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Friday, 17 November 2017

IFR Mid East 2006 - SEPC - Four in one

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The signing of the US$1.8bn of financing facilities for the Saudi Ethylene & Polyethylene Company’s new petrochemical complex marked a major milestone. By Darren Davis, Director, Project & Export Finance, HSBC.

The financing is linked to a series of four interlinked complexes being developed in Saudi Arabia by the private sector. SEPC, which comprises a mixed feed gas cracker and two polyethylene lines, is the largest of the complexes that together comprise an investment of approximately US$5bn, representing the bulk of the latest round of private investment in the Kingdom's petrochemical sector, which has been actively encouraged by the government since the late 1990s.

Development of these plants is being spearheaded by three of the leading Saudi private sector groups involved in the petrochemical industry. They are Tasnee Petrochemicals, which was one of the first private groups to develop a world-scale petrochemical complex in Saudi Arabia with the establishment of its 450,000 tpa polypropylene plant; Saudi Polyolefins Company (SPC), which began commercial operations in 2004; and Saudi International Petrochemical Company (Sipchem), which was a fellow pioneer in the development of the private sector petrochemical industry in the Kingdom and also has a successful track record having developed first a 1m tpa methanol plant that also commenced operations in 2004 and a 75,000 tpa butanediol plant that started up late in 2005. The company is now developing an acetyls based complex that will utilise feedstock from the methanol plant as well as the SEPC project.

Sipchem is a company founded by the Zamil Group, one of Saudi Arabia's oldest companies, and following on from the success of Sipchem, Zamil founded another of the private groups behind the current complexes, Sahara Petrochemical Company. Sahara conducted a very successful IPO in May 2004, evidence of the interest among investors in the growth prospects of the local private sector. In addition to its ownership interest in SEPC, Sahara is now developing a new polypropylene production facility, the Al-Waha project.

A common strand across the SEPC project, the SPC project and the Al-Waha project is the presence of an international partner, Basell Polyolefins. Basell is the world's largest producer of polypropylene and advanced polyolefins, a leading supplier of polyethylene and catalysts and a global leader in the development and licensing of polypropylene and polyethylene processes. The company was formed in 2000 by the merger of the polyolefins businesses of Shell and BASF. In August 2005, Basell was bought by US-based investment group Access Industries. An early investor in the sector in Saudi Arabia, Basell contributes expertise in technology, operations and marketing.

Among them then, these investors have four major new projects under construction, the centrepiece being the SEPC project, which is owned by Tasnee Petrochemicals, Sahara and Basell.

Project structure

The integrated complex currently being developed comprises four distinct production facilities each owned by a different project company with some common but ultimately different ownership.

The principal physical relationship between the plants, apart from being physically proximate, is that the SEPC project will be the supplier of ethylene and propylene to the other three new projects, although in the case of Sipchem's acetyls project, this supply will be only for the period until Sipchem's own cracker-based complex comes on stream in around 2011.

In terms of financing, the total debt required for the projects comes to about US$3.5bn. Fortunately, this amount is split among the projects, meaning that the Al-Waha and Sipchem acetyls project require around US$250m of commercial debt financing in addition to the debt financing available from local development funds, a number comfortably manageable in the regional bank market. More stretching was the financing for the SEPC project, which required US$1.8bn of financing, representing by far the largest amount of finance ever raised for a private sector project in the Middle East.

Chief among the challenges that faced the sponsors in raising this debt were:

  • Finding sufficient debt sources to meet the funding requirement
  • The need to raise finance on the basis of a non-recourse structure (no completion guarantees)
  • The need to have the financing process accommodate a more complex EPC contracting strategy
  • Meeting lenders' security requirements
  • Managing the inter-project risk

Funding sources

Raising debt finance for a privately sponsored project of this size would be a challenge anywhere in the world but there are certain aspects of the situation in Saudi Arabia that make this an even more interesting prospect. On the positive side, the Kingdom has long made available significant funding for projects of this type from two government-owned development funds. The Saudi Industrial Development Fund (SIDF) is able to lend up to SR600m (US$160m) of funds to each project and in this case the SIDF agreed to consider the SEPC complex as being two projects: the cracker, and the polyethylene plants. This enabled loan applications to be made for US$320m of finance.

The Public Investment Fund (PIF) has a larger capacity to lend to projects but has a process that is closely aligned to that of the SIDF, effectively meaning that PIF approval cannot be obtained until SIDF approval has been given. The SIDF process is itself lengthy, involving detailed due diligence, and at present SIDF is extremely busy supporting the current high volume of new projects in the Kingdom. What this means is that PIF funding cannot be secured until quite late in the financing process and potentially, as was the case here, after the remaining financing is in place.

The regional bank market currently has limited appetite for privately sponsored projects, although the currently very low pricing on government sponsored projects means that appetite has increased to a degree for the private sector deals, which price higher. But even so, we estimate that regional appetite for a Saudi based private sector project of this type, taking into account the non-recourse structure, is probably no more than US$400m at present. Combining this with the PIF and SIDF monies, this gives a maximum capacity for indigenous funding sources of about US$1.4bn. Of course, at this level there would be almost no competitive pressure on the bank market, and in any case, for this project, this would still be some way short of requirements.

The financing strategy was based on the principle of approaching debt sources for more finance than would be needed to (1) ensure sufficient capacity in the event a source of debt were to become unavailable, and (2) maintain competitive pressure on the sources and allow the sponsors to choose the most attractive sources both on the basis of cost but also in respect of the borrowing terms obtained.

The deepest potential sources of liquidity beyond the regional bank market are international banks and Export Credit Agencies (ECAs). International bank appetite for Saudi projects has been muted for some time and remains limited compared with some of the other markets in the region. This is a situation that we believe will change but at the time the SEPC debt was raised we were aware that international bank liquidity was unlikely to provide a great deal of commercial bank debt, despite the inherent strength of the project itself.

ECA finance offered a better prospect, given that ECAs were known to be eager to increase their exposure to the Middle East generally and Saudi Arabia in particular. Very little ECA finance has been used in previous Saudi projects and among the ECAs we could approach (based on the EPC contracts) only two had previously taken exposure in Saudi Arabia (Hermes and Kexim), and even then to a project with significant government involvement. In addition to these two agencies, we also approached SACE and the second South Korean agency, KEIC. Of course, the added benefit of having ECA financing facilities is that this can pull in more liquidity from international lenders.

By combining these sources then, we were able to generate potential capacity for the project well in excess of the amount actually required to finance it.

Involving ECAs in a financing process is often seen as inevitably introducing undue delay and difficulties for complex project financings. Our experience with the SEPC project belied that to a large degree and the strategy of engaging with the ECAs early and encouraging them to work as a single team paid off well in terms of securing commitments on reasonable terms and on a reasonable timeline, which in fact was not too much longer than that achieved with banks.

As can be deduced from the timeline, at the signing of the financing in June, there had to be sufficient finance in place to cover the PIF loan, which at the time was uncertain. To allow for this, a bridge tranche was incorporated into the commercial bank facilities that provides for funding in the event that the PIF does not support the project.

Non-recourse structure

The most demanding aspect of the financing structure was undoubtedly its non-recourse nature. It was determined early on that the sponsors would not be in a position to guarantee repayment of the US$1.8bn debt package, and thus the structure from the outset was on the basis that completion risk mitigation would be made through directly addressing the identified risks rather than relying on the blanket cover of a corporate guarantee from sponsors.

Completion risk for a petrochemical project can essentially be broken down to two components: (1) technology, ie, the risk that the processes will not operate as intended, and (2) delay, ie, the contractor is unable to complete the plant to schedule and the project runs out of funds during the delay.

The technology risk aspect was dealt with by utilising, where possible, well proven technology. Where technology of a less proven nature was adopted, a considerable amount of time was invested with the technical consultant to the lenders in explaining and discussing the technical risks involved. Through this process, the technical consultant was able to provide comfort to lenders that the technology risk was low.

The risk of delay is a somewhat more open-ended risk to analyse. The key is to determine a '90%' case for delay and structure the financing to deal with such a case. Again, the involvement of the lenders' technical consultant from early on was crucial and a detailed analysis of the causes of delay in this type of project was undertaken to determine the scenario on which to base the funding. The conclusion was that a maximum 18-month delay could be considered as sufficiently prudent and thus additional standby funding (from sponsors and lenders) was established based on the costs of such a delay, essentially the fixed costs (primarily labour) and debt service for that period.

EPC contracting

It has been an unavoidable part of the project financing business in the past year or so that project costs have escalated substantially due to rising EPC contracting prices. The cost of raw materials such as concrete, steel and precious metals has certainly contributed to this, but the lack of contracting capacity in the face of a huge wave of infrastructure development has enabled contractors to regain pricing power after a long period when it was owners who held the negotiating leverage

The contracting strategy adopted by the SEPC sponsors was driven by the need to limit the impact of this change in the contracting market and manage the project cost-effectively while maintaining a contract structure that could be readily financed on a non-recourse basis. The contracting involved two EPC contracts, one covering the cracker and the utility requirements for the complex as a whole, and a second covering the two polyethylene units.

The construction time schedule for the cracker and utilities is longer than that for the PE and hence was started earlier. By June 2005, lump sum bids on the cracker and utilities had been received that were competitive but it was clear that delaying award of the contract would expose the project to potentially substantial price increases. At that point, the sponsors took the decision to award the contract and start work on the basis that sponsors would fund the costs until the financing could be obtained. An Early Works Agreement was signed in July 2005 and work began with the form of a LSTK EPC contract already substantially agreed with the contractor, most importantly with the price fixed.

For the polyethylene units a different strategy was pursued. Noting the rapid shift in the contracting market, the sponsors decided in July 2005 to appoint a contractor on the basis of a contract that would convert to a lump sum after an open-book process. This approach removed a good deal of the procurement risk from the contractor and thus avoided a heavy risk premium being included to the lump sum price. The timing of the conversion was such that the price would be fixed prior to the conclusion of the financing and thus lenders would not be required to take price escalation risk.

Obviously, using this approach the sponsors had to take a view on the likelihood of being able to raise the required finance given that entering into the Early Works Agreements entailed a very substantial financial commitment.

Lenders' security

The legal system in Saudi Arabia makes the lending environment unusual in a number of respects for banks (and ECAs) used to lending to projects in other jurisdictions. Beyond the obvious prohibition of interest, which has been dealt with through mechanisms developed some years ago by the Saudi central bank, SAMA, the ability to take security over project assets is the principal remaining difficulty faced by lenders.

Although there is some debate over the issue, it is generally accepted that it is currently not possible for lenders in Saudi Arabia to take and register a mortgage over a borrower's physical assets to secure a debt. There is, however, one exception to this and that is that the SIDF is empowered to establish such mortgages to secure its loans.

Historically, the lack of a mortgage has been accepted by local banks, which have often not required such a security or, as has often been the case, they have taken advantage of SIDF's ability to do so and have sought to benefit from this by entering into arrangements with the borrower and SIDF whereby any proceeds from SIDF enforcing its security can be paid to other lenders following repayment of SIDF's own loan facilities.

This unusual arrangement has also been accepted by international banks on projects in the past but we were aware that the principle of being second ranking in respect of security would be difficult for ECAs to accept. However, it was quickly established with the ECAs involved that the preference would be to have the SIDF involved in the project and provide for this less than ideal (from the other lenders' point of view) onshore security package rather than have no SIDF involvement and thus no enforceable security over the project's physical assets at all. The offshore security package remains largely standard for project financing based around the usual secured offshore accounts and assignment of reinsurances.

Inter-project risk

One issue that was less problematic than might be expected was that of inter-project risk. Almost 500,000 tonnes of ethylene and propylene are to be sold each year by SEPC to the other three projects, and this obviously makes up a significant portion of expected revenues. The usage of this product by the off-takers is dependent on the completion of the other three projects, including the expansion of the SPC plant.

In respect of the propylene sales (285,000 tpa) to SPC, the risk was assessed as low given that the expansion project at SPC is well advanced with an EPC contractor appointed and with the extent of the project in any case being quite limited due to significant pre-investment in the original SPC plant. The modest cost of the expansion is being financed directly from SPC's cashflows.

For the ethylene sales, the situation is slightly different given that both the Sipchem acetyls and Al-Waha projects are greenfield projects that at the time of the SEPC signing had yet to secure their full financing packages. Although both projects have progressed well, the contractual structure adopted to remove the offtake risk from SEPC's point of view was that instead of the project companies themselves being off-takers, the principal sponsors of each project, ie, Sipchem and Sahara, will act as off-takers from SEPC, which will then sell on the ethylene to the actual project companies.

There remains an additional comfort to lenders in that both ethylene and propylene are valuable chemical feedstocks in their own right, with considerable demand. The SEPC project will be connected to the existing ethylene and propylene pipeline grids in Jubail Industrial City, which will enable the project to sell to the numerous petrochemical companies in the area. Connections to the export facilities at nearby King Fahd port will also allow these products to be exported to overseas buyers as a fall-back.

A project as complex and as sizeable as SEPC will always be more of a challenge to finance than the more common government-sponsored projects we typically see in the Middle East. However, what SEPC demonstrates is that with a sound project concept, sponsors that are able to commit to and support the successful execution of the project, and a well planned financing process, a major debt package can be assembled in a reasonable period of time and on terms that deliver value to the project owners while offering a reasonable risk profile to lenders.

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