Huge investment is needed to support the continued development of the oil and gas industries in the region
The Middle East and North Africa region (MENA) leads the world in oil and gas production, but the cost of holding the number one position is set to go up massively over the next five years. This was the main conclusion of extensive research carried out by the Riyadh-based Arab Petroleum Investments Corporation (Apicorp), and published over the last few months.
The region, it notes, currently accounts for 67% of the world’s proven oil reserves and 44% of gas reserves.
On the production side, in 2005, MENA was responsible for 37% of world oil output and 15% of natural gas production. These are big numbers, and to keep the oil and gas flowing at this level it is clear that the region’s countries will need to continue putting new money into exploration, production and downstream activities, such as refining.
The question is how much, and at first sight the answer is a large and rapidly rising amount. Back in late 2003, Apicorp estimated that the MENA countries would need US $180 billion worth of new investment to maintain output trends over the following five years (2004-08). But the ‘next five years’ figure then jumped to US $210 billion in 2004 (for 2005-09), US $260 billion in 2005 (for 2006-2010), and this year it has been calculated at a whopping US $395 billion (for 2007-2011). This represents an increase of 52% in only one year.
To put the number in context, it is almost US $80 billion a year, just a little under the total value of New Zealand’s gross domestic product.
Why is the cost going up so much and so fast? Apicorp detects a number of reasons. One issue is that investment cost inflation seems to be more acute the further downstream you move. The MENA countries have of course been moving progressively downstream in pursuit of a greater share of the value-added to be captured along the entire production chain. Capital costs have increased most in oil refining, gas-based petrochemicals, and fertilizer projects.
Another factor is that as researchers have surveyed expansion plans in the pipeline over each of the last three years, they have noticed a marked trend towards fewer and larger projects. This suggests the oil producing companies in the region are also driving toward the achievement of greater economies of scale. This is leading them to opt for bigger, sometimes more complex, and almost always more costly facilities. The desired benefit is that unit costs will fall, but to achieve that, the up-front investment must be that much larger.
However, it is not always possible to judge from the outset whether bigger really will be better. In principle it is easier to work out when a large production facility has one main product line, such as liquefied natural gas (LNG). In this sector there has in fact been a clear trend towards much larger production trains, and the revenue numbers seem to justify them.
In contrast to this, Apicorp cites the example of the Petro-Rabigh project, a joint venture between Saudi Aramco and Sumitomo Chemical, which has become a gigantic refining and petrochemicals complex delivering a variety of inter-related product lines. The total investment cost was initially estimated at around US $3 billion in June 2003 when the project was launched, and it then climbed, in a series of steps, to just under US $10 billion three years later, in June 2006. At the end of Year 1 there was a 43% cost update, followed by changes in scope and scale (+45%), another cost update (+30%), and finally, at the financial close of the project, a funding update, which added another 17%.
Kapilkumar Kumra, the Arab Bank’s vice-president for project finance, has commented that ‘the continuous increase in engineering, procurement and construction costs has resulted in the economies of the project being completely altered in many cases.’ This escalation process is familiar to many large scale and complex investment projects in different industries and parts of the world, from airports to Olympic cities, but the oil industry may be particularly prone to them. As Apicorp puts it, there are potential ‘costs of excessive largeness’ that need to be monitored.
Apicorp says a typical oil industry investment project is around 90% capital cost and 10% financing costs. The 90% in turn breaks down into 70% for engineering, procurement and construction (EPC) costs, and 20% for other costs, items such as contingency, taxes, licensing fees, land, maintenance, spare parts and training. With US and international interest rates rising, financing costs have admittedly been pushing up, but the real driver of the rising capital bill seems to be the EPC component.
This EPC ‘price explosion’ can in turn be traced to three main factors, Apicorp suggests. First the costs of raw material inputs, particularly metals such as steel needed in refining plants and pipelines, have rocketed. Metal and minerals prices have increased by an annual average of 52% since early 2003, according to the World Bank. Shortages of skilled labour have also contributed to high set-up costs. Second, the specialised engineering companies and contractors that build the new facilities have increasingly found themselves in a seller’s market where they can dictate terms and boost their margins. According to US research, contractors’ margins as a proportion of total EPC costs were progressively compressed down to around to 2-5% in the 12 years to 2002, but have since widened sharply to 9-12%. This may be one of the undesired effects of a shift to fewer, larger and more complex projects: there seems to be only a small pool of international companies able to deliver them, and they can therefore pretty much name their price. In third place, under the prevailing lump-sum turn-key contracts, it is the contractors who must absorb project risks, undertaking to deliver the completed facility on time and on budget. They have therefore opted to take out comprehensive insurance packages and build the substantial extra premium cost into the overall contract price.
Apicorp analyses the capital cost requirements of the next five years from a variety of angles. In terms of distribution, Arab world countries take the lion’s share of the total required, at US $345 billion out of the MENA total of US $395 billion. The greatest value of future investment projects in MENA is concentrated within three countries, Saudi Arabia, Qatar, and Iran.
Saudi Arabia, with its massive oil output, dominates the investment picture, with the capital cost of future projects in 2007-2011 put at US $85 billion. If countries are ranked in terms of those which have experienced the sharpest rises in future investment costs, the list is led by Kuwait, Egypt, Qatar, and Libya, with increases of 115%, 86%, 84% and 61% respectively on year-ago levels.
Qatar has moved into second place after Saudi Arabia as the country with the biggest investment requirements over the next five years (close to US $60 billion), followed by Iran (around the US $50 billion mark) and Algeria (over US $30 billion). While the value of future investment projects in Saudi Arabia has increased by a large proportion – 47% – it is moderated by the fact that the kingdom already has a large capital base and the main project sponsors, Saudi Aramco and SABIC, have a large portfolio of potential projects from which to select the more cost effective.
The oil supply chain, including oil-based refineries and petrochemical plants, accounts for 39% or US $154 billion of the future investment projects in the pipeline. The gas supply chain, including gas-based petrochemical and fertilizer plants, is responsible for a larger 46% or US $182 billion, with power generation, whether oil or gas based, accounting for the remaining 15% or US $59 billion. As already mentioned, investment costs have grown most sharply in the downstream sectors, particularly in oil based refining/petrochemicals and gas-based petrochemicals and fertilizers.
Apicorp tries to map out which countries offer the best operating environment for new projects, using what it describes as a ‘perceptual mapping of the energy investment climate’. It does this based on scores on three axes: investment potential (which ranges from ‘vast’ at one end of the scale to ‘limited’ at the other); country risk (from ‘high’ to ‘low’) and what it describes as the enabling environment (‘strong’ to ‘weak’). One of the top scorers is Saudi Arabia, which emerges as closest to the ‘ideal point’ marked by a vast investment potential, a strong enabling environment, and a low country risk. Another high-scoring group is a cluster formed by Qatar, the United Arab Emirates, and Kuwait. Iraq and Iran come out lower in this particular ranking because of higher country risk scores and, in Iraq’s case, a weak enabling environment.
One of the key questions is whether the MENA countries will actually be able to raise the funding for the US $395 billion worth of investment they must find over the next five years. Apicorp suggests that both the national oil companies (NOCs) and the international ones (IOCs) will basically use retained earnings (equity) to fund upstream and midstream projects, moving to a wider mix of funding sources in the downstream sector, where they will incorporate more debt and external equity. At present the funding of LNG, GTL, and petrochemicals projects tends to be on a 70:30 debt:equity split, rising to 75:25 in power generation projects. Analysing the composition of forthcoming projects and applying these rough guidelines, the conclusion is that the total funding requirement over the next five years will be 53% debt and 47% equity.
Last year the balance was the other way round, at 47% debt and 53% equity, indicating that the overall borrowing requirement for future investments is increasing substantially.
Apicorp concludes that ‘while retained earnings are expected to provide NOCs and IOCs with sufficient funds to self-finance the upstream and midstream sectors, the highly leveraged downstream sector will face an increasingly challenging funding prospect as the total amount of debt – some US $42 billion per year – far exceeds the record of US $30 billion raised in the loan market during 2005’.
The report suggests that there is therefore an emerging funding gap, which will need to be covered by bonds and sukuks.
Apicorp’s research suggests a number of conclusions. One is that MENA countries should react to the sharp rise in investment costs, particularly in the EPC sector, by trying to secure a better deal from contractors. This might involve renegotiating the terms of current lump-sum turn-key contracts, possibly with a more even distribution of project risks between the parties.
In addition, more specialised contractors must enter the market to enhance capacity and make it more competitive. If this does not happen there is a risk that project sponsors ‘might consider delaying or even cancelling some of their capital projects on the grounds of expected lower investment returns’ – a risk that is highest in ‘the refinery and petrochemical links of the hydrocarbon supply chain, where the uncertainty of future revenues outweighs that of costs’.