Middle East construction: contracting in a rollercoaster market

Historically, construction contracting in the Middle East in the oil and gas sector, as well as other industries, has been typified by projects being tendered based upon lump-sum engineering, procurement and construction (EPC) contracts, with project sponsors having little tolerance for variances to the contract terms and conditions. Under a lump-sum pricing structure, the contractor delivered the project for an agreed price, while entirely assuming the risk of cost overruns.

But in the past couple of years, contractors and sponsors in the Middle East found themselves on a rollercoaster fueled by surging oil prices and an unprecedented number of projects, many of unrivalled size and scale, with a limited number of contractors available to construct these projects. And with skyrocketing commodity prices, currency fluctuations, and limited availability of materials, equipment and labor providing further unpredictable bumps along the ride, sponsors and contractors have found little amusement in allocating risk under these circumstances.

Consider the following…

The Gulf Cooperation Council (GCC) has experienced an unparalleled construction boom with more than $2.1 trillion worth of projects planned or under way in 2008 — amounting to more than double the gross domestic product of the economies of the GCC — with the greatest activity for each member of the GCC being in the real estate and oil and gas sectors. Not only are the number and estimated value of recent construction projects in the GCC impressive, but the size and scale of the projects are unprecedented, from the world’s largest petrochemical complex to the world’s tallest building, biggest mall, largest airport, and longest and tallest arch bridge.

This flurry of construction activity has strained available construction labor and material resources, driving up the cost of labor and commodity prices and, ultimately, the overall cost of construction in the region. Labor costs in the Middle East increased by 67% over the past three years, with 40% of these cost increases resulting from a tripling of the cost of accommodations.

The cost of steel and cement, approximately 30% of the overall construction costs for many projects, increased at an unprecedented rate in the Middle East. Steel prices rose globally from May 2007 to May 2008 by 67%, but in the UAE and Saudi Arabia, they increased approximately 90% and 50% respectively in the first half of 2008 alone.

Likewise, cement prices escalated 50% in 2007 and continued their ascent in 2008. From February through August 2008, cement prices rose 23.5% in the UAE and 12.5% in Saudi Arabia. This uncertainty in the rising costs of labor and commodities reportedly caused some contractors to add a contingency of 30% or more in their lump-sum pricing, thereby further inflating project costs. Accordingly, the overall cost of oil and gas projects skyrocketed, catching many sponsors off-guard. For example:

• In 2007, Abu Dhabi National Oil Company (ADNOC) and ConocoPhillips planned to develop sour-gas reserves at Abu Dhabi’s offshore Shah field, as well as its Bab field, at a cost of $10 billion. But as a result of inflation, the cost of the Shah sour-gas field alone increased to $10 billion. Saudi Aramco’s offshore heavy oilfield Manifa project, originally estimated to cost $9 billion, ballooned to $15 billion in price.
• Saudi Aramco and Total’s new 400,000 bbl/day Jubail refinery, increased from an original estimated amount of $6 billion to more than $10 billion.
• ExxonMobil and Qatar Petroleum abandoned the Palm gas-to-liquids project, the largest of its kind to date, due to escalating project costs. Project costs increased from $5-7 billion in 2004, up to $18 billion by early 2007.

The jolting effect of these events caused some Middle East sponsors to scale back their ambitions by either canceling projects or using alternative contracting structures and tendering methods.

Certain sponsors determined that the rising cost of project development in the GCC was not cost-effective. For example, citing cost concerns and falling margins, ConocoPhillips pulled out of the UAE’s Fujairah refinery. Additionally, The Dow Chemical Company pulled out from the development of a petrochemical complex in Sohar, Oman for identical reasons.

Other sponsors attempted to avoid the effects of inflation by either delaying the tender process and hoping for more favorable market conditions during re-tendering, or by offering alternative contracting and pricing structures. Kuwait National Petroleum Company (KNPC) originally budgeted $6.3 billion for the Al-Zour refinery project, but when bids came in at more than $15 billion, KNPC cancelled the tender and later invited new bids on the basis of cost-plus pricing.

When bids for the EPC contract to install the gas compressors at the Bab oil field expansion returned at over $1.8 billion, over three times the originally estimated cost, Abu Dhabi Company for Onshore Oil Operations (ADCO) cancelled the original tender. And though ADCO later retendered the project, it removed the procurement of the compressors from the contracting structure to reduce costs and decrease the overall development period.

In mid-2005, Saudi Aramco paved the way for alternative contracting structures in the Middle East by introducing convertible lump-sum contracts to attract contractors to bid on the 500,000-bbl/day Abu Hadriyah, Fadhili, and Khursaniyah (AFK) oil field development. Under this approach, contractors performed the initial phase of development on a cost reimbursable basis, which was later converted to a lump-sum arrangement once 60 to 70% of the engineering work had been completed.

Since then, Saudi Aramco has awarded most of its major oil field development work on a similar basis, with Saudi Basic Industries Corporation (SABIC), national oil companies, and other private sector petrochemicals companies also adopting this model. But recently, when costs escalated on the Jubail refinery, Total and Saudi Aramco sought to minimize the effect by splitting the project into smaller, more manageable packages and asking contractors to submit lump bids.

How will the recent economic challenges affect the construction of oil and gas projects in the Middle East?

The crest of the rollercoaster peaked in the fall of 2008. Since then, with the recent economic turmoil, lack of available financing, and falling oil prices and commodity prices, numerous sponsors have delayed or canceled projects in the Middle East. The oil and gas sector alone has experienced a reduction in contracting activity from $35 billion in January through March 2007, to $15 billion during the same time period in 2008. And this decline appears likely to continue.

Warnings have emerged that the rapidly declining crude oil prices have begun to affect the viability of oil and gas projects. After peaking at $147 per barrel in July, the price of crude oil has dropped 66%, causing many sponsors to reevaluate their projects. An official at the Organization of Arab Petroleum Exporting Countries warned in September that the Middle East oil producers would likely cancel projects if oil prices dropped below $80 per barrel, and some sponsors have since cancelled, even though Abu Dhabi has purportedly based its 2008 budget on an estimated oil price of $45-50 a barrel. For example:

• Saudi Aramco, which awarded contracts to develop the Manifa offshore heavy fuel oilfield project, instructed contractors to halt procurement and construction and to continue only with the initial engineering work. Citing a dramatic decline in commodity prices, including the price of oil, Saudi Aramco asked contractors to resubmit prices based upon the prospect of Saudi Aramco delaying the project for one year, and to identify the cancellation charges that would result if Saudi Aramco cancelled the project.
• ADCO is internally evaluating whether to retender the Sahil, Asab & Shah (SAS) full-field oil development.
• Qatar Petroleum (with South Korea’s Honam Petrochemical Corp.) delayed the $2.6 billion petrochemical project in Mesaieed Industrial City for one year due to tight credit markets.

Oman put its Duqm refinery and petrochemicals complex on hold after raising doubts over its ability to secure vital project financing for the deal amid falling oil prices.

The effect of the recent global economic downturn on the cost of labor and construction commodities has been varied to date. Recently, MEED consultants found that the average pay for construction workers at all skill levels has only experienced minor fluctuations between July and October of this year, which may indicate that the labor shortage is leveling. Analysts have also predicted that the GCC could experience layoffs of up to 50% of their private sector workforce, which is comprised of 90% foreign workers.

While layoffs have begun in the real estate sector, with four large developers posting job cuts and others preparing for future layoffs, the current backlog of projects and the need to develop adequate infrastructure throughout the GCC could provide future employment for many workers. For instance, to ensure that experienced workers are not forced to leave the country, officials in Dubai are considering options to extend the thirty-day grace period for expatriate employees who are laid off.

As a result of a steep drop in international demand, steel prices have dropped precipitously since July. The top three Saudi steel manufacturers and Qatar’s steel manufacturer have each cut steel prices by at least 30%, while several international mills have cut production in an effort to stabilize falling prices. But declining international demand has also fueled higher steel imports into the GCC, particularly in the UAE after the government exempted cement and steel from the 5% customs duties earlier this year. And as a result, after peaking in July at Dh 6,000 per tonne, steel prices dropped 70% in the UAE to Dh 1,800 / tonne.

So far, unlike steel, there is no indication that cement prices are dropping in the GCC. But considering the increase in imported cement and an overcapacity at cement manufacturing plants, cement prices are likely to moderate.

The decline in international demand, the decrease in transportation costs by as much as 80% due to lower fuel prices, and the custom duties exemption for cement in the UAE have combined to cause the world’s largest cement producers to eye the GCC as a destination for their excess capacity. However, favorable market conditions for importing cement may be thwarted by the lack of port facilities to load and unload the cargo. Additionally, the GCC may have already reached overcapacity in its supply of cement, as the total capacity is expected to reach 85.4 million tons in 2008, while total consumption in 2008 is estimated to be only 65.1 million tons.

Amid such uncertainty in the global economic market, how should sponsors proceed when entering into construction contracts to develop oil and gas projects?

With the recent delay and cancellation of numerous projects, contractor and labor availability may surge. Based on our recent experience, this could result in a significant increase in contractor interest in projects, and consequently more bids, resulting in a more competitive environment. In such environment, lump-sum turnkey EPC contracting may again become an economically viable option in the Middle East in the near future.

Whether competitive lump-sum pricing becomes a reality depends upon a number of factors, including whether contractors believe the current market conditions will be short lived. Contractors remain busy with ongoing projects, but they are intensely focused in winning future projects to maintain their revenue and employee ranks, which have swelled over the years due to the strong construction market.

If lump-sum pricing is sought, sponsors should consider including price escalation clauses for certain commodities, as contractors may otherwise seek large contingencies to account for a potential upward shift in the market. Including price escalation clauses for certain commodities will not only avoid significant contingencies, it will also allow the sponsor to enjoy the benefit of a further decline in material prices, if that should occur.

Recently, labor has been the subject of escalation clauses in certain construction contracts. While not used to the same degree as commodity escalation clauses, labor escalation clauses are useful when contractors specify large contingencies in their lump-sum pricing. It is too early to predict if and to the extent that labor rates will decrease due to the delay and cancellation of projects. However, if a contractor includes significant contingencies for labor escalation, or the sponsor believes the labor rates will drop substantially, the sponsor should seriously consider making craft labor subject to escalation.

One of the challenges with respect to labor escalation clauses is how to monitor changes in labor rates, as labor is not tracked in the same manner as commodities. However, a number of different labor indices do exist, and it is important for the contractor and sponsor to choose an index that is reasonably accurate for the project.

Other alternatives exist. For example, the sponsor and contractor could set up a standing board to conduct labor surveys for the project and the region, to determine whether compensation for craft labor rates for the project are competitive in the region. However, an increase in the labor rate is only advisable if the contractor is unable to attract craft labor at the given rate. While craft rates could be adjustable for certain contracts, labor availability and productivity should be risks that remain with the contractor, particularly in a slumping market.

If competitive lump-sum pricing is not available, a sponsor may consider the use of “target pricing,” whereby an incentive or bonus is offered to the contractor if the project is completed below the target price and a “penalty” is assessed if the cost of the project exceeds the target price. In this circumstance, the contractor is not solely responsible for cost overruns as it would be in a lump-sum contract; rather, the contractor typically agrees to put a negotiated sum at risk. Because a dollar-for-dollar (or dirham-for-dirham) penalty is not assessed if the actual costs exceed the target price, the contractor is less concerned about risks and escalation.

The target price also benefits the sponsor, in that the sponsor only pays the actual costs, plus a negotiated markup; it does not pay for contingencies not realized. When following a target price approach, however, the sponsor should be aware that while the so-called penalties will help focus attention on the actual total installed cost for the project, projects with target pricing can nevertheless experience substantial overruns, with the sponsor typically bearing the majority of the cost overrun.

In our experience, incentives in a target price contract generally provide better motivation to a contractor, as compared to penalties, and, therefore, we recommend that this behavior be taken into consideration when drafting the contract. To avoid the typical variation or change order behavior generally seen in lump-sum pricing, and to focus on delivering a project that is within the budget and schedule, we also recommend that the sponsor limit the circumstances in which the target price may be adjusted. A sponsor may also consider dividing the project into multi-prime contracts, which is particularly advantageous for very large projects where typically only a handful of “mega-sized” contractors can compete.

This approach — commonly used in conjunction with an engineering, procurement and construction management contractor (EPCM) who performs the engineering and manages the multi-prime contractors — allows more contractors to bid on the project, providing for more competitive pricing, while also reducing contractor markup. Because the sponsor is essentially acting as the general contractor, the sponsor must take care when dividing up the project so that the interfaces and associated risks between the various multi-prime contracts can be managed effectively.

In this current rollercoaster market, a sponsor should consider all of the approaches mentioned above, as well as others, in an effort to decide what works best for their particular project. These are challenging times for the development of projects, and no one contracting methodology will serve as a remedy for all projects.

About the authors

Scott Greer is a partner in the Houston office of King & Spalding LLP, an international law firm with 13 offices worldwide, including Dubai, Abu Dhabi, and Riyadh. Formerly an engineer, he is the head of the firm’s global construction transactions team, which focuses exclusively in the representation of sponsors and lenders in the drafting and negotiation of construction-related agreements for oil and gas, LNG, power, petrochemical, desalination, mining, cement manufacturing, and other industrial projects.

Amy Miller Hollis is counsel in King & Spalding’s Houston office. She has experience drafting and negotiating construction-related agreements for projects located throughout the world.