Middle East Economic Survey

VOL. LIII

No 4

25-Jan-2010

Load factor is a key indicator of economic performance of the power sector since it affects the unit cost of electricity. A high load factor means that fixed costs are spread over more kilowatt-hours of output. Because of the seasonality of demand and the inability to store electricity, generators need to maintain a substantial  back up reserve. As a result, load factors in the power sector are much lower than the rates of capacity utilization in other industrial sectors. As revealed by past trends (Figure 1), in order to compensate for insufficient investment, power generators in both the GCC and the non-GCC improved load factors markedly during the 1990s and in the early years of 2000s to around 60% in 2004. However, as a result of a substantial rise in capacity in recent years, capacity utilization has settled at a lower 54%. But whatever past trends may have been, capacity utilization in the region remain lower than the 65% minimum assumed in more developed countries.

Figure 1: Load Factor In The GCC And Non-GCC Areas

Demand for electricity has so far been constrained by actual capacity and resulting production. During the 1990s, the region’s aggregate GDP grew by an average of 3.1% per year while electricity production increased by 5.5%. However, as a result of governments’ budget constraints the capacity needed to generate that production grew at only 1.8% per year. In the period 2000-08 production continued to increase at a higher annual rate of 6.7% compared to 5.8% for GDP. During that period, however, capacity expansion, witnessed an annual 5.5% growth thanks to governments’ improved fiscal positions, and the encouragement of private investments.

Obviously, the previous aggregates and averages conceal considerable country differences that reflect different demographic, economic and energy structures, as well as climate conditions. A significant country by country pattern is revealed in the 2008 cross-section regression analysis (Figure 2), which correlates log-transformed per capita capacity and log-transformed per capita GDP. The figure shows three distinct developing groups, with the GCC and Libya occupying the upper ground. The higher ranking of the GCC countries stems from a series of factors for which GDP per capita is a proxy in this area, including:

• Momentous urban expansion and faster economic and industrial development.

• Climate-related penetration of air-conditioning.

• Water scarcity and pressure to supply water from seawater desalination.

• Rising incomes and affordable (actually heavily subsidized) electricity and water.

This cross-section also highlights an important potential growth for the lagging areas.

Figure 2: Country By Country Pattern

Investment Outlook

Even assuming capacity savings can and will be achieved through better load management and the implementation or enhancement of sub-regional interconnections, capacity growth, which has been worked out on a country by country basis, is expected to be much higher than that of GDP over the next decade, notwithstanding current economic contraction.³  The resulting aggregate forecast of 7.7% annual increase for the period 2010-14 translates into a five-year capacity increment of 70gw above the estimated level of 155gw for 2009. Therefore, with current reference costs – reflecting prevailing prices of engineering, procurement and construction (EPC) and country investment climates – the resulting capital requirements will be in the order of $80bn for the forecast period. As shown below, the GCC area, which will continue to grow at the highest rate, accounts for nearly 60% of this total.

Table 1: Potential Power Generation Expansion in the Arab World, 2010-14

* 2009: estimates.

¹ Maghreb: Algeria, Libya, Mauritania, Morocco and Tunisia.

² Mashreq: Egypt, Iraq, Jordan, Lebanon, PT and Syria.

³ GCC: Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and UAE.

⁴ Remaining countries include Sudan and Yemen but exclude Comoros, Djibouti and Somalia for lack of data.

Source: Compilations and projections by APICORP Research.

These amounts are consistent with APICORP’s review of capital expansion in the Arab energy sector for the period 2010-14. The review has established that the potential investment in the power and power/water generation sector (excluding transmission and distribution systems as well as systems interconnection) accounts for 17% of the potential capital investment requirements of $470bn in the Arab petroleum and energy sector as a whole. In rolling out such programs, however, policy makers and project sponsors will face serious challenges, including fuel gas constraints and limited funding.

Fuel Gas Constraints

The power and power/water sector in the Arab region relies heavily on petroleum-fired thermal plants. In 2008, 56% of output was generated from natural gas and 40% from oil products. The remaining 4% was from hydro and smaller amounts of imported coal (Figure 3). Accordingly, this sector is the single most important industrial user of natural gas in Saudi Arabia, the UAE, Egypt, Algeria and Qatar.

Figure 3: Generation Of Electricity By Fuel Type, 2008

‎It is well known that the region holds about 30% of the world’s ‎proven natural gas reserves, but only ‎accounts for 13% of ‎total ‎gas output. Although a great number of Arab countries are endowed with substantial gas reserves, their supply ‎situation is difficult to gauge. A tentative attempt can be made through an optimal supply pattern (OSP) positioning. Reflecting the structure and use of resources, OSP is defined as the one set of solutions that equalize the share of gas ‎production in total ‎petroleum production with that of gas reserves in total petroleum reserves. A simple Euclidean distance shows how far different countries are from that optimum. Obviously, countries above the OSP dotted line (Figure 4), as is currently the case of Bahrain, use more gas than they could afford. On the contrary, countries below that line, as is the case of all others, have room (some plenty) for more use of gas. Tending towards OSP should be encouraged, unless such a move is perceived too expeditious as a result of demand growing faster than additions to reserves. This seems to be the case of Saudi Arabia, the UAE, Kuwait and Oman.

Taking a longer term dynamic view than the above characterization, Saudi Arabia has eventually resorted to gas supply rationing to new industrial projects. However, it is pinning great ‎hopes on new gas discoveries from the currently actively explored Rub' al-Khali basin. The other countries have had no other option but to contemplate imports. In this regard, the UAE exhibits a second position in Figure 4, ‎which highlights a significant shift of its supply position in the wake of substantial gas ‎imports from Qatar through the Dolphin pipeline. ‎Kuwait, which was denied a similar option for transit considerations, has been compelled to opt for LNG imports from very far afield‎.⁴

Figure 4: Gas Supply Positioning In The Arab World, 2008

Funding Challenges

A simple way to characterize the capital structure of investment is through a single debt-equity ratio. It has been demonstrated in previous APICORP reviews that the average capital structure of the Arab power and power/water sector was about 75% debt and 25% equity. However, as a result of the severe deleveraging prompted by the credit crisis, the debt-equity ratio has been reset at 70:30, resulting in an annual amount of debt close to $11.2bn per year. This amount is higher than the record level of debt (loans) financing of $9.8bn concluded in 2007 (Figure 5).

Figure 5: Loans To The Arab Power And Power/Water Sector

Nowadays, such amounts of debt for the power and power/water sector can ‎‎hardly be met owing to lesser credit availability and tighter lending conditions, not to mention the much higher costs ‎of ‎borrowing (Figure 5). ‎To weather the current funding situation, public utilities with investment grade ratings such as the Saudi Electricity Company (SEC), are considering tapping again the local capital market. This comes on top of the ‎move by public ‎investment funds to draw on ‎governments’ savings ‎and step up their lending and ‎involvement in the ‎local debt market.‎ All this, however, does not resolve the funding difficulties faced by many other utilities, which have further to cope with a shrinking involvement of the private sector.

Shrinking Private Sector Involvement

Nearly all Arab governments have engaged, albeit to differing degrees, in restructuring and liberalizing reforms of their power and power/water sector with the long term goal of developing competitive markets and prices. A more immediate objective of these reforms is to encourage private investment in developing energy infrastructure projects on a cost-competitive basis. As a result, and as far as investment is concerned, a number of project developments have, in recent years, involved independent producers. These are non-utility entities that focus on generating power (IPP) or combined power/water (IWPP) for sale on a long term basis to public sector offtakers with payment obligations generally guaranteed by governments. The investments are undertaken on a project finance basis, mostly via a non-recourse structure, whereby equity and debt are paid back from the revenues generated by the project company.

To boost their return on equity, private investors have indulged in very high leverages. However, as noted earlier, in the current more risk-averse and fund-limited environment, lenders have required higher equity stakes and asked for much higher loan margins, weakening as a result investment profitability. Furthermore, currently planned IPPs/IWPPs would hardly attract debt financing without lenders satisfied with additional risk ‎mitigation measures. These include higher quality of sponsors, reduced tenors for long term debt, longer term purchase agreements and ‎effective hedging of fuel supply risks.‎

‎Whether or not these ‎tightening measures will end up creating more disincentives to private investment expansion remains to be seen. For the moment, the costs of electricity and water expected from some IPP/IWPP projects are cited as no longer competitive, to justify decisions to revert to conventional development under EPC contracts. The most publicized such cases – Ras al‐Zour (Water and Electricity Company) and Yanbu (Marafiq) in Saudi Arabia – may, however, not be specific. Announced IPPs/IWPPs for the period 2010-14 have shrunk from a pre-crisis number of more than 20 projects to a dozen projects in the GCC countries, plus possibly Morocco and Tunisia. But this trend could not be expected to persist, as not all public utilities would be able to shoulder for long a bigger share of the burden of investment. Indeed, as long as electricity and water tariffs remain distorted and cost recovery is low, they will need government support. This may not be forthcoming, given the increasing and competing demands on public funds.

Conclusions

Notwithstanding the current economic contraction, many Arab countries will need to continue to catch up with unmet potential demand for electricity and desalinated water. Rolling out the corresponding massive investment program should remain a priority for policy makers and project sponsors. The most critical challenge they face, however, is funding. Indeed, due to global economic conditions, public resources have been inadequate and private investment has somewhat retreated. As a result, Arab governments are faced with a difficult balancing act, stepping up to fill the current funding gap while providing the assurances critical to regaining private investment momentum.

Notes:

1. Statistics for 2008 include those provided by the Arab Union of Producers, Transporters and Distributors of Electricity (www.auptde.org).

2. The GCC groups Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates (UAE).

3. Generally, demand for electricity/water is determined by the evolution of population, economic growth and prices. It is beyond the scope of this commentary to analyze how social and economic conditions and price subsidies are affecting demand in the Arab world.

4. Kuwait received a first cargo of LNG at its floating regasification terminal at Mina al‐Ahmadi in August 2009. LNG was shipped by Shell from the Sakhalin II LNG plant.