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910N14

EAST CAMERON PARTNERS: THE SUKUK BOND1

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Stephen Sapp wrote this case solely to provide material for class discussion. The author does not intend to illustrate either effective
or ineffective handling of a managerial situation. The author may have disguised certain names and other identifying information to
protect confidentiality.

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Richard Ivey School of Business Foundation prohibits any form of reproduction, storage or transmission without its written
permission. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies
or request permission to reproduce materials, contact Ivey Publishing, Richard Ivey School of Business Foundation, The University
of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca.

Copyright © 2010, Richard Ivey School of Business Foundation Version: (A) 2010-08-13

INTRODUCTION
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It was July 2005, and Campbell Evans, chief executive officer (CEO) of East Cameron Partners LP, had
just returned to his office to ponder the financing proposition he just received from halfway around the
world. Over the past several months, Evans had been trying to figure out how to effectively reverse East
Cameron’s current relationship with Macquarie Bank (“Macquarie”) — Macquarie was a 50 per cent
equity partner that was not interested in further investing in the business. Since Evans wanted to both
regain majority control of East Cameron and take advantage of soaring oil and gas prices with new
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exploration and development (see Exhibit 1), Evans was looking for alternatives to raise the funds in order
to buy out Macquarie and finance new exploration and development. Though the proposal he just received
to use a Sukuk bond was something new to Evans, it did appear to have several advantages over the other
financing options he was facing.

HISTORY
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East Cameron Partners was a father and son independent oil business based in Houston, Texas, that had
been operating — in one form or another — for 57 years. The business typified what were called
“wildcatters” (oil and gas speculators). Evans and his father together held an approximately 66 per cent
interest in East Cameron. Campbell acted as the general partner of East Cameron through Open Choke
Energy, LLC (see Exhibit 2). East Cameron, like most other companies in the industry, was subject to the
cyclical nature of the oil and gas business and, in its short history, had been through several booms and
busts. In 2005, they were enjoying the benefits of both a successful exploration and development program
and increasing oil and gas prices.
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Oil prices were rising as the demand for oil and gas from rapidly-growing economies — such as China and
India — continued to grow while world supplies were not keeping pace. During the 1990s, the interest of
oil companies in building more capacity to pump oil was low due to the excess capacity and low price of

1
This case has been written on the basis of published sources only. Consequently, the interpretation and perspectives
presented in this case are not necessarily those of East Cameron Partners LP or any of its employees.

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oil at that time: this was allowing companies who could rapidly bring new capacity online an opportunity

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to benefit greatly from the increase in prices while the demand remained high.

East Cameron Partners’ main assets were two gas properties located in the shallow waters off of Louisiana.
These two properties were obtained in early 2000, when East Cameron had acquired a government lease
from Conoco Phillips, one of the world’s largest integrated energy and refining companies. The lease gave

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East Cameron the right to explore and exploit two gas properties (EC71 and EC72) located in the East
Cameron region of the Gulf of Mexico, just off the coast of Louisiana.

At the time East Cameron obtained the exploration rights, they required outside funds to develop and
exploit the sites. Macquarie, a well-established Australian bank specializing in infrastructure investment,
was willing to provide the required financing for this venture, but at a significant cost. Macquarie provided
East Cameron with the US$45 million it required for development and exploitation of the sites, but

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demanded interest on the loan of 15 per cent per annum and a 50 per cent equity stake.

Exploration on the East Cameron site began shortly after Macquarie’s financing closed. The reserves
proved to be extensive, and oil and gas prices were increasing at that time: East Cameron was quickly able
to repay the Macquarie debt.

These two properties consisted mainly of natural gas and were found to have net proven reserves of
approximately 68 Bcfe,2 with an estimated remaining production life of 14.5 years. With the price of
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natural gas skyrocketing (see Exhibit 1), Evans was eager to develop this site further. He believed that they
could expand their reserves by at least 50 to 75 per cent with further exploration on these two large
properties; however, Macquarie was unwilling to fund further development. This left Evans considering
funding options that would leave him and his father in control of the company they built and entitled to as
much of the cash flows from their successful gas explorations as possible.
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Most of the financing proposals they received from hedge funds and major investment banks included an
equity component. It was in response to their inquiries for financing that East Cameron received a
significant offer from BSEC.

THE BSEC OFFER

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Evans had just finished a telephone call with Ibrahim Mardam-Bey, a financier at Lebanon-based Bemo
Securitization (BSEC), who had approached him with an interesting financing solution — the use of a
Sukuk bond. While Evans had never heard of Islamic finance or Sukuk bonds, the proposed financial
solution sounded interesting. The Sukuk bond would allow East Cameron to buy Macquarie’s equity stake
and replace it with high-yielding bond-like instruments.

Evan’s mind was filled with questions: How did this Sukuk structure really work? Was there anything
about it that would put East Cameron’s assets as risk? How did it influence their control over East
Cameron and its operations? What was the downside to this structure? Who would buy such a debt
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instrument? How would the effective cost of this debt compare to his other alternatives? Was there
sufficient demand in the U.S. market for such a product? Based on Evans’ understanding of the proposal, if

2
Bcfe stands for billion cubic feet of gas equivalent. A term typically used to measure the amount of natural gas that is either
untapped in reserves, or being pumped and delivered over extended periods of time (such as months or years). The
"equivalent" is used to describe the equivalent amount of energy liberated by the burning of this type of fuel versus crude oil,
with every 6,000 cubic feet of natural gas being equal to one barrel of oil.

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East Cameron and BSEC could pull this off, then Evans and his father could benefit from the high returns

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from gas prices and take back a greater degree of control over the company.

On the other side of the ocean, Mardam-Bey put down the telephone and was hopeful that he had
convinced Evans of the value of his proposal. He recognized that it was a foray into a new market for his
firm, but he was confident that it was the right product at the right time. Mardam-Bey had spent months

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designing a Sukuk structure that he believed would be of interest to players in the North American oil and
gas sector. Given that these companies would generally have to accept a combination of debt and equity
from U.S. hedge funds and investment banks to receive funding, he was convinced that despite the
unfamiliar nature of the bond-like Sukuks to U.S. investors, small-cap oil and gas companies in the United
States would be keen to test the demand for such instruments.

Although “Sukuk” is the Arabic name for a financial certificate, it is frequently viewed as the Islamic

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equivalent of a bond. Since interest bearing bonds are not permissible in Islam, Sukuks are securities that
comply with Islamic law and its investment principles by not paying interest but still provide investors
with regular payments. The Sukuk essentially sells to the investors the ownership of a cash-generating
asset, and it is the ownership of this asset which provides investors with predictable returns. The key is that
the investor’s returns are derived as payments from the set of assets that the investors purchased when they
bought the Sukuk bond, and therefore these payments are not classified as interest payments. The issuer of
the Sukuk therefore sells assets to the buyers of the Sukuk and provides to the Sukuk holders regular
payments based on the cash flows generated by the assets that were sold. The issuer of the Sukuk also
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gradually repurchases the assets from the Sukuk holders and thereby is able to decrease the cash flows that
it owes to the Sukuk holders.

FINANCING ALTERNATIVES: CONVENTIONAL BONDS, BANK LOANS AND EQUITY

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Before making any decisions, Evans knew he needed to compare the proposed Sukuk bond with the more
standard alternatives in front of him. Most of the potential financiers he spoke to within the United States
offered him deals that were very similar to the original deal they had struck with Macquarie. The deals
were mixtures of equity and debt.

Small oil and gas companies like East Cameron were considered high-risk by credit providers. To manage
this risk, traditional financing for firms like East Cameron typically resembled private equity transactions
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and consisted of a combination of equity, mezzanine finance and commercial debt. These structures were
employed because the suppliers of finance felt that these risky companies also provided opportunities to
achieve a significant return on their investment. Simply lending to these firms put a cap on the potential
returns they could get from the investment (the interest paid and principal repayment) with a large potential
for loss; to overcome this, a combination of debt and equity was required with overall returns targeted at
rates such as 20 per cent.

The structure of most financing required that all of the assets were used as collateral and the cash flows
from the assets were used to service the debt — the better the cash flow-generating ability of the assets, the
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greater the ability to repay the debt. The equity portion therefore allowed the investor to participate in the
upside if the project succeeded. In either case, the value of debt or equity would be the residual value of the
assets if the project failed. Unfortunately, such financing alternatives would put East Cameron back into
the same situation as with Macquarie but with a different partner.

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To determine some of the other alternatives, Evans looked at recent financings in the market. One

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alternative that he thought was interesting was provided to another small oil and gas firm: it was a five year
convertible bond issue with a European syndicate which invested in high risk mining operations. The
syndicate had provided a $150 million five-year 10 per cent Eurodollar bond with quarterly interest
payments and equal annual sinking fund payments starting in year three. The conversion option allowed
the investors to obtain up to a maximum of 45 per cent of the firm’s equity if the exploration projects were

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successful; specifically, at the end of the third year and for each year thereafter, the bond holders could
either take the full cash amount of the sinking fund payment (one-third of the principal, $50 million) or
they could convert up to $20 million of the payment for up to 15 per cent of the equity in the firm. Though
this was a substantial discount on the current stock valuation, the timing of the repayment of principal and
conversion decisions were attractive to Evans.

The other alternatives he found were all from private equity and hedge funds that proposed structures

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similar to that used by Macquarie. The most consistent packages that Evans saw for similar situations and
those he expected he would be offered were from U.S.-based hedge funds, and included interest payments
in the 10 to 10.5 per cent range on five year bonds with full repayment at maturity and 30 per cent of the
equity.

Since the Sukuk bond was the only alternative unfamiliar to Evans, he wanted to understand more about it
to be able to make a fair comparison between the alternatives.
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THE SUKUK BOND

The Sukuk bond being proposed to Evans would be the first of its kind issued in North America. Because
of its novelty, Mardam-Bey needed to assess the support in the United States for such an issue, and
therefore approached several U.S. investment banks to gauge their interest. They were sceptical of whether
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a Sukuk issuance would be well-received.

Mardam-Bey realized that to get the issue placed, BSEC would need the help of a partner with a global
distribution network and international credibility. Although BSEC was a prominent player in the Islamic
finance industry, BSEC was an independent Lebanese-based financial institution only having significant
operations in Lebanon, Syria, Cyprus, Luxembourg and France. After meeting with several banking teams,
BSEC struck a partnership with Merrill Lynch (London). The Merill Lynch team had a great deal of
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experience in oil and gas, and had recently purchased a large oil and gas commodities trading business
based in the United States. The Sukuk issue would be marketed as an asset-backed bond equivalent where
the asset was the rights to the revenue from the oil and gas reserves.

To increase U.S. investor confidence in this offering, Mardam-Bey approached Standard & Poor’s (S&P)
to get a credit rating for the bond issue. From S&P’s viewpoint, the structure of the Sukuk offering needed
to include some form of credit enhancements in order to be rated. To mitigate some of the volatility in the
cash flows from the oil and gas sales, a large percentage of the expected production volume had to be
hedged using Shariah-compliant hedges, and reserve accounts had to be created to gradually disperse the
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funds for exploration and to cover the bond service shortfalls if cash flows varied over time. It was also
necessary that the terms of the bond contract ensured that East Cameron would utilize the proceeds of the
Sukuk issue to undertake the most efficient ways of getting the resources out of the ground and into the
market. Consistent with this agreement, the funds would be deployed pursuant to specific, pre-agreed
capital expenditure plans submitted by East Cameron. Ultimately, S&P gave the bonds a CCC+ rating.

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Because of its below investment-grade rating, the cash flow outflows from the bond to investors would

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have been 11.25 per cent.

Although Mardam-Bey believed that investors for the Sukuk offering would be groups from the Middle
East and North Africa, places that were already familiar with the Sukuk structure and the oil and gas
industry, the majority of investors expressing interest were non-Shariah name brand hedge fund investors

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out of New York.

STRUCTURE OF THE EAST CAMERON SUKUK BONDS

The basic structure of the Sukuk was to securitize hydrocarbon sales from the East Cameron gas properties
(see Exhibit 3). This meant that the rights to the cash flows generated by the sales of oil and gas were sold

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to the Sukuk holders, and therefore the Sukuk holders were to be paid these cash flows.

Despite the basic structure being straightforward, to ensure its Shariah compliance it was necessary for the
Sukuk to have a large number of components. The structure revolved around a Cayman Islands special
purpose vehicle (the Cayman SPV). The Cayman SPV was the entity that would issue the Sukuk bonds to
investors, and with the funds they received from selling the Sukuk bonds, the Cayman SPV would buy all
of the outstanding shares of a simultaneously-created U.S. special purpose vehicle, Louisiana Offshore
Holdings (the U.S. SPV). With the money obtained by the U.S. SPV, the U.S. SPV would buy the equity
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from Macquarie, purchase from East Cameron the rights to the cash flows from the sale of oil and gas (the
rights are referred to as the overriding royalty interest or “ORRI”), place the remaining funds in earn-out
and reserve accounts and purchase the necessary derivatives to hedge future cash flows from the sales of
the oil and gas.

One of the key requirements of this transaction was that the exploitation of the oil fields and the
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corresponding flows of money had to be legally separated from East Cameron. The cash flows had to be
put into a “bankruptcy remote” vehicle which received the cash from the sale of gas and paid it to the
investors while not allowing for recourse to East Cameron should something happen in the oil fields and
should not allow for recourse to the oil fields by East Cameron should something happen to East Cameron.
Since the oil rights were conferred by the U.S. government to East Cameron, the oil rights could only be
sold to a U.S. corporation — this was the reason for the creation of the U.S. SPV; however, to provide the
necessary legal rights to the Sukuk holders, an SPV had to be established in the Cayman Islands to oversee
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the payments to the Sukuk holders.

The Sukuk was a Musharaka,3 with the two parties to the Musharaka being East Cameron Partners and the
Cayman Island-based SPV issuing the Sukuk bond. The funding agreement that linked the issuer SPV to
the purchaser SPV was required to make this transaction Shariah-compliant because it formalized the
contribution of capital by each party, most importantly the issuer SPV, and conveyed to the issuer SPV the
risk and reward profile which was passed on to the Sukuk holders.

This structure was slightly more complex than the initial idea which had been to structure the Sukuk as an
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Ijarah,4 in which the oil rigs and drilling equipment were to be used as the underlying asset to be

3
Musharaka is a type of Sharia-compliant contract which is similar to a joint venture. Two parties invest in a project in which
they share in the profits and losses.
4
Ijarah is a type of Sharia-compliant contract which is similar to a lease in which the assets (i.e. the drilling rigs etc.) would
be sold to the Sukuk bond holders and they would then receive regular payments from East Cameron for the use of the
assets.

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securitised. Unfortunately, this was not possible as there were not enough assets to sell in order to raise the

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required capital. Evans estimated that they needed between $150 million and $170 million to buy out
Macquarie5 and start a new exploration and development program, but the rigs and other equipment were
worth less than $100 million.

Once again, to ensure the Shariah-compliance of the transaction, the cash flows from the oil fields had to

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follow a circuitous route to reach the Sukuk holders. East Cameron would sell the oil and gas it extracted
from its 68 Bcfe of reserves to Cedar Gas/Shell Trading U.S. Of the total amount paid to East Cameron for
the gas hydrocarbons, 89.68 per cent of the sale proceeds would go to the Cayman SPV to pay the 11.25
per cent return to the Sukuk investors, put excess funds in the reserve account and work toward repaying
the principal, while 10.32 per cent would go back to East Cameron.

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SHARIAH COMPLIANCE

Although Mardam-Bey felt that this structure would meet Shariah requirements (the transaction would be
based on the acquisition of a real asset, the ORRI), this was a key risk in the transaction. To be Shariah–
compliant, the funding agreement between the Cayman SPV and the U.S. SPV had to be such that the
Cayman SPV owned specific real assets which had a certain risk and reward profile which was passed on
to the Sukuk holders. It had to be viewed as a sale of the ORRI to the Cayman SPV, and not as a secured
loan. Consistent with this, the cash payments to the Sukuk holders could not be viewed as fixed payments
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and therefore as riba (interest), they had to be viewed as a sharing of the cash flows being generated by the
oil fields through the ORRI. The structure described above was designed to accomplish each of these
goals.

Looking at other requirements for Shariah-compliance, the oil and gas reserves in East Cameron were now
proven, so the transaction would not be considered speculative and thus violate Islamic laws; further, the
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oil and gas industry was not an industry which was considered haram and thus was an eligible investment
according to Shariah scholars. Consequently, the oil and gas reserves from East Cameron would be
deemed Shariah-compliant underlying assets upon which financing could be provided. The Sukuk was
therefore able to avoid breaching Shariah law’s restrictions on the payment or receipt of interest by
providing a predetermined income from specified assets (the ORRI in this case).
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DECISION

Evans needed to consider the different alternatives he was facing. The proposal he received from halfway
around the world was very promising: it allowed Evans to effectively reverse East Cameron’s current
relationship with Macquarie by buying out Macquarie’s 50 per cent equity position. This proposal would
also allow East Cameron to obtain the capital necessary for future gas exploration while natural gas prices
were high. But were the risks associated with this new form of financing too high? Were the constraints it
imposed on East Cameron too high? It appeared to meet all of the key criteria Evans had initially laid out
for the financing, but those conditions were based on the conventional methods of financing. The Sukuk
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was a novel structure with different characteristics, so he had to sit down and carefully consider its pros
and cons.

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Recent merger and acquisition activity in tracks around EC71 and EC72 had been valued using multiples of between $3.00
and $3.75 per mcfe of proven reserves.

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Exhibit 1
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NATURAL GAS HISTORICAL SPOT PRICING

NG2 COMB COMDTY

Range 01/-9/04 – 12/30/05 Currency USD
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Last price 11,369
14,000 High on Sep 30/05 14,431
Average 7,750
Low on Jan 30/04 5,113
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12,000

11,369

10,000
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8,000

6,000

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4,000
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Jan30 Feb27 Mar26 Apr30 May28 Jun25 Jul30 Aug27 Sep24 Oct29 Nov26 Dec31 Jan28 Feb25 Mar25 Apr29 May27 Jun24 Jul29 Aug26 Sep30 Oct28 Nov25 Dec30

Source: Bloomberg Finance L.P. (2009).

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Exhibit 2

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OWNERSHIP AND MANAGMENT STRUCTURE OF EAST CAMERON

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Exhibit 3

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SUKUK TRANSACTION OVERVIEW

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EAST CAMERON
PARTNERS
“ORIGINATOR”

Gas Properties
(68 Bcfe)

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10.32%
Remaining Net CEDAR GAS/
BT Reserves (8 Bcf) SECURED
OPERATING SHELL
ORRI (60 BCF) ACCOUNT
TRADING US

89.68%
ORRI

SUKUK
Hydrocarbon SPV
HOLDERS
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Sales
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Source: http://www.assaif.org/content/download/369/2339/file/The%20East%20Cameron%20Gas%20Sukuk.pdf.
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