Smart contracting in uncertain times: Ben Hughes, Deloitte

With oil prices depressed, allied with a more uncertain security position across the region, governments have taken a more measured approach to spending, which has typically resulted in spending cuts. Non-essential projects have been deferred and an increasing proportion of fiscal budgets are being diverted to military spend. Indeed, lower oil prices are likely to result in oil-export related losses of approximately $360bn during this year alone. MEED Projects also forecasts oil prices will remain low, between $50-70 per barrel until 2020, so this is an issue that will need to be managed for the foreseeable future.

This uncertainty and tightening of budgets inevitably impacts the private sector, not only because public sector awarded contracts have become increasingly scarce, but also as a result of weakened market sentiment which then has a cyclical effect on industry. This is often experienced first, and most directly, by the construction sector which is either reliant on government spending on major capital and infrastructure projects, or reliant upon the private sector who typically deliver projects during times of stability and prosperity.

The value of projects awarded during Q1 of 2015 equated to a record $172bn. Kuwait has outperformed its targeted spend, whilst Qatar has remained on target against forecasted spend.  Saudi Arabia and the UAE, the region’s two biggest spenders, have experienced a slowdown in the pace of growth and this is expected to become even more pronounced in 2016.

However, taking the increasingly cautious economic outlook to one side, there is still a healthy pipeline of projects across the region that are considered to be essential and therefore unlikely to be delayed or cancelled.  MEED Projects considers this pipeline to be around $1.8tr in value, with Saudi Arabia being the largest net spender at around $800bn; the UAE following behind with projects in the pipeline of $600bn; Qatar contributes $200bn in projects; and Kuwait follows with c. $175bn in projects. Of this total, almost $1tn is focussed on the construction sector, i.e. buildings, transport and commercial related projects, so there is clearly still a large market for contractors to tap into.

The new PPP law in Dubai, which came into force on 19 October 2015, may also help sustain this level of expenditure as the Dubai government has recognised the benefit of delivering major projects using both private sector cash and expertise.  Indeed, this may well be viewed with interest across the GCC as other governments, looking to hedge their expenditure on essential projects, may consider this a viable option to share the financial and operational risk in delivering projects such as education facilities, hospitals, transport projects and power projects. Whilst PPP in the region has not achieved the same level of adoption than in more developed economies, who would bet against the Dubai government in creating an environment that positively encourages partnering between the public and private sectors, and in doing so delivers a range of significant projects across the Emirate for many years to come?

However, given there is a reduced amount of expenditure across the construction sector, it is inevitable that there will be increasing competition to secure a share of the market, and this can sometimes translate into behavioural patterns that actually contribute to long-term issues. With less money being spent in the market, contractors tend to reduce their margin during the estimation phase to remain competitive. But if they have a constant cost base, i.e. their staff numbers remain the same, and they retain the same amount of plant, equipment and office accommodation, then as gross margins decline so too does their net cash position as relatively more cash generated may be used to cover fixed overheads. Such issues might include non-payment of staff, long delays in paying supplier invoices and delayed payments on banking facilities, all of which again lead to cyclical problems that are often difficult to fix.

So how are such issues avoided in the longer term? By adopting a more measured approach to pricing, such as protecting margin, contractors will ensure a more reliable and robust cash position which may help avoid the issues outlined above. But this is only part of the solution. Ensuring that projects are delivered efficiently is also a key factor in ensuring financial performance. For instance, many contractors across the region speak of having excellent policies and procedures, world-class project controls and integrated ERP systems. However, unless their project staff fully understand the contract and are delivering to that contract, they are managing change efficiently and also balancing project cash flow. At that point, gross and net margins could be reduced to the extent that they become negative which, if replicated across a number of projects, can have a significant impact on a contracting business’ balance sheet.

Having clear, concise and well implemented project controls can help protect against margin erosion.  For instance, understanding contract provisions around variations can go a long way to protecting that margin. Frequently contractors implement changes without the necessary approvals in place, and this often leads to conflict, and in accounting terms, provisioning a proportion of this at year end.  So using recognised practices such as Cost Value Reconciliation may help protect the margin of the project and allow management to make more informed decisions during the execution of the project.

The contracting environment across the region is diverse, complex and can sometimes be contentious. Whilst international standard project controls and efficient project delivery go a long way, clients themselves also need to share the responsibility in improving the trading conditions for contractors.  A consensus view on variation orders and extension of time claims is a rare thing, but if clients and contractors acted in a more collaborative way using recognised and transparent project controls, such conflicts may be avoided in the future.

Perhaps the current economic conditions may actually be viewed as an opportunity for more efficient and collaborative project delivery, which if adopted across the industry, may lead to a longer term improvement in working practices and a more mature contracting environment, i.e. “survival of the fittest”.