Middle East Economic Survey

VOL. L

No 40

01-October-2007

MENA Energy Capital Investment Outlook: New Trends, New Challenges

The following article by Ali Aissaoui, Head of Research at the Arab Petroleum Investments Corporation, is published concurrently in APICORP’s monthly Economic Commentary dated October 2007. Comments and feedback may be sent to research@apicorp-arabia.com

Despite higher capital budgets, MENA energy investments appear to be losing momentum. Policy makers and project sponsors who, until recently, have been boasting ambitious investment plans, have voiced concerns about two critical issues that can seriously impede future development prospects. On the one hand, project costs have unrelentingly been escalating and show no sign of abating. On the other hand and most recently, problems in the global credit markets, which are looming larger, may constrain capital flows into the region. In this unsettling environment, the annual review of investments in the oil, gas, petrochemical and power sectors of the MENA region, just released by APICORP Research, shed fresh light on the medium term outlook. The review, now in its fourth consecutive year, has used the same methodological framework to identify, on a rolling 5-year basis, new investment trends and challenges.

This article summarizes the key findings for the outlook period 2008-12. It first provides an overview of the energy capital investment and identifies geographical and sectoral patterns. It then highlights the changing capital structure and the likely tighter financing conditions. Furthermore, to complement the limited sample of sovereign credit ratings currently available, the commentary offers a comprehensive mapping of MENA energy investment climate. This has been developed to illustrate how each petroleum-producing country in the region is positioning itself to be able to attract and retain capital.

Overview

With 67% of world’s proven oil reserves and 45% of proven natural gas reserves, the MENA region is well endowed to bridge the widening gap between rising global energy demand and slowing supplies from other areas. During the last decade or so, the region’s share in world’s production has increased from 35% to 37% for crude oil and condensate and from 12% to 17% for natural gas. If sustained, the demand for MENA petroleum, demand which has been even more vigorous for natural gas, is likely to provide the region with the needed growth opportunities to realize its full potential.

Against this backdrop, the 2008-12 review has yielded valuable insights. The most significant is the continuing upsurge in the cumulative energy capital investment, which now stand at $490bn for the MENA region ($420bn for the Arab world). As detailed in Table 1, this represents a 24% increase over APICORP’s last annual survey of $395bn for the period 2007-11 (22% over $345bn for the Arab world).

Table 1

Energy Capital Investment

Source:  APICORP Research.

Past reviews up to that of 2006-10 had shown that rising capital investment was mostly matched with an increase in the number of projects. The 2007-11 review established that the number of projects had leveled off. In the present review, the number of projects has for the first time declined by 10% across the whole region and, except for the UAE, for all countries. In both last reviews, project costs have increased tremendously. As fully analyzed in Economic Commentary Vol 1 No 9 and MEES 49:36,¹  the factors most responsible for the escalation of project costs are notable changes in scope or scale of key projects and, above all, continued soaring EPC costs. Admittedly, the latter have been caused by rising prices of factor inputs, higher contractors’ margins and the systematic pricing of project risks.²

It is beyond the purpose of this review, which is in essence a data-driven analysis, to dwell on the rationale of capital accumulation and the numerous models of optimal investment decisions. It is worth noting, however, that, apart from the few cases involving strategic or political criteria, targeted projects for development are expected to generate a return on invested capital that is greater than the cost of capital. This implies that the marginal product of capital (additional value of output from an extra unit of capital) is higher than its marginal cost. With unrelenting increases in project costs, MENA project sponsors have sought greater scope and larger scale as a way to raise the marginal product of capital. In doing so, however, some of them have probably underestimated what economists call the “costs of excessive largeness”. Anecdotal evidence suggests that the economies of scope and scale of some large projects in the region are being offset by the diseconomies of the resulting complexities.

Geographical Pattern

Reflecting the distribution of petroleum resources, nearly half the planned energy investments are located in three countries namely Saudi Arabia, Iran and Qatar. Saudi Arabia has continued to top the energy investment ranking with an $105bn mark. Iran has moved from third to second place surpassing Qatar in the country ranking. Although having scaled down its investment plans, in terms of number of projects, Iran seems to experience far more inflated project costs than its GCC neighbours.

For reasons developed further below when discussing the energy investment climate in the region, the GCC area, which accounts for 56% of MENA total energy capital investment, is perceived as providing a comparatively much better enabling environment for investment.

Sectoral Pattern

Of the expected $490bn total energy capital investment in the MENA region, the oil supply chain (including the oil-based integrated refinery-petrochemical link) accounts for 41%, the gas supply chain (including the gas-based petrochemical and fertilizer links) for 45% and the oil-or-gas-fuelled power generation sector for the remaining 14%.

The extent to which the investment outlook in each link of the supply chain has evolved is shown in Figure 2. It reveals a much higher increase in the downstream sector, most dramatically in the oil-based refining/petrochemical sector.

Obviously, several factors can affect the investment outlook. As already anticipated in previous analyses (see for example Economic Commentary Vol 1 No 9), and confirmed by this review, soaring EPC costs have prompted most project sponsors to postpone or even cancel some of their capital projects on the grounds of expected lower returns. In this context and in view of the uncertainty regarding oil prices and margins, the refinery link in the oil supply chain would be affected most.³  Furthermore, the availability of low-cost and high-quality feedstock adds a further element of uncertainty for the ethane-based chemical industry.

Capital Requirements

Capital requirements and the associated capital structure and risk tolerance profile are complex corporate finance issues beyond the scope of this commentary. They can, however, simply be characterized by a single parameter ‒ the equity/debt ratio. The industry standard is for project sponsors and investors to first use retained earnings (internal equity) to fund highly risky but highly profitable upstream and associated midstream activities. By contrast, they tend to rely more on debt and external equity for less risky downstream activities. Current trends continue to point to an average equity-debt ratio of 30:70 in the refining, LNG, GTL, and petrochemicals sectors. In the power sector, the ratio is put at 25:75 to reflect the highly-leveraged IPPs and IWPPs.⁴

As shown in Table 2, the resulting capital structure for the period 2008-12 is likely to be 50% equity and 50% debt, compared with the equity-debt ratio of 47:53 found in the 2007-11 survey. Despite an overall lower debt ratio, however, the volume of debt of some $49bn per year is still considerable.

Table 2

Capital Structure

Source:  APICORP Research.

Financing Options And Challenges

Assuming oil and gas export prices remain strong, retained earnings are expected to provide project sponsors with enough funds to self-finance the upstream and associated midstream. By contrast, funding prospects for the highly leveraged downstream are uncertain. Not only does the required annual volume of debt of $49bn exceed by 25% the all-time record of $39bn achieved in the loan market in 2006, but current trends in global credit conditions and the consequent up-pricing of risk are likely to translate into tighter lending standards and higher borrowing costs. To be sure, with growing risk aversion among investors, the appetite for debt issued in the region is expected to be subdued.

In this context, and more than any time before, projects’ and companies’ credit ratings, which are almost always capped by sovereign risk limits, will be closely scrutinized. Regrettably, not every country in the region has a sovereign rating. Of the 16 MENA petroleum-producing countries, only nine have solicited one and just seven of them have managed to attain investment grade. The fewer countries in the GCC area, whose rating has recently been upgraded from A+ to AA- by S&P - or equivalent ratings by other credit rating agencies (CRAs) - will be able to achieve lower borrowing cost and better lending terms.

Investment Climate

To complement the above limited number of sovereign credit ratings, APICORP Research has developed a “perceptual mapping” of the energy investment climate that encompasses all 16 MENA petroleum-producing countries (Figure 2). The mapping is based on three attributes: Investment Potential, Country Risk, and the Enabling Environment. The resulting 3D map (flattened to two dimensions for greater clarity) shows an IDEAL POINT, which is the centre of gravity of the highest achievable scores (see Economic Commentary Vol 1 No. 6 for further details).

Saudi Arabia (KSA) on the one hand, and the cluster formed of Qatar (QAT), the United Arab Emirates (UAE) and Kuwait (KUW) on the other hand, occupy the most desirable quadrant [Vast Investment Potential - Strong Enabling Environment – Lower Country Risk]. They all appear nearest to the Ideal Point. Iran (IRN), which used to be marginally within this quadrant has moved out of it. Iraq (IRQ) remains the farthest from the Ideal Point. It has to drastically improve its security environment to enable investment. All other countries are clustered to reflect similar degrees of perceived investment climates.

Conclusions

Notwithstanding the shelving of a substantial number of previously planned projects, whose viability has been weakened by continuous escalating costs, APICORP’s review of energy investments in the MENA region for the period 2008-12 highlights a further acceleration of capital requirements in nominal terms.

Although the resulting capital structure has overall slightly shifted to equity, the downstream industry remains highly leveraged. In a context of higher risk aversion and tightening credit conditions, securing the appropriate amount and mix of debt are likely to be considerably more challenging, particularly outside the GCC area. Our perceptual mapping of MENA energy investment climate continues to outline the importance of improving the investment climate, which should remain a key focus of policy-makers’ concerns.

Figure 1

Evolution Of Investments By Country In The Successive Reviews

Figure 2

Evolution Of Investments By Sector In The Successive Reviews

Figure 3

Perceptual Mapping Of MENA Energy Investment Climate

Notes

1.   Aissaoui, A. (2006). “What is Inflating Energy Capital Investment Requirements in MENA Region: Scope, Scale or Cost?” MEES 49:36.

2.   For a perceptive analysis of the pricing of project risks see: Merrow, E. W (2006), “The Cost of Project Risks: Contracting for Large International Projects in the New Era”, Independent Project Analysis, Inc.

3.   At the time of writing, the fate of Kuwait’s Fourth Refinery Project (615 kb/d), whose cost soared from US$6 billion to US$15 billion in less than three years, was still in the balance. 

4.   As private investors seek to enhance returns on equity, IPPs/IWPPs have generally a much higher debt-equity ratio of 85:15. However, they represent only 40% of the expected 70 GW capacity-increment for the period 2008-12.