The Middle East: Just how bad?

24 March 2003 00:00  [Source: ACN]

John Richardson and Clara Tan analyse what impact a war against Iraq would have on the Middle Eastern global petrochemical industries. They also consider some of the other long-term challenges facing the Middle East

The impact on the Asian petrochemicals industry of the seemingly inevitable war against Iraq (which as ACN went to press seemed certain to have begun as you read this article) has been the subject of huge concern and debate over the last few months.

There would, of course, be the impact on a macro level as a result of higher oil prices and weakening demand that could delay the sustained recovery in petrochemical pricing and margins that everyone has been waiting for.

And another long-term impact could be the delay in the completion of projects due to the evacuation of staff from the region, may be delays to or even cancellation of financing, and delays in the shipments of equipment. Expatriate staff working for petrochemical companies were being evacuated as this feature went to press.

In the immediate term, a war could present a physical danger to plants, forcing some that are closest to Iraq to actually shut down. Plus even those which continue to operate could be compelled to seek alternative routes for moving product due to the closure of ports. Whether some of these routes would be viable was in doubt.

Whether the US and the UK attack Iraq or not, the tension in the Middle East could produce another tangible effect - higher war-risk insurance premiums and surcharges.

To return to the longer term, nobody seemed to be in doubt that when the almost certain war is over, the region is hardly likely to lose its attraction as a petrochemicals investment location.

But in all this focus on Iraq what shouldn't be ignored are other major factors that will influence the extent of petrochemicals investment in the Middle East. An illustration of this point is some disappointment over the pro-gress of investment climate reforms in Iran.

Macro view

The big concern is over the impact that a war would have on crude oil prices and how this might translate through to overall demand growth and therefore the timing of a petrochemicals recovery.

Industry sources say recent high crude-oil prices have included a war premium because of possible supply disruptions, and were also reflective of the lingering effects on supply of the general strike in Venezuela.

There are fears that a disruption in oil production during the war could lead to even higher prices.

The International Energy Agency (IEA) in early March forecasted that there would be a 1.68m bbl/day shortfall in oil output if a war on Iraq were launched by the end of the month. This deficit would be reduced to 580000 bbl/day in April with modest supply flexibility returning in May, due to seasonal falls in demand, the agency added.

However, the IEA, and also the US, subsequently said that they could tap into their oil reserves if Iraqi supply was brought to a temporary halt.

Oil prices, as a result, fell quite sharply after spiking above US$40/bbl in February.

The point behind the IEA and US indications is the forecast that Iraqi supply could be brought to a halt and Kuwaiti supply could be disrupted by a war. This would amount to 2.5m bbl/day.

However, if you add the IEA reserves, drawn from 26 countries, to the US Strategic Reserve and to greater oil production from other producers such as Saudi Arabia, it could be that there is no shortfall.

But you have to throw in factors other than Iraq that could determine whether there is a sharp spike in oil prices over the next few months.

For example, Japan has increased consumption because it has shut down nuclear power stations over an inspections scandal, and supply could be disrupted ahead of general elections in Nigeria. Shell in mid-March disclosed that it was losing about 30000 bbl/day of oil becuse of violent protests in Nigeria. What is also unclear is how quickly Venezuela will climb back to full output.

As for petrochemicals consultants who spoke to ACN, they believe that oil prices will stay high for some time no matter what happens over Iraq.

'With high oil prices expected to prevail in the near term, it is unlikely that significant economic recovery can be expected before mid-2004,' says Rizwan Sheikh, a consultant with Nexant ChemSystems.

'Higher oil prices will push producer input prices higher in most of the regions, especially the US and the UK. As global economic growth tends to follow the developed economies, this may affect overall recovery,' he adds.

However, Sheikh is optimistic that a partial recovery is possible for the petrochemicals sector in the later part of this year. 'But real recovery will take some time to materialise,' he says. 'It would depend on how long it takes to resolve the Iraq conflict.'

Even if an attack an Iraq does not occur, the damage has already been done to some extent.

'The threat of war over the past months, nervousness by companies and high feedstock costs have already had an impact on the timing of economic recovery,' says Peter Jordan, a consultant with DeWitt.

Plus, it hasn't been all about Iraq over the past few months. Consumer spending has stalled in the US recently, which is not entirely down to war fears.

The problem remains the irrational exuberance of the 1990s and the subsequent stock market crashes that have left the private sector heavily indebted.

Even without a war, some economists say the US is heading for another downturn if not a recession, and Europe is also in a bad state with Germany, in particular, facing deep, long-term problems.

If a war has to happen, then the hope is that it will be over quickly, leaving everybody to focus on and perhaps resolve the other economic difficulties.

The consequences for Asia of a prolonged campaign and the extent of damage to oil wells that Saddam Hussein's regime inflicted in Kuwait during the last Gulf War, are frightening to contemplate.

Financial consultancy IDEAglobal forecasts that Asia's overall GDP (gross domestic product) growth could slow by 0.4% if oil prices are 10-20% higher than current levels for more than three months.

Most countries in Asia would suffer, other than, for instance, Malaysia, which would see only a GDP (Gross Domestic Product) slowdown of 0.2%, and Indonesia, which would actually benefit through a 0.1% increase in its economic growth. Both are major oil exporters.

Immediate term

Producers in the Middle East would have to make adjustments to their usual operational and logistic routines, depending on their location and the scale and duration of any war.

Most observers note that Kuwait could face the greatest threat to its security since the northern part of the country is scheduled to be used by US ground forces for an attack on Iraq. The presence of US troops conducting security checks and increased maritime traffic have already caused delays to exports from Kuwait's Shuaiba port, ACN was told.

In the worst-case scenario, plants would have to be shut, industry observers concede.

Shipping companies might reduce the number of shipments to and from the Arabian Gulf, or might even bring shipments to a complete halt, because of the risk of terrorist attacks, some source say.

Another argument is that because oil shipments from Saudi Arabia and other Middle Eastern countries could become even more crucial as a result of an interruption in Iraqi supply, every effort will be made to keep shipping lanes safe and therefore very busy.

Equate, the Kuwaiti cracker, monoethylene glycol (MEG) and PE producer, says it has drawn up 'solid contingency' plans if the worst was to happen.

Equate's complex, which centres on an 800 000 tonne/year cracker, is 20-50 km from the Kuwait-Iraq border.

Dow Chemical, the 45% shareholder in Equate also has a 24% stake in Optimal Olefins in Kerteh, Malaysia, which supplies ethylene from a 600 000 tonne/year cracker to produce MEG. The MEG plant is also partly owned by Dow. Product-swap arrangements could therefore be possible.

The cracker also provides feedstock to Petlin, an ldPE producer, which is co-owned by Petronas, Sasol and Sabic.

If all the plants in the region continue to run normally, it might still be the case that alternative export routes will be necessary.

M Ehtiati, chairman and managing director of Iran Petrochemical Commercial Co, the commercial arm of National Petrochemical Co (NPC), recounted the company's experience during the Iran-Iraq War when it had to transport solid cargoes via truck to Bandar Abbas. Bandar Bushehr port, which is nearer to the border with Iraq and also more convenient for NPC's plants, was closed due to military action.

For Kuwait, one way round any closure of shipping routes is to move goods overland into Saudi Arabia and to export from the kingdom's ports, according to a source from the Kuwaiti state-owned Petrochemical Industries Co.

Impact on projects

For projects which are either in the early stages of execution or have reached the engineering phase, the companies behind the projects and the contractors are expected to move engineering work outside the region.

But for projects where construction has already started, it is, of course, a great deal more tricky.

The first concern for investors in these projects will be the safety of expatriate staff in the Middle East.

Some contractors have made contingency plans for evacuation. A spokesman for Toyo Engineering told ACN that it has drawn up three evacuation plans for its 70-80 Japanese staff who are based in Saudi Arabia.

They involve either moving employees by bus to Bahrain or Dubai from where they would be flown home, or moving them to safer areas of Saudi Arabia.

The contractor is currently undertaking the last stage of work for Petrokemya's 800 000 tonne/year lldPE/hdPE project in Al-Jubail. The project is due to be commissioned in mid-2003. Al-Jubail is more than 300 km from the Saudi-Kuwait border.

Toyo also has an office in Tehran where around five Japanese work. It would be comparatively easy to fly them back home from Tehran if war has broken out. Toyo has been awarded engineering and procurement contracts for NPC's Aromatics No4 and ammonia-urea projects in Assaluyeh.

As for Mitsui & Co, a company source admits that the Japanese trading major may have to stop construction on its joint-venture methanol project in Saudi Arabia to ensure the safety of its workers in the event of a war. It has already flown its Japanese staff in Kuwait back home to Tokyo.

Chiyoda, the turnkey contractor for Mitsui's project, started construction earlier this year on the 1m tonne/year methanol project in Al-Jubail, Saudi Arabia, which is expected to come onstream in early 2005.

A source from Chiyoda told ACN that although construction work was continuing as normal, its four expatriate staff at the site had been told to carry enough cash with them at all times sufficient to cover a sudden evacuation. They would have to be moved by bus to Jeddah in order to be flown home, he added.

LG Engineering last week evacuated seven South Korean staff stationed in Kuwait who are carrying out engineering work on Kuwait National Petroleum's refinery project in Shuaiba.

Some western contractors had already started recalling their staff from the Middle East as ACN went to press, on advice from their governments.

The British government had advised against non-essential travelling to Bahrain, Jordan, Qatar and Saudi Arabia. British nationals already in those countries were advised to maintain a high level of vigilance. American and British citizens were urged to leave Kuwait immediately as war loomed last week.

Japan's Ministry of Foreign Affairs' classified Kuwait, Iraq and their bordering regions as places where Japanese nationals must not remain in or travel to unless necessary.

Even if projects stay on track as scheduled, their cost could increase due to higher war-risk surcharges and war-insurance premiums.

Asian non-life insurers last week increased the number of ports in the Middle East classified under 'held-cover', which has led to higher war-insurance premiums for shipments headed to the affected ports.

The affected ports are those that are located west of 56.1^o east longitude, according to the insurers. They include those in Saudi Arabia, Bahrain, Qatar, Iran, Kuwait and the United Arab Emirates (UAE).

Bandar Abbas port in Iran, Jeddah port in Saudi Arabia and those ports along the Red Sea and in India are not expected to be affected.

Insurers previously charged war-insurance premiums at 0.05% of cargo value on shipments heading for Saudi Arabia, Iran, Bahrain, Qatar, Abu Dhabi, Kuwait and the UAE.

With the new 'held-cover' status, war-risk insurance premiums on cargoes to the affected ports will be above 0.05% and could reach more than 1% in certain areas.

ACN understands that some insurers have stopped offering insurance coverage to shipments going to Iraq and Kuwait.

Iraq, Israel, Palestine, Pakistan and Afghanistan remain under 'held-cover'.

Shippers such as Nippon Yusen Kaisha and United Arab Shipping were placing US$54/ teu (twenty-foot equivalent units) and US$108/feu (forty-foot equivalent units) war-risk surcharges on shipments to Iran, Saudi Arabia and the UAE. A revision is expected after the war has broken out. Shippers had not revised these rates since the last revision made last August.

Who eventually ends up bearing additional insurance costs is always the subject of debates between contractors and investors.

But extra insurance premiums on shipments would not significantly raise the costs of major projects in the US$1bn range, says Darren Davis, manager project finance, GCC Business group, which is part of the Arab Petroleum Investments Corp.

In addition to insurance premiums on shipments, those imposed on projects could also be increased.

A banker believes that insurance premiums on projects in the Middle East could be increased in a protracted war scenario.

Investors have already seen higher insurance premiums on projects since 11Septem-ber. They also have difficulty in persuading insurers to include war and sabotage clauses in insurance agreements.

According to the banker, lenders are generally fine with funding projects which are insured up to the first US$100m if the balance coverage is provided by the government of a country where a plant is being built.

Other major projects presently under construction in the Middle East include Iran's Olefins No6, Olefins No7 and Sabic's cracker project in Al-Jubail.

Sabic's 1m tonne/year cracker project in Al-Jubail is potentially one of the projects in the Middle East likely to be affected if work has to be suspended. Construction has started on the project which is slated for startup in 2004-05.

However, DeWitt's Jordan says: 'Most project startups are too far down the road to be severely affected by a short war.'

The projects which fall into this category and are therefore least likely to be affected are those with startups after 2005-06, he adds.

These projects include Iran's Olefins No8 in Bandar Imam, Chevron Phillips Chemi-cal's aromatics project in Al-Jubail and Qatar's No3 cracker project.

But still, even if the timing or realisation of projects further down the line are not ultimately adversely affected by a war, sentiment towards the region could be dented.

Plus, of course, nobody is likely to be in a rush to commit investment dollars in the current climate.

ACN understands that Dow Chemical has reached an understanding in principle for the second Equate project in Kuwait, although there is as yet no MoU and therefore no final agreement.

But while fears are high among investors, they are aware that they should not allow what could be a short-term problem to cloud their outlook on the long term.

'The impact of a war, provided it is only a short war, is likely to be minimal,' a foreign investor in Iran says. 'Other issues [such as feedstock and infrastructure] are longer term and therefore more fundamental.'

Other challenges

The Middle East is also facing other challenges such as whether there is enough gas to feed its projects and an urgent need to resolve the region's shortage of backhaul to cope with substantial export volumes, Sheikh says.

Investors in the Middle East need to look for solutions on logistics infrastructure in order to cope with anticipated large exports of derivatives in the next few years. At least 15m tonne/year of ethylene and derivatives are due onstream this decade, according to Sheikh.

On the feedstock issue, in Kuwait, for instance, there is currently insufficient gas to feed Equate's proposed second cracker complex and expand the existing complex.

And as for Saudi Arabia's Saudi Gas Initiative, the local media have reported that the initiative could be reduced to two rather than three core joint ventures because of insufficient gas. The reportedly shelved core venture was to have explored gas south of Ghawar in the North Rub Al Khali region of eastern Saudi Arabia. The core venture was expected to produce more than 2m tonne/year of ethylene and derivatives in Al-Jubail and Yanbu.

However, a great deal of gas-exploration work is taking place, and many industry sources therefore believe that the Middle East's feedstock advantage will remain sufficient to lure substantial investment.

After all, Saudi Arabia and Iraq own the world's largest and second largest proven oil reserves respectively and Iran has the world's second largest gas reserves, after the Russian Federation.

And one industry observer even goes as far as to suggest that a petrochemicals industry could be developed in a post-Saddam Iraq.

'The logic of investing in the Middle East will, obviously, not change if there is a war,' Davis said. 'It's hard to see foreign investment sentiment declining.'

The Middle East offers a significant feedstock advantage for a gas-based cracker compared with a naphtha cracker elsewhere, especially when crude oil prices are above US$15/bbl, according to Shell Chemicals.

'If crude oil prices are high, advantaged feedstock owners such as those in the Middle East, enjoy a significant advantage. But if prices go below US$15/bbl, it is cheaper to use feedstock locally from the Asia Pacific,' says Rein Willems, Shell's executive vice-president for procurement and business units.

But as for financing, the war might have an impact on lenders in both the short and perhaps even medium term.

'It's possible that banks might be reluctant to rush into a wholescale support of new Middle Eastern investments immediately after cessation of hostilities,' says Jordan. He adds that financiers may want to be more selective on which investment to fund.

And then there is Iran which faces some major other issues beyond Iraq. They are the US investment ban, accusations that it supports terrorism (it is part of Bush's 'axis of evil' and could therefore eventually also be attacked by the US) and a weak economy in need of further reform.

The US has just extended a sanction by 12 months which bans US firms and citizens from trading with and investing in Iran. The sanction, first introduced in 1995, has been renewed because of tension over Tehran's nuclear power programme.

Iran also faces another US sanction which was introduced in 1996. This bars all foreign companies from investing more than US$20m/year in the energy sectors of Iran and Libya. The sanction caused an uproar from European countries and is not rigidly enforced by the US.

Internal strife between the Iranian reformist parliament and the powerful conservative clerics has resulted in a deadlock in formulation of domestic and foreign policies.

For instance, the draft Foreign Investment Promotion and Protection Act (Fippa), which was first approved by the parliament in mid-2001, was rejected on three occasions by the conservative clerics who form the Guardian Council (GC). They argued that the proposed law would result in foreign domination of the economy.

The debate finally came to an end when the Expediency Council mediated between the parliament and the GC in May of last year. Last September, the Board of Ministers finally approved a draft of Fippa's executive bylaws. Fippa replaces the old 1956 Law on Attraction and Protection of Foreign Investment.

But the trouble is that politics keeps on changing in Iran. It could be that the conservatives again gain the upper hand and block effective implementation of Fippa.

An Export-Import Bank of Korea (Korea Exim Bank) official says that the lack of authority of the parliament compared with that of the GC makes it difficult to read the political direction of the country.

Nevertheless, a foreign investor in Iran says: 'Politics will determine whether or not you invest in the first place. Once you have decided to invest, you work with the system.'

But it should be noted that the country managed to raise Euro625m (US$675.7m) last July through a sovereign bond issue, the first since the Islamic revolution in 1979. The issue was oversubscribed despite Moody's decision to drop Iran from its sovereign rating last June.

Encouraged by the response to this bond issue, Iran launched a second sovereign bond issue and raised Euro375m last December. Both issues were arranged by BNP Paribas and Commerzbank.

'Iran is increasingly looking at diversifying its sources of financing and the recent two sovereign bonds can only help the country better establish itself in the field of financing its capital expenditure programme in the oil and gas sector, as well as the petrochemical and power industries,' says Christophe Mariot, country head of BNP Paribas Iran.

Mariot adds that NPC has a very impressive track record.

Financing schemes for projects in Iran mainly comprise export credits backed by sovereign guarantees provided by the country's Ministry of Economic Affairs and Finance, or structured finance packages backed by offtake agreements as collateral.

NPC is now contemplating project financing, mostly with the support of export credit agencies, Mariot says.

Though it is impossible for Iran to obtain funding from US sources, financing is still possible, mainly through Asian and European banks. President Mohammad Khatami has cultivated good relations with Asian and European countries since his election in 1997.

NPC still needs much more funding for its projects in Assaluyeh and Bandar Imam, which include Olefins No8, Olefins No9 and Olefins No10.

Fippa is aimed at enhancing foreign participation in Iran. Its provisions include allowing foreign investors to repatriate their dividends as well as capital in hard currency, and the promise of compensation to investors if the government causes disruption to business activities, such as a halt to gas, electricity or raw-material supplies.

Fippa also allows the resolution of disputes to take place in courts outside Iran. However, a foreign investor can seek external arbitration if only there is a bilateral investment treaty between Iran and the particular investor's government.

Foreign investors are generally happy with Fippa, but say that more could be done.

'Iran has made a big step forward but further improvements are still needed especially in implementation,' says the foreign investor. He adds that bureaucracy is another issue.

While American investors are prevented from investing in Iran due to the sanctions, European and other investors are free to take advantage of the country's potential.

In what was seemingly a testament to its confidence in the country, Sasol signed a 50:50 joint-venture agreement with NPC last month to invest in the latter's Olefins No9 project in Assaluyeh.

The agreement is considered a coup for NPC, which has been facing difficulties in persuading foreign investors to sign on the dotted line.

BP withdrew its interest in taking a stake in Olefins No9 in early 2002 due to cutbacks in expenditure.

And Shell and Basell are taking a long time to make a decision over their interest in NPC's Olefins No8 project in Bandar Imam.

Both companies were expected to have completed a study for the project last year and reach a decision in the early part of this year.

When the war is over, the Middle East is surely going to be remain a very strong investment location despite problems beyond Iraq.

The trouble is that nobody can really know what the repercussions will be for not only the realisation of projects, but also for the global petrochemicals industry.

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