reserves. Iranian oil and gas production coming back online could spell continued downward pressure on global energy prices and consequently, a continued slowdown of energy projects. However, given Iran’s previous isolation, investment opportunities are abundant across various sectors. Mining, aviation, rail, power, petrochemicals, pipelines, and upgrading existing facilities and infrastructure are all candidates for Islamic project finance in 2016.
Depressed oil prices means it won’t be business as usual for Islamic project finance in 2016. To prosper it must change its strategy — focus on expansions and Sukuk — and enter new sectors in post-sanctions Iran.