Taking the fast road: Despite the rise in material costs, infrastructure upgrades boost long-term prospects

Buoyed by prolonged government stimulus, Saudi Arabia’s construction sector is experiencing rapid expansion, with no shortage of contracts in any segment of the industry. From housing to utilities and transport infrastructure, public spending is driving the contracting industry forward. While operational challenges remain, including concerns or labour regulation, contractors are likely to have favourable conditions for the foreseeable future.

BY NUMBERS: In many ways, construction has become one of the mainstays of the Saudi economy. According to the Council of Saudi Chambers (CSC), the sector is the second-largest economic segment in the country after oil. In 2012 the industry grew at 16.5%, well above private sector GDP growth of 11.5% and overall expansion of 8.6% in current prices. Assets in the sector were valued at SR200bn ($53.3bn), according to the CSC. While 2013 was not quite as impressive, the industry continues to outperform the economy as a whole. In the third quarter construction grew at 5.7% year-on-year, according to Riyadh-based Jadwa Investment. While this was down from the second-quarter growth figure of 6.5%, it was above the same period of 2012, when the industry rose 4.9%. Furthermore, the performance of the sector remains well above the overall GDP growth rate of 3% (see Economy chapter).

ON THE UP: In many respects, 2013 was another stellar year for the industry. According to data prepared for The Big 5 Saudi, an international building and construction show, by Middle East Economic Digest (MEED), $42bn worth of construction contracts were awarded in 2013, an increase of 147% on the $17bn seen in 2012. This marks 2013 out as one of the biggest years for the industry in the last decade, according to MEED. NCB Capital had different data, but showed a similar upward trend. According to the bank, SR293.4bn ($78.2bn) worth of projects were awarded in 2013, a 25% increase on 2012 and a 9% rise on 2011. Indeed, 2013 represented an all-time high in terms of contract awards. Projects came thick and fast in a number of areas. The transportation sector accounted for SR92bn ($24.5bn) worth of contracts; the power sector, SR48bn ($12.8bn); real estate, SR40bn ($10.7bn); industry, SR19bn ($5.1bn); and petrochemicals, SR18bn ($4.8bn).

As such, there were numerous opportunities for both general contractors and those specialising in certain segments of the market. As the above list suggests, however, the industry has become highly dependent on public spending to keep it buoyant. The government set five successive expansionary budgets in the years up to 2013. While the state intends to have a balanced budget in 2014, planned allocations are up on 2013, signalling another record budget for the Kingdom.

GOVERNMENT SPENDING: Expenditure is forecast to hit SR855bn ($227.9bn) for the 2014 fiscal year, an increase of 4% on planned 2013 spending. However, this figure is below the actual amount spent in 2013 of SR925bn ($246.6bn) and represents the smallest rise in planned expenditure since 2007. Nonetheless, it will provide plenty of opportunities for construction firms to add to their workbooks. Social infrastructure remains a key priority for the government, with education and health care accounting for 38% of expenditure in the 2014 budget. This will include the construction of 465 new schools, 1500 school refurbishments and the construction of 34 new health care facilities.

Approximately 8% of the Kingdom’s 2014 budget will go toward transport and infrastructure projects, with spending in this segment up 2.5% on 2013. This will include rail and port projects in Jubail, Yanbu and Ras Al Khair and 3500 km of new roads. Water and agriculture infrastructure will take up 7% of the budget, while municipal projects and inter-city roads will account for 4.6%.

TRANSPORT: One of the most significant areas for expansion is the transport sector (see Transport chapter). With the government eager to position the Kingdom as a key logistics and trade hub for the region, as well as support economic and demographic growth, there has been a strong emphasis on upgrading and expanding the country’s transport network. This encompasses projects from port and airport upgrades to road building and maintenance, with the greatest focus on a new country-wide rail network and inner-city rail systems. According to a 2013 report from Kuwait Finance House (KFH), railways account for 46.9% of all ongoing infrastructure projects in the Kingdom, with the remainder comprising metro (19.3%), port development (13.6%), airports (10.1%), roads (6%) and other projects.

TURNING TO RAIL: Planned rail projects are valued at approximately $90bn, according to KFH. The Haramain High-Speed Rail, which runs between Makkah and Medina via Jeddah, has provided substantial construction work over the previous five years. The last major contract for the project was awarded to the Al Shoula Consortium, which consists of two Saudi and 12 Spanish companies, in October 2011 for €6.7bn. The line is expected to be open by the end of 2015. However, most of the major projects in the Saudi rail segment have only just been awarded, or are set to be awarded in the next 24 months, suggesting that there will be a raft of contracts and sub-contracts hitting the market.

In 2013 contracts for the $22.5bn Riyadh Metro project were awarded. Three consortia – the Bechtel-led BECS consortium, the Ansaldo STS-led Arriyadh New Mobility consortium and the FAST consortium led by Spanish firm FCC – were selected to develop the six-line, 176-km network.

Digging began in late March 2014, with the project expected to be complete at some point in 2018. According to FCC, construction of the metro network will require around 600,000 tonnes of steel and 4.3m cu metres of concrete and will provide employment for more than 30,000 people.

BEYOND RIYADH: In July 2013 it was also announced that the Makkah Public Transport Programme would begin in 2014. The project is set to cost $16.8bn, with the first phase scheduled for completion by the end of 2017. In total, the system will have four lines covering 180 km of track and connecting 88 stations, and is projected to be fully operational by 2023. Work on a metro system in the Red Sea city of Jeddah is also scheduled to begin in 2015. The design phase for the 293-km metro began in February 2014. The cost for the network, managed by the Jeddah Metro Company, a joint venture between the municipality and the Jeddah Urban Regeneration Company, is expected to reach $9.3bn.

One of the most important developments in the pipeline is the Saudi Landbridge project, an east-west rail line between Dammam (with an extension to Jubail) and Jeddah. In September 2013 the government awarded an eight-year project management contract to US group Parsons Brinckerhoff and Fluor Corp for the 950-km line. Originally envisaged as a public-private partnership, the $7bn initiative was taken on by the Public Investment Fund as a state-funded project in October 2011 following a failure to agree financial terms with private partners. The project is also likely to bring a number of contracts to the market over the next 24 months.

AIRPORT EXPANSION: Outside the rail segment, one of the biggest ongoing infrastructure projects is the expansion of the King Abdulaziz International Airport in Jeddah. Opened in 1981, the airport is facing increasing demand from both domestic passengers and pilgrims coming to perform the Hajj and Umrah. As such, the airport is being expanded to cater to 30m passengers by the end of 2015, at a cost of $7.2bn. There are also plans for two further phases that would bring a range of new tenders to the market. If it is given the green light, the second phase will increase the capacity of the airport to 55m by 2025 and 80m by 2035.

HOUSING: While major infrastructure projects such as the Riyadh Metro project or the Saudi Landbridge railway will dominate the construction industry in the Kingdom for some time to come, real estate projects will offer an opportunity to a wider range of less specialist contractors. Spending on transport infrastructure will be accompanied by substantial investment in real estate. Some SR40bn ($10.7bn) worth of real estate contracts were awarded in 2013, according to NCB Capital. With a new mortgage law likely to be approved in the last quarter of 2014 and a major home-building plan – known as Eskan (Arabic for “housing”) – introduced by the Ministry of Housing (MoH), this level of spending is likely, at the very minimum, to be maintained for the foreseeable future. As part of the $67bn housing initiative, the MoH will build 500,000 units across the country in its efforts to resolve the Kingdom’s housing deficit. Given that the government has expressed its preference for private sector involvement in meeting this target, it should help not only contractors but also developers as well (see analysis).

On the supply side private sector players are absorbing the majority of these contracts. According to NCB Capital, almost 2330 contracts with a total value of SR157bn ($41.9bn) were awarded to the private sector by the government in 2013. Across the GCC region, the construction sector is on the up and sentiment among contractors is positive.

A survey by London-headquartered law firm Pinsent Masons, released in the first quarter of 2014, found that 90% of construction companies in the GCC perceived “greater optimism in the market”, with 77% also reporting a more positive order book for the coming 12 months.

CHALLENGES: While contractors, consultants and developers remain confident in the industry, it does not mean the sector is without its challenges. Indeed, as the Kingdom rises to prominence as a leading market for construction contracts in the region, competition for work is likely to increase. “We are facing an interesting conundrum. Although there is a big supply of projects, there is also a big supply of competitors,” Rayed Jeffa, business development officer at the Saudi Binladin Group, a Jeddah-based construction multinational, told OBG. To this end, Jeffa notes that the extensive rail network and large number of foreign specialists competing for work has meant that many projects are out of reach for local firms. “We just about have a balance between supply and competitors,” he said.

Notwithstanding, there have been calls for consolidation in the regional construction market, given the increasing presence of large, well-capitalised multinational construction firms in the GCC. In June 2013 Abdulrahim Hassan Naqi, the secretary-general of the Federation of GCC Chambers, told the local media that contracting firms in the Gulf should look at mergers as a way of maintaining competitiveness. While the GCC contracting sector grew at an annual rate of 22% to $137bn in the first half of 2014, according to Naqi, the robust competition from multinational firms is expected to make mergers inevitable.

One of the other major challenges for a congested market, even for firms that have won contracts, is the coordination and delivery of projects. “The biggest problem is not the nature of contract itself, as we are used to pricing risk and making our returns,” Jeffa told OBG. “Rather, given the size of projects now in the market, the biggest challenge is the interface with other contractors and managing the relationship between the design phase and construction, which can overlap and become a problem.”

This is likely to be a key concern for some of the major ongoing projects in the Kingdom. The Riyadh Metro, for example, requires the construction of six metro lines simultaneously, with the involvement of three consortia and multiple contractors. Given the impact this will have on traffic flows in the city, there are concerns that this could lead to delays and phased delivery of the project.

INPUT COSTS & CONSTRAINTS: Given additional competition in the market, there has also been something of a price squeeze in the Saudi construction sector. Mazen Fayed, corporate communications manager of Saudi Oger, a local construction and facilities management services provider, told OBG, “There is a lot of pressure on pricing as we see competition increasing. Many new companies are entering the market: companies from the US and Europe, and even East Asia, are all coming to Saudi Arabia.”

Across all segments of the market, the addition of new entrants from around the world is leading to rigorous competition in terms of pricing. Ahmed Sindhi, general manager of the Saudi Arabian Trading and Construction Company, a contractor that works on facilities and residential construction, among other things, told OBG, “Competition in the Kingdom is fierce, with many new contractors entering the market from China and South Korea, and bidding with very low prices to win contracts.”

In October 2013 Fahd Al Hammadi, chairman of the National Committee for Contractors at the CSC, told the local press that contractor margins now stood in the range of 4-8%, but were still under significant pressure. “With construction costs going up by at least 12%, contracts have started to suffer from a sharp fall in profits and large losses in some cases,” he said. Indeed, the squeeze on margins is largely a result of increasing pressure on both contractor pricing and input costs, but it is the latter that has been making life particularly difficult for all players in the industry.

LABOUR & RESOURCES: The most prominent change in 2013 in this regard has been the government’s stance on labour. As a means of promoting Saudi employment, the authorities attempted to address the issue of informal foreign labour in 2013 (see analysis). In March of that year the government announced an amnesty for illegal workers, giving them until November 2013 to leave the country without sanction. Once this period expired, the mass exodus – as many as 1m workers – was felt strongly in the construction industry. With the availability of a flexible labour force reduced, and costs for construction workers rising, the impact on the operations of contractors has been substantial.

Saleh Al Habdan, CEO of Cercon General Contracting, told OBG, “The labour reforms are good in concept, but their implementation has been rushed. What should have been done over a period of years was forced on the market in a matter of months.”

“The new labour regulations are negatively affecting the market right now. However, these changes will be absorbed and will end up benefitting the market in the long run,” Fakher Al Sawaf, the general manager of Al Bawani, told OBG.

The other significant input cost challenge is material prices. With a major expansion in construction projects over the past decade, there has been consistent pressure on cement supplies. Between 2002 and 2012, annual cement consumption increased from 25.9m tonnes to 53m tonnes. The highest growth trajectory came from 2007 to 2012, with consumption achieving a compound annual growth rate (CAGR) of 11.6%, according to Aljazira Capital, a Jeddah-based brokerage and advisory firm.

Domestic production is just about capable of meeting this demand. Production capacity rose at a CAGR of 11.2% between 2007 and 2012, reaching 56.2m tonnes in the latter year. The central and western regions of the country, which are home to the majority of real estate projects, account for more than 50% of this capacity. This growth trend is expected to continue in the medium term, according to Aljazira Capital. The company estimates that production will rise by 12.1% annually until 2015, bringing another 23m tonnes to the market.

CREEPING COSTS: Nonetheless, while supply has managed to stay marginally ahead of demand, there has still been substantial pressure on prices. Indeed, inventory levels of clinker are diminishing rapidly, falling from 25% of clinker production in 2009, or around 10.9m tonnes, to 13.4% in 2012, or roughly 6.4m tonnes. This tight supply situation has pushed prices upward, which, according to Aljazira Capital, increased by 2.6% in 2011 and 4.2% in 2012.

Average cement prices in the first half of 2013 stood at SR236 ($62.92) per tonne, while Yanbu Cement and Qassim Cement command prices from traders as high as SR252 ($67.18) per tonne. The government has intervened to ensure prices do not rise further, specifically by enforcing an export ban and, in March 2012, placing a cap on cement prices of SR240 ($63.98) per tonne. “The government has a very careful approach to ensure cement products availability at any time and with sustainable prices,” said Guy Chaperon, CEO of Al Safwa Cement, told OBG. “It is unlikely the export ban will be lifted in the near future.” Nonetheless, with traders stockpiling cement, an informal cement market has emerged with prices exceeding the state’s official cap.

The government has been proactive in intervening in the steel market to control prices. In October 2013, for example, Saudi Basic Industries Corporation issued instructions for steel traders to lower prices on a range of products by SR200 ($53.32) per tonne. Steel rods sized 8 millimetres (mm) now sell for SR3015 ($804) per tonne, 10-mm rods sell for SR2975 ($793), 12-mm rods for SR2775 ($740), and those between 16 mm and 32 mm for SR2765 ($737). Given the high demand for steel products, the government is likely to have to stay active in the market to keep construction costs down. According to a report by business research and consultancy firm RNCOS, steel consumption is expected to grow at a CAGR of 11.7% from 2013 to 2017.

SPIKE EXPECTED: With demand for basic materials over the next five years expected to continue to grow, there is likely to be substantial price pressure and a consequent impact on contractors’ margins. “I expect a new spike in construction material costs coming up. In the last three years we have seen a sharp rise in concrete, but not so much in steel. The increases in this period were not expected to create this much of a spike, so many contractors are experiencing a squeeze on their margins,” Jeffa told OBG. This is likely to be compounded by price escalation in other input costs.

While the government has worked to alleviate this, the industry may still face challenges. Mohammed Al Khalil, president of Riyadh-headquartered FAD Investments and Akwaan Holdings, told OBG, “The Ministry of Commerce and Industry has done a good job ensuring the basic goods of steel and cement are available and reasonably priced by supporting local manufacturing. However, there is a shortage in other secondary inputs such as doors, windows, and the electricity to get these units up and running.”

The price increases will affect all elements of the construction industry. However, contractors have been, and will likely continue to be, particularly vulnerable. The nature of contracts in the Kingdom mean that contractors are largely exposed to cost escalations. Indeed, in the last decade, the country has moved away from cost-plus style contracts with lump sum arrangements becoming the market norm. While most of these have some degree of flexibility, allowing for a 10% escalation or 20% reduction in scope, contractors have less protection against unforeseen cost increases and therefore have to absorb such fluctuations in their margins. However, many firms remain optimistic about overcoming these challenges. As Jeffa says, it is the nature of the contracting business to price risk and most firms are comfortable working under lump sum contracts.

BUILDING EFFICIENCY: A potentially bigger problem for the industry is the timeliness of payments and the potential impact this can have on cash flows. Under Saudi law, there is little protection for contractors in terms of ensuring payment. For example, the Procurement Law specifically forbids contractors from suspending work as a result of the government’s failure to pay. Thus, while contractors can potentially stop work on private projects under the terms of their contract, they have no means of ensuring payment when it comes to public sector contracts. While some contractors express satisfaction with timely payment from public sector clients (often within 30 days of approved billing), others, working for different public entities, are more concerned about late payments and cash flows.

Indeed, while contractors can build in a risk markup for late payments into their bids, this offers no solution to potential cash flow problems. A survey released by Pinsent Masons in the first quarter of 2014 found that 62% of construction companies in the Kingdom complained about longer payment periods (although this is down from 78% of respondents to the same survey in 2013). Even for contractors working with the private sector, the issue of payment and enforcement is not always straightforward. The World Bank’s 2014 “Doing Business Report” provides an illustration of the challenges in the Kingdom. While the country ranks a highly competitive 26th out of 189 economies for its overall business environment, in terms of enforcing contracts it scores 127th, down from 124th in 2013. These issues are particularly heightened at times when contractors are already facing cost pressures and additional expenditure to complete projects.

The cost implications of demand for materials and labour resulting from the current growth in the sector are also felt by developers in the real estate market. Building costs have increased by as much as 15% in the last 24 months and can range from SR1200 to SR2500 ($320 to $667) per sq metre in the residential segment depending on specifications. Given that land prices can reach as much as 50% of the total cost of a development, the ability of the private sector to deliver affordable housing units is limited (see analysis). To this end, the majority of the cost of bringing a unit to the market – up to 80% according to some sector players – cannot be controlled by developers.

For this reason, and owing to the critical housing gap, the government has been intervening to bring down material costs in the industry. With the MoH aiming to deliver some 500,000 residential units throughout the Kingdom in the coming years, this level of state intervention in the materials market is unlikely to change any time soon.

OUTLOOK: The current constraints in the Saudi construction market could hinder the growth of the industry in the shorter term. For example, Jadwa Investments has estimated that $26.7bn worth of projects have been affected by alterations to the implementation of labour regulations and as such could be pushed back. Over the next 12 months supply constraints in the material and labour market could also slow the high rate of expansion in the industry. Business Monitor International, for instance, has revised its industry forecast downwards for 2014, estimating growth of 7.2% for the year. While this is still impressive, it is down on previous expectations given the trends of the last five years. Nevertheless, the market researcher predicts double-digit growth will return from 2015 onwards.

This is hardly surprising, as the country is in the midst of a major government-led infrastructure programme. Public spending is targeting a range of sectors from social infrastructure to utilities, transport and housing. This ambitious programme should help stimulate the economy and foster sustainable non-oil growth. Coupled with the natural demographic and economic growth of the GCC’s biggest market, ample contracts in the construction sector should be available for the next decade. Although cost and operational challenges remain, they are easily outweighed by the opportunities. The Kingdom is likely to be a regional leader for the foreseeable future.