MACE looks at how global growth and oil price recovery will boost MENA activity
Fergus Rossiter, director of Mace Cost Consultancy – MENA looks at a potential recovery for the MENA construction market
2018 is expected to see a recovery in tender prices, driven in part by an uptick in activity and in part by growing costs. This, as companies face fiscal consolidation policies in cash strapped MENA countries, such as the introduction of VAT pushing up prices of materials, potentially cutting into margins. Whilst increased activity may allow some boost to tender prices, the market is still competitive and, as such, we may see some of the additional cost coming out of margins, rather than through increased tender prices.
With the construction market still reeling from a two year contraction in project spending, a fuller pipeline for 2018 is providing optimism in the region as economic reforms and fiscal consolidation start to pay off. However, financing is likely to remain a challenge, with increased reliance on private sector funding across the board. Going forward, demand for construction in the region remains strong and as solutions to the financing challenges are found, we can expect to see spending levels climb in the medium term.
“Increased project activity is anticipated to drive up tender prices across MENA markets, as contractors see their order books fill up again after the recent slowdown. However, the new economic reality means bringing financing to the table is becoming increasingly important, as contractors compete for diminishing government funding,” says Fergus Rossiter, director of Mace Cost Consultancy – MENA.
As oil prices and consequently budgets recover from the slowdown across the region and activity picks up, we are seeing a general recovery in tender prices. This
steady recovery is set to continue in Saudi Arabia, picking up to 2.79% growth in 2018 from 2.54%, reflecting the launch of many new projects to market and hence
increased competition for suppliers. Saudi Arabia is set to see strongest growth in tender prices of the countries considered, followed by Oman, which has seen a significant jump to 2.46% growth in 2018. Increased investment in oil and gas in Oman is tightening the market and allowing contractors to push for higher prices. A similar trend is reflected across the markets considered, apart from Bahrain which is due to see slower tender price inflation. Egypt is likely to see significant tender price inflation this year having jumped to the second largest MENA project market. This jump in project activity will dramatically increase contractor power to raise prices as demand squeezes limited labour and contractor capacity.
However, with the introduction of VAT and reduction in subsidies for power and water in some countries, as they seek to reduce expenditure and increase revenues, inflation could grow by more than tender prices where competition remains strong. For example in both the UAE and KSA consumer inflation is expected to be higher than tender price inflation. Where this occurs, and competition is too strong to allow for pricing in inflated construction costs, margins could be eroded as contractors fail to cover the increased costs from VAT and utilities with tender price increases.
The MENA construction sector is still reeling from the two-year contraction in project spending which saw the value of annual contract awards shrink by almost 40%. The lack of new project opportunities, combined with the delays in payments, meant that finding new revenues continued to prove challenging and cash flow remained a problem. Many construction companies have been downsizing in response to these tougher market conditions, and several international businesses have even reduced presence in the region.
However, at the national level, there has been positive news for some countries, with Egypt, the UAE, Iran, Iraq and Oman all recording sizable rises in contract awards in 2017, offsetting declines in other markets.
With a fuller pipeline going into 2018, the industry can see glimmers of hope, anticipating at least $170bn of awards in the coming year, a respectable increase on 2017’s figure. Driving this potential improvement in the market are a host of flagship schemes across a range of sectors, highlighting an industry less reliant on key sectors than in the past. Areas of particular interest for the region include a resurgence of oil and gas activity, investment in power (and renewables) and ongoing development of transport infrastructure across the region. These flagship industry schemes will be accompanied by an array of real estate projects, led by the $5bn Dubai Creek Harbour.
Financing remains the biggest challenge for construction projects in the region, with government spending slashed, but private sector investment still weary of uncertainty.
Governments are therefore increasingly looking to use Public Private Partnerships (PPPs) to finance and operate public services. With a strong track record in delivering PPPs in the energy sector, but limited success in other areas, the coming year will likely see an increased focus on packaging commercially attractive projects for private investors. Meed estimates that about 156 PPP projects requiring about $206bn investment are planned across the region outside of the energy sector. Without sovereign guarantees for revenues, and with a limited track record of commercially successful PPPs, it is likely progress will be patchy. In addition to the use of PPPs, increasing use is being made of export credit support brought in by contractors and suppliers from overseas.
During the challenging years since 2014, many contractors in the region have learnt to rely on the Dubai market for new opportunities, with other markets such as Saudi Arabia likely to disappoint. There are signs that this is now shifting.
Although contractors remain busy tendering for work in Dubai and continue to struggle in other markets, consultants coming in at an earlier stage, are telling a different story. Whilst fewer new opportunities for work are coming out of Dubai, they have been increasingly competing for work in KSA. In 2017 the kingdom launched a slew of major projects, including Neom City, which are now starting to engage consultants for PM, design and engineering. As the boost to pipeline in Saudi Arabia progresses, it should absorb any slowdown in Dubai as Expo 2020 projects are completed and not immediately replaced.
Despite the challenging circumstances of 2014-2017, the long term drivers of project activity remain positive. There are still $2tn of projects in the GCC’s pipeline: with expanding populations and economies, the demand for housing, education, healthcare and utility schemes is as great as ever. Given their restive populations, the governments of the MENA region know they cannot afford to fall behind for too long on their social infrastructure programs. Solutions to the financing challenges will be and are being found. Once they are we can expect project spending to once again climb to historic levels.
Across the region construction costs will receive a shock from fiscal consolidation policies, with the worst effects of this felt in Saud Arabia and the UAE, with the introduction of VAT raising the cost of many construction materials by 5%, and cuts to energy subsidies impacting on the cost of construction. With exemptions to the most onerous parts available to public sector companies in Saudi Arabia for example, minimising tax burdens could be another incentive for private contractors to enter into PPPs, further financing the government’s spending plans.
Aside from costs related to government policy, we are also likely to see the depreciation of the MENA currencies feed through into higher material prices, with most countries in the region heavily reliant on imports of materials for construction.
Mixed fortunes are generally anticipated for the MENA region: whilst greater stability in oil markets is expected to restore confidence, political shocks are expected to continue to affect investment and confidence in 2018. Both the increased price of oil (from an average of $54 per barrel in 2017 to an anticipated average $62p/b in 20181) and the economic reforms undertaken to diversify economies are contributing to an improved regional economic growth outlook. GDP growth in the region is expected a whole percent point faster in 2018 than 2017, at 3.2%. This outlook is supported by the strengthening global economy, which is enjoying the first period of coordinated recovery in both advanced and emerging markets, since the financial crisis.
However, while the macroeconomic outlook may be improving, challenges at the operational level will remain, with the region continuing to adjust to a new economic paradigm in which oil revenues are not sufficient to fund government spending requirements. However, efforts are being made to reduce fiscal reliance on high oil prices. Most countries have reduced the oil price required to fiscally break even (see figure below). The impact of the UAE and KSA’s recent fiscal reforms can be clearly seen in the significantly lower price of oil needed for their budgets to break even.
In addition to fiscal reforms, in 2018 privatisation of state services across the MENA region will accelerate as governments seek to reduce their balance sheets. This will be a significant opportunity for the private sector to pick up lucrative contracts and develop long term relationships in markets newly open to them. This will be dominated by plans to publicly float 5% of Saudi Aramco, the state’s oil company, the unbundling and privatisation of state utilities and sales of other state owned enterprises across the region.
Egypt is set to see a take-off in growth, growing at the strongest rate of countries considered in 2018 (4.46%) and averaging 5.5% growth annually through to 2022. This strong growth is anticipated to be driven by strong external investment into the country, particularly from China and Middle Eastern investors. Kuwait is also anticipated to see significant growth over this period, with 4.1% growth in 2018 and averaging 3.5% annually to 2022. Oman (3.74%) and the UAE (3.36%) will see stronger growth levels in 2018, and consistent average growth through to 2022.
However, Bahrain and Saudi Arabia are both set to remain in lower growth cycles, without sufficient momentum to improve conditions for the majority in these countries, at 2% and 1.7% average growth to 2022 respectively. In the meantime, Saudi Arabia will be grateful for relief from 2017’s negligible growth, rising from only 0.1% growth to 1.13% this year. It is worth highlighting that with better prospects for the price of oil, and the oil based economies increasingly diversifying, the dichotomy we noted between diversified and non-diversified economies in the H1 2017 update, appears no longer applicable. Egypt, Kuwait and the UAE are set to see the highest average growth rates to 2022, and Saudi Arabia and Bahrain the lowest. This mix of fortunes is unrelated to diversified vs non-diversified economies.
Inflation is due to pick up across the board in the Middle East region, reflecting several contributing factors driving prices up. These include:
• The impacts of fiscal policy such as VAT introductions, removal of subsidies on utilities, and increased taxes. VAT, in particular, will drive price growth in the UAE and Saudi Arabia
• Depreciating currencies making imports more expensive, a significant factor in markets mostly dependent on imported consumer goods and materials
• Economic expansion driving prices higher
Of the Middle Eastern countries, Saudi Arabia and Qatar are to have the highest inflation, at 4.96% and 4.85% respectively, having both grown from minimal levels (and even minor deflation in Saudi Arabia’s case) in 2017. Whilst the rates are similarly high, the drivers are very different. In Saudi Arabia, the fiscal impacts of VAT and tax/subsidy changes have significantly raised prices domestically. These represent the main influencing factor, with VAT alone adding 2.5% to inflation in 2018. The impacts will be felt strongly in construction markets, and we can expect to see some impact on margins if tender prices cannot be raised to cover these increased costs. The other Middle Eastern countries remain within the acceptable range for the region of 2-4%, with all either registering a pick-up in 2017 or remaining steady. Egypt on the other hand is a different story. The very high inflation in 2017 will ease slightly in 2018 as the effects of the major currency crash continue to work their way through the system. Inflation will nonetheless remain very high at 21.34%. However, over the longer term, inflation in Egypt is expected to moderate down to 7% (by 2021) which would bring it within the acceptable range for stable growth in the country.
With many currencies in the region pegged to the dollar, its continuing strength against the euro means a similar story to the last update. USD depreciation against the euro is linking through to roughly 15% depreciation for the pegged currencies (Dirham, Riyal, Rial and Royal) over the past year. However, the rate of depreciation in these markets has slowed considerably, seeing only 1.1% change over the past month, as compared to 3% in the H1 2017 update. This depreciation continues to make investment in the MENA region comparatively cheap and will take the edge off growing inflation for foreign investors as fiscal measures, such as introduction of VAT, start to bite.
The Egyptian pound has seen slightly less depreciation against the strong Euro at 14.22% over the past year, 1.24% of which over the last month. After the currency crisis of 2016 resulted in a dramatic 112% yearly depreciation, recorded in our H1 2017 update, the pound has stabilised, moving in line with other countries in the region. However, the continued depreciation against the Euro maintains favourable investment conditions for foreign direct investment, a significant driver in the Egyptian construction market.