With project costs expected to remain high, there is a compelling argument for buying, rather than building new downstream capacity, according to Darren Davis, HSBCs Head of Project and Export Finance, MENA. This, alongside the growing confidence of Middle East energy companies as players on the international stage, suggests that the recent rash of M&A activity is set to continue. Melanie Lovatt reports from Dubai.
The huge jump in project costs seen over the last two years, driven by the rising cost of raw materials and insufficient EPC capacity, looks set to continue as the defining factor for investors in oil and gas downstream industries. While HSBC sees prices coming down for raw materials in the next year or so, the overheated contracting market is expected to take much longer to cool down. For that reason, we think capital costs are going to stay high, probably for two years, maybe longer, and major projects will be deferred, said Mr Davis, speaking at theFleming Gulf 3rd Annual Project Finance In The Middle East Forum in Dubai on 21 May. He suggested the private sector was more at risk because the public sector was less sensitive to investment return. Given the high cost of greenfield expansion, not to mention possible delays in construction, companies should examine the option of buying additional capacity, he said. A simple analysis showed costs of around $1,500-3,000/B to buy capacity (based on recent acquisitions in Europe) versus the $10,000/B price tag of the most recently built Middle East refinery (Omans Sohar). More recently proposed refineries look even more expensive at $15,000-20,000/B (see table below).
This is a simple analysis and certain parameters should be taken into account, such as age of the refinery and configuration. But the numbers are so stark it suggests there is a mismatch between how much it costs to buy and how much to build, he told MEES , adding that even if costs were closer to parity, purchases would bring instant cash flow, while building a refinery would take three to four years, during which the market might move against the sponsor: This is particularly relevant now because the market is in an attractive state in both refining and petrochemicals.
Although refineries and petrochemical assets are of high value under current market conditions, sales are still taking place because sellers want to lock in these gains, with some European and US companies looking to exit the commodity sector for strategic reasons, possibly in order to move further downstream. In the current market there is scope for investors to exit and we think that this will continue, Mr Davis said. There is a lot of capital in the region and companies are getting more confident in investing abroad. There was caution in terms of investing in the US and Europe, but this is now changing. He went on to cite recent rumors that Middle East investors were looking to buy the US Dow Chemical, which would be a $50bn-plus acquisition.
To Buy Or To Build?
European Acquisitions | Date | EBITDA Multiple | Cost Per Refining Barrel ($) |
Tupras | September 2005 | 10.0x | 2,707 |
Mazeiku Nafta | May 2006 | 9.2x | 1,523 |
Coryton | February 2007 | 5.6x | 678 |
Projects | Total Project Cost | Refining Capacity | Cost Per Refining Barrel |
($ Bn) | (Tons) | ($) | |
Sohar (2003) | 1.2 | 116,000 | 10,345 |
Saudi Aramco Export Refineries | 6.0 | 400,000 | 15,000 |
Ras Al-Zour (Kuwait) | 12.0 | 615,000 | 19,512 |
Source : HSBC.
Aggressive Competition
Competition for assets, particularly from aggressive new Middle East-based companies like TAQA and the growing numbers of private equity energy firms, could drive up the price of assets and close the gap with the cost per barrel of constructing a new project. The odds are that it will continue to push prices up, but a case-by-case analysis must be undertaken, Mr Davis told MEES . Ultimately prices could go up but it could still be more attractive to buy than build. He stressed that the full impact of Middle East capital had yet to be seen because there had historically been a bit of nervousness in investing in industrial assets outside the region. The regions investors have focused on property and stock markets, but there have not been a lot of major acquisitions of businesses, although this is starting to change, he continued.
Nevertheless, according to Mr Davis, if a company decided to take the greenfield route, then the Middle East was still the best location, given the low cost of feedstock, such as gas for the petrochemical industry. But he warned that even in the Gulf the project finance market would remain tough for both sponsors and lenders. Given that EPC contracts had now moved to open book conversion, with the lump sum turnkey contract only available late in the process, it made it more difficult for sponsors to raise finance because final project costs were unclear. This forced sponsors to purchase equipment before their financing was ready, increasing their risk as they put more equity on the line, Mr Davis added. This was a double whammy, because not only was sponsor equity percentage increasing but total project costs too were rising. As a result, some projects, particularly in the private sector, would struggle and some would be cancelled.
Bank Liquidity
While sponsors are feeling the negative impact from increased costs, banks continue to suffer lower margins, with the Gulfs pricing perception improving markedly and moving into line with European and US pricing for projects as bank liquidity continues to outpace debt requirements, said Mr Davis. But in his view this could change for some of the largest projects proposed. The higher capital costs meant banks were also being saddled with projects with lower debt service coverage ratios and higher tenors. The risks on projects in the Middle East are not particularly high, but theyre certainly greater now than they were a few years ago, he said. However, the silver lining is that, given some projects had been deferred or cancelled, the increase in capacity and resultant market downturn that normally followed the period of high prices might be less severe, particularly for the petrochemical and refining sector. Therefore market conditions could be more benign than expected and the peak could thus last longer, he said.
