Saudi contractors push for change

27 June 2008
With the cost of raw materials rising ever higher, contractors are urging Riyadh to take inflation risk into account on new contracts, and there are signs that changes will be made.

Contractors in Saudi Arabia are growing dissatisfied. The fact that rising materials costs are hitting construction projects throughout the world is now an accepted truth. But many complain that instead of cost increases being factored into Riyadh’s project plans at the tender stage, they are left to negotiation. As a result, contractors have the choice of exposing themselves to greater cost risk, engaging in lengthy negotiations over terms and conditions, or withdrawing from the market altogether.

It is a delicate time for Riyadh. More than $470bn worth of projects are tabled for development, but little more than 20 per cent have reached the construction phase. With the construction market booming globally, contractors are having to choose the contracts to which they are willing to devote their limited resources. If Saudi Arabia wants to attract international expertise, it is important that it does not lose sight of the industry’s concerns.

Table: Saudi construction investment

YearInvestment (SRbn)Change (%)

na = not available

Source: Saudi Arabian Monetary Agency (Sama)

Inflation risk

The fundamental issue for contractors is that government contracts, which represent the bulk of the work in Saudi Arabia, do not take inflation into account. While it is becoming increasingly common for costs to increase substantially over the lifetime of a contract, or even between the signing of a construction deal and the beginning of work, contracts do not include price-escalation clauses. This means the burden of risk is carried by the contractor.

As a result, contractors are becoming more nervous about getting involved in government-led projects. Just as construction in the kingdom is peaking, firms are having to choose contracts based not on the best return but on the least risk.

“We are suffering,” says one Riyadh-based contractor. “The recent challenge we are facing is an unprecedented one. It is extraordinary inflation such as we have not seen in 30 years. The price of steel has doubled from SR2,600 {$693] to SR5,200 a tonne in eight months.”

A failure to take these inflationary pressures into account is likely to have a disproportionate effect on smaller companies, forcing them either to rethink their risk exposure or, ultimately, to leave the market. “We feel the heat and if we were not a big company, we would not be able to withstand the strong wind of inflation,” says the contractor.

“The government has a lot of surplus [capital], so it won’t slow down,” says Bilal Ansari, a divisional manager at Saudi Oger. “Maybe developers will slow down as the price of construction means that revenue will not be as much as they want.”

Incorporating rising costs into a contract estimate can be difficult. “One example was a recent incident over a contract we signed for a SR80m concrete works on a Riyadh project,” says Usama Adel, deputy manager of Jeddah-based Al-Redwan Contracting. “We were not able to get on site due to a redesign. After a year, the client asked us to come and start. We claimed SR20m in the increased cost of mat-erials, which the client disputed. It took six months to prove this was reasonable, after which we had to ask for another SR10m.”

Because of the economic climate, the firm has had to adapt its tendering process. “We are hibernating,” says Adel. “We don’t want to be [operating] at a loss. [A contract] either comes with a margin or we don’t worry about it. We are adopting a strategic approach, to keep away until the market settles or we get projects with good risk margins. I know two colleagues in other companies who are doing the same, and I am seeing others suffer. We have seen many projects near to signing that did not go through.”

Benchmarking steel

Contractors have also urged the government to establish a steel price index in a bid to bring a greater understanding of costs to the market. The index could track the market price of steel, providing an industry-wide benchmark. Consultants and contractors argue that such a move would bring greater transparency to the sector and lead to more realistic bids.

“This greater transparency and information would not only ensure wider knowledge, but [would also] reduce spiralling costs,” says Zuhair Fayez, senior vice-president of local consultant Zuhair Fayez Partnerships. “If they do not consider a steel price index, you are going to see projects stopping.”

Rising costs are being compounded by administrative failings, say contractors, who are becoming increasingly critical of the government’s handling of major infrastructure projects, particularly when it comes to estimating costs. “It does not consult on estimates, and usually takes it from previous projects,” says one contractor in Riyadh.

According to the contractor, the bill of quantities prepared by the Transport Ministry, which covers the cost of raw materials for a project and provides an indicator for project value, consistently underestimates these values. The cost of a planned 120-kilometre-long highway between Uqair and Salwa in the Eastern Province is expected to double from the ministry’s original estimates, say industry sources. “The quantities they use are estimates and in most cases are much less than required,” says the contractor. “It is not necessarily inflation related; it is ill-prepared tenders.”

Poor communication is another issue cited by contractors. “They don’t answer your queries for many months, then they answer out of the blue and demand tenders in just one month,” says one contractor involved in the Mecca-Medina rail link. “It is not possible.”

In response to these pressures, contractors have written to the government to request compensation for losses incurred as a result of increased material costs. Fortunately, there are signs that Riyadh is listening. The government has announced it is considering compensating contractors who suffer a loss based on a fixed-term agreement.

Compensating contractors

“Contractors wrote to the custodian of the two holy mosques expressing their grievances,” says Khaled el-Seif, chief executive officer of the local El-Seif Engineering & Contracting. “He ordered a review by the Council of Ministers and they resolved that they would compensate the contractors for increases in cost, but the contractor had to finish the job first.”

“We are preparing documentation to file a claim,” says Joseph Daher, a project manager at local contractor Al-Mabani. “We are waiting for the government to issue clear instruction and advice on how it intends to compensate contractors.”

In the meantime, the firm is increasing the margin of risk in its tenders. “We used to take a 1 or 2 per cent margin,” says Daher. “Nowadays, we are forced to take it up to 5 per cent. It is not yet delaying contractors, but it is building up pressure, and this pressure will have a negative effect. We believe the government will take the necessary measures to make up contractors’ losses. It is in the interests of all parties.”

As yet, the government has not introduced any specific measures to implement its policy. “There are a lot of talks, but until now there has been no clear-cut mechanism,” says Daher. “We have not seen anything that is really clear. The intent is there, but the regulations we hear of are vague.”

“They did set up a committee at the Finance Ministry to receive the claims, but there is nothing done yet,” says Ansari, adding that the process for dealing with claims is still unclear.

Last month, the Jeddah Chamber of Commerce held a meeting attended by 600 contractors to discuss the various issues concerning the firms. The chamber agreed to look into setting up a committee to create a new department charged with helping local firms enter into joint ventures to enable them to compete on the same level as the larger firms.

“If just 50 per cent of what was discussed materialises, it would be a good move forward,” says Adel.

Facilitating the creation of joint ventures would be an important step. The concern is that megaprojects will suffer should companies not be in a position to participate in such developments because of spiralling prices or a lack of resources. “It leaves the area open for Chinese and other foreign firms,” says Adel. “Only two or three contractors can do mega-projects, so they are encouraging companies such as Al-Redwan to join up to create a bigger entity. You cannot easily divide up a SR100bn project into small pieces - you need people with the capability to do it. It will take time, but at least it is a start. These big firms are dealing with thousands of millions of riyals; we are dealing in hundreds of millions.”

Al-Redwan is already in an advanced stage of negotiations with a Chinese firm to ensure it is in a position to seek out the big jobs in the future. “We are making ourselves ready, and when we have settled we will be ready to crack on,” says Adel.

Such tie-ups could become increasingly common for Saudi-based contractors looking to work on large-scale projects.

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