Islamic finance makes headway in the energy sector
Sharia-compliant financing structures are becoming increasingly prominent in oil and gas transactions, explains James Gavin
AFTER a lengthy gestation period and a few false starts, Islamic financial instruments are set to play a growing role in energy finance – in the Muslim world and beyond. Sharia-compliant instruments, traditionally confined to the retail banking market, have broken out of that niche over the past five years, migrating towards infrastructure sectors including energy.
Islamically structured tranches in Middle Eastern project-finance deals are now commonplace. The use of Islamic project financing in the energy sector took a big step forwards with the $3.45bn Dolphin Energy project financing, in September 2005. This included a $1bn Islamic tranche to fund construction of a 370 km pipeline delivering Qatari natural gas to the United Arab Emirates (UAE).
Signed between Dolphin Energy and 14 financing institutions, it was the oil and gas sector's largest Sharia-compliant deal, organised alongside a conventional $2.45bn facility. The four-year financing facility was structured as an Istisna'a – sale of assets to be constructed (see box) – transaction, under which Dolphin Energy agreed to build the portion of the project relating to the gas-transport system on behalf of the Islamic investors and entered a forward-lease agreement for the use of those assets.
lslamic financing tranches using the Istisna'a and Ijara (Islamic lease) combination had already been successfully deployed in a string of large financial transactions, including a $0.53bn Islamic tranche in the Qatargas 2 financing in 2004.
A year after the Dolphin transaction, Saudi Aramco's debut project financing, a $5.8bn deal to help fund the Saudi national oil company's (NOC) $9.9bn Petro-Rabigh refining/petrochemicals complex, included a $0.6bn Islamic-financing tranche provided by domestic, regional and international banks.
A benchmark for future use
These big deals, struck at the height of the Mideast Gulf's economic boom, set a benchmark for future use of Islamic tranches in multi-sourced transactions. But the freezing-up of the project-finance market since 2007 has slowed the advance of Islamic financing in energy projects; in addition, a series of defaults affecting some prominent issuers of sukuk – Islamic debt-capital market instruments, targeted primarily at institutional investors – has weakened confidence in the asset class.
But despite these setbacks, energy sector interest in Sharia investment and finance mechanisms is growing. The shake-up of the international credit market may yield a more prominent role for Islamic financial institutions (IFIs), because they are less exposed than their conventional counterparts to toxic, collateralised debt obligations.
"Islamic finance in the energy sector is being looked at as a real potential source of capital in view of the reduced bank participations we are seeing post-credit crunch," says Craig Nethercott, a partner at law firm Latham & Watkins, who has worked on some of the largest Gulf energy transactions.
Middle Eastern governments have strongly supported the participation of Islamic banks in project-finance transactions, yet energy financing in the Middle East has traditionally been dominated by large conventional banks from outside the region. Few IFIs have the balance-sheet strength to commit to long-tenor financings that are typically required of large energy projects.
"Islamic banks couldn't fully subscribe to, or arrange funding for a multibillion dollar project from their own resources. Historically, they didn't have the balance-sheet depth of conventional banks," says Ayman Khaleq, a Dubai-based partner at law firm Vinson & Elkins, which has advised on a number of energy financings. "That's why multi-tranche financing came into existence and I can't see the trend slowing down."
A much more prominent role
The use of Islamic capital-market instruments, such as sukuks, can be expected to play a much more prominent role in future deals. Capital-market instruments can replace some of the capacity lost from the commercial-bank market in recent years. "What the bigger projects are looking to do is tap the Islamic capital markets to provide significant additional finance on large energy projects," says Nethercott.
Saudi Aramco and Total, sponsoring a 400,000 barrels a day joint-venture refinery at Jubail, in Saudi Arabia's Eastern Province, are seeking a large Islamic capital-market component to help fund the $10bn project. In late 2009, Banque Saudi Fransi, Samba Financial Group and Deutsche Bank were appointed to lead manage the sukuk issue, which is expected to be around $1bn. In late March, Saudi Arabia-based Islamic Development Bank approved a $120m loan for the Jubail project.
The Jubail sukuk would be the first bond for an oil refinery in the Gulf, but advocates say it is well suited to other energy projects, complementing the equity participation. In the Petro-Rabigh project, provisions for the issuance of sukuk post-project were built in to the financing structure.
Other energy groups have issued sukuks in the past three years. In 2007, the UAE's Dana Gas issued a convertible sukuk that received such a positive response from the market that Dana twice increased its size – eventually reaching $1bn. In 2009, Malaysia's Petronas issued a five-year $1.5bn Ijara sukuk, the NOC's first Islamic paper, alongside a $3bn conventional bond.
However, sukuks have not always enjoyed an easy introduction to the energy sector, as the experience of the first US sukuk issuer, oil producer East Cameron Partners, shows. The oil company raised $167.8m through a sukuk in 2006, structured as a musharaka between East Cameron and a special-purpose vehicle in the US, to which it sold oil and gas royalty rights.
Sukuk investors used the proceeds to buy the 50% equity stake held by a previous financier, Macquarie Bank, as well as to fund capital expenditure and working capital in the gasfield. However, the offshore Louisiana wells failed to yield the expected returns, forcing the company to file for bankruptcy in a Louisiana district court in October 2008.
The US court is now deciding whether the East Cameron Partners sukuk holders own the oil revenues that underwrote the sukuk issue. The court is understood to be heading towards treating them as equity holders, which should give greater clarity on where investors stand in non-Islamic jurisdictions.
The default did not, however, put off other large US companies from testing out Islamic paper. In November, General Electric issued a $0.5bn sukuk, marketing it to investors in the Middle East, Asia and Europe. Non-Muslim investors are likely to continue to use Islamic finance structures. "East Cameron opened the door," says Vinson & Elkins' Khaleq, who advised on the East Cameron sukuk and is considering more deals in the US.
Another non-Middle Eastern energy sukuk was planned in 2007 by a Switzerland-registered investment-holding company, EnergyMixx, which was investing in a series of renewable-energy projects in Europe. It wanted to issue a €50m ($64m) sukuk to raise capital to help fund development of a 270 megawatt wind farm in Italy.
The proposed sukuk did not reach the market because of problems encountered in building the project's infrastructure. However, James Hume, a consultant to EnergyMixx, says sukuks still make sense in the funding of renewable-energy projects. "It particularly works for projects that have tangible assets," he adds. Sukuks rely on returns from tangible assets, such as rents to produce cash flows, rather than interest, to pay investors.
The principal attraction of sukuks is that they open up a bigger range of investors. "In the Middle East there are a number of investors who want to invest only on a Sharia-compliant basis," says Hume.
But the success of the sukuk market in energy projects depends on the appetite for the long tenors normally needed, usually 12-15 years. "The question is whether there is a deep enough pool of capital on the sukuk market," says a Gulf-based project-finance lawyer. The viability of sukuks depends partly on the project. The Aramco-Total Jubail refinery, for example, is seen as a relatively safe investment because it is supported by a Saudi state-owned entity. But projects with weaker sponsors may not be able to attract sufficient interest.
There are other factors that will limit IFIs' exposure to the energy sector. One of the biggest is the limited number of IFIs with the technical capacity to assess risk on energy-related matters. Many will still prefer to team up with large international banks that can operate through their own Islamic units, such as HSBC's sharia-compliant HSBC Amanah division.
The real advances will probably come in middle-market sukuk issuances that are backed by energy assets. Says Khaleq: "It could be a company that is expanding, or that has an asset it wants to borrow against for a sale leaseback."
In Saudi Arabia, the Petro-Rabigh and Ras Tanura refining and petrochemicals projects planned by Saudi Aramco are looking to raise large project-financing deals that will inevitably include significant Islamic tranches. "People want to do things Islamically. Everything I'm working on now has an Islamic tranche," says the Gulf-based project-finance lawyer.
However, there are still big hurdles to overcome. The wider Islamic sector is still coming to terms with the defaults of last year. In December, Dubai real-estate developer Nakheel requested the postponement of a $3.4bn sukuk repayment, eventually settled by an Abu Dhabi government loan, but this had followed large defaults at Kuwait's Investment Dar and problems at two Saudi-owned conglomerates.
The market is still lacking confidence. "Negative sentiment is dragging the market down. But if confidence does come back then companies will want to issue securities to fund projects. So long as there is solid backing and there's an explicit guarantee from a creditworthy sovereign, the demand will be there," says Khaleq.
The problems affecting sukuks are mainly short-term in nature and are unlikely to be a permanent hindrance to their relevance to energy financings. "The main problem is not with sukuks per se, but with the weakness of the companies' debt," says Justin Dargin, research fellow at Harvard University's Dubai Initiative. "Abu Dhabi's Taqa, for instance, utilised sukuks to fund its large assets-acquisition drive in 2007. However, its main problem was that it had too much debt load, as opposed to the sukuks themselves."
Islamic finance will have to clarify the legal contours of sukuks to make investors feel more secure, but many financial institutions in the region, local investors and governments are committed to the use of sukuk as a way to fund energy projects. "Regional actors do not see the problem of the sukuk market as being intrinsic, like the securitised mortgages in the US market, rather it is a problem of familiarising the court systems and standardising the offerings," says Dargin.
Green shoots of recovery
Some have spotted the green shoots of recovery. According to Moody's Investors Service, regulatory actions to improve sukuk offerings in new markets are raising its appeal as an issuance structure. Similar legislative actions by governments within the Gulf Cooperation Council and the Asia-Pacific region have created an environment of confidence, especially among international issuers.
The governments of Saudi Arabia, Abu Dhabi and Bahrain are planning further issuances either through central governments, or through government-related issuers. The Islamic Development Bank has announced continued support for the issuance of a further $5bn in sukuk over the next five years, starting with $1bn in 2010
"I think appetite is returning," says the Gulf lawyer. "People are generally feeling more comfortable with liquidity. They are dipping their toes in the water and new deals are coming to the fore."