The Kingdom of Saudi Arabia’s ambitious Vision 2030 is building entire cities in a bid to future-proof its economy. Yet, when Vision 2030 was announced in 2016, nobody could have imagined events that would unfold.
COVID-19 has been far reaching combined with the energy crisis caused by conflict in Europe and sanctions on Russia are several factors exacerbating the fastest rise in construction materials costs seen in decades.
RLB professionals are currently providing advice to multiple Public Investment Fund (PIF) entities on several Vision 2030 giga projects with work worth approximately 1 trillion US Dollars. These giga projects are facing a significant challenge: inflation coupled with significant supply and demand issues.
In the latest RICS Global Construction Monitor for Q1 2022, 91% of respondents agree the increase in building materials is holding the industry back. Furthermore, 71% of respondents indicated that basic availability of materials is also an issue.
Causes of inflation in KSA
The Public Investment Fund’s large-scale investment in the Vision 2030 plan is significantly stimulating the economy. Demand outstrips supply, and contractors have their pick of work.
If a contractor has reached work capacity and has a healthy pipeline, there are two ways to continue increasing profits:
- maintain resource level and start bidding more projects at reasonable competitive rates, or
- maintain current resource level, safe in the knowledge of a secure pipeline, and increase bid profit margins.
Given the KSA’s high level of available work and the restricted supply of labour, plant, and materials, contractors are likely increasing profit margins.
Wider global factors such as high oil prices, instability in major producing nations, and logistical problems are also increasing basic raw material prices. Lack of sufficient staff and KSA’s Value Added Tax (VAT) have also caused price increases.
Anecdotally, we understand that contractors have expressed concerns about working with international Project Management companies. The perceived risk leads to:
- increased pricing as they anticipate more management resources are required or
- pricing the risk of delay if it will be harder to achieve practical completion on projects.
RLB continuously surveys contractors to determine if this factor is impacting pricing.
Recommendations to Address Inflation
Traditionally, the KSA’s default position has been for the supply chain to bear the costs associated with inflation risks. Today’s volatile market could see contractor cash flows squeezed to the point of insolvency. Without large cash reserves or lines of credit, a single project could threaten a contractor’s survival.
It is time to consider who is best placed to take this inflation risk and provide best value for the client. Clients with deep pockets may be better placed to carry this risk and provide the supply chain with confidence to submit more competitive tender returns as described in the following six strategies.
- Adopt Fluctuation Clauses in Contracts
Cost professionals provide valuable advice during volatile markets, including adopting risk sharing provisions in standard contract forms. JCT, FIDIC, and NEC all have contract provisions that allow parties to manage the risk of cost increases during the project’s duration. FIDIC and JCT often use fluctuation clauses based on indexes to fairly adjust costs to align with industry-wide cost increases, although the JCT removed this option from their 2016 suite of contracts it may be time to put them back in. Generally, FIDIC is the contract of choice in the middle east, so Cost Managers should become accustomed to utilising the necessary provisions.
Fluctuation clauses could be used to fairly share the risk of cost increases over the life of Vision 2030 projects. The KSA market’s challenge is the lack of available and robust indexes. Establishing and maintaining an index would require an independent and centralised data gathering exercise. Most KSA projects are publicly funded government projects, and the PIF could work directly with organisations including the British Cost Information Service to establish and maintain a Saudi alternative, the Saudi Arabian Cost Information Service. Establishing a KSA cost index would also benefit Cost Managers to more accurately forecast costs on future projects.
- Prime Cost Sums
Another method of allocating the risk of material increases to the client, is by utilising Prime Cost Sums. The contract will be setup to enable fixed costs for some costs (labour, plant, OHP etc) whilst allowing the material costs to be adjusted at the time of purchase.
This could be a simple method that would be easily implemented into existing contracts, but still managed by the Cost Manager.
- Advance Payments to Reduce Fear of Future Price Increases
Inflation is cumulative and persistent, and one method of reducing its impact is to purchase materials earlier.
An agreement to pay for materials in advance allows the contractor to secure current prices to allay their fears relative to price increases. This tactic’s success is dependent on the contractor’s ability to agree to prices in advance within their own supply chain. For example, raw structural steel members could be pre-purchased based on initial designs, with an off-site payment and vesting process put in place to protect the client’s interests (advanced payment bond, vesting certificates etc.).
This practice is commonly used throughout the middle east, so it is important the Cost Manager manages payments according to contract requirements.
- Adapt Procurement and Contract Strategies
Vision 2030 owners should be pragmatic with contract strategy and explore risk sharing options to encourage tenderers to prepare more competitive lower bids, knowing they will be compensated if prices rise. Other strategies include reviewing potential package sizes with supply chain contacts to understand which sizes are most valuable. Also, opening procurement to wider markets may attract new contractors and improve the competitive landscape.
Centralized procurement teams could also take advantage of large quantity orders and put pricing framework agreements into place with major material suppliers. Owners could realise buying gains by agreeing to a set of rates and favourable payment terms, which could be passed onto contractors.
- Review and Adapt Payment Processes
Cash flow is paramount to contractors, and reliable and fair payment processes are critical. Contractors know it can be difficult to receive prompt payments from clients, so they often demand large advanced payments, or factor in slow payment risks into their tender.
Late payment practices could also be preventing established contractors from abroad from entering the Saudi market. When more contractors tender the work, the marketplace becomes more competitive, resulting in decreased tendered prices.
Payment processes could be addressed with Project Bank Accounts/Trust Funds, where an objective third party manages and approves release of funds. Contracts could specify international arbitrators to enforce potential disputes, which would give contractors faith that payments will be dealt with fairly. Smart contracts could also be explored by executing payment processes in line with terms distributed on a blockchain, allowing automated payments when a certain set of criteria are matched.
Ultimately, these practices could make the KSA market more attractive and give potential new entrants confidence to join the market.
- Use Modular and Other Construction Methods
Modular or off-site construction is not a new concept. Currently, there are few established and suitable companies working within the KSA market, and most modular construction is carried out in other countries and then shipped to the Kingdom. Off-site manufacturing could also see contracts being secured earlier than with traditional procurement, which would help stave off inflationary impacts.
If procurement teams expanded their reach to companies with different construction methods, then more companies would tender bids, and the competition would naturally result in lower prices, provide transparency, and give all suppliers a fair opportunity to win business.
Summary
KSA is not alone as it faces inflationary challenges to its Vision 2030. RLB is fully on board to advise, equip, and help Saudi owners navigate this global crisis.
