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Oil and gas contractors feel interest rate pinch

24 February 2023

Commentary

Wil Crisp

Oil & gas reporter

Rising interest rates are eating into the profits of some contractors developing oil and gas projects in the Middle East and North Africa (Mena) region and are likely to force them to put up prices for clients.

Although contingent upon the agreed financing arrangements, higher interest rates will likely leave many contractors paying more to borrow the money they spend on project execution.

This month, the central banks of the UAE, Saudi Arabia and Bahrain raised their benchmark borrowing rates after the US Federal Reserve raised its key interest rate in its first policy decision of the year on 1 February.

GCC currencies, except for that of Kuwait, are pegged to the US dollar and therefore follow US monetary policy.

The Fed increased its policy rate by 25 basis points as it continued to push to bring inflation down towards its target range of 2 per cent and restore price stability.

This was the eighth rate increase since the US central bank started raising rates in March last year and pushed rates in the US to their highest since the 2008 financial crisis.

Rising interest rates have raised costs significantly for some contractors executing projects in the Mena region, dramatically reducing profit margins.

Contractors that have taken out loans to execute projects using a build-operate-transfer (BOT) contract model are among those hardest hit.

Under a BOT contract, a public entity grants a concession to a company to finance, build and operate a project.

The company usually deploys debt and equity upfront to build the project and then operates it over the long term to recoup its investment. It then transfers control of the project back to the public entity.

Because the company only usually starts paying off its loan gradually once the project is completed and the facility is operational, it can take many years to pay back. The higher interest rates are likely to significantly impact the contractor’s profits.

Contractors that have taken a loan to execute a project using the engineering, procurement and construction (EPC) contract model are also likely to be negatively impacted by higher interest rates, but to a lesser extent.

This is because EPC contractors are usually fully paid for their work when the project is completed, allowing them to pay off their loan far more quickly than if a BOT contract model has been used.

The additional costs associated with higher rates are likely to be especially problematic for contractors wrestling with supply chain issues and higher material costs due to inflation.

For clients looking to tender major oil and gas projects, the higher interest rates could mean a project may see less enthusiasm from contractors if it tenders a contract using the BOT model.

If they use this model, they can also expect to see higher prices quoted as contractors try to pass on the cost of higher interest rates.

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Wil Crisp

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