December 18, 2017

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Saudi Arabia: A bitter pill

Pinsent Masons to enhance presence in Saudi Arabia
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Saudi Arabia, reeling from an economic crisis induced by an historical over-reliance on oil sales to support the economy, finds itself at a crossroads that could make or break its future. Dhairya Negandhi writes.

Saudi Arabia has been an eminent figure in shaping and moulding the Middle Eastern region into what it is today. Geographically, economically, and culturally, the Kingdom is the heart of the Arab and Islamic worlds. Oil is an integral facet of the nation’s history, with oil-based revenues accounting for an overwhelmingly significant portion of Saudi Arabia’s economy.

Today, Saudi Arabian oil exports constitute 25% of the proven world reserves. The nation has developed enormously as it took full advantage of the insatiable demand for fossil fuels, and quickly grew into a global powerhouse.

The unbridled and exponential growth of the Kingdom as it burst onto the world economy meant it had to adapt and adjust to its new international status. Infrastructure swiftly became a top priority, and as investments came flooding in, construction and development snowballed into an impressive industry.

The country’s construction sector contributed around 8% of Saudi Arabia’s total gross domestic product (GDP), making it the largest construction market in the Middle East. Around 67% of construction investment is direct from the government with large-scale projects in the sector for the coming years set to reach $800bn, according to recent reports.

Saudi Arabia had, through the careful and cunning exploitation of domestic resources, shifted from an inconspicuous society to a dominant country whose immense wealth and a seemingly ceaseless supply of oil was the envy of the world. However, the collapse of the global oil price since the summer of 2014 slowly impacted the Kingdom’s public finances –given that it depends on oil sales for 90% of state revenues. The Kingdom’s budget deficit for 2015 swelled to 15% of its GDP.

The construction sector took a severe battering as demand for building projects of large and small scales alike dropped drastically, due to concerns over the economic stability and future. The Saudi government began to try and aid their flailing economy by introducing an “austerity” budget and taking other corrective action. This simply could not work as the concept of income tax is foreign to Saudi citizens and state subsidies render petrol and energy dirt cheap.

With the closure of some of the big names in the Kingdom’s construction sector including Saudi BinLadin and Saudi Oger, experts remain of the opinion that the existing ones should react best to the market conditions. Spencer Wylie, KSA country director for Faithful & Gould, says: “When any global market contracts, every company, not just construction ones, within that market is forced to look at ways and means of essentially staying alive.  Many companies do so by cost cutting measures, headcount reductions, and the like.  Others simply make the toughest strategic call of all and say this isn’t working and exit the market.

“Those companies that react best to the market conditions and make those tough decisions are the ones that survive and are then best placed to re-engage with the market leaner and more efficient than before.  It will be the companies that react best and quickest to change that re-merge stronger in the future.”

The International Monetary Fund (IMF) predicted that Saudi Arabia would exhaust its foreign exchange reserves at an alarming rate- merely five years. This meant that the Saudi government’s savings consisted predominantly of cuts in planned building projects. Reserves worth $746bn in August 2014 have already fallen to $646bn.

Due to the economic crisis, the outlook for Saudi Arabia’s construction market has remained sombre in 2017. It did not help that a substantial amount of construction projects and sector revenues were sponsored by the state, and a deterioration of its fiscal position translated to a radically low demand. This nationwide degeneration of demand has led to increased competition, as builders work on lower and lower margins in order to be competitive in a tough market and obtain contracts.

While banks had followed a very open loan policy strategy in the past, lending has now turned very constrained and regulatory due to the difficult economic situation and increasing default rates. This, coupled with the deteriorated demand situation, has burdened the management of working capital and the cash flow position of most construction businesses.

Wylie continues: “With the advent of reduced liquidity in the market, clients have placed alternative financing solutions firmly on the agenda with initiatives such as public private partnerships (PPP) and the first half year has seen some significant tenders on this basis.  This bodes well for the short term as the industry hunts for positivity and work with the trend expected to increase, although with some caution as over exposure to alternative finance can cause long term fiscal issues.”

Vision 2030

Saudi Arabia’s predilection to rely almost entirely on their vast reserves of oil for economic revenue gradually led to a nationwide collapse. Previous generations may have basked in the opulence of an oil-obsessed economy, but the glory days are nearly over. The Kingdom had come hurtling down to reality, disillusioned with the profitability of oil export, and realised the need for diversification in order to survive.

This is where Vision 2030 comes into the fold. It is a declaration of the new crown prince of Saudi Arabia, Mohammed bin Salman’s, intent to reduce the Kingdom’s dependence on oil exports and revenues, due to the harsh effects the global dip in oil prices had on the nation, as well as diversify its economy away from energy, and develop service sectors such as health, education, recreation and tourism. In essence, Vision 2030 aims to reform the way in which Saudi Arabia is governed. The fiscal policy reform sets out specific commitments for government ministries, with the ultimate goal of achieving budgetary balance, strengthening financial governance, and increasing non-oil revenues.

Analysts and experts have grasped that Vision 2030 will be a pivotal key to opening up the infrastructure market and providing some measure of relief for the construction sector, which has been restricted since the 2014 economic crisis. Maroun Deeb, head of project and development services, KSA and Bahrain, JLL, says: “We have observed continuing desire from the public sector to involve the private sector in development projects. We feel that the current dearth of quality construction companies is being filled by more qualified contractors from within KSA and the wider GCC. Our understanding is that the market will start to ramp up by end of 2017.”

Future Outlook

In Saudi Arabia’s endeavours to generate more non-oil based revenue, it became the driving force behind the OPEC agreement of November 2016 that saw all the members of the Organisation of Petroleum Exporting Countries (OPEC) – barring Iran, Libya, and Nigeria – agreeing to cut production by 1.2mn barrels per day, which makes up 4.5% of current output. This monumental decision saw OPEC committed to its first oil production limits in eight years, and Saudi Arabia proved to be the linchpin of the accord.

The OPEC agreement is crucial as it proves to investors, citizens and the rest of the world that Saudi Arabia is breaking its addiction to oil. It also becomes evident that the nation places a remarkable amount of value on their construction sector and the power of their infrastructure market, hoping that the industry will be aided by greater private sector participation, ensured by the fiscal reforms of Vision 2030.

Furthermore, Saudi Arabia is set to offer 5% of their state-owned oil company, Aramco, to the public sometime in 2018. The nation believes that the capital market will evaluate Aramco at $2tn, earning the Kingdom $100bn, which is meant to be devoted to diversifying and varying the heavily oil-dependent economy. Wylie adds: “The construction market within Saudi Arabia is likely to continue with a period of re-structure and re-focus, while significant and strategic social infrastructure programmes such as Riyadh Metro continue apace. The re-prioritisation that has taken place in recent years and months was necessary to ensure the country was spending its money strategically, on the correct programmes and projects that deliver the best value for money and provide the greatest impact to the country.

“The re-focus that comes from the review of “which projects” to deliver, will ensure alignment with Vision 2030, whilst also tackling historic issues such as late delivery and budget overruns through effective and efficient management.”

While many claim that Saudi Arabia would revert to the familiar and previously profitable energy sector as the primary generator of the economy, the Kingdom remains loyal to its cause, unwavering in their belief that the time for change is now.

 

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