Inflation increases pressure for contract model change in Saudi Arabia

11 April 2008
Contractors’ bids are coming in up to 40 per cent higher than clients expect.

Construction clients are coming under pressure to change the traditional forms of contracts used in Saudi construction because of rising inflation, say industry sources.

Inflation in Saudi Arabia, which reached a 27-year high of 8.7 per cent in February, is putting strain on the construction sector, with bids from contractors coming in at up to 40 per cent more than the client’s budgeted costs.

The impact of rising prices has led to some projects being put on hold because of a lack of funds, while others are being scaled back to ensure they stay within budget.

The traditional contract model used in the kingdom, which typically allows for prices to increase by 6.5 per cent a year, is proving inadequate in the face of rapid material price increases, according to George Dinic, programme manager at Saudi Arabian Bechtel, which is supervising the expansion of Jubail industrial city.

“Sabic announced [on 8 April] that it was going to increase the cost of rebar [reinforced steel bars] by SR825 [$220] a tonne,” he says. “That is a 25-30 per cent escalation of cost overnight.

“There is also a shortage of cement because Dubai and the other emirates are removing all trade barriers and customs. Prices for cement have increased by 20-30 per cent almost overnight.

“You apply to the government for a budget and say it will cost a certain amount, taking into account the 6.5 per cent escalation rate, but when it comes to award the contract a year and a half later, after the design is finished and the bidding is done, the bids are 30-40 per cent higher than you expected,” Dinic says. “That is causing a problem with securing sufficient funds to do the job.”

Some projects have already been put on hold as clients grapple with budgets based on outdated cost information.

Despite offering the lowest bid for 10 government contracts in 2007, totalling $491m, one contractor based in the Eastern Region only received $45.8m in orders. The remaining eight projects are still on hold.

A key factor in the problem is that the budgets for many of the projects now coming on line were originally drawn up six to eight years ago.

“It is evident that tenders are being called for based on budgets worked out some years back, thus not considering the significant increases in almost every cost component, be it materials, equipment or manpower,” says one contractor working in Al-Khobar. “Not to forget the eroded purchasing power of the dollar and therefore the riyal.”

Industry observers say that clients could be forced into increasing the escalation rate on contracts, to link it more closely to the rate of inflation. However, this will not necessarily solve the problem.

“With inflation at 8.7 per cent, you could take the escalation rate over next year to 8.5 per cent, but if the cost of steel increases overnight by 30 per cent and cement by 30 per cent, what are you going to do?” asks Dinic.

The difficulties for the construction sector come at a time when the wider Saudi economy is also growing fast. According to Riyadh based Samba, gross domestic product is expected to reach $464.5bn this year and $517bn next year.

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