Volume 42 | Number 1 Fall 2006
Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field
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II. Fundamentals of Islamic Finance and Applicability to Oil and Gas Transactions
A. Fundamental Principles of Islamic Finance
Islamic finance can trace its roots back more than a millennium, but only in the past few decades has Shari’a-compliant banking and investment become a major facet of the global financial marketplace. Beginning with its modern inception in the late 1960s through cycles of expansion, first in the 1970s, and, more recently, with the rise in oil and natural gas prices in the past few years,7 Islamic finance has finally evolved into a significant component of the modern international banking sector—with an estimated $250 billion in assets currently held by Islamic banks.8 Other reports put the total amount committed by Muslim investors at $1.5 trillion—and growing at 15% annually—with some 50–60% of this amount dedicated to Islamic finance activities.9 Islamic finance is no longer just a novelty—“[i]t’s mainstream business . . . [and] [t]hat’s why every bank wants a bigger piece of it.”10 Once a purely Middle Eastern commercial activity, modern Islamic finance techniques originally conceived in Egypt quickly spread to other parts of the Muslim world and beyond.11 Sensing a lucrative trend, European, North American, and Asian banks have become deeply involved in the industry, with some financial institutions even offering a limited selection of Shari’a-compliant products to European and American investors and “borrowers” in areas such as home finance—including Shari’a-compliant mortgages provided by Freddie Mac.12 More than three hundred Islamic banks now operate in some seventy-five countries (including a number of Western jurisdictions).13 The Middle East and Southeast Asia are still home to many major players with billions of dollars in Shari’a-compliant investments (especially in Bahrain, the United Arab Emirates and Malaysia14), but Western financial institutions such as Citibank, HSBC, UBS, BNP Paribas, ABNAmro, American Express, and Deutsche Bank now also have active Islamic arms.15 As Islamic banking has grown, international standards have been introduced and have helped eliminate uncertainty, making Islamic finance increasingly sophisticated, mainstream, and productive.16 While the rapid expansion and increased complexity of the still-evolving field of Islamic finance has caused some controversy among the Muslim faithful, modern Shari’a-compliant financial practices are unmistakably an important part of the global marketplace.17
Islamic finance rules are taken from the Muslim holy book (called the Qur’an) and from other traditions ascribed to the Prophet Mohammed (called the Sunna or Hadith),18 as interpreted throughout the centuries by Islamic scholars. Detailed practical rules drawn from these sources are called Fiqh (or “Islamic jurisprudence”).19 Collectively, these components and interpretations form the Shari’a (sometimes referred to as “Islamic law”). Importantly, a basic tenet of the Muslim faith is that Shari’a governs all aspects of Islamic life, including private business affairs and commercial transactions.20 There is no central clergy in Islam, and areas of disagreement remain among the four main lines of Sunni jurisprudence (the Hanafi, Maliki, Hanbali, and Shafi’i schools)—the Islamic theology under which the vast majority of Islamic finance is practiced. The proclamations of the scholars of one school of Islamic jurists does not necessarily mean that scholars of other schools will agree with the judgments arrived at in a particular Fatwa, which is essentially a Shari’a legal opinion or pronouncement.21 For this reason, it is advisable to consult multiple Shari’a scholars in preparation of a transaction. Each individual transaction must be vetted by scholars or a board of scholars who bless the deal by issuing the requisite Fatwa. Shari’a advisors and Shari’a boards “provide . . . legitimacy” to Islamic finance transactions, and are a necessary adjunct to all such transactions.22 Although the scholarship comprising the field of Islamic finance is complex and deeply academic, with some disagreement among scholars as to certain matters, the basic principles reflected in all the schools can be distilled into a few common elements.23
1. Riba
First and foremost, Muslim investors and lenders are not allowed to charge or receive interest, known as Riba. Western-style loans and conventional debt instruments designed around interest charges are therefore simply not part of true Islamic finance. As one leading scholar of the subject succinctly explained: “In Islam, one does not lend to make money, and one does not borrow to finance business.”24 As discussed further in this Article, while interest is obviously the most elemental component of traditional financing and Western concepts of capital markets in general, there are methods of structuring a transaction in order to provide a return that is similar in form and substance to amortized interest and principal payments without violating Islamic restrictions.25
The Qur’an contains almost a dozen references to this fundamental prohibition against interest, and it is discussed often in the Hadith.26 The Qur’an proclaims: “Allah hath permitted trade and forbidden usury.”27 This fundamental prohibition is “unequivocal,” and the Qur’an and early Islamic writings clearly consider Riba a very serious offense:
The Messenger of Allah . . . cursed the one who devours Riba, the one who pays it, the one who witnesses it, and the one who documents it.28
. . .
There are seventy three different types of Riba, the least of which is equivalent [in sin] to committing incest, and the worst of which is equivalent [in sin] to destroying the honor of a Muslim.29
Riba literally means “increase” in Arabic,30 and Islamic scholars, both modern and ancient, have debated exactly what the teachings of Prophet Mohammed forbid and permit with respect to earning “increased” returns resulting from the use of money.31 But all seem to agree that, at a minimum, Shari’a prohibits usury32 and the charging of interest on commercial loans.33 “[N]obody can correctly deny that interest on loans is . . . forbidden . . . .”34
The notion of Riba has deep roots in Islamic society and custom. In Islam, money itself is not considered to have any intrinsic value; currency should only have value as a medium of exchange, and one should not make money merely off the use of money.35 “Simply stated, Islamic law prohibits interest because it fosters the accumulation of wealth that is not a product of work.”36 There is also an important social justice component—avoiding the exploitation of poorer members of society by unscrupulous merchants—underlying the prohibition on Riba, which dates back to the barter economy of pre-Islamic civilization in the Middle East (before the seventh century A.D.).37
2. Avoidance of Vice and Encouragement of Financially Sound Investing
Second, Shari’a prohibits Islamic investment in certain industries considered to promote Islamic vices, including alcohol, pornography, gambling, and pork products; it also discourages investment in companies with high debt levels.38 For equity investments in stocks, the prohibition includes investments in companies with heavy debt (an extension of the proscription of Riba and Gharar). This prohibition also applies to Muslim investment in stocks of companies engaged in such “unethical” behavior.39 In essence, Islamic investments must be socially responsible, not encourage activities considered sinful from an Islamic point of view, and be invested in a financially sound manner. As discussed below, oil and gas operations are acceptable activities from an Islamic perspective.
3. Gharar
The avoidance of Gharar—or unacceptable risk taking—is another fundamental principle of Islamic finance central to the structuring of Shari’acompliant transactions. Sometimes translated as “trading in risk,” the Hadith discusses Gharar at length.40 Intrinsically, the limitation on Gharar is related to the Islamic prohibition on gambling.41 Unlike Riba (which is an absolute prohibition) some level of risk remains a fundamental aspect of commercial life and risk allocation a necessary component of Islamic finance; only disproportionate risk, speculative trading and transactions meeting exceeding limitations are considered Gharar.42 The key element of Gharar is uncertainty. This concept arose in early Islamic times where Gharar was often associated in the Hadith with the sale of unborn livestock or unripened fruit on trees, or the payment of a fixed price upfront for a fisherman’s prospective catch. But hiring the fisherman to go fishing for you and paying him for his labor would be acceptable, as labor is not an uncertain concept.43 Because of Gharar, Islamic jurists typically forbid the use of conventional forward contracts (but certain types of Shari’a-compliant forward sales, called Bai Al-Salam, and construction arrangements, called Istisna’a, are allowed),44 swap agreements, hedges, options, derivatives, and financial insurance.45 For an Islamic bank to be able to offer or participate in a hedge fund or an options transaction, such a fund or transaction must be structured in compliance with Shari’a, a challenging process that has been tackled successfully by only a small number of Islamic banking pioneers with assistance from some of the leading Islamic scholars.
4. Participation in the Performance of Assets
Finally, and largely as a consequence of the elements discussed above, Shari’acompliant finance is primarily asset-based46 and hinges on the sharing of risk.47 “In a nutshell, Islamic finance is based on the trade of productive assets, the sharing of risks in the development of projects, [and] the promotion of entrepreneurship.”48 Islamic investing is essentially a hybrid of debt and equity, but is recognized by Islamic scholars to be unique from both. Islamic scholars prefer that investors obtain some form of ownership or participating interest in the underlying asset, although such ownership may be only indirectly beneficial in nature, and the level of actual participation is often passive. The key, however, is that the investor’s return must be tied to the performance of the underlying asset. Because the “borrower” cannot pay interest, it instead shares the profits from its endeavors with the investors, with each bearing some of the risk that the underlying assets could underperform. Even though Shari’a prohibits “payment or receipt of any interest on loans of money,” Islamic law “permits and actually encourages the allocation of risks and rewards and sharing in the resulting profits or losses.”49 As discussed in greater detail below, in the oil and gas context this means the investors would likely share in reserve, price, and operating risks, but the Islamic investor could still hold a merely passive economic interest (such as a royalty). Therefore, Islamic finance is essentially non-recourse to the “borrower” or his assets beyond the specific assets that support or collateralize the transaction. In this context, collateral serves as added security in the event of a breach of contract or fraud by the “borrower,” not as traditional security for a secured loan. It also follows that both private equity and venture capital investing are encouraged under Islamic teachings.
B. Types of Islamic Finance Structures and Applicability to Oil and Gas Deals
1. Ijara
An Ijara is essentially an Islamic finance lease or sale-leaseback, often used to purchase real estate, plant, or machinery.50 A lease transfers the usufruct associated with the asset for a specified period of time, not the ownership of the asset, and Islamic law supports the sale of usufruct.51 The lessor (which could be a bank) leases the assets for a set lease term at an established rental price; at the termination of the lease, subject to the terms of the lease agreement the assets can either revert back to the lessor or may be acquired by the lessee.52 However, unlike traditional leases, there can be no predetermined sales price for the asset at the end of the term, and the lessee cannot be required to purchase the asset at the end of the term.53 Ijara are therefore more akin to traditional operating leases rather than a capital lease. Also, unlike some traditional Western leases, the financier would be responsible for maintaining insurance, and the lessee is not responsible for full rent in the case of a casualty loss affecting the asset during the lease.54 A financial institution serving as the lessor in an Ijara transaction would likely use the underlying value of the leased asset, depreciation estimates, creditworthiness of the lessee, and the opportunity costs of the capital employed in calculating rental payments for conventional lease; the lease payments will reflect an implied interest rate based on these factors. Despite these similarities with conventional leases, however, with an Ijara, “in the final analysis, the difference will be in the form of the contract. If the lease is structured in accordance with the various conditions . . . of [Islamic] jurisprudence, it will contain no Riba . . . .”55
In the context of the oil and gas industry, an Ijara could be an ideal mechanism for leveraged lease financing of large pieces of oilfield equipment, notably deepwater platforms or drillships; provided that, in the context of a Sukuk offering (a type Islamic asset-backed security described in more detail below), the value of such oilfield equipment should be equal to, or represent a material percentage of, the offering amount. Although Ijara has not yet appeared in the U.S. marketplace in the upstream context, oil and gas companies have employed conventional leverage lease or sale-leaseback structures, and Ijara should be an ideal Shari’a-compliant substitute. The Dolphin Gas Project in the Persian Gulf and a Pakistani pipeline project, both discussed in more detail below, were financed using Ijara, but it is not a form yet used in the oil and gas industry outside of the Muslim world.
2. Musharaka and Mudaraba
A Musharaka—literally “partnership” or “sharing” in Arabic—transaction involves capital contributions by investors or financial institutions in a partnership arrangement with a client who is operating a business venture. The client also provides some capital, but mainly provides “management efforts and expertise”; profits and losses from the partnership venture are shared on a pre-arranged basis.56 A related type of transaction, a Mudaraba arrangement, compares well with venture capital financing in traditional capital markets—the investors in a Mudaraba provide capital and the “borrower” puts in only sweat equity by managing the venture; only the investors contribute capital.57 In a Mudaraba both the investors and the “borrower” share in the profits on a predetermined basis (as is the case in a Musharaka), but losses are treated differently in a Mudaraba. In Musharaka “losses are borne in proportion to the investment” as predetermined by the parties, but Mudaraba investors are solely responsible for economic losses and financial liabilities because the “borrower” contributes no money on its own, just sweat equity.58 Mudaraba deals can involve multiple investors sharing in the risk associated with a large project, such as the financing of an oil tanker, which may bear a level of concentrated risk a single bank may find unappealing.59 A series of such investments can be combined to create a Mudaraba fund with a fund manager lending expertise in deciding where to invest the capital provided by a number of Muslim investors.60 In either a Musharaka or Mudaraba transaction, the underlying business must be Shari’a-compliant.
Either Musharaka or Mudaraba could be used to finance upstream activities. Investors or financial institutions would provide a portion (Musharaka) or all (Mudaraba) of the capital, and the oil and gas operator would operate the oil and gas properties and provide the necessary expertise (in the case of a Musharaka, the oil and gas operator would also provide some portion of the initial capital). The arrangement could be documented in a joint venture agreement, or the parties could form a limited liability company, providing for dividends to be shared in a set proportion predetermined by the parties at the outset. The successful development of the oil and gas project could provide significant upside for the investors. While the investors would be passive in the sense that they would not have any operational control over day-to-day operations, the operator could agree to abide by certain covenants, and would likely be held to a prudent operator standard. A development or business plan may also be agreed to in advance to help define the scope of the operations to be carried out. Given the flexibility of these types of Islamic finance arrangements, Musharaka and Mudaraba could be used widely at all levels of the energy industry for operations of various sizes and levels of complexity.
3. Murabaha
The most common form of Islamic finance,61 Murabaha (also referred to as “cost-plus financing” or “cost-plus sales”), is a form of a sales contract in which the financial institution or investors buy an asset and then later sell it to the “borrower” at a marked-up price, which includes a profit component.62 Payments are made in installments, either on a deferred basis or through upfront payment with deferred delivery.63 Murabaha instruments usually supply only short-term financing. One major difference between Murabaha and conventional purchase money contracts is that if there is a default the “borrower” is only liable for the contract price—not additional interest, fees, or penalties.64 Despite its popularity, Murabaha would not likely serve as a source of funds for significant oil and gas exploration and production activities because of the long time horizons associated with such projects, but Murabaha could possibly be used for the purchase of equipment for use in oil and gas operations. One other obstacle facing growth in the utilization of Murabaha instrument stems from the fact that Murabaha is considered by certain Islamic schools to be a debt instrument, making it difficult to market Islamic financial products broadly in the Islamic world. Therefore, Sukuk offerings that are supported by Murabaha contracts are not readily tradable under some interpretations of Shari’a.
4. Istisna’a
Istisna’a (commissioned manufacturing) remains a popular vehicle for the financing of large infrastructure projects in the Middle East and is the most widely-used Shari’a-compliant funding technique used for long-term project financings.65 Under Istisna’a, particular assets are manufactured or constructed to certain specifications set by the financial institutions financing the project. Istisna’a has already been used, as discussed below in greater detail, in several downstream projects in the Muslim world. In addition to project finance for large downstream projects such as refineries, petrochemical plants, and the like, this form of Islamic finance holds much promise for the financing of large equipment purchases in the upstream sector (such as the multimillion dollar platforms becoming increasingly common in deepwater exploration) and in the construction of midstream assets (including pipelines, gathering systems, and storage facilities).
5. Sukuk
Sukuk is a recently-developed Islamic investment product that first appeared in 2002, when Malaysia issued a government-backed Sukuk, the first of its kind.66 Sukuk are essentially asset-backed instruments representing a beneficial ownership interest in the underlying asset. Sukuk is a certificate that resembles in many respects a traditional bond or asset-backed security, but is technically neither debt nor equity. Sukuk are normally combined with other forms of Islamic finance (many are Musharaka based), and they are best viewed as a means to raise funds from a wider spectrum of investors rather than an entirely separate category of Islamic banking. Since its inception in Malaysia in 2002, Sukuk have expanded to other Southeast Asian and Middle Eastern countries,67 and now Sukuk offerings have even appeared in the United Kingdom and continental Europe (where the government of Saxony-Anhalt in Germany raised 100 million in a Sukuk offering in 2004).68 Despite the incipient nature of this form of Islamic finance, Sukuk offerings have taken off and has proved to be very popular with investors. For example, a $3.5 billion Sukuk for the construction of port facilities in Dubai offered in 2006 (based on an underlying Musharaka transaction) was oversubscribed by as much as $8 billion.69 Oil and gas properties can serve as the underlying asset backing a Sukuk offering; the financial institution or investors can use the funds raised by the Sukuk issue to purchase a “passive” economic interest in the oil and gas properties, in the form of an overriding royalty or profits interest. The “borrower” would then use the funds to conduct exploration, production and development activities, with production from the underlying oil and gas properties creating a stream of income for the investors (who would concomitantly share in operational, pricing and reserve risks associated with the underlying properties). The International Monetary Fund has noted that Sukuk “could lay the groundwork for the emergence of Islamic capital markets. But while the Sukuk market is developing rapidly, it remains primarily a market where holders keep bonds to maturity, with limited secondary market trading.”70