Sukuk-based project finance takes off

Towards the end of June, lenders agreed to the Gulf's largest project financing deal of the year, a $8.5bn funding package for Saudi Aramco Total Refinery and Petrochemical Company's (Satorp) greenfield refining and petrochemical project at Jubail in Saudi Arabia's Eastern Province.

The deal is in the classic mould of multi-sourced transactions seen in the Gulf in recent years, bringing together export credit agencies, international banks, Islamic financiers and public investment funds.

Diversity of funding sources is the watchword for major projects in a market where traditional forms of project financing support have been restricted by the global banking crisis.

Yet missing from the Jubail deal was a long-mooted $1bn Islamic project bond, or project sukuk - that was to introduce an explicit capital market element to the financing arrangements.

The original plan conceived in late 2009 was for lead managers Banque Saudi Fransi, Samba Financial Group and Deutsche Bank to issue a riyal-denominated Islamic bond through the Satorp joint-venture company in the first quarter of 2010.

However, according to one Riyadh-based project financier, the timing for such a bond was not right. "The capital markets aren't too favourable right now and the sponsors decided to make senior loans to the project in order to fill the gap, which is a small one in the context of the overall size of the financing."

Poor conditions

Market conditions are not ripe for sukuk issuance, an asset class that is still dealing with the aftermath of a traumatic year marked by defaults on major corporate sukuk. Confidence has yet to return to the Gulf's fixed-income market since Dubai World shocked creditors by coming to a standstill on $26bn of debt repayments in November 2009.

Gulf issuers raised just $2.3bn from sukuk sales in the year to mid-June, some 19% less than the same period of 2009, Bloomberg data shows.

And it is not just the sharia-compliant sector that is suffering. Emirates Aluminium was looking to secure $2bn of financing for its smelter via the issuance of conventional bonds, but in early July resorted to securing $737m of export credit agency facilities to plug the gap.

Satorp is nonetheless confident that it will at a later stage complete an Islamic bond for the Jubail refinery, whose total costs are estimated at $14bn. Project sukuk have garnered increased attention in the Middle East in recent years, with major issuers such as Aramco and Qatar Petroleum showing willingness to explore this type of asset funding as a means to diversify their funding base.

Large energy projects need to tap additional funding sources, given that non-capital markets Islamic structures only provide limited capital. The Gulf region's major economic sector has yet to experiment with project sukuk, though some major corporate issuers have launched debt capital market instruments linked to projects in the pre-financial crisis period. In 2007, Dubai's DP World issued a 10-year $1.5bn senior unsecured mudaraba bond, with period payments to sukuk holders made through returns made on the investment assets.

Project bonds translate well to the Islamic finance universe. There is, for example, no interest expense linked to the transaction, even though the actual amounts repaid are designed to meet debt service payments.

"From a conceptual level, project finance sukuk is very much in keeping with spirit of Islamic finance, which promotes risk sharing," says Mohammed Dawood, head of debt capital market at HSBC Amanah. "You're looking at financing real assets and real projects. In project finance sukuk, you become a stakeholder in the business and are very much dependent on the viability of the project to be able to generate the returns to pay the sukuk holders. So from a theoretical perspective it ticks all the boxes."

Forward thinking

Sponsors are thinking ahead about issuing project-related Islamic debt capital instruments; Aramco's $20bn-plus refining-petrochemicals project with Petro Rabigh contains provisions for the issuance of sukuk.

Aramco fits the ideal profile of a project sukuk issuer, as a sovereign-rated national oil company. Investors are more prepared to buy paper viewed as being backed by what is essentially a Saudi government entity.

Yet the fact that the Saudi oil giant has not so far engineered a smooth bond issue for the Jubail refinery suggests that it might be more than inclement conditions in the capital markets that is preventing lift-off for Islamically structured project sukuk.

"I don't think the demand is there for these sukuk right now as there isn't an investor base that can take 12- to 15-year paper," says one UAE-based Islamic finance lawyer.

The region's investor base is also still not mature or large enough to support large project-linked bonds. "The money market funds here are a bit leery about paper with a maturity longer than five to seven years," says the Riyadh-based project financier. "Existing sukuk have all been placed but they are illiquid. People buy them, hold them to their chest and don't let go, so there's no active secondary market even for ones listed on the stock exchange. Trades are very small, so they don't have liquidity for money markets."

This fundamental obstacle will stymie the uptake of project sukuk over the near-term, but it is Saudi Arabia's comparatively deeper sharia investor base that is likely to make the running when appetite returns. The country's two large annuity institutions, the General Organization for Social Insurance and the Public Pensions Agency, are already significant bond investors.

"In Saudi Arabia, where you have the institutions with the capacity and ability to go longer term, that is certainly the vital selling point for Islamic project sukuk," says Mr Dawood. "It has a whole variety of investor types with the ability to be able to commit longer-term funds necessary to ensure a vibrant market. There are government, pension funds, insurance companies and banks - you don't have that same constituency of investors elsewhere in the Gulf."

The Jubail sukuk, when and if it takes place after the current delay, could set the template for other deals to be done. The success of that deal will determine how quickly the market will pick up. But the region's wider capital market will need to revive if the sharia sector is to live up to its potential. "You need to see longer tenors in the vanilla sukuk market as the first step to seeing long-tenor project sukuk becoming more mainstream," says Mr Dawood.

Rival option

There is another reason why project sukuk have struggled this year. Many of the largest Islamic banks are awash with liquidity, and it is easier to find a home for that liquidity via traditional bank lending commitments than with capital market issuance. "Saudi banks are able to fill the hole, so you may need a liquidity crunch to encourage the development of additional funding sources," says Craig Nethercott, a partner at law firm Latham & Watkins, who helped arrange the project financing for the first phase of Saudi Aramco's Petro Rabigh project in 2006.

Structural issues will also need to be ironed out in the methodology of project sukuk. Most bond transactions are asset backed, but with project finance sukuk typically funding greenfield projects, there are no physically existing assets.

Changes are afoot that will support the gestation of a more mature investor base able to support such sukuk issuance. Saudi Arabia's central bank, Saudi Arabian Monetary Agency, is active in the development of the debt capital market and is working closely with banks to boost sukuk liquidity, for example, by encouraging them to buy large portions of issues and see if they can make a healthy return.

The current sukuk market torpor will lift eventually. More and more government-linked entities and utilities in the region will be forced to look to the bond market to be able to fund their expansion projects. However, time is the key. "It's a function of the evolution of the Islamic investor base - certainly over the past four to five years, we've seen a gradual change in that base and governments in the region realise they need to establish institutions that can provide longer-term funding to the region's capital market. This will be one of the spurs to seeing more activity in the market," says Mr Dawood.