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Expert Insight

Contract crunch: Ben Hughes, Deloitte ME

The International Monetary Fund (IMF) predicts GDP growth across the GCC to increase to 2.3% in 2017 from 1.7% in 2016, which is a reflection of a stabilising oil price and increased market confidence, underpinned by government’s restructuring initiatives aimed at reducing oil dependency and boosting the private sector, such as Vision 2030 in Saudi Arabia.

The current oil price rebound has resulted in the price per barrel reaching anywhere between $50 and $60, which is a marked improvement on previous lows of mid-high $20’s per barrel. That said, oil prices hovered around US$100 per barrel for a prolonged period of time until mid-2015, and it is therefore not unreasonable for oil-generating economies to tighten their belts against a backdrop of falling revenues.

Ben Hughes1

Governments have reduced spending and prioritised projects to meet social and economic development objectives. The decline in project awards in 2016 has negatively impacted the construction industry across the Gulf region, with the most affected markets being Saudi Arabia, Qatar and Abu Dhabi due to a greater level of dependence on oil income.

Impact on the construction industry is significant

The reducing volume of project awards has been a major issue affecting the construction industry, but it is not the only one. Due to the lower number of projects and tightening budgets generally, there is an increased level of competition across the industry to secure those few contracts which are still being awarded, and this has translated into downward pricing pressure, i.e. reduced margins when preparing project budgets or estimates.

The lower volume of project awards has not necessarily translated into quicker decision-making either. In fact, it has also affected the decision-making process because ever-more scrutiny is being placed on award decisions, and this in turn is affecting the contracting industry which is reliant on a steady pipeline of projects just to remain solvent.

Moreover, the tightening of budgets has unfortunately manifested in a number of government entities delaying, or in some cases, deferring payments and this has constrained cash flow across the entire industry – in some cases resulting in significant financial issues and social unrest. The 2015 Deloitte Powers of Construction report, analyzed the key findings of a C-Suite survey conducted with regional construction companies and the feedback provided compelling reading. In particular, it was noted that the average collection cycle from completing the work to collecting the cash totalled 225 days, and there have been no reported improvements in the cycle since then. Indeed, the simple act of processing invoices has become ever more protracted and adversarial with innumerable examples of “the Engineer” either not certifying interim payment certificates (PCs) or substantially reducing the certified amounts for very minor technicalities or differences of opinion. In other well reported cases, government agencies have issued promissory notes in lieu of physical payments as they do not have the funds to honor those payments. Often the promissory notes are later converted into a reduced cash payment, which then exacerbates the same cash flow issues being experienced by the contractors and their supply chain.

In a similar vein, pricing strategies are becoming more divergent. Given the prevailing market conditions, many contractors will look to reduce margin and accept work to maintain turnover, but will do so without necessarily considering or pricing-in risks for fear that this will make them commercially uncompetitive. In a more buoyant market, contractor pricing converges, where many bidders will consider both risks and opportunities and factor this into their commercial offer – which benefits all parties because risks are known and foreseeable, and opportunities are proactively considered.

Linked to this trend of low margin pricing is the increasingly common occurrence of contractors looking to enhance revenue through variations. For a substantial number of contractors, their bidding strategies are predicated on making money from variations, either client-driven changes to the scope or technically derived changes due to constructability or design issues. This in turn can lead to conflict during the delivery of projects and often manifests in contractual claims for time and cost, as has become increasingly apparent during this latest economic cycle.

What does the future hold for construction across the GCC?

There certainly are a number of macro-economic factors that will continue to drive growth. Demographic pressure is giving rise to a growing need for infrastructure to be developed, including transport infrastructure, social housing, schools and hospitals as well as power and water projects. It is imperative the GCC countries diversify their economies by moving from an oil-based to a knowledge-based economy that will provide a sustainable source of growth and employment when oil resources are exhausted. Localized construction drivers like the mega events in Dubai and Qatar, and ultimately a strong tourism drive for a number of governments across the region will also play an important role.

According to MEED, the total value of projects either in the planning or the delivery stage across the GCC is $2.8tn. Saudi Arabia leading the way with $1.1tn of projects, followed by the UAE with $830bn and the remaining total spread more modestly across Kuwait, Qatar, Oman, and Bahrain. Clearly, a pipeline of projects of this magnitude has to be perceived in a positive light by the construction industry. The key question is when these projects will reach the contract award stage, as only then will the positive economic impact be truly felt.

Whilst the economic headwinds prevail in the short term, there are signs that these will dissipate over the coming months and that 2017 will represent an improvement over 2016. The sheer volume of projects either being planned, or currently being executed, in addition to the wider strategic initiatives being set in motion by governments across the region, has to give cause for optimism. Such factors will then hopefully manifest into widespread positive sentiment which will result in governments re-engaging in major project expenditure, and contractors (and their supply chain) taking more confidence in this and pricing more conventionally.

With more focus on Capex efficiency, return on investment and much more targeted investment strategies, clients will similarly feel the need to manage risk and balance this against the potential rewards, thereby creating a more focused yet positive contracting environment moving forwards.

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