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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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    Gulf banks are proving adept at navigating the economic and geopolitical turbulence that comes with operating in the region. These skills have come to the fore this year, as regional lenders draw on stable funding profiles and ample capital and liquidity buffers that protect them from near-term credit risks. 

    GCC banks’ fundamentals have proved remarkably resilient to the Iran-related turmoil, assuming the intensity of the February-April stage of the military conflict does not resume.

    There have not been any significant outflows of external funding. While anecdotal evidence suggests some depositors briefly moved funds out of the region at the start of the war, ratings agency S&P Global notes that their return reflects confidence that the war will prove short-lived.

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    Funding and liquidity is generally a strength for the region

    Gulf states’ heavy reliance on public sector and government-related deposits has proved valuable in the current environment, anchoring banks’ funding profiles and helping reduce potential risks.

    Fund outflows have not materialised to any significant degree. “We had some anecdotal evidence of funds being withdrawn, but they returned in the following weeks,” says Ramsdale.

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    GCC banks entered the conflict period in strong shape. According to S&P, domestic private sector credit growth in the region remained robust in the first quarter – the annualised growth rate was 8% at the end of March. 

    Core capital buffers are about 15%-16% – higher still for the top lenders – ensuring total loss-absorbing capacity stays below 9% of equity. Regulatory ratios exceed relevant thresholds, providing a significant buffer, according to ratings agency Moody’s.

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    “This was visible in Saudi Arabia and the UAE, the two largest economic diversification engines in the region, which happen to also represent more than two-thirds of total banking system assets,” says Shubailat.

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    Gulf banks have also been helped by the fact that those economic sectors most impacted by conflict – tourism, hospitality, energy – do not generally form a large part of their collective loans books. 

    “There will be weaker performance of borrowers in the most obvious affected sectors like infrastructure, tourism, logistics, transport and real estate, but tourism is actually a pretty small exposure for the banks – less than 3% of loan books,” says Ramsdale. “There might be a bit of pressure on small and medium-sized enterprises (SMEs), which are less able to cope with the pressures than the larger corporates, but again, for banks, SME lending is not very big.” 

    Banks’ exposure to the real estate and construction sectors is highest in Qatar – 31% of total credit at the end of March – while the exposure in Kuwait stands at 25%, with Saudi Arabia at 16% and Bahrain at 12%, notes S&P. UAE banks have been consistently reducing their exposure to these sectors, down to 13% at the end of March, compared to 21% at year-end 2020. 

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    Gulf bankers are not resting on their laurels. They know that even if bad loans have been limited, they cannot forestall the possibility of problem exposures further down the road. 

    “Asset quality deterioration is a risk that we expect to materialise later in the year. This is because of weaker macro expectations, and negative impact on some of the corporate sectors, albeit varying across different GCC countries,” says Lescova.

    On average, for the region, S&P expects 20 bps of increases in credit losses for this year. When it comes to asset quality, the regulatory forbearance measures announced by three central banks will help alleviate the impact.

    Policy support

    Central bank moves have added another layer of support. Forbearance measures from the UAE, Kuwait and Qatar central banks have allowed additional headroom.

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    Forbearance measures from the UAE, Kuwait and Qatar central banks have allowed additional headroom

    Such measures were not a response to a banking crisis, says Ramsdale. “Some of the support packages that we have seen coming out of the central banks, in the UAE, Qatar and Kuwait, were preventative support measures,” he says.

    “They were designed to boost confidence and limit that pass through from temporary deposit volatility. It was not to do with acute banking stress.”

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