Managing Supply Chain Disruption and Construction Price Fluctuation
28th November 2023
The Middle East construction sector is thriving (growth of 3.3% in 2023) [1]https://construction.globaldata.com/ and is forecast to enjoy consistent year-on-year growth for the next few years. However, one of the major issues that the industry faces is high inflation and upward pressure on key materials, a trend that is likely to continue for a number of years. Managing supply chain disruption has become more and more important, especially as the Saudi Arabian giga-projects ramp up.
“More than one in four projects (26.6% are embroiled in cash flow and payment issues)”[2]HKA Crux Insight, Sixth Annual Report (Middle East section
Traditionally in the Middle East, the risk of material price fluctuation in construction has been placed with contractors. To consider the potential impact of material price fluctuation, it is worth noting the reinforcement bar fluctuations that occurred in 2008 and the ramifications of which were felt throughout the UAE industry:
In December 2007, reinforcing bars in the UAE cost AED 645 per ton. In July 2008, the price had risen by over 238 percent, to AED1,540 per ton, before plummeting to AED 440 per ton by November 2008[3]https://www.mesteel.com/. These fluctuations caused chaos in the market, causing delays to projects as well as unforeseen economic problems.
What are the risks of supply chain disruptions?
The potential problems arising from disrupted or volatile supply chains and prices are not limited to cost. Perhaps a bigger risk is delay due to the unavailability of materials, or a cash-strapped contractor’s appetite or ability to suffer excessive commercial losses to avoid critical delays.
The effect on raw materials caused by the issues in Ukraine is another reminder that large price fluctuations in construction can happen, largely unforeseen, and can cause significant strain on projects. Analysis by HKA in 2023, identified that the cost of diesel in the UAE increased by an average of 65% since the start of the Ukraine-Russia crisis. The knock-on effect to plant, machinery, and material costs from this one issue were significant.
Potential outcomes of managing supply chain disruptions
In the case of supply chain disruption, employers may consider recourse to delay damages for events such as material supply delays. However, delay damages are usually capped at 10% of the contract price and tend to hit the cap within 100 calendar days of delay. Beyond the 10% cap, an employer’s options are usually more drastic and risky.
Termination brings its own issues, usually leading to project completion well beyond the original planned completion date and with significant additional costs to complete, coupled with expensive disputes to resolve. Furthermore, replacement contractors are well positioned in negotiations and will adjust for market rates (and then some) for materials, equipment, staff, labour, and consumables.
Assuming the terminated contractor was performing adequately aside from the commercial squeeze or delays due to market fluctuations, or supply chain problems, termination would not typically resolve the issues. Instead, they would simply pass them to the replacement contractor unless they become the employer’s risks anyway.
Another grave potential outcome is bankruptcy. Contractors operate on relatively small margins and the industry has a tendency to contract with onerous clauses. Of course, this tends to be a disaster not only for the bankrupt contractor but also for the employers left with incomplete projects and lengthy delays.
Potential solutions to material price fluctuations very much depend upon whereabouts in the lifecycle a project is:
How to manage supply chain disruptions and price fluctuations
Potential solutions to managing supply chain disruptions and material price fluctuations very much depend upon whereabouts in the lifecycle a project is. More specifically, whether it is in the pre-contract or post-contract phase:
Pre-Contract
At the pre-contract stage, a pragmatic approach to risk apportionment when drafting contracts is recommended. Who is best equipped to take-on the risks? How can an employer secure the best price at tender whilst ensuring that they haven’t created a situation where commercial factors threaten to derail the project later on?
The procurement model itself should be brought under scrutiny:
“…many employers – not least in oil and gas – are exploring alternative procurement models to lump sum contracts with a view to managing risk more effectively. Options include cost plus or target price, still novel in the region.” [4]HKA Crux Insight, Sixth Annual Report (Middle East section
Of course, if a change in procurement strategy is deemed a step too far, the FIDIC suite of contracts, both the Red and Yellow Books include formulaic mechanisms for adjustment to items to be included in the Appendix to Tender (in both 1999 and 2017 versions). The parties are free to agree what items or materials are to be included. Those that are not included are considered to be included within the contract sum and not subject to adjustment. Whilst the applicable sub-clauses appear troublesome and are often deleted, in practice they can provide a relatively fair adjustment of key materials such as reinforcement. The existence of such clauses provides the parties with a number of benefits, including:
a) Competitive pricing at tender (lower risk for bidders to factor contingency in material prices);
b) Lower risk of claims/disputes;
c) Employer enjoys the benefit if costs decrease; and
d) Less likelihood of serious default by the contractor.
Given the apparent complexity of these adjustment formulae, it may be advisable to restrict the number of materials or other elements which are subject to adjustment only to those which are especially susceptible to large fluctuation and for which such fluctuation would be of particular impact to the project.
The drafting of the applicable formulae and their application warrants significant consideration and should be worked through between suitably qualified representatives of the parties.
Post-Contract
The majority of contracts in progress within the Middle East at the moment do not incorporate provisions for contractual relief in the event of substantial price fluctuations. Furthermore, the majority of contracts specifically preclude claims for price fluctuations, whilst confirming that the contract price is accepted by the contractor as being sufficient to meet all obligations and ‘everything necessary’ for the execution of the works.
The parties are not entirely without options, but they tend to be limited. In the first instant, diligent contract management can help to improve a contractor’s cashflow. This includes ensuring timely agreement and payment of variations and claims as well as on time payment. It may also be possible to alleviate cashflow by providing other relief, such as reduction or early release of retention (or acceptance of a retention bond).
In the event that the employer decides to make payments for material price fluctuation, it is prudent to assess how much contingency the contractor had allowed for in its tender for fluctuations. Given that the risk was placed and priced with the contractor, the aim should be to provide relief only against the ‘extraordinary’ element of price fluctuation, or in case of ensuring consistent supply, the premium paid to ensure supply. An open book approach is recommended.
Managing price fluctuations in construction: the verdict
In summary, price volatility is likely to be a feature of the Middle East construction market for years to come as most countries in the region are focussing on their own future vision plans all at once, added to which the Kingdom of Saudi Arabia is booming like no other time before. A pragmatic approach to risk apportionment at tender time is highly recommended, since apportioning material price fluctuation risk to contractors as a matter of course may not be practical or represent best value to the employer.
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About the author
Alastair Gray is a highly experienced Chartered Quantity Surveyor with over 25 years in the field. As a proven expert witness, he specialises in productivity and disruption analysis, offering clear and concise reports on complex quantum matters. He has been involved in disputes exceeding $2 billion, providing expert determinations in various industries globally.
With a diverse background in buildings, civil engineering, and oil and gas projects, Alastair has worked across the Middle East, Far East, Australia, and the UK. He is a fellow of the Chartered Institute of Arbitrators, a member of the Royal Institution of Chartered Surveyors, and holds degrees in management and design for building, along with a post-graduate diploma in construction law and arbitration.
